Secure Trust Bank — Update 26 April 2016

Secure Trust Bank is a well-established specialist bank. It was incorporated in 1954 and since 1985 has been part of the Arbuthnot Banking Group, which currently holds 51.92% of STB shares. Secure Trust Bank was floated on AIM in 2011 and subsequently acquired the Everyday Loans Group (2012 – unsecured personal lending), V12 Finance Group (2013 – point of sale retail loans) and assets of Debt Managers Group (2013 – debt collection services). The bank’s core business has traditionally been the provision of banking services to UK customers who may not have been well-served by the larger banks. While it has offered current and budgeting accounts in the past, these are no longer available and following the disposal of Everyday Loans Group to Non-Standard Finance it does not have a branch network.

The remit has been progressively diversified in recent years from consumer unsecured lending to motor, retail point of sale and business finance; the latter includes real estate finance, invoice discounting and factoring and asset finance. This broadening of activity has contributed to strong expansion of the loan book since the financial crisis with compound growth of 64% between 2010 and 2015. The growth has primarily been in secured lending and the sale of ELG has reduced the unsecured part of the loan book contract further. The capital released allows STB to accelerate organic growth in motor, retail and SME lending books and to consider an acquisition should the right opportunity present itself. Looking ahead, the management team aims to have three broadly equal legs for the business: consumer, business and mortgage lending, with this third activity in the process of being prepared for launch.

The rapid expansion of the business and migration towards a more diverse portfolio suggest that it could be grouped with challenger banks, although, even in mortgages, it is not planning to take on large banks directly, instead focusing on specialist lending where returns can be more attractive. It also differentiates itself from some of the challengers in that, despite its growth, it has not driven for scale at the same pace and does not have a branch network. It is perhaps better described as a specialist challenger.

Customer lending continued the rapid growth that has characterised recent years, with total loan growth of 72% in 2015 taking compound growth since 2010 to 64% (Exhibit 1). This reflects the group’s strategy of growing the loan book by addressing consumer and business markets with niche product offerings that command higher margins than standard/prime products.

The segmental analysis of the loan book for 2014 and 2015 is shown in Exhibit 2, highlighting the diversification of business areas, which has been broadening over the last three years. In absolute terms, the largest growth was seen in real estate finance, a business launched in 2013, and retail point of sale finance. The real estate finance book is split roughly 50/50 between funding for residential developments and residential investment finance (professional buy to let); the risk/reward balance of commercial development lending is seen as unattractive. Proportionately the newest parts of STB’s loan portfolio have seen the fastest growth, namely asset finance (hire purchase and finance leases) and commercial finance (invoice discounting and debt factoring). Prospectively, as noted above, the group is in the process of launching a mortgage business, looking to address the non-standard, near-prime part of the market.

STB’s net interest income increased by 49% (including ELG) in 2015, compared with growth in average loan balances of 68% with the differential evident in the reduced net interest margin (12.7% versus 14.0% shown in Exhibit 3), reflecting changes in loan mix and, potentially, distortions introduced by our simple average of loan balances over a period when growth was rapid.

Similarly, a 93% increase in the profit and loss impairment charge, to £16.8m, reflects a change from a low base, and the increase in impairments from 1.9% to 2.3% of average balances can be attributed to changes in mix and rapid growth. The group notes that the levels of impairment are running at below the rate assumed when the loans were made. An example of mix change is that retail point of sale finance has been extended into domestic appliances, where the level of impairment is higher but returns are correspondingly higher, and both interest margin and the impairment percentage have noticeably higher readings for 2015 than 2014 in our calculations.

The group’s funding policy is unchanged with limited exposure to wholesale and interbank funding. Fixed-term, fixed-rate customer lending is broadly matched with customer deposits on a similar basis. Exhibit 4 shows the structure of deposits, with term deposits now accounting for 57% of the total and the increase in average tenor made to match the liability position. The growth in lending in 2015 was largely funded through customer deposits, with only modest use of the Funding for Lending scheme. As shown in Exhibit 5, the cost of funds has benefited from trends in market rates as maturing deposits have been replaced at lower rates. The year-end loan to deposit ratio was 104%, little changed from 2014 (102%).

The £50m of fresh equity capital raised in the second half of 2014 has been progressively deployed through growth in the loan book so that the CET1 ratio has fallen from 18.7% to 13.6% in 2015 and the leverage ratio has been reduced from 14.7% to 10.4% (compared with the 4% minimum stipulated by the Prudential Regulation Authority). Adjusted for the ELG disposal (see next section), the CET1 ratio would have been 24.1% and the leverage ratio18% at the year end.

Announced at the beginning of December 2015, the sale of ELG followed an unsolicited approach from Non Standard Finance. While STB was not looking to sell the business, the opportunity to reduce exposure to unsecured loans on favourable terms was attractive, with a competitive loosening of lending criteria evident in this area tending to support this decision. Under Non Standard Finance’s ownership there will be investment in ELG’s branches and a wider product offering addressing a broader customer base, providing opportunities for growth that would not have been pursued within STB. The terms of the transaction included:

Completion was on 13 April 2016. The expected profit on disposal is more than £115m, and STB will pay a special dividend of 165p or c £30m to its shareholders.

STB will retain the remaining part of its personal unsecured loans business, Moneyway, which at the year-end had a lending balance of £74.3m (2014: £87.5m), with loans being closer to prime than at ELG and sourced through its established network of UK advisors.

Even after the special dividend, there will still be significant capital headroom for organic expansion of other areas within the group, including the nascent mortgage business. Inorganic expansion is another option that will be seriously considered, but the group has a preference for building rather than buying. Simplistically applying a 12% CET1 and 35% risk weighting the group could write an additional £2bn of mortgage business or, alternatively, nearly £1bn of consumer and commercial business, assuming a 75% risk weighting. The assumptions in our estimates (see Financials section, page 7) mean that organic loan growth does absorb much of this surplus capital by 2018.

Modest add-on acquisition(s) could increase the pace at which the balance sheet becomes more efficient, but a larger transaction (STB was linked with Williams & Glyn in the press at one point) would in any case entail fresh equity and require a critical decision by parent Arbuthnot Banking on the level of its holding following such a transaction.

The overriding observation for STB and, to a greater or lesser extent, other challenger banks is that there is very substantial market share to compete for. The potential remains particularly promising while the major banks are addressing capital issues and focusing on core activities. Based on 2014 data, STB has presented implied market shares of 2.1% in retail/point of sale finance, 0.31% in motor finance and less than 0.1% for asset and invoice finance. It has yet to initiate residential mortgage loans, where the target segment is near-prime loans within an overall market where outstanding loans stood at £1.3tn at the end of 2015 (source: Bank of England).

From a competitive perspective, challenger banks are lobbying for a regulatory regime that provides a more level playing field to allow them to compete with the major incumbent banks. In his evidence to the Competition and Markets Authority (CMA) retail banking market investigation, STB Chief Executive Paul Lynam highlighted four key problems in the market that inhibit change: disproportionate capital requirements for smaller banks (employing standardised risk-based assessments rather than an internal ratings approach); more expensive funding; access to payments infrastructure (challengers have to use the clearing banks); and the proportionate impact of regulation. The extension of the CMA’s time to report is seen by the group as a positive indicator and any recommendations to ease capital requirements or reduce regulatory burden could be positive for STB on a medium-term view, although there are limitations on how far incumbent advantages in the retail and SME market can be countered.

Turning briefly to the macroeconomic background, this remains uncertain, with GDP forecasts for the UK being trimmed in parallel with a more cautious global outlook. The Office of Budget Responsibility (OBR), for example, in its March outlook reduced its central growth forecasts for this year and next by 0.4 and 0.3 percentage points respectively to 2.0% and 2.2%. The result of the EU membership referendum could give rise to additional volatility, but if current OBR and similar forecasts prove a reasonable guide, then continued growth and muted unemployment (between 5.0% and 5.3% forecast over the next five years) would provide a favourable environment for lenders such as STB with the potential for impairments to remain at low levels (mirrored in the relatively low company liquidation and, compared with the post crisis peak, individual insolvency rates shown in Exhibit 6).

While STB has small market shares, as noted, it is useful to set the scene in terms of UK consumer and SME lending trends. Exhibit 7 shows how consumer credit lending (here excluding credit cards) has strengthened since the financial crisis, which is attributed to both supply and demand; in Q116 demand increased markedly and the Bank of England Credit Conditions Survey indicates that credit scoring criteria loosened significantly, an observation that accords with STB’s comments in relation to unsecured credit. Commenting on its own credit risk management in consumer finance, STB indicates that it has commissioned work on motor finance risk management, developed its unsecured lending methodology and maintained its scorecard in point of sale retail lending during a period of rapid growth.

The growth in car finance through dealerships (Exhibit 8) has been an important contributor to consumer credit growth and STB’s motor finance loan growth has markedly outpaced strong industry figures from the Finance & Leasing Association (FLA) shown here. STB is in the process of extending its offering into prime motor loans; the returns may be lower in this area of the market but it will still provide incremental returns and will allow STB to act as a one-stop shop for dealerships and to offer an alternative to customers who just fail to meet prime criteria. Because of an annual cycle in motor dealers’ arrangement of financing there is unlikely to be evidence of this initiative until 2017. Providing the macro backdrop does not take a significant turn for the worse, the prospects for STB’s motor finance business appear to remain positive. Latest FLA data shows no sign of growth flagging, with the value of new business up 20% and 27% y-o-y in January and February respectively.

As far as SME lending is concerned, Bank of England data show that growth has only resumed quite recently even though supply is reported to have become more available over the last two years. Subdued demand has been a factor, with the latest SME Finance Monitor reporting that 78% of survey respondents were ‘happy non-seekers’. This perhaps contributes to the rising percentage of successful applications indicated in Exhibit 10, potentially a sign of easing of criteria in some areas but also a degree of normalisation in the market as supply has been increased following the introduction of the Finance for Lending Scheme in 2012, its subsequent extension and, to some extent, the growth in alternative providers.

Within STB’s Business Finance activity, real estate is the largest area, split between residential development finance and professional buy to let companies. On our estimates this area would account for nearly 40% of the group loan book in 2018. The early experience in this area has been positive, with no losses incurred and a number of repayments being made ahead of expected dates. The long-term outlook for residential development is seen as favourable given the shortage of appropriate housing stock in the UK. Lending is currently mainly in the South East but the geographical spread is being broadened, while the group keeps a close eye on the market background with a view to responding quickly should the environment become more difficult. On the buy to let side of the business, loans are typically at low loan to value percentages to companies with 30-40 properties earning good returns on equity. These corporate customers are likely to be less sensitive to legislative changes relating to buy to let (interest costs still tax deductible) than individual investors, but, again, STB is monitoring the market closely.

Prospectively, development of the mortgage loan book will be a key element in the expansion of the group loan book and, within our estimate assumptions, could account for 15% of the loan book by 2018. Management see this as having the potential to form a third leg for the business, suggesting further substantial expansion could follow. The growth in mortgage lending we have estimated represents a big step from a standing start in 2016, but a c £400m loan mortgage book would still represent a very small position in the market and an experienced team has been hired to undertake the development of this business.

Earnings for 2015 were ahead of our expectation (Exhibit 11) and we have adjusted our estimates for the ELG disposal and subsequent deployment of capital through organic loan growth. There is an initial dilutive effect from the sale evident in the reduction of estimates for 2016, but thereafter estimates introduced for the first time for 2017 and 2018 show strong growth (39% and 28% respectively at the earnings per share level).

Underlying our estimated earnings progression are our assumptions for loan growth, set out in Exhibit 12. Within the existing activities, management indicate that the emphasis will be on motor, retail and the commercial loan books. Personal unsecured lending is likely to see more moderate growth. The asset finance and commercial finance areas are relatively new and expected to see further substantial percentage growth as they increase their penetration. The mortgage business is assumed to grow rapidly from its launch this year, making a significant contribution to the total by 2018.

The loan growth assumed, together with the payment of a special dividend of £30m this year and increasing ordinary dividends, means that our estimated CET1 ratio moves to 12.6% for 2018. This compares with the pro forma figure of 18% for end 2015, after adjusting for the ELG sale (see financial summary in Exhibit 16 for the expected evolution of risk assets and CET1).

The growth in mortgage lending results in a reduction in group net interest margin (net interest income as % of average loans) from 10.0% in 2015 to an estimated 7.4% by 2018. However, this should be seen in the light of the lower expected risk from this lending that is reflected in a fall in the group impairment charge as a percentage of average loan balances falling from 2.1% in 2015 to 1.6% in 2018e. It can be argued that this change in risk profile would warrant a lower target return on equity.

Group return on equity is set to fall significantly as the equity added through the ELG sale is deployed over several years. On our estimates the normalised ROE falls from 25.2% in 2015 to 14.1% in 2016 before rising towards 19% in 2018. This could prove a conservative figure depending on the extent to which operational leverage comes into play as the newer business areas operate at higher volumes while the overall net interest margin may prove too cautious depending on business mix.

The chart below (Exhibit 13) summarises how shareholders’ equity has grown since the IPO in 2011 to a pro forma figure of £226m following the ELG sale and the associated special dividend that is still to be paid. There is an increase of £207m between the starting and pro forma figures and, adding back dividends, this would be £274m, of which 30% came from new equity issuance, 28% from capital generated and 42% from profit on sale of ELG. Dividends paid and to be paid are equivalent to 25% of this figure.

We start by looking at a comparative table for challenger banks and a selection of specialist lenders. The group is varied, differentiated by size, business mix and strategy. Nevertheless, the group provides some context for assessing the valuation of STB. In terms of historical P/E ratio and its price to NAV, STB is at the upper end of the range, but also has an above-average return on equity and yield.

Exhibit 15 gives an indication of whether the price to book premium is justified by comparing STB’s position with the peer group, plotting price to net asset value versus return on equity. This uses historical figures; as noted earlier STB’s ROE is set to fall following the ELG disposal before progressively rising as the resulting capital increase is employed. We have added an arrow to indicate management’s target 20% ROE for Metrobank; this would place the stock broadly in line with the peer group. Although STB’s return on equity will head in the opposite direction this year, it should migrate towards 20% in subsequent years and growth in loan book and earnings are expected to be strong. On this basis, we would argue that its ‘in line’ positioning versus peers is at least supportive with the potential for significant upside depending on its relative prospective growth.

As a further step, we have refreshed our ROE/COE valuation, basing this on the end 2015 NAV adjusted for the ELG profit and special dividend (1,243p). We add the prospective special dividend back to the resulting value to compare with the current (cum div) share price. Using a 10% cost of equity, nominal growth of 5% together with a return on equity of 19% (similar to our estimate for 2018) the value indicated is c 3,600p, 26% above the current share price. On the same assumptions, the current share price suggests the market is only discounting an ROE of c 16% (below our 2017 estimate of 16.3%) and is not yet ready to acknowledge fully the potential for growth or the returns that may be earned as the current excess capital is utilised through organic or inorganic growth.

There is a range of macroeconomic, regulatory and internal management factors that have the potential to influence the business and its valuation positively or negatively. We highlight a number of these.