S&U — Set for further growth with tighter credit criteria

Until 2015 S&U comprised two businesses: a home credit company and Advantage Finance, the non-prime motor finance company. Home credit has its roots in a business originally founded in 1938 by the chairman’s grandfather, Clifford Coombs, but the decision was taken in 2015 to sell it to Non Standard Finance for a consideration of £82.5m, generating an exceptional profit of £50.5m. The funds released were partly allocated to the payment of a £15m special dividend with the balance available to support growth at Advantage and the launch of a new specialist lending activity. As a result, S&U now comprises the fast-growing Advantage motor finance business and Aspen Bridging, a property bridging finance business at a pilot stage.

Formed in 1999, Advantage is based in Grimsby and has over 140 employees. The majority of the management team has been with the company since launch. Expansion has been rapid, with 36% compound growth in net customer receivables over the last five years to £251m at the end of January 2018. It has over 54,000 live customers and recorded 24,500 new transactions in FY18. Advantage focuses on the non-prime area of the market and 90% of its lending is through about 40 brokers, with 5% each from dealerships and existing customers. The brokers in turn source their business through dealer relationships and, increasingly, the internet. Almost all the loan applications are submitted to the Advantage web-based system, which provides immediate in-principle lending decisions.

Most loans range from £5,000 to £7,000, with a maximum loan amount of £12,000; the average advance in FY18 was c £6,200. The average original term was 51 months with a flat interest rate of 17.8% (£11,100 repayable including interest). The provisional approval rate for loan applications in the last financial year was 29%, with c 250,000 applications approved out of 860,000. The 24,500 that actually signed up were therefore equivalent to about 10% of approvals or 3% of original applications; to some extent the small ratio of deals signed reflects buyers’ increased use of the internet to source finance before shopping for a car and is not onerous for Advantage given the automation of responses to applications. Advantage’s recently introduced Dealflo e-signature system has helped to increase the sign-up rate following approval, by guiding customers through terms and conditions and verifying their digital signatures.

Advantage has achieved 18 years of consecutive profit growth, reflecting growth in the loan book paired with successful credit control underpinned by the continuous refinement of a bespoke underwriting and scoring system developed in conjunction with Experian. Exhibit 1 shows the growth in receivables and revenue at Advantage since 2007.

Aspen Bridging opened for business in February 2017 as a pilot project to test the viability of developing property bridging finance as a diversifying activity and alternative source of growth for the group. The plan is to invest up to £20m in loans in the pilot phase (£10.8m outstanding at the financial year end) and a review of the business and decision on whether to go ahead is expected in the second half of 2018. In the first year, 35 secured facilities were provided with an average value of c £380,000, an average maximum loan to value of 67% and an original term of nine months. Aspen follows a cautious underwriting approach with a process that includes third-party legal and valuation input, together with a visit to each property by a member of the five-strong Aspen team. The company also needed time to establish its position with brokers in the sector, which meant the initial pace of growth was slow. However, the business has found a niche financing small-ticket refurbishment projects that larger institutions would find difficult to service. The group describes the venture as promising, suggesting it has a good chance of being given the go-ahead to move beyond the pilot stage following this year’s review.

S&U’s overall results were similar to our expectations. Impairments were moderately above our forecast but this was largely offset by lower than expected other costs including interest expense. Receivables and revenue growth at Advantage of c 30% led to group pre-tax profit growth of nearly 20% despite a 61% increase in the impairment charge. Key points from the results are highlighted below with comparisons against FY16.

Looking more closely at the Advantage result, Exhibit 3 shows the evolution of revenues and impairments as a percentage of receivables since 2007. There was a period of higher yields following the financial crisis, reflecting more favourable competitive conditions with a contraction in the availability of credit. More recently there has been some erosion partly reflecting the removal of insurance revenue in FY15 as well as competitive pressures. The revenue yield increased by 1.8 percentage points in FY18 versus FY17. This reflected the mix change mentioned above with the shift towards higher risk loans evident in returns and impairments (+2.0 percentage points), which are shown in the same chart. In Exhibit 4 the effect of these trends on pre-tax profit margin is evident, with profitability somewhat lower than in previous periods mirroring the increased rate of impairment relative to sales and, prior to that, the absence of insurance income from FY15.

Exhibit 5 tracks the trends in Advantage’s average customer credit score and the flat interest rate by period of origination. This again shows an offset between pricing and risk with rates rising as the mix was adjusted towards lower credit scores. The movements in FY18 showed the impact of a tightening of Advantage’s backward-looking credit scoring and forward-looking affordability criteria. S&U indicates that the live portfolio at the time of the announcement had a slightly higher average yield and lower credit score than shown here because the high-scoring FY12–14 originations had mostly settled. The arrears profile (not shown) saw a decline in the percentage of receivables where payments are up to date (down 3.4 percentage points to 83.3%, a smaller reduction than the 4.3-point reduction seen in FY17). While the impairment and arrears trends are somewhat less favourable than we expected, they are likely to prove lagging indicators with the implementation of tighter criteria set to flow through to impairment and arrears in future periods, all things being equal.

A post-financial crisis normalisation of competitive pressure and the increasing importance of internet broking are evident in Exhibit 6. The original duration of loans has increased over the period shown from 44 months to 51 months, which helps attract customers as it reduces the monthly payments but does imply some increase in risk for the lender (potentially compensated for by the interest rate). The chart also shows a rise in the cost of sales per loan. After falling between FY12 and FY15 this has now increased, largely reflecting the increase in payments to the brokers that originate most of the loans. The increasing role of the larger internet brokers and competitor behaviour contribute to this trend. Internet brokers account for 65% of business.

While uncertainty over the potential impact of Brexit remains a feature, forecasters’ views of the economic outlook in the UK have remained broadly stable in recent months. Estimates for GDP growth for 2018–20 range between 1.1% and 1.9% per year according to the IMF, OECD, Bank of England and the Office of Budget Responsibility. Unemployment is an important indicator for the health of consumer lending and tends to lag GDP changes. Forecasts here are not flagging noticeably higher risks. Similarly, the level of redundancies has not shown a marked trend over the last year, remaining at a relatively low level following a post-crisis decline (see Exhibit 7). Consumer confidence, as measured by the EC indicator (Exhibit 8), is below the levels seen in 2014–16 but has recently been fluctuating around a modestly negative reading.

Sales volume in the new car market has seen a significant decline (−5.7% for 2017: SMMT data) and the latest reading for March (−15.7%) was exacerbated by the rush to buy ahead of changes in Vehicle Excise Duty last April. In comparison, used-car market volumes and used-car finance (Exhibits 9 and 10) have been resilient and remain at high levels, although the unit volume figures for the used-car market from the SMMT have shown declines on the prior-year period since the second quarter of 2017. Used-car finance has continued to show year-on-year growth with 12% growth in value and 6% by volume for 2017. In January and February this year the figures were +18% and +11% for value and volume, respectively, compared with the same period in 2017.

In Exhibit 11 we have collated BCA data on auction prices, selecting fleet and lease sales and dealer part exchange as the nearly new category has a substantially higher value and is therefore less comparable with S&U’s customer purchases. While the BCA data will depend on the mix of business it is dealing with, as a broad indicator the figures do suggest stability in prices over the period shown. The level of depreciation that has already been incurred on the cars for which Advantage is providing finance reduces the sensitivity to a weakening in prices, although clearly this could still be a factor in a sharp slowdown (possibly prompting early repayments and reducing residual values) but in this case a more relevant risk would be rising redundancies that could trigger defaults.

The FCA is continuing its work on the motor finance market, issuing an interim report in March with the full review expected to be completed in September this year. One of the questions the FCA is addressing is whether firms are appropriately managing the risk that asset prices fall. The relatively low value of the vehicles Advantage finances and the simple structure of the hire-purchase contract it offers (rather than personal contract purchase) both mitigate the risk in a downturn. Another strand of work is on responsible lending, which has so far identified that lower-credit-score borrowers have seen a greater increase in defaults in recent years. The next stage of work will examine the assessment of affordability, where S&U believes its close attention to regulatory developments and well-developed credit assessment process including affordability means it should already be in a good position to address findings from the review in this area. The FCA has also examined commission arrangements that could harm consumers. Here Advantage only pays brokers remuneration that is fixed and does not depend on the loan size or interest rate. Finally, the FCA is examining the quality and transparency of information provided to consumers. Its initial review of websites has been generally favourable and is being followed by mystery shopper exercises. Advantage prides itself on providing clear, compliant and timely information. In general, Advantage regards itself as well placed in relation to the areas the FCA is examining and is addressing a relatively small part of the market with a straightforward product using well-tested processes. While the final review could lead to recommendations that require work by all lenders, as things stand this does not appear likely to be a major task for Advantage.

Summarising the outlook, maintenance of GDP growth as currently expected and low unemployment and redundancy levels should be supportive for S&U, both in terms of impairment levels and appetite for loans. A significant worsening of consumer sentiment from current levels could have a more noticeable impact on demand for loans but, unlike the private new-car market where spending tends to be more discretionary, car purchases of the value that Advantage finances tend to be more utilitarian and are therefore less likely to be deferred substantially. Competitive pressures are likely to remain a factor and it is unclear whether developments such as the move by Moneyway (Secure Trust Bank subsidiary) towards near-prime and prime segments and Moneybarn’s (Provident Financial) tightening of criteria from Q217 will prove to be part of a trend that has helpful impact. Overall used car sales volume may be softening but demand for finance has been more robust and within this Advantage has good scope to increase its c 1% market share, partly helped by a higher conversion rate of loan approvals through its Dealflo system. In terms of Advantage profitability, the tightening of its own criteria and continuous refinement of its scoring should have a positive impact on impairment levels.

The Aspen Bridging business is at a very early stage and addressing a completely different market area than Advantage. Even so, the reasonably benign economic outlook described would also be helpful for Aspen although specific factors are likely to be the dominant influence for the medium term and it is not yet certain that S&U will decide to continue to develop the business beyond the pilot stage.

We set out our key P&L estimate assumptions in Exhibit 12. For the motor finance business we have factored in receivables growth that is still strong but at a moderating level in FY19/20. The revenue yield is expected to fall modestly as the lower-risk element of the book increases, which we also assume drives a reduction in the impairment charge relative to receivables or revenue that would leave the risk-adjusted revenue yield broadly flat.

For Aspen we assume receivables rising to £18m and then £20m but the actual result is likely to be more binary with the activity winding down quite rapidly if the decision is not to continue or expanding more sharply if given the go ahead.

As shown in Exhibit 13 we have made only small changes to our FY19 estimates following the result for FY18 that was in line with expectations.

The cash-flow analysis below highlights the increased investment made in the expansion at Advantage with a cash outflow of £42m. Aspen property bridging absorbed a further £11m and after dividends there was a total outflow of £56m, taking net debt to £105m. Following the year end, committed funding facilities have increased to £135m, providing additional headroom and, on our estimates, net debt could rise to £145m in the current financial year and potentially £170m in FY20; debt to equity would increase to 86% and 90% respectively.

S&U indicates that it expects a transitional charge to equity of 1–2% of receivables on adoption of IFRS 9. This would be equivalent to c £2.5m net of deferred tax. For the moment we have not made any adjustment to our estimates for the P&L impairment charge resulting from the new standard. The expected loss provisioning adopted with IFRS 9, while designed to result in earlier recognition of losses, could give rise to significant swings in charges particularly at turning points in the credit cycle. Importantly, the new standard changes reporting but does not have an impact on the cash flows of a business, the key focus of management at S&U.

We have updated our valuation comparison table, which includes peers involved in non-standard lending or that have motor finance as one of their activities. S&U trades below the average P/E and has an above-average yield (Provident Financial’s historical yield is excluded given its cautionary August trading statement). S&U’s return on equity is above average (also ex-Provident Financial) and the price to book is similar to the group average. The small sample size and differences between the businesses qualify this comparison, but S&U appears moderately valued in this context.

Using unchanged assumptions (return on equity of 17%, cost of equity of 10% and growth of 5%), our ROE/COE model gives a value of 3,060p reflecting an increased NAV and modest changes in estimate with a new explicit forecast for FY20. The return on equity assumption is only slightly above the 16.7% earned in FY18 and below the c 18% and 19% returns indicated by our estimates for FY18 and FY19, respectively, so does not seem overly ambitious. The multiples implied by the valuation (c 2.4x book and 12x prospective P/E) seem reasonable in the context of peer valuations and the output of a DDM model so we adopt 3,060p as our valuation compared with 2,700p previously.

Exhibit 16 shows recent share price performance for the peer group. The impact of Provident Financial’s difficulties on its share price is still a key feature of the table, but all the stocks are below their 12-month highs. S&U is only marginally down on this measure and over 12 months is the second-best performer and is close to the average for the other shorter periods shown.