S&U — Strong loan growth continues

S&U’s first half results were broadly similar to our expectations with motor finance receivables ahead of our estimate, while revenue was slightly above and pre-tax profit slightly below our forecast. Compared with H117 receivables and revenue growth were both above 30%, while pre-tax profits and earnings per share increased by over 20%. Key points from the figures are summarised below with percentage changes from H117 unless stated.

Exhibit 2 provides context by showing the longer-term evolution of the Advantage loan book and revenues, with particularly strong growth recorded from 2013 onwards. S&U notes that Advantage still has less than 1% of the used car market. The next chart shows the risk-adjusted revenue yield (calculated by deducting the P&L impairment charge from revenues and expressing the result as a percentage of average receivables) and pre-tax profit margin over the same time period. This shows some erosion of the risk-adjusted revenue yield in recent periods, in part reflecting the removal of insurance revenue in FY15 and, from FY15 to September 2016, a short-term experimental shift in the risk criteria towards higher-risk borrowers, which was terminated as it did not generate commensurate returns. Nevertheless, between 2007 and H118 risk-adjusted return improved from 24.5% to 27.5%, which can in part be attributed to a continuous process of refinement in Advantage’s customised credit scoring system (current version is Delphi 10).

Next (Exhibit 4), we show the trends in Advantage’s average customer credit score and the flat interest rate by period of origination. This shows that there has been a balance between pricing and risk with rates rising as the mix was adjusted towards lower credit scores. S&U reports that Advantage has more recently tightened both backward-looking credit scoring and forward-looking affordability criteria. This is evident in the modest uptick in the average credit score in H117, but the delayed effect of changes in the mix within the portfolio also meant that the live portfolio at the time of the announcement had a slightly higher average yield and lower credit score because the high-scoring FY12-14 originations had largely settled. The arrears profile (not shown) has previously shown a decline in the percentage of receivables where payments are up to date (for FY17 this was 86.75% compared with 91-92% for the previous three years), but in the first half there was a small increase to 86.95% signalling stabilisation as Advantage adjusts its criteria.

Exhibit 5 shows two metrics that have been influenced by competitive behaviour in the market. 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 initially falling, this has increased noticeably over the last three years, largely reflecting the increase in payments to the brokers which originate most of the loans. The increasing role of the larger internet brokers plays a role as well as competitor behaviour.

Despite uncertainties surrounding Brexit, the UK economy has shown resilience and estimates for GDP growth and unemployment for both 2017 and 2018 have been stable recently. Exhibit 6 highlights the positive trend in the level of unemployment and redundancies since the financial crisis. Consumer confidence, here measured by the EC indicator (Exhibit 7), has followed a more bumpy path over the same period, softening somewhat recently, although still well above the lows recorded during the crisis. Further weakening in confidence could affect the appetite for borrowing in the car market, although the segment within the overall UK market addressed by Advantage is arguably less sensitive to this.

Used car market volumes and used car finance (Exhibits 8 and 9) remain at relatively high levels, although the unit volume figures from the SMMT showed a marginal year-on-year decline for the second quarter. Used car finance has continued to show year-on-year growth of 9.7% in the first half.

Prospectively, maintenance of GDP growth as currently expected and low unemployment and redundancy levels should be favourable for S&U, both in terms of impairment levels and appetite for loans. Competition remains a factor, but S&U reports that there have not been notable changes here in recent months (it remains to be seen whether Provident Financial’s difficulties with its home credit operation will have any impact on its Moneybarn, motor finance subsidiary). While overall growth in second-hand car transactions may be softening, demand for finance has been more robust and within this Advantage has good scope to increase its c 1% market share.

Regulators have been paying attention to the high level of growth in consumer finance, including motor finance, and this has played a part in the FCA undertaking work on the market for motor finance. This appears likely to be focused on Personal Contract Purchase (PCP), which has been the main source of finance for new cars. Under these contracts, at the end of the agreement the customer can choose to buy the car for a guaranteed future value (normally set at 85-95% of the expected value), enter a new contract or simply give the car back. Because of the guaranteed future value that forms part of the contract, the lenders (frequently subsidiaries of car manufacturers) are exposed to potential weakness in second-hand car values.

S&U does not operate in this market as its contracts are conventional hire purchase contracts with an average loan of £6,200. Most of its transactions involve used vehicles, which have already experienced the period of most rapid depreciation so the sensitivity to weaker used prices may be reduced. There have been specific concerns relating to the value of used diesel engine cars that account for c 48% of the Advantage book. Here S&U reports that it has not experienced any softness in auction values to date and, prospectively, any price weakness for these cars would mean that new customers might obtain ‘more car’ for a given value.

S&U management notes that it would be more concerned by deterioration in the economy and credit experience rather than the impact of a potential decline in second-hand values or increase in voluntary terminations (an option HP customers have once they are halfway through their contract and currently running at 8-9% of loans). It illustrates this with a scenario in which there is a15% incidence of bad debts, 10% of borrowers opt for voluntary termination and there is a £400 (20%) loss on the value of a £2,000 car. Although these are cautious assumptions this would only mean an average loss of £100 compared with a typical profit on a contract of £2,000. We estimate increasing the rate of voluntary terminations to around 15% (double S&U’s historical experience) might have a further £100 impact on profitability reflecting both increased exposure to the lower sale price assumed in the scenario and a lower return as a result of early termination. These scenarios would represent negative developments, but would be manageable for the business.

Aspen Bridging finance remains at a formative stage so the outlook here depends on the pace at which the business develops. As noted, lending has been slower than expected, but the conservative approach taken is reassuring with capital protection remaining a priority rather than growth. Even so, we assume lending picks up more strongly from here now that relations with brokers have become more established.

We have made only marginal changes to our pre-tax profit and earnings estimates for FY18 and FY19, reflecting the trends seen in the first half with a higher revenue yield offset by a somewhat higher level of provisioning.

Further investment, mainly in the motor finance loan book, meant that net debt (not including preference shares) increased by £31.5m to £80.7m. Net debt to equity at the end of July stood at 56% compared with 35% at the year end. Since the period end, the group increased its borrowing facilities through the addition of a £20m rolling credit facility (to March 2021), taking the total to £115m. On our revised estimates, growth in the motor finance and bridging finance loan books could take net debt to c £133m by end FY19 and debt to equity to 79%.

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 2,871p (2,825p previously) reflecting an increase in the NAV. Given this modest change and taking account of the peer valuations we maintain our valuation at 2,700p, suggesting c 30% upside from the current share price.

Exhibit 12 shows recent share price performance for the peer group. The salient feature here is the severe impact Provident Financial’s difficulties have had on its share price, but all the stocks are significantly below their 12-month highs. Given the track record of the Advantage business and potential to continue to achieve good growth, the performance of S&U’s shares can be seen as offering an opportunity for investors.