Secure Trust Bank — Tangible evidence of repositioning

STB is a specialist bank with a strong growth profile that is shifting into a lower-risk lending mix. A strong capital base underpins the expansion plans along with ongoing investments in people and systems, and the existing niche opportunities. The lower-risk mix has been driven both by market conditions and Brexit concerns. Personal unsecured lending has been curtailed recently while the subprime motor finance segment is being repositioned into prime and near prime. It has also exited the asset finance business (it would re-enter if risk-adjusted margins improve). In contrast, invoice discounting (commercial finance) is surging strongly as is real estate (but with greater caution). Retail point-of-sale lending is also posting robust growth. STB recently launched a specialist mortgage lender, focusing on contract, self-employed and less-than-prime clients.

We continue to forecast that STB will roughly double its balance sheet and earnings between 2017 and 2020. We believe its CET1 of 13.6% gives the bank headroom to be able to deliver this growth and still pay a generous dividend. We estimate that the balance sheet capital deployment will help drive STB’s ROTE to 18% by 2020 (management expectations are high teens). We think STB will seek alternative growth plans if market conditions do not allow currently earmarked growth segments such as mortgages and motor finance to provide the profitable growth opportunities it seeks. Being diversified and small facilitates this nimbleness and STB’s management has shown it is willing to exploit this advantage. Our projections are based solely on organic growth. However, management has its eyes open for M&A opportunities that may arise, especially in mortgages, asset finance and commercial finance segments. We would imagine that if the purchase size is large enough, management would consider either raising capital, securitising some loans (eg motor finance) or paring back growth in other segments.

We maintain our DDM-derived fair value at 2,350p with no changes in forecast dividends. At our valuation, STB is trading at a 2018e P/NAV of 1.7x. This seems reasonable in the context of forecast profitability in the high teens. STB is trading at a 16–20% 2018–19e P/E discount relative to peers, which is not unattractive since its growth profile compares well with peers.

Risk factors to consider include:

STB is a specialist UK lender and has been trading since 1954. It is now independent, after its previous parent, Arbuthnot, reduced its holding to below 20% in 2016. The bank was floated on AIM in 2011 and joined the Main Market in 2016.

The bank has been growing its loan book at a robust pace since the financial crisis (51%+ CAGR 2010–17) and increasing its diversification organically and through acquisition. STB’s loan book is roughly split evenly between business and retail.

The bank’s business lending is focused on real estate finance and invoice discounting. It is running down its asset finance book.

Retail lending is centred on motor finance (using the Moneyway brand), retail point-of-sale lending and a recently launched specialist mortgage business. Moneyway was traditionally a subprime business, but is now metamorphosing into a prime and near-prime activity. A new management team has been appointed to spearhead efforts in this segment. The mortgage business is focusing on traditionally underserved segments such as contract workers, sub-prime and self-employed people. Retail point of sale lending serves a primarily prime end-client base, with a diverse set of retail partnerships increasingly including internet-based companies. There are four hubs: sports and leisure equipment, jewellery, consumer electronics and furniture.

The sale of Everyday Loans Group (personal unsecured loans) in 2016 resulted in a £116.8m post-tax gain and even after the distribution of a 165p special dividend has left STB with sufficient capital to drive growth in other segments that management sees as more attractive. The strategy is built on organic growth coupled with M&A should opportunities arise, especially in the mortgage, asset finance and commercial finance sectors.

STB reported normalised pre-tax earnings of £16.5m for H118 (+38% y-o-y) and an ROTE of 12.3%, up from 10.3% in H117. The results showed the bank has progressed in rebalancing its loan book further than expected. There was an offset between better than expected impairment charges and interest income. The performance of the motor finance business was particularly noteworthy, with the impairment charge reducing from 871bp to 468bp. Management highlighted that this reflects the ongoing migration from subprime towards prime and near-prime in STB’s motor lending. This suggests that further improvement in this segment is likely.

The main features in the business segment were the continued strong performance of commercial finance (invoice discounting) and the greater than expected contraction in the asset finance book that is being run off in the face of unattractive near-term pricing and a change in ownership of its introducer and outsourcing partner, Haydock Finance.

The roll out of mortgage lending was slower than we had anticipated. Management is somewhat concerned with loan pricing in this competitive market in the UK. It wants to grow the business in disciplined fashion and STB believes the biggest opportunities may arise from 2020 when the bigger banks will feel the imposition of higher regulatory capital requirements in this product line.

Total lending growth was a robust 22% y-o-y, despite management pricing caution in some segments and Brexit concerns. The net interest margin NIM reduced from 7.9% of average loans to 7.4%, reflecting the change in asset mix and some price pressure. Drilling down into the segments beyond the motor finance repositioning, we note that margins were slightly better than expected in commercial finance, and a bit tighter in retail point-of-sale finance and real estate. The net margin reduction was counterbalanced by the greater-than-expected decline in the impairment charge at the group level from 224bp in H217 to 190bp in H118. The only segment that disappointed on the impairment charge level was asset finance, but this is a shrinking part of the business.

The introduction of the IFRS9 had a surprisingly muted impact. The initial transitional impact on the balance sheet was in line with guidance (a £25.8m reduction) whereas the effect on earnings was minimal as the H118 impairment charge on an IAS39 basis would have been marginally higher at 2.0% versus 1.9%. STB is taking advantage of the opportunity to phase in the impact of IFRS9 on regulatory capital over five years and in FY18 there is an add-back of 95% of the £25.8m reduction. Strong loan book growth meant the CET1 ratio dropped by more than 200bp to 13.6% in H118, still leaving the bank with significant capital headroom to support growth. For reference, taking full account of the IFRS9 change, the CET1 ratio would have been 12.2%.

Finally, we note that the loan-to-deposit ratio edged upwards from 108% to 112% in the last six months. However, this is still a good retail deposit ratio and is slightly lower than the 113% a year ago. We believe that with the end of the Term Funding Scheme (TFS), access to funding has become more competitive but the bank’s introduction of a new banking platform should help mitigate these pressures.

The economic backdrop in the UK is dominated by the uncertainty of Brexit. Together with rising levels of consumer debt and more aggressive loan pricing, this was among the factors that informed the company’s decision to reduce its risk appetite and shift its lending to a lower-risk mix. We recognise that with the Brexit deadline fast approaching, newsflow may generate volatility in expectations over the coming months. Current consensus forecasts point to UK GDP growth in the region of 1–2% a year for the next three years and unemployment and inflation both remaining low. This would be a fairly supportive macro scenario. The market expects another 75bp of central bank rate hikes by 2020, something we assume would be manageable for business and retail borrowers.

STB’s size allows its management to be relatively nimble in its market positioning; pursuing new opportunities and cutting back where pricing/risk ceases to be attractive. This is useful given the propensity of the UK’s incumbent banks and new entrants to shift focus between market areas periodically.

The following are the key company outlook comments and views by segment:

Real estate: cautious regarding credit quality, but committed to further growth. Relatively higher capital requirements hamper ability to be competitive in all parts of this market.

Asset finance: they are running down the book, which should be close to zero by year end. However, they are keeping their options open with regards to possible M&A in this area, should the opportunity arise and margins improve.

Commercial finance: expected to continue to be one of the pillars for loan growth. The bank plans to invest further in the regional model for better client reach and will allocate more resources. It has an experienced team at the helm and confidence to grow. This is also an M&A target area.

Motor finance: has a new management team on board to drive the repositioning in this segment. It is still in a transition period, but expected to grow strongly in the future. By focusing on prime and near-prime, it is addressing a much larger market segment and therefore greater opportunities. However, the bank expects to proceed with caution to get the pricing and credit quality right. The desire is to reach £1bn loan book (current £272m) in five years, market conditions permitting. We note some players, like Close Brothers, are showing some concerns about competition in the prime/near-prime segment.

Retail finance: recent growth has been strongest in jewellery and fashion segments. However, STB’s management expects growth in this segment to be broad based and will invest in systems and people to back its efforts.

Consumer mortgages: the business is still in its incipient stage. Market conditions are challenging, even in STB’s specialist target slot. It is a relatively fast growing niche, but one where some of the players with greater scale such as Nationwide and Halifax want also to compete. STB plans to grow in a disciplined manner to protect profitability. The bank believes greater opportunities should open up in 2020 when the larger players will need to comply with higher capital requirements.

Savings: management expects increased competition for funds with the end of the TFS. The company had already invested in new platform ahead of this and is introducing new products to improve the customer offer. This includes monthly income bonds, fixed-term cash ISAs and launching Business Savings to tap broader range of potential clients.

Exhibit 5 shows the progress that STB has made in changing its loan mix. It has exited personal unsecured credit (22% of the loan book in 2015, including Everyday Loans Group (ELG), and the remaining unsecured personal loans, PLD that were subsequently sold, is running down the asset finance book and (not visible on the chart) has made progress in changing the mix within motor finance. In contrast, the bulk of the mortgage book development is still in prospect.

Exhibit 6 details our loan forecasts for the group. These have been trimmed by about £100–200m. Asset finance forecasts have been cut due to faster than expected loan run-off and £100m has been cut from mortgages, reflecting greater management caution. Small reductions have been made in real estate and motor finance. Meanwhile, we have upped growth in retail finance and commercial finance.

While management has a cautious view on the economy and concerns with protecting margins and profitability, it still sees good potential for loan growth in the areas it is addressing and this is reflected in our forecasts. We have not factored any M&A activity in our numbers, but we recognise that management has stated that it is looking for opportunities, especially in the consumer mortgages and asset finance segments.

Finally, we believe that if market conditions in the key growth segments such as specialist mortgage or motor finance do not develop as hoped, management by virtue of building a diversified portfolio of businesses will conceivably look at other areas for more attractive growth and deploy the capital capacity it has available.

We are trimming our earnings forecasts by 4–5% for 2018–20, mostly to reflect the run-off of the asset finance business together with greater management caution on growth in mortgages.

STB retains its strong growth profile. We are forecasting pre-tax earnings growth of 27% this year, followed by 29% and 19% for 2019 and 2020. Exhibit 8 shows some of the growth dynamics. We expect earnings growth to shadow the loan growth to some extent. The margin compression from the lower-risk mix is projected to be offset by lower impairment rates and some operating leverage with scale. On this point, we note that the company is careful to invest first in its structure before it growing into it.

Exhibit 8 shows how the growth rate in loans flows through to operating income given the lower-margin mix with lower impairment rates allowing underlying profits and post-tax earnings to broadly match loan growth.

Exhibits 9 and 10 show the forecast progress in NIM and impairment charges at the group level as well as in motor finance, which is undergoing a significant shift in risk profile of its target segment.

On our forecasts, STB’s return on average risk weighted assets stays broadly the same at around 1.6–1.7%. This is consistent with our earlier comments that our estimates show earnings growing at similar pace to loans.

Assuming the company is able to deploy its excess capital in the coming years at such a value-enhancing rate, its ROTE should climb significantly and we are forecasting it to reach 18% by 2020. Indeed, profitability in the high teens is what management is aiming to achieve. This seems achievable with existing capital, but we note that M&A activity would require consideration of funding. Options might include equity issuance, securitising some loan portfolios or perhaps holding back growth in some segments.

We continue to value STB taking into account output from a DDM and a peer group comparison. With moderate near-term estimate changes and unchanged dividend assumptions, we maintain our valuation at 2,350p per share.

Exhibit 12 compares STB’s multiples with some of its UK peers. Although we show Metrobank in the table, we exclude it from the averages because of its outlier multiples. We note that STB is trading at a 12% 2018 P/E discount to its peers, which rises to 16% in 2019. STB trades at a hefty 32% discount to the average P/NAV of its peers. While its 2018e ROTE 12.7% is below the peer average, it is based on fairly depressed profitability due to the excess capital on its balance sheet. As mentioned, by 2020 its ROTE is forecast to reach 18%, suggesting the current P/NAV discount is conservative. Finally, STB’s 5.1% prospective dividend yield is the highest within this peer group.

Exhibit 13 plots the 2018e ROTE for STB and its peers against P/NAV. It can be argued that our estimate for STB’s 2020 ROTE of 18% would justify a P/NAV closer to the 2.0x level than the current 1.3x, even adjusting for the fact this is forecast, not current, profitability. Our fair valuation of 2,350p would place it at a P/NAV of 1.7x.

STB’s share price has underperformed its peers significantly over the last 12 months, and this has contributed to the discount of its current valuation multiples. The shift in asset mix and the impairments lag during the transition has affected forecasts and possibly raised uncertainty. We would expect the shares to perform better and unwind the discount as the bank shows continued evidence of delivering on its strategy. We believe the H118 results provide an encouraging start in this process.