Secure Trust Bank — V12 Retail Finance to support refreshed targets

At its CMD, management refreshed STB’s medium-term targets. The overall RoAE, net interest margin and capital ratio targets are unchanged, but volume growth and the cost-income ratio (CiR) have been revised. The previous 15% CAGR target on its loan book has now been replaced with an absolute target of c £4bn over the medium term, which implies a high single-digit CAGR over the next three years. Offsetting the lower projected volume, the CiR target has been upgraded from less than 50% to 44–46% (see Exhibits 1 and 2). STB also delved into V12 Retail Finance, presented by Nick Davies (CEO) and Andrew Phillips (commercial director) of V12.

Implicitly, the RoAE target depends on scale and capital allocation. The expansion of V12 within the mix will play an important role in achieving a high risk-adjusted return overall. Thus, the ultimate credit quality at V12 is a key factor in profitability and currently probably an uncertainty holding back the valuation of the group during a difficult economic environment. In this regard, management addressed the question of how unsecured ‘interest-free’ lending within Retail Finance should be of higher quality than other, more popular forms of lending such as personal loans and credit cards. In particular, retail customers using interest-free lending often do not actually need to rely on credit to make a purchase, but value the ability to defer payments without additional cost.

Following successive growth in its lending book – 45% over the last 30 months – management no longer believes it needs to grow its lending at a 15% CAGR to achieve its RoAE target of 14–16%. The bank is focused on managing for risk-adjusted return, but the £4bn target loan book still leaves room for solid growth from the Q323 level of £3.2bn. In FY22 and H123, the loan impairment rate or cost of risk (CoR) in V12 was 1.6%, far below the pre-pandemic figure of 3.0% in 2019, as STB has tightened credit standards and shifted to more prime ‘interest-free’ lending – 90% of new business and 86% of receivables in V12 at H123. STB views this as a structural shift and projects an across-the-cycle group CoR of 1.3–1.5%, which should benefit medium-term returns. The market will likely adopt a ‘wait-and-see’ stance on CoR in the very near term, but successful execution here would be a major driver of a re-rating in the shares, in our view.

Underpinning the pathway to the RoAE target are STB’s cost efficiency initiatives and scalable digital platform. Project Fusion has now been extended to deliver c £5m in annualised savings by end-FY24, an additional £1m over the £4m targeted for FY23. Administrative office space has been reduced by just over 50% and the bank plans to reduce some of its more expensive office space in London. Digitisation has boosted operational efficiency and simultaneously reduced costs. STB recently launched its savings account mobile app that allows users to access their account and transfer money, which has reduced the number of calls to its call centre. Notably, the proprietary platform in V12 Retail Finance has enabled average staff numbers to fall slightly since 2019 while the loan book has grown by 70%. Combined with continued lending growth, the bank should generate improved positive operating leverage.

Management noted that for a period of time the bank will consume capital to facilitate its growth, but will then generate capital over time as it achieves its fundamental return objectives. Its capital stack remains healthy with a 13% CET1 at H123, 1pp above the 12% target and positioned to fund growth. A loan book of £4bn is still expected to result in a CET1 above 12%. The tier 2 capital raise in February this year has enlarged its capability to lend by c £700m. Without the tier 2, it would have had to fund growth through its common equity, which would have resulted in a slower pace of growth.

The mix shift towards Consumer Finance business and more prime interest-free lending both has improved the credit quality of the loan book and is positioning the bank to achieve its net interest margin (NIM) targets. With the CoR in the Consumer Finance book lower than pre-COVID levels, the bank expects a through-the-cycle CoR of between 1.3% and 1.5% for the group. The bank highlights in Exhibit 3 that a book with 55% weighting towards Consumer Finance lending increases group NIM by 30bp and will help it achieve the upper bound of its NIM target range, all other things being equal (see Exhibit 3). In addition, a flattening yield curve from the current inverted one would provide an additional benefit as the loan book tends to reprice more slowly than deposits.

With balances of £1.2bn at Q223, V12 Retail Finance represents 37% of group loans, up from 30% at end FY20. The loan book has grown by 79% over the period compared to 45% for the group. The NIM is not split out from Consumer Finance as a whole, but Retail Finance now represents 73% of Consumer Finance and Exhibit 3 shows that NIMs are nearly three times those achieved in Business Finance.

V12 Retail Finance offers both interest-free and interest-bearing products to customers via retailers at the point of sale. Its most popular form of lending is interest free and in April this year V12 piloted AppToPay (with 27 retailers), a mobile app offering three-month, interest-free credit solutions for small ticket items.

The model is attractive to retail partners in that it drives incremental sales through stronger conversion rates through to checkout, while offering retail customers the flexibility of being able to spread the cost of purchases with fixed monthly payments.

V12 works by integrating its proprietary software via application programming interface links into the software of the retail partners, which then use the link to provide customers with financing options. At the point of sale, once the retail customer has applied for the credit option, V12 will perform the appropriate credit checks and provide a rapid automated credit decision, within six seconds for 90% of applications. Once the customer has purchased the product under the appropriate loan terms, V12 will send the net payment to the retailer (purchase price minus the credit charge) and receive monthly repayments direct from the customer for the purchase price. See Exhibit 4 for an illustration of the interest-free credit model.

Payment from the customer only begins once the product has been delivered. This explains why V12 sees a lag in interest rate pass-throughs. Since a large part of lending is in furniture, delivery of the product can take up to three months, meaning that only after three months from the date of initial purchase will V12 begin to receive payments. Thus, following the rapid rise in interest rates seen in the UK, margins tend to fall initially but then recover as rates are passed through to the retailer later.

Addressing concerns about the credit quality of the unsecured lending, management pointed out the correlation between the CoR falling as the interest-free lending proportion of the loan book has increased. A key feature of interest-free credit is that often the retail customer does not actually need to access credit but sees the ability to spread payments as a ‘deal’ with no additional charges. Moreover, the application process tends to self-select customers who are more confident of being accepted. Management has focused on the furniture and jewellery segments as they have proved to have the highest credit quality customers compared to lower credit quality segments such as consumer electrical products. In the past five years, V12 reduced its share in the electrical sector from 19% of volume to just over 0.3%, while it has increased its share in furniture from 20% of volume to 47% in the same period. Management further claimed that this form of lending has a better credit quality than other popular forms such as personal loans and credit cards.

Since the launch of its online retail finance platform in 2001, V12 has gradually grown its market share by offering a competitive, proprietary platform and leveraging its retail partnerships. Currently, V12 has more than 1,400 retail relationships. Since 2014, it has generated new business at a strong pace, barring the COVID-19 era. Success in generating new business is contingent on the seamless integration with the retailer. Management believes V12 is favourably positioned to deliver a competitive online lending service compared to traditional banks and fintechs. V12 has the technology and nimbleness of a fintech with the banking expertise of a traditional lender (supported by STB). The unique technology allows V12 to on-board new retailers swiftly, with the ability to integrate with several retailers within a week whereas some competitors can only integrate with a few in a year, according to management.

The focus on providing a scalable digital platform has also led to cost efficiencies. In 2017, V12 launched a self-service portal that allowed customers to manage their accounts. Today, 74% of its more than one million customers use the portal. Operationally, this has been extremely efficient for V12 and has allowed it to gain operational leverage. Since 2019, calls to the customer service team reduced by 63% and in the same period the average number of (full-time) staff decreased from 230 to 224 while the loan book grew 70%.

It is worth emphasising that V12 passes on the cost of funds to the retailer, not the retailer’s customers. Currently, 60% of its retailers receive automatic quarterly pricing changes, while the remaining 40% receive immediate pricing changes. Hence, the lag effect is particularly compounded in its furniture lending where the time between the sale and receiving payment already lags (as explained above). This may also help with credit quality in a rising rate environment, although there is exposure to the underlying retailer for rate increases of course.

Thus far, growth in V12 has been strong. Additionally, it has modest concentration risk. Its largest client comprises 14% of business and only surpassed 10% of outstandings recently. With an addressable market of £10bn, there appears to be ample room for growth. At H123, it had 13.2% of market share and believes a reasonable target is in the mid-teens. Focus is on improving and growing in its current market segments, but also expanding into new lower-market share segments such as home improvements.

In Exhibit 6 we compare STB to a peer group of mid-sized/specialist lenders in the UK. In comparison to peers and on a calendarised basis, STB trades at a far lower 2023 P/E ratio despite having a more competitive return on equity (ROE). Furthermore, with an FY24 ROE roughly in line with the peer average, STB trades at a CY24 P/E ratio of almost half the average. Alongside this, STB offers a good current dividend yield of 6.5%, slightly below the average of 6.6% as it continues to retain capital for growth. At the current price, its FY24 dividend yields 8.3%.

Using our assumptions for FY23, STB is currently trading at a diluted P/BV of 0.36x (see Exhibit 7) and a P/E of 3.9x. STB looks highly undervalued based on our peer comparison chart where we have plotted calendarised 2023 P/BV against ROE. On a peer valuation comparison, STB should be trading closer to c 0.6x P/BV or c 1,000p/share. This implies an upside of c 55% from the current share price. Management targets an ROE of 14–16% in the medium term and, should this come to fruition, we would expect STB to trade closer to book value.