Secure Trust Bank — FY21 earnings beat with momentum

STB had already flagged in its November 2021 update and its pre-close statement in January 2022 that earnings would be coming up ahead of expectations and loan momentum was strong. Earnings were indeed ahead of expectations due to the significant reversion of provisions. The level of provisions for FY21 was only 0.1% of average loans and this boosted the ROE to 15.9%, which is an exceptional level of profitability. Revenue and expenses were as we expected, flat and up 12%, respectively. This substantial increase in costs related to investments that will help the bank to significantly expand its balance sheet in the next couple of years. Loan balances grew 7% year-on-year (12% if we consider only core lending) and interest margins remained resilient. STB followed its new 25% dividend pay-out policy and its FY21 DPS was 61.1p (we had forecast 56.6p) for a 4.8% yield.

Inflation has been rising ahead of expectations and this may have an adverse impact on forecast economic growth. However, the consensus expectations are for healthy GDP growth (4.4% and 1.7% in 2022e and 2023e) and low unemployment, while lending margins remain good. STB sees attractive lending opportunities and its acquisition of App2Pay (announced in November 2021 and still subject to regulatory approval) will open up a new market in the digital buy now pay later (BNPL) business to complement its existing retail lending business. Economies of scale come into play as the balance sheet increases and should help the cost to income ratio decline from 63% in FY21 to 58% in FY22e and 53% in FY23e. We see the net interest margin (NIM) remaining relatively steady at 6.2% and we estimate this will lead to ROEs of 10.2% in FY22e and 12.8% in FY23e. We estimate that the balance sheet expansion will lead to the CET1 ratio dropping down to 12.3% by FY23e, which is still a comfortable level. We are increasing our FY22e PBT and EPS estimates by 12% and 7%, respectively.

We have increased our FV from 2,234p per share to 2,491p after rolling our model forward one year. We discount the present value at the end of FY22 based on the (ROE-g)/(COE-g) formula back to FY21. All other assumptions remain the same: sustainable ROE of 13.5%, a 10% COE and 2% annual growth. STB is trading at very undemanding market multiples with an FY22e P/BV of 0.74x and P/E ratios of 7.7x for FY22e and 5.5x for FY23e.

In our view the main risk factors are:

STB’s FY21 reported PBT was £56m while its normalised PBT £57.4m was 9% ahead of our forecasts (as shown in Exhibit 1) and almost triple that reported in FY20. This beat was essentially due to the significant provision reversals that continued into H221. Loan losses for the full year were only £4.6m (0.2% of loans) versus our forecast of £7.9m (0.3% of loans). The reported FY21 ROE was 15.9% (we forecast 14.9%) was boosted by this extraordinary (but welcome) level of provision reversions.

Impairments aside, STB’s numbers were fairly close to our expectations. Net interest income and operating income were relatively flat versus FY20. Pre-provision profit did fall by 18% year-on-year (but was 2% above our forecasts). This decline was due to the 12% increase in operating expenses as STB made some investment spending that was held back from FY20 as well as investing to position the bank for the strong lending expansion planned by management. The investments have been in both people and technology.

Loan growth was ahead of our forecasts. We were expecting loans as a whole to be relatively flat year-on-year at the end of FY21. However, loans grew more than 8% (an annualised 17%) in the last six months of FY21, after declining by 1% in the first six months. If we adjust for the sale of the mortgage business in June 2021 and consider just the core loans, growth was 11.6% year-on-year.

Balance sheet funding remained good with a loan to deposit ratio of 120% (as forecast) and a robust CET1 ratio of 14.5% (we had forecast 14.4%), which supports future balance sheet expansion.

The dividend per share was 61.1p versus our forecast of 56.6p, as the board elected to follow the targeted 25% pay-out ratio.

The lending pick-up was broad based in the second half of 2021 with all four key loan portfolios growing an annualised 10% or more.

STB had slowed down its real estate finance lending out of caution in 2020, and it was flat during the first six months of 2021 before ending 2021 5% higher year-on-year. There was a similar picture in vehicle finance (as STB now refers to its motor finance division). Vehicle lending was considerably affected by lockdowns but is now rebounding. Vehicle lending growth was flat in the first six months of 2021, before finishing the year up 8% year-on-year.

Commercial finance (essentially invoice discounting) and retail finance had even stronger momentum in FY21, increasing 36% and 16% year-on-year, respectively. Exhibits 2 and 3 show the loan breakdowns in FY20 and FY21.

COVID-19 fears have given way to concerns about inflation and its impact on economic growth. These concerns have been exacerbated recently by the war in Ukraine. Consensus forecasts as collected by the Bank of England (BoE; Exhibit 4) still looks quite supportive for UK banks. The economy continues to grow at a good pace, while unemployment remains low. The latter is particularly important for banks since unemployment levels are a key factor for their asset quality.

Inflation is STB’s cloud in a relatively rosy outlook. Private consumption and GDP could be negatively affected if price inflation continues to outpace wage growth. Interest rates are rising, and this could put further pressure on consumers, especially with big ticket items such as mortgages, which are mostly floating rate in the UK. This problem would be exacerbated if central banks end up having to compensate for the excessively accommodative policy actions with very punishing interest rate hikes to contain inflation.

Exhibits 5 and 6 show the rising inflation and interest rates expectations. Current market expectations (based on overnight bank swaps) are that the BoE policy rate will be slightly above 2% by December 2022. The compares with market expectations of 1.2% back in December 2021. We feel that this is not a particularly onerous level of interest rates for banks and in fact it will likely help bank interest margins since some of their funding is essentially interest free. In the case of STB the potential uplift to margins is muted because most of the lending is at fixed rates and STB does not have many demand deposits.

The BoE-collected inflation forecasts for 2023 of 2.3% also reflects the market’s relative optimism regarding the transitory element of the current quite elevated inflation levels. However, clearly there is still significant uncertainty and a materially worse outcome than the current consensus cannot be ruled out.

The transient element in inflation is driven by supply chain constraints as economies rebound from various lockdowns and as consumers spend the money they saved during the pandemic.

These supply-side problems have led to soaring materials and food prices. Some of this has now subsided, but there are other sources of elevated inflation such as energy and commodity prices. These are also expected to come down as bottlenecks are resolved. The Ukrainian war has pushed up oil, gas and food prices, but this should also be (hopefully) a transitory effect.

Although STB’s management acknowledges some uncertainty in the macroeconomic outlook, it is keen on the lending opportunities that it sees in its niches. We note that STB has a good track record of nimbleness in reacting to changing lending conditions. This is helped by the relatively short duration of its loan book. Management’s medium-term average annual growth target of 15%+ loan growth is testament to this optimism.

A key feature of STB is that although it is a specialist lender, it is well diversified across several retail and business segments. At the same time, management is comfortable with completely exiting segments that do not fit its desire for attractive risk-adjusted margins in niches it can be competitive in. STB sold its asset finance and consumer mortgages businesses in July 2021, closed the OneBill banking product and in March 2022 announced the sale of a debt management service business (which is still waiting for regulatory approval to be concluded). These sales aim not only to reinforce focus on the preferred segments, but also to simplify the corporate structure.

STB maintains its two-prong growth strategy of using both organic growth and acquisitions to take advantage of opportunities.

Although the bank does not see itself as a fintech company, technology is an important tool for both growth and client retention and will be key in STB’s plans for the digital BNPL business in retail finance and also the prime personal contract purchase (PCP) solutions for used vehicles in vehicle finance. In 2021 it invested £1.7m in vehicle finance and savings.

On 25 November 2021, STB announced it was buying AppToPay (as we discussed in our note in November 2021). This is still subject to regulatory approval and would help STB move into digital BNPL products. It aims to start offering digital products in 2022.

STB has adjusted its medium-term targets as a result of the expected debt management services (DMS), which is expected to add about 50bp to capital. The DMS business had high interest margins but also correspondingly higher costs and it contributed a £0.5m loss in FY21. STB has adjusted its medium-term NIM target from 6%+ to 5.5%+ (it was 6.2% in FY21) and the cost to income ratio from 50–55% to 50% or less (63% in FY21). The other targets have remained the same: ROE of 14–16% (FY21:15.9%), CET1 ratio of more than 12.0% (FY21: 14.5%) and 15%+ loan growth (FY21: 7%).

These targets continue to seem to us appropriately ambitious and at the same time achievable and consistent with STB’s business model. If achieved, this means attaining a value-creating ROE well above the COE (we use 10% as the benchmark), while maintaining a solid capital base.

We are forecasting loan growth of 17% and 15% for 2022 and 2023, respectively. We forecast a loan balance of £2,960m for year-end 2022, which is similar to our previous forecast of £2,985m despite the 2021 loan book being about 6% above our forecasts. This is because we were already assuming rapid loan growth in 2022 (24% year-on-year on previous 2021 estimates).

We expect to see rapid loan growth in all the core lending segments, as shown in Exhibit 9. We retain the debt management loan book in our forecasts until the sale is completed; it represents 4% of the loan book.

We show the impairments assumptions in Exhibit 10. The loan losses tend to be centred in vehicle finance and retail finance. We are assuming a 3% loan loss ratio in 2022 and 2023 for both segments, and 1.3% and 1.4%, respectively, for the whole loan book. This compares with the 0.2% loss ratio (0.1% if we add loan modification losses) in 2021, which was an outlier year as was 2020 (2.3% with loan modification losses). Clearly, the outcome may end up being different from these assumptions.

We continue to value STB on an NAV approach using the (ROE-g)/(COE-g) formula. We maintain our assumptions of a sustainable ROE of 13.5%, a 10% COE and a 2% increase in long-term earnings. The FV has increased from 2,234p to 2,491p, reflecting moving forward one year. This is equivalent to a P/BV multiple of 1.44x, compared to the trading FY22e P/BV of 0.75x, suggesting significant upside our FV.

STB is still trading below its book value despite its track record of value-creating ROEs. We are estimating a 10.2% ROE this year and 12.8% in FY23e.

Exhibit 12 compares STB’s market multiples with some of its peers. STB is trading at a 16% premium in terms of P/E to its peers (7.7x vs 6.6x; we remove Metrobank from the average since it is loss making). However, we feel the size of this premium is almost inconsequential as the whole sector is trading at very depressed ratings, a reflection of macro concerns. STB’s dividend yield is 55% higher than its peers. Its FY22 ROE is 14% below its peers (10.2% vs 11.8%) but it is trading at a wider FY21 P/BV discount of 28%, which is attractive from a valuation point of view.

We continue to see STB as a well-capitalised bank with a good business model that is still intact, and the FY21 results have shown that management seems to have kept a good control on asset quality. We therefore believe that market multiples suggest room for the share price to recover strongly as it starts to move back to a growth stage and earnings growth is boosted as impairments come down.

We expect FY22 and FY23 to have a more normalised level of impairments and profitability. After loan loss ratios of 2.3% and 0.1% in FY20 and FY21, we are forecasting 1.3% and 1.4% in FY22e and FY23e. We are forecasting relatively steady margins at 6.2% and that net interest income will increase by 13% and 16% in FY22e and FY23e driven mostly by asset growth. We estimate total revenue growth to be similar at 13% and 15%, respectively.

We are expecting some operating gearing to kick in as STB grows into its cost structure after its recent investments. We estimate operating expenses rise 4–5% pa in FY22e and FY23e. As a result, we estimate the pre-provision profit will grow from £60.5m in FY21 to £101.2m in FY23e.

Normalised PBT is forecast to fall from £57.4m to £40.8m in FY22e due to the higher (and more usual) level of impairments. We then estimate that PBT increases to £56.4m in FY23e. This is equivalent to ROEs of 10.2% in FY22e and 12.8% in FY23e.

Despite the good profitability, we estimate that such rapid loan growth (along with the IFRS 9 transition deduction relating to loan impairments) will eat into STB’s capital, but we expect it to remain healthy. We note that the five-year phase-in of the deduction of these impairments from regulatory capital ends in FY22. We estimate that STB’s CET1 will decline from 14.5% in FY21 to 12.3% in FY23.