Manx Financial Group — Record PBT driven by niche growth strategy

Exhibit 1 details the key profit and loss items over recent years and the half years for FY22.

During 2022, MFG grew its loan book by 27% to £291.5m (FY21: £229.3m), as the consolidation of PAL augmented the robust organic growth across the majority of the group; excluding the three-month contribution from PAL, PBT would have grown 48% y-o-y.

Despite the cost of deposits increasing to 2.4% (FY21: 1.5%), as the Bank of England raised interest rates, the group’s net interest margin (NIM or NII/average assets) improved to 7.1% (6.2% in FY21). This is the result of the consolidation of PAL (which has higher margins) and higher utilisation of the deposit base underlined by the loan-to-deposit ratio increasing to 95.8% from 90.4%.

Net fee income decreased 10% y-o-y to £1.2m, although this made a small 4.5% contribution to overall core operating income. Commissions in the Edgewater Associates Independent Financial Advisory (IFA) business declined due to weak investor sentiment and activity. Commission expense was also affected by the acquisition of PAL, accounting for 11.7% of interest income, roughly in line with the 11.5% in H122. Commission income growth at subsidiaries Conister Bank (+15.7%) and MFX (+14.1%) was not enough to offset the above factors.

Total operating expenses for the business increased 32% to £16.9m (£12.8m), mainly from an increase in personnel costs (including an additional one-off £200 per employee to provide support during the cost-of-living crisis) following the acquisition of PAL and hiring in readiness for expected approval of a UK deposit-taking licence. Expenses were also affected by IT investments to improve operational efficiency.

Looking at H2 versus H1, operating profits before impairments were roughly flat at £4.6m mostly as a result of the notable cost items above.

Profit before tax for the company reached a record £5.2m (FY21: £3m) and post minority interest (nearly all the 49.9% that MFG does not own of PAL) net income attributable to shareholders for the year totalled £4.3m, up from £2.8m in the previous year.

Improved profitability had a positive impact on average ROE, which increased to 15.9% versus 11.8% the prior year.

MFG’s subsidiary Conister Bank remains well capitalised with a CET1 ratio of 12.4% (FY21: 15.2%), well above the minimum requirement of 8.5%. The fall in CET1 is a result of the PAL acquisition and we would expect this to rebuild rapidly due to the group’s high ROE and low dividend payout. Consistent with the board’s policy to reward shareholders with 10% of group profit in cash and shares, a dividend of 0.3764p/share has been recommended to shareholders (FY21: 0.2443p/share).

The group has taken a conservative approach to credit risk in recent years, moving away from unsecured lending towards secured. Currently only 16% of the book is in unsecured personal loans (albeit this slightly increased with the acquisition of PAL). Hire purchase (HP), finance leases, vehicle stocking plans, block discounting, secured commercial, personal loans and wholesale funding arrangements are all secured.

Exhibits 2 and 3 illustrate the change in loan mix over the year. Following the PAL acquisition, unsecured personal loans have risen somewhat from 13% to 16% of the loan book. However, in the context of a highly secured book overall, this is not very significant and we note the impairment allowance has increased to 4.7% of gross loans (FY21: 3.7%).

Total gross loans and advances in FY22 were £305.7m. Of those loans, £27.0m are in stage 3 (the highest risk of default) and overdue 30 days, representing 8.8% of total gross loans (see Exhibit 4) and up from 7.7% the previous year. Stage 3 loans are 52% covered by impairment reserves, which rises to 100% including £12.9m collateral held (FY21: 108%). Total gross loans overdue 30 days amount to £31.4m or 10.3% of total gross loans, remaining in line with FY21 (see Exhibits 5 and 6). Overall, we conclude asset quality remains well managed and stable and consistent with 2021.

Note: Stage 1 loans are not deemed credit impaired with payments up to date to 30 days. Stage 2 loans are not deemed credit impaired but payments are over 30 days overdue. Stage 3 loans are deemed credit impaired and payments are more than 90 days overdue. Grade A loans are the lowest risk within each stage, while Grade C are the highest risk.

The recent failure of Silicon Valley Bank (SVB) has focused investor attention more acutely on liquidity and interest risk management in financial institutions. MFG maintains a very conservative risk profile compared to peers, with a mostly fixed-term deposit book matching its fixed-term loan book (ie no material mismatch).

Exhibit 7 shows the maturity profile of the assets and liabilities is well matched with a short aggregate duration. 40% of assets and 32% of liabilities reprice within six months. 54% of assets and 65% of liabilities reprice within one year.

Exhibit 8 shows that on a cumulative basis the group is slightly liability sensitive up to three years by just over £12m or only 3% of total assets. Conister Bank has a significant proportion of term deposit funding compared to a typical high-street bank. The bank’s interest rate disclosure in accordance with FSA reporting standards shows that an instantaneous 2% increase in interest rates benefits net interest income by £1.08m or only 3% of revenues.

The end of 2021 marked the beginning of global interest rate rises. In the UK, rates rose from 0.1% to 3.5% by the end of 2022. Given recent events in the banking sector and the lagged impact of monetary policy on the economy, there is continued potential for additional economic and market turbulence. On the other hand, the most bearish economic forecasts for the UK are moderating and the Office for Budget Responsibility (OBR) currently expects the UK to avoid a technical recession (two successive quarters of negative GDP growth) in 2023, with GDP growth for the year as a whole of 0.5%.

MFG has been growing its business despite the uncertain backdrop, through a strategy of operating in niche or underserved markets, but which are large in relation to the size of MFG and have demonstrated the ability to generate high returns through varying economic cycles. This strategy appears to have been validated considering the growth the company has achieved in the past several years, during which markets and economies have endured a series of disruptive events (Brexit, COVID-19, Ukraine war, rapid reversal of monetary policy, the UK ‘fiscal event’ fallout, accelerating inflation and interest rates, etc).

MFG’s management sees ample scope to continue to pursue its growth strategy on an organic basis and through selective acquisitions.

The recent acquisition of PAL is a good example of how MFG is rapidly building out its franchise without taking excessive risk. MFG has been familiar with PAL for some years as it has been providing finance to it through Conister bank. This has allowed MFG management to gain a good understanding of the business.

PAL is the UK’s leading automotive repair point-of-sale finance provider and distributes through prominent national organisations such as Halfords and Formula One. There are additional organic growth opportunities in insured products (eg warranties) and retail as well as the core market, which is still quite fragmented, according to management. Expansion into new areas will take advantage of using trusted partners to mitigate risk.

PAL helps customers spread one-off or larger costs over relatively short time frames. Thus, the loan book is short duration and granular, and problems with individual customers can be identified early and action taken. The short duration loan book enhances the credit management process through fast identification of potential payment problems and subsequent loss mitigation. PAL performed well during the COVID-19 pandemic and, with a similar current squeeze on household incomes from persistent inflation, we would expect a similar resilient demand for PAL’s financing services.

PAL has an attractive business model. The average loan duration is c 10 months. This means PAL is able to turn its loan book over 1.2 times on attractive one-year funding from Conister Bank.

Management maintains strict risk management policies, writing off debt over three months past due. Currently, write-off volumes remain low as vehicles remain an essential means of transport for many households.

The economics of the deal appear highly favourable: the initial 50.1% stake cost £4.2m in cash, which compares with an annualised attributable profit contribution of c £1.1m based on the three months of PAL contribution in FY22. This represents an annualised 26% return on investment and immediate earnings accretion.

Rather than buy out the whole of PAL in one transaction, MFG has retained an option to buy the remaining 49.9% stake for a variable cash consideration of only two times average net profit, capped at £5m. The option can be exercised before PAL declares a dividend for FY26, which gives MFG time to rebuild the capital required to finance the deal through retained earnings.

The acquisition of the remaining 49.9% looks to be a potentially attractive option that could provide the company with further upside in earnings.

We outline below how the other two main business areas within MFG are similarly performing strongly during the current difficult economic environment.

During FY22, Conister Bank continued to grow its lending, adding £57.7m to its loan book totalling £292.1m (FY21: £234.4m). The bank retains a strong customer base in the Isle of Man (IOM). Lending to customers and small and medium enterprises (SMEs) reached a record £50.5m (FY21: £42.9m) with over 65% originating from the online portal (FY21: 60%).

Loan quality also remains stable as loans overdue by 30 days are in line with FY21 at 10.3% of gross loans and just above the five-year average of 9.9%.

The bank has shifted to secured lending over the past few years. Thus, Conister Bank was able to increase its structured lending in the UK by 34.8% to £150m (FY21: £114.1m), and at the same time hold lower loss provisions due to the collateral support.

To diversify funding and support its growth ambitions on the UK mainland, Conister Bank applied for a UK deposit-taking licence in October 2022. The regulator’s go-ahead is still pending, but the bank’s management has shown its confidence in the approval process by already staffing up operations and incurring an extra £1m in personnel expenses. The UK branch would give Conister Bank more flexible funding options and access to cheaper deposits to support its ambitions to grow in the UK, according to management.

The growth potential and relatively large addressable markets in its chosen lending segments have led management to guide to increased lending in H123 in comparison to H122. Through its structured finance lending in the UK and strong reputation in the Isle of Man, the group is well positioned to expand its activity in the UK in niche markets, be it organically or through acquisitions.

MFX Limited is the subsidiary of MFG that provides access to competitive foreign exchange and international processing facilities, serving predominantly SMEs in the IOM. Increases in global interest rates have resulted in increasing currency and interest rate volatility, on which MFX was able to capitalise. In FY22, MFX generated £1.74m in fee and commission income (FY21: £1.53m), generating a pre-tax return on assets of 260%, above the five-year average of 171%. This highly cash-generative business provides a useful counter-cyclical benefit to the group during periods of market and economic volatility.

Currently, there are no consensus forecasts for MFG. Exhibit 9 shows the market’s current relative valuation of the peer group based on 2022 figures. In our valuation we compare current price to FY22 book value (P/BV) against both reported ROE and an adjusted FY22 ROE figure using the three-month annualised contribution from PAL.

MFG shares trade at a P/BV ratio of 1.35x, calculated using a diluted share count. On a non-diluted basis, the P/BV for MFG is 1.01x. MFG trades at a premium to peers, which we believe is supported by a higher profitability on an ROE basis compared to the peer group (see Exhibit 9). Considering MFG’s FY18–22 ROE averaged 12.5%, the group remains attractively priced at book value.

Using either MFG’s disclosed full year PBT for PAL of £1.5m or the actual three months’ annualised profit would imply a pro-forma profit range for the group of £6–7m (15–35% above reported FY22 PBT).

In Exhibit 9, MFG* is the pro-forma figure for FY22 based on the actual three-month profit contribution from PAL.

Based on these assumptions, the implied adjusted FY22 ROE for MFG is 19%. Using the current valuation of 1.35x P/BV, and the reported 2022 ROE of 15.9%, the market is currently pricing in a cost of equity (COE) of 11.8% (COE = ROE/PBV) with no implied growth. Conservatively assuming zero growth, the same COE of 11.8% and adjusted FY22 ROE of 19%, the implied P/BV would be 1.61x, which is 19% above the current P/BV ratio.