Secure Trust Bank — Solid FY20, ready for growth

STB is a specialist bank with a strong growth profile that had been shifting into a lower-risk lending mix ahead of the pandemic. This was being driven by market conditions and Brexit concerns. The bank was quick to adjust to new lending conditions due to the pandemic while the UK government and central bank provided important support measures. As a result, impairments came in lower in FY20 than expected as did loan payment holidays. Loan volumes did decline (especially in motor finance, which was more affected by the lockdown) but recovery in some segments (such as commercial finance) before the end of the year led loans to be down only 4% y-o-y on FY19. Interest margins held up while cost cutting led the cost to income ratio to drop 57% to 55%. As a result, while FY20 PBT was down almost 50% on FY19, it still ahead of our forecasts by more than 50% and the reported ROE of 6.2% showed good business resilience.

The latest lockdown is impacting business this year. However, the successful vaccine roll-out leads to expectations of a likely return to more normal trading conditions this year, particularly in the second half. We expect UK government and central bank to continue to be pragmatic in their support measures and we do not envisage an economic cliff-edge scenario where this support is removed excessively quickly or in a disorderly fashion. We expect that STB’s loan growth will be relatively modest in FY21 (forecast 4%). We forecast that a decline in impairments (from 2.3% to 1.6%) will help drive ROE to 7.8% in FY21. We introduce FY22 forecasts, and we expect loan growth to increase to 15%, interest margins to remain stable and a ROE of 11.1%. STB’s Common Equity Tier 1 (CET1) is 14.2% which allows STB room to expand its balance sheet. The bank plans to explore possible value-accretive M&A opportunities in addition to organic growth. In its disclosed mid-term objectives, management has included a ROE of 14–16% with a CET1 of more than 12%.

We have increased the FV from 1,756p per share to 2,163p after rolling forward one year. We discount the PV 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%, 10% in COE and 2% annual growth.

STB reported PBT of £20.1m well ahead of our forecast of £13m. Earnings were about half of what was achieved in 2019; but the fact that STB managed to deliver a return on equity (ROE) of 6.2% with the challenges of such an unusual year is quite salutary. The key positive surprise was the lower than expected loan impairments, which are in part due to the government support measures including the job furlough scheme.

The reported earnings, strengthened capital base, proven business model and management’s confidence in the outlook led management to declare a surprise dividend of 44p per share.

Net interest income grew 4% y-o-y in 2020, similar to our forecast of 5%. Net interest margins remained sturdy at 6.3%. Interest margins received some support from lower interest rates on the funding side, but STB also protected its margins on the lending side.

Fee income inevitably suffered from lower new business volumes. Net fees (and commission income) declined by 24%; however, they were actually 8% above our forecasts. Total operating income held up during the crisis and was flat at £166.1m and was similar to our forecast of £167m.

Operating costs fell 3% as a result of cost cutting and some investment reduction and this allowed pre-provision profit to grow 4% y-o-y in a difficult year. The cost to income ratio was 55%.

Total loan impairments were 2.1% of average loans, or 2.3% adding the losses on loan modification due to payment holidays. We were forecasting 2.4% and 2.7%, respectively.

The good impairments performance was helped by STB having already a relatively cautious lending stance coming into the pandemic and then it reacted quickly as the outlook deteriorated because of the pandemic. In addition to this, the UK government’s support measures, notably the extension of the employment furlough system in the second half of 2020, were supportive. The good asset quality trends were already flagged by the bank’s management in its trading update in October and the pre-close statement. The motor and retail finance loan payment holidays came down sharply from their peaks in May 2020. Retail finance holidays peaked at over 2% of loans and were only 0.5% at the end of 2020. Motor finance payment holidays reached almost 15% and dropped to only 1.2%.

Although there was a 4% decline in total loan balances in 2020, we note that the loan book was flat in the second half of 2020 if we exclude the two non-core books (asset finance and retail mortgages, which combined represent 3% of loans) being run down.

Real estate loans grew 9% y-o-y in FY20 driven by existing deals, but the pace of growth slowed down in the second half of the year with STB’s increased caution. The trend was different in some of the other books. Commercial finance was initially hit very hard by the lockdown and loans fell 24% in the first half of 2020. Commercial finance lending (essentially invoice discounting) then rose 20% in the second half of the year as business picked up with the end of the first lockdown and also adjusted to new trading conditions. Commercial finance loan balances nevertheless dropped 8% y-o-y in FY20.

Consumer loans fell 12% y-o-y in 2020, with motor finance (-25% y-o-y) particularly hard hit by the lockdowns, which have closed car dealerships. Lending in retail finance fell 4% y-o-y, with lending volume recovering in the second half of the year. These lending trends had already been highlighted in previous statements and we believe were expected by the market.

The loan book profile at the end of FY20 is shown below. Commercial real estate (70% for investment and 30% development) is now almost half of the loan book, while retail (V12, point of sale) lending represents 28% of the loan book.

STB’s CET1 ratio rose from 12.7% in FY19 to 14.2% in FY20. We had forecast 13.9%, the difference being mostly the higher than forecast earnings. Retained earnings and the balance sheet reduction drove this increase. The Bank of England’s IFRS 9 transitional capital relief measures provided a 20bp boost to CET1 in 2020. As it currently stands, we see the CET1 as not only comfortable but also allowing STB to be in a position to resume significant balance sheet expansion as well as explore M&A opportunities. Balance sheet liquidity remains good and the loan to deposit ratio was 118% at the end of FY20.

The successful vaccine rollout and the roll back of lockdown conditions provides a strong light at the end of the tunnel. Risks still exist to this progression, for example new variants may alter the outlook. There is also the uncertainty regarding the impact on the economy and banks as central bank and government support measures (such as the job furlough scheme) come to an end.

Our view is that there will be no cliff-edge scenario where an unfavourable economic shock is created by a hurried and early end to these support measures. We believe that lessons have been learnt from the previous economic crisis of 2007–8. The UK government and the central bank have been very pragmatic in their support and we see no reason why this will not continue. We think great care will be used in the tapering of support.

Having said this, it is inevitable that there will be an increase in the unemployment rate and this is a key factor for nonperforming loan (NPL) formation for banks and for STB. Exhibit 5 shows the latest collected consensus forecasts: a 1.1% percentage point increase is forecast in UK unemployment at the end of 2021 (to 6.2%). This does not seem extraordinarily difficult for STB to manage and we note that earlier forecasts in mid-2020 suggested that unemployment would already exceed 8% by the end of 2020. The company’s internal scenarios forecasts are discussed and shown in the ‘Impairment internal scenarios’ section on page 7.

The lockdown in H121 is affecting lending, especially in the consumer lending segment. We expect loan growth will be stronger in the second half, particularly in motor lending. STB management is still not issuing guidance due to the uncertainty in the shape of the economic recovery. However, it obtains confidence from the proven resilience of its diversified business model and the strong balance sheet.

We expect STB to be able to return to growth once lending conditions improve and the economic outlook becomes clearer.

The message when David McCreadie was appointed as STB’s new CEO in January 2021 was of a seamless transition and that the core growth strategy of organic expansion and M&A opportunities was expected to remain the same.

As the economy emerging from this crisis, management sees the bank as well positioned to explore and capitalise on opportunities. The bank has operational scalability in its lending segments, comfortable capital ratios and expected good profitability to help fund growth. At the same time (and despite the surprise dividend payment announcement) the pay-out ratios may need to be revised downward to support identifiable growth opportunities We believe that this may lead to pay-out ratios perhaps not being as high as the c 50% in the past if management does not believe it is in the best interests of the bank.

STB management has disclosed several medium-term performance targets for the group: (1) a net interest margin of 6.0% (FY20: 6.3%), (2) a cost to income ratio of 50–55% (FY20: 55.1%), (3) an ROE of 14–16% (FY20: 6.1%) and (4) CET 1 ratio of more than 12.0% (FY20: 14.2%).

These targets 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 cost of equity (COE) (we use 10% as the benchmark), while maintaining a solid capital base. And as we discuss later in the valuation section, this would result in considerable upside potential in the share price, which is currently only trading at a price to book value (P/BV) multiple of 0.79x. Exhibit 6 shows the historical ROEs with our two years of forecasts. STB’s returns have always been above 10% except for FY17 (8.9%) and this was only because the bank was still carrying significant undeployed capital after some asset sales. The CET1 ratio in FY16 and FY17 was 18.0% and 16.5%.

A core part of the strategy is to continue to focus on lending to high-yield niches where the cost of risk is appropriately remunerated. Management also aims to simplify the business and this involves continuing with running off the mortgage and asset finance books.

Management is also keen to increase the leveraging of its technological platform and investments. Technology is an important factor in client connection and service delivery in segments such as motor finance and retail finance as well as STB’s savings product. For example, the technology platform in the Motor Finance division allows STB to receive applications, make automated decisions, facilitate documents production through to the pay-out to motor dealers and also then manage in-life loan accounts.

The Exhibit 7 summarises STB’s outlook comments by business area as disclosed in the annual management report.

STB will organise a capital markets day in the second half of H221 where it will introduce leaders of the various business units, providing insight on the same and update on its progress and growth ambitions.

The continued lockdown in 2021 has been having an impact on STB’s business. We are making a downward revision to our loan balance forecasts for 2021 by 4% to £2,480m. This still represents a 5% increase from FY20. We expect most of this growth to come in the second half of the year after the lockdown ends and there is a return to something closer to normal in terms of business conditions.

We have also introduced estimates for 2022 with a forecast of a 15% increase in loans. We are assuming that consumer finance (motor and retail) and commercial finance will be growing in the mid-teens in 2022. After being more resilient during the pandemic, we are assuming that the commercial real estate finance will be growing at single digits. Exhibit 8 details our assumptions.

Exhibit 9 shows our impairment assumptions. STB management expects impairments to decline significantly in 2021. We are assuming they decline from 2.1% (2.3% with loan modification losses) down to 1.6% in 2021 and then further down to 1.5% in 2022. When making the comparison with previous years, the motor finance lending business has moved from a sub-prime to near-prime segment.

We think there is risk to the impairment forecasts due to general macro risks and the aforementioned uncertainty of how unemployment in particular will react to the tapering of government support. The IFRS 9 impairment rules do encourage companies to front load their provisioning by looking at expected losses throughout the life of the loan as opposed to current conditions. But this does not mean that initial provisioning levels may end up being optimistic, especially if there are worse than expected macro developments.

STB does have the advantage of a relatively short duration in its lending book that allows the bank to more quickly adjust to lending conditions. This also means that problems tend to occur and be seen earlier rather than build up on the balance sheet and result in later, but larger adjustments.

STB discloses a range of forward-looking scenarios that it uses internally under IFRS 9 to help it set provisioning levels. The scenarios and their weightings help calculate the probability of default (PD) and the consequent expected credit loss (ECL). Exhibit 10 shows STB’s four scenarios with varying levels of unemployment and house price movements, which reflect different degrees of severity in the economic recession.

In our view, unemployment is the single most important factor in loan loss creation, and we draw some comfort from the fact that the peak unemployment assumptions that STB uses are higher than the 2021 year-end consensus expectations in all IFRS 9 scenarios except the ‘low’ scenario.

STB estimates that if it had changed the weightings of the above scenarios to 100% severe case, it would have resulted in an additional £15.7m in impairments in FY20. This would involve heavier estimated impairments in Retail Finance, Motor Finance and Business Finance (as shown in Exhibit 11). On the other hand, a 100% weighting on the low-case scenario would have led to an £8.9m reduction in impairments. To put this into context, STB reported operating profit of £74.5m before impairments in FY20 and £54.5m in impairments (including the payment holiday-related value adjustments). Therefore, in its 100% weighted internal worst-case scenario, STB would have still reported a positive PBT (theoretically £4.4m, all other things being equal).

Assuming a 25% tax rate, the £15.7m of impairments would be only a 55bp hit to STB’s CET1 of 14.2%; this is an amount easily absorbed by the capital.

We continue to value STB on an NAV approach using the (ROE-g)/(COE-g) formula. The assumptions are the same: 13.5% sustainable ROE, 10% COE and a 2% increase in long-term earnings. We have assumed that this valuation is for end FY22 when the earnings will have started to normalise. We then discount this value back to end FY21 using the COE as the discounting factor. The FV has increased from 1,756p to 2,163p reflecting moving forward one year. This is equivalent of a P/BV of 1.42x compared to the current 0.79x, suggesting significant upside to fair value.

STB is still trading below its book value despite its track record of value-creating ROEs. And while we are forecasting an ROE below its COE (we use 10%) for FY21 at 7.8%, we estimate it to be above this at 11.1% already in FY22.

Exhibit 13 compares STB’s market multiples with some of its peers. The valuations and forecast earnings continue to be heavily affected by the COVID-19 restrictions and economic outlook. The FY20e P/E comparisons are of limited usefulness due to the depressed earnings of the companies and the high degree of uncertainty in broker forecasts. The FY21 numbers are closer to cruising speed, but impairments are still elevated. STB is trading at a similar P/E to its peers (10.5x vs 10.3x, we remove Metrobank from the average since it is loss making). STB’s dividend yield is twice as high as the peer average. Its consensus forecast FY21 ROE is 14% lower than its peers yet it is trading on a significant P/BV discount of 30%, 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 FY20 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.

Following the 6.2% ROE in FY20, we are estimating ROEs of 7.8% in FY21 and 11.1% in FY22. We estimate that STB’s PBT will rise from £20.1m (FY20) to £27.4m (FY21) and then £41.5m (FY22).

The decline of loan impairments from their cyclically elevated levels will be a significant driver of the increase in earnings as the they are modelled to decline from 2.7% of loans to 1.5% in FY22.

We are assuming interest margins remain relatively stable in FY21 and FY22 and net interest income will therefore be mostly driven by balance sheet expansion in the coming years. We are estimating a small decrease in net interest income (-3%) in FY21 as a carry-on effect from the contraction of the lockdown. We estimate an 14% increase y-o-y for net interest income in FY22.

Net fees will pick up more noticeably than interest income as new business volumes pick up. We forecast fee growth of 23% and 21% for FY21 and FY22. We are assuming a cost to income ratio of 60.8% in FY21 and 57.0% in FY22 with the rise in operating expenses in FY21 reflecting STB investing for growth.

We estimate that the CET1 ratio will move from 14.2% (FY20) to 12.8% (FY22) with a 40% dividend pay-out ratio assumption. The bank’s capital position therefore is expected to remain strong and clearly STB can afford to grow more than we are estimating should management choose. STB’s relatively good profitability and its high capital starting point of 14.2% permits this flexibility to comfortably grow the balance sheet.