Secure Trust Bank — Upbeat update

The message from the update was clearly that Q3 had been stronger than expected with respect to asset quality, repayment holidays and loan demand. STB disclosed that it is ‘significantly ahead’ of consensus FY20 PBT forecasts. The consensus average is £2.2m and ranges from a loss of £14.8m to a profit of £9.7m; our estimate is £6.6m.

Repayment holidays have come down dramatically in the Motor and Retail Finance divisions where they were centred. Motor Finance repayment holidays peaked at 19.3% in mid-summer and were only 0.9% by 30 September. Retail payment holidays fell from a peak of 2.6% to 0.7%. Given that credit concerns are a key factor weighing on STB’s shares (as is the case with most UK banks at the moment), this is very welcome news.

STB’s update disclosed that that Motor Finance demand ‘has been strong’ and that ‘used car prices also held up’, which is further good news. STB opened its prime car lending business for customers on 1 October 2020 but the impact on lending balances will initially be limited due to lending caution. However, this is an important step in repositioning Motor Finance from sub-prime into near prime and prime segments.

Retail Finance lending is back to close or at pre-COVID-19 levels despite the ‘significant tightening of credit criteria’.

Invoice lending is up 10% from 30 June 2020 and looks on track to meet our estimate of a 15% increase from 30 June 2020 by the end of December 2020.

The capital and liquidity outlook had been previously fine, so STB’s comment that these remain good is of relatively little surprise. STB also highlighted that its deposit funding costs are coming down with lower interest rates. Besides lowering its own funding costs, the current very low interest environment narrows the funding cost disadvantage STB has compared to the large UK commercial banks.

With the pandemic and Brexit uncertainty remaining relatively high, STB maintains its suspension of formal guidance to investors, notwithstanding the upbeat trading update. STB will continue to review forward-looking scenarios and the resulting appropriate IFRS 9 provisioning.

We have made some adjustments to our forecasts to reflect the Q3 update. At the same time, this upgrade comes against a backdrop of suspended formal guidance and with aforementioned pandemic and Brexit uncertainty. Credit quality remains the key risk to forecasts despite STB’s resilient performances to date.

On the balance sheet we have reduced the loan forecasts by 5% in FY20 with a similar knock-on effect for FY21. We now estimate loan balances will contract 5% in FY20 (previously 0%) and then grow 10.6% (previously 10.7%) in FY21. This was mostly due to pencilling in lower loans in the real estate division (£990m vs £1,075m, previously). This portfolio has been doing well, but STB had several loans repaid in full and the bank has been exercising caution in the current lending environment.

We are raising our FY20 PBT from £6.5m to £13.0m. This driven by a £10.2m reduction in impairments from £73.6m (including £6.6m in loan modification charges) to £63.4m. As a percentage of loans, impairment charges were cut from 3.0% to 2.7%. The lower impairment forecasts are mostly attributable to the Motor and Retail Finance segments. Our previous forecasts had assumed a further deterioration in the impairments and credit quality in H220 and this does not seem to be happening.

The Motor Finance impairment charge assumption has changed from 10.2% of loans for FY20 (this was 9.7% at half year and thus implied 10.7% for H220) to 8.6% (thus 7.2% for H220). The impairment charge assumption was cut from 6% of loans to 5.5% for FY21.

In the Retail Finance division, the cut was from 4.3% of loans for FY20 (which implied 5% in H220) to 3.7% (and 3.8% for H220). FY21 retail finance impairments assumptions were reduced from 4.2% down to 3.7%.

Under the IFRS 9 rules, impairments are front loaded, with banks having to provision for expected credit loss (ECL) during the entire life of assets instead of the previous ‘incurred loss’ framework. This has the effect of basically penalising a marked acceleration in new business in higher-margin consumer lending. This is an IFRS 9 model charge that will act as a drag on profit (as opposed to actual loan loss experience) as STB scales up, particularly in the near prime motor finance loan portfolio. The contraction in motor finance in FY20 has had the opposite effect on the estimated impairments.

The estimated CET1 for FY20 has increased from 13.1% to 13.9% (it was 13.5% in H120) due to earnings and loan balances adjustments.

STB’s valuation situation has not really changed in recent months. The market continues to be concerned with impairments risk on bank earnings and has been marking down the sector. There are also concerns regarding sector interest margin due to the low interest rates. This has contributed to STB currently trading on an FY20e P/BV multiple of 0.53x (0.56x excluding intangibles) despite its track record of delivering value-creating returns, ie ROE above its COE (we use 10%).

Under our current assumptions we estimate an ROE of 3.9% in FY20 and 9.1% by FY21. We believe that from FY22 STB should be back to posting ROE above 10% and hence we think that a premium to book value and not a discount would be fairer. The Q3 trading update also indicates that STB is less likely to have losses or capital destruction that would justify a discount to book value. We also note that due its lending profile, STB is less exposed to the current low interest rates on the asset side than the large UK commercial banks.

The good news from this Q3 update should provide some relief to investor concerns, but we think that it might be the case that we need greater clarity on both the pandemic and Brexit trajectories before fundamentals start to be more realistically priced into STB’s share price.

We value STB based on an NAV approach using the (ROE-g)/(COE-g) formula. We have maintained our assumptions of 13.5% sustainable ROE, 10% in COE and used a 2% increase in long-term earnings growth. 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 FY20. We have assumed no dividend payments in FY21 and FY22. This is very conservative, since we think there is a good chance that STB will pay dividends in 2021 and this will be quite likely in 2022. Besides our explicit forecasts for FY20 and FY21, we have assumed an 8% addition to equity in FY22 from retained earnings.

This results in an FV of 1,756p per share, slightly higher than the 1,704p in our August note. The slight increase is due to the book values for FY21 and FY22 being slightly higher due to our earnings upgrades. The FV is more than twice the current share price of 762p and implies an FY20 P/BV of 1.2x.

Exhibit 4 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. However, we note that on pre-COVID-19 earnings, STB is currently trading at a significant discount of 22% below its peers. STB’s share price has fallen more than its peers as seen in Exhibit 5. STB is also trading at the largest discount of 29% to its peers on the basis of the last reported P/BV (0.55x vs 0.78x), yet it delivered an ROE of 13.4% in FY19, well above (31%) above its peers.

STB is a well-capitalised bank with a good business model that is still intact and that has shown resilience so far during this crisis. We therefore believe that market multiples suggest room for the share price to recover strongly as clarity improves and as we move through the recession and the pandemic.

We note that STB’s CEO, Paul Lynam, increased his holding from circa 60,000 to circa 70,000 shares on 26 October 2020 and is now one of bank’s top 20 shareholders.