The valuation seems even more anomalous once you consider that Arbuthnot raised £75m in the summer by selling down its stake at around Secure Trust’s current share price, so there is clearly demand for those shares. Indeed, Secure Trust also raised £48.8m by placing equity at the same price to institutions. That share placing was well received and the new investors are already enjoying a positive return on their investment. It’s justified too.
Secure Trust motoring
In the third quarter this year, Secure Trust Bank’s new lending volumes soared 87 per cent year-on-year to take the total loan book above £500m for the first time. The company’s Solihull-based motor finance business has been accelerating, reflecting strong consumer demand for car loans as the UK economy recovers. In fact, the UK new car market has recorded 31 consecutive months of growth, breaking the record set in the late 1980s. New car registrations were up over 5 per cent to 425,000 last month, recording the best September for a decade. This is clearly good news for the motor finance market which is Secure Trust’s main area of speciality.
Other key areas of growth in the third quarter include real estate lending to property developers on a short-term basis and with prudent loan-to-value levels; a recently launched invoice finance operation; cycle loans; and a season ticket financing product.
Funded for growth
Importantly for a company growing so quickly, Secure Trust funds its lending from a deposit base and is not reliant on wholesale money markets. At the end of last year, customer deposits of £436m covered customer loans of £391m and by the end of June its £448m loan book was being funded by £476m of customer deposits. New lending to its borrowers is being funded by additional two-year, four-year and seven-year fixed rate deposits from savers in order to mitigate the impact of interest rates rising faster than the market is pricing in. It also means that the maturity of Secure Trust’s loan book can match that of its deposit base, so removing both funding and interest rate risk.
This funding structure has obvious attractions right now as it not only creates a decent net interest margin for Secure Trust to profit from, but it takes advantage of the current low interest rate environment and the desire of savers to search for yield. Moreover, this environment is set to last for some time yet. That’s because even when the Bank of England starts raising base rates, any rise will likely be modest.
It’s equally important that credit quality is sound and lending practices are prudent. On this score there are no concerns. Impairment charges are well below the level expected when the loans were originated and, after factoring in the July equity raise, the company’s Tier 1 Capital Ratio is 31 per cent, making Secure Trust Bank one of the most strongly capitalised banks in the UK. Its leverage ratio (calculated as total customer lending divided by equity capital) was three times greater than the minimum requirement at the end of June and that was before factoring in the additional £48m of equity issued in the July placing.
A profit surge
So with the business motoring ahead, Secure Trust now expects profits this year to be at or above the top end of current market estimates. Before yesterday’s trading update, analysts Mark Thomas and Martyn King at equity research house Edison Investment Research predicted that Secure Trust’s operating income will rise by almost a quarter to £96.7m in the 12 months to December 2014 to lift pre-tax profits from £25.2m to £30.3m. On this basis, expect EPS of 135p and a dividend of 65p, up from 118p and 62p, respectively, in 2013. These estimates will be at least matched if not exceeded now.
Moreover, there should be upside potential to forecasts for 2015 given the momentum being seen in the business. Edison had been forecasting operating income of £125m, pre-tax profits of £39.8m, EPS of 160p and a dividend of 68p, but the risk here looks to the upside. But even without upgrades, a prospective PE ratio of 15.8 for 2015 is good value for a company forecast to generate 19 per cent annual earnings growth next year. That equates to a PEG ratio of 0.8. A prospective dividend yield of 2.7 per cent is also attractive which helps to explain why Secure Trust’s shares have been so resilient in the market shake-out.
Valuation anomaly
The strength of Secure Trust’s business certainly makes the current stock market valuation of Arbuthnot stand out. That’s because not only are Arbuthnot shareholders in effect getting shares in Secure Trust Bank on the cheap, but they are also getting the company’s 180-year old private banking arm, Arbuthnot Latham, in the price for free. That unit is expected to report pre-tax profits of £2.5m this year, rising to £3.5m next, buoyed by fee income from assets under management and the pay-off from new offices including one that opened in Dubai.
And Arbuthnot looks on course to deliver that profit growth next year. Not only has the bank been enjoying a good flow of new client introductions which has been boosting funds under management, but the company revealed in yesterday’s trading update that the Dubai operation is bang on track to break-even next year too. As a result Arbuthnot’s board now expects the company to exceed Edison’s EPS estimate of 90p this year. It also means that analysts’ EPS forecasts of around 114p next year are looking very reasonable. On this basis, Arbuthnot shares are rated on a modest 10 times EPS estimates, a third less than Secure Trust even though Arbuthnot owns half that company.
In the circumstances, I feel that the risk:reward ratio continues to favour a rerating of Arbuthnot to correct this valuation anomaly. In my view, a much fairer valuation for the company’s equity is 1,500p a share, or 35 per cent above the current offer price. Needless to say I rate Arbuthnot shares a buy on a bid-offer spread of 1,090p to 1,125p on a 12-month basis.
Please note that I initiated coverage on both companies in the summer (‘Bank on a valuation anomaly’, 2 July 2014). Shares in Secure Trust Banking were priced at 2,439p at the time and those of Arbuthnot were being offered in the market at 1,190p, around 5.5 per cent higher than the current offer price. In the past 15 weeks, the FTSE Aim index has fallen 12 per cent, so both Aim-traded companies have shown relative strength against their benchmark.
■ Simon Thompson's book Stock Picking for Profit can be purchased online at www.ypdbooks.com, or by telephoning YPDBooks on 01904 431 213 and is being sold through no other source. It is priced at £14.99, plus £2.75 postage and packaging. Simon has published an article outlining the content: 'Secrets to successful stockpicking'
