Just before the half year end the company sold off 6m shares of its holding in fast growing unsecured lender Secure Trust Bank (STB:2,130p). The shares were sold at 2,500p each and realised £148m of cash proceeds after expenses, representing a net gain of £100m. The share sale has reduced the company's stake in Secure Trust from 51.9 per cent to 18.9 per cent and means its remaining holding of 3.43m shares is worth £73m at current prices.
In addition, Secure Trust’s disposal of its Every Day loans business at the end of 2015 generated a gain of £117m which, together with Arbuthnot’s £9.1m share of Secure Trust’s ongoing profits up to mid-June 2016, meant that the bank’s profits from discontinued operations of £228m exactly match Arbuthnot’s own market capitalisation. A consequence of the hefty gains made was to deliver EPS of 1,111p and boost net asset value by over £100m to £282m, a sum worth 1,852p per Arbuthnot share or 21 per cent more than the current share price.
Shareholders have been rewarded with a special dividend of 25p a share which was paid at the end of last month, and a raised interim payout of 13p a share (ex-dividend date of 1 September). This means that the bank has also paid out total dividends of 70p a share since I included the shares in my 2015 Bargain shares portfolio at 1,459p. I last updated the investment case in early June at the time of the Secure Trust disposal when the price was 1,597p (‘Banking on solid gains’, 1 June 2016), since when it has paid out that 25p a share special dividend. The fact that the shares are only down fractionally since then tells a story in itself given the far heftier falls post Brexit in the share prices of the UK's challenger banking sector.
Scaling up operations
The plan now is to use the cash raised to develop its private and commercial banking business, Arbuthnot Latham. Bearing this in mind, the division posted half year pre-tax profits of £4.5m on a 15 per cent hike in operating income to £19.4m. It’s well funded as customer deposits of £939m cover loans and advances to customers more than 1.4 times over and this liquid funding and balance sheet strength is highly supportive of the ongoing double digit growth in loan balances. Deposits have increased by 23 per cent in the past 12 months as the bank continues to attract new clients and at a lower deposit rate of 0.87 per cent in the first half this year, down from 1.04 per cent in the same period in 2015, reflecting the desperate search for yield on deposits by customers in the current low interest rate environment. As long as Arbuthnot Latham can recycle these deposits into high quality lending and commercial and private banking activities at an economic net interest margin then this it will be value accretive to the bank’s shareholders. Impairments were a miniscule 0.12 per cent of loans in the first half on an annualised basis, highlighting the quality of the book.
Also, assets under management have risen by 14 per cent to just under £800m in the past 12 months, and increasing penetration of wealth management products is a target area for the bank to boost related fees. Arbuthnot Latham already has the customer base, so expanding the product range and cross selling to them should be good source of incremental growth.
Investment in additional private bankers, and the establishment of a presence in Manchester and Exeter to augment the teams in London, means that headcount will hit 30 by the end of the third quarter including 17 relationship managers with more than 20 years commercial banking experience.
Property deals to boost profits
I would also point out that Arbuthnot has made substantial gains from property over the years, so it’s worth noting that £53.4m of the £148m raised from the Secure Trust share disposal has been invested in a property in the prime location of 20 King Street in London’s West End. The purchase price was £50.2m (with associated costs of around £3.2m) and the property has a current net annual rental income of over £1.8m, so the initial gross yield is 3.4 per cent. The property comprises 22,500 sq ft of office space and 7,000 sq ft of retail space. The premises should enable Arbuthnot Latham to develop its presence in the West End, occupying part of the property for client purposes, but for now the property is purely an investment property and one that will make a very useful contribution to the bank’s bottom line.
Substantial balance sheet firepower
Clearly, there is substantial balance sheet firepower to be deployed on expanding its operations. To put this into perspective, analysts at research firm Hardman & Co estimate that Arbuthnot has a core Tier 1 ratio of 40.5 per cent and equity to assets ratio of 22.4 per cent. However, if the core Tier 1 ratio was reduced to around 12 per cent, and leverage ratio cut to 6 per cent, then this would imply surplus capital of around £150m to be redeployed.
Assuming all capital is retained and used for organic growth, and with some incremental profit growth, Hardman believe that it could support 50 per cent higher risk weighted assets than its base case scenario and support additional lending of £200m in 2017, £500m in 2018 and £900m in 2019. Applying a 3 per cent net interest margin, 30 per cent marginal cost income ratio, and a loss ratio of 0.7 percentage points to average loans (a higher than current rate given the new SME lending being targeted), then Hardman believes Arbuthnot’s expected profits would rise sharply to around £33.5m by 2020, or two thirds higher than their base case. And there are deals to be done because Arbuthnot is a prime buyer for sellers of loan portfolios in the range of £25m to £250m.
Moreover, with the benefit of a relatively low funding cost, loan book acquisitions should be immediately earnings accretive and a material source for growth as proved to be the case with the opportunistic acquisition of Dunfermline Building Society’s £106m loan book from the administrators in December 2014. That deal was priced 10 per cent below the level of outstanding mortgages even though the average loan-to-value ratio was 72 per cent and the book was geographically well spread and over half was in buy-to-let mortgages.
Impact on profits
Of course, projecting how quickly Arbuthnot’s profits will ramp up is nigh on impossible as it is clearly dependent on the exact timing of investments made and their nature too. However, analysts at Hardman believe that based on a 26 per cent rise in operating income to £52m in 2017, the bank’s adjusted pre-tax profits will increase from £6.9m to £11.8m and boost EPS from 30p to 69p. The respective figures for 2018 are operating income of £66m, pre-tax profits of £15.9m and EPS of 95p.
I would also point out that another benefit of the Secure Trust sale and de-consolidation of that investment in Arbuthnot’s accounts is that the banking group’s taxable profits will fall below the £25m threshold for the 8 per cent bank corporation tax surcharge. Hardman estimate the saving will be in excess of £1m in 2017, rising rapidly thereafter.
So, with Arbuthnot’s balance sheet undergeared, the company ready to deploy its hefty cash windfall from Secure Trust, and the shares trading 17 per cent below book value, there is obvious value on offer and I reiterate my buy recommendation. A move to last summer's all-time high of 1,650p and beyond is warranted, the catalyst for which is likely to be news on loan book acquisitions and likely earnings upgrades. On a bid-offer spread of 1,490p to 1,530p, I rate the shares a value buy.
