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Diversify into Paragon at a discount

The alternative lender is diversifying its income and funding streams by placing its banking business at the core of its growth strategy
February 9, 2017

Shares in Paragon (PAG) took a hammering following the announcement of an increase in stamp duty for buy-to-let landlords at the end of 2015. However, we think the company's buy-to-let business looks relatively well insulated, and importantly, even before these changes were announced the challenger bank was already diversifying both its funding and revenue streams to tap into other areas of growth. Indeed, buy-to-let accounted for less than half the group's lending activities in the first quarter of the current financial year compared with nearly 90 per cent a year earlier. We think the progress being made diversifying the business means the extent of Paragon shares' discount to rivals is unwarranted.

IC TIP: Buy at 411.9p
Tip style
Growth
Risk rating
High
Timescale
Medium Term
Bull points
  • Diversifying revenue streams
  • Cheaper cost of funding
  • Strong balance sheet
  • Discount to peers
Bear points
  • High buy-to-let exposure
  • Credit cycle risk

Since establishing Paragon Bank three years ago, Paragon has accelerated the diversification of its income streams. In 2015 it entered the asset finance market by acquiring Five Arrows Leasing for £117m. The business, which lends to specialist UK small- and medium-sized enterprises (SMEs), has since been rebranded Paragon Bank Asset Finance. At the end of September 2016 the asset finance business had a loan book of £250m, up almost a quarter on the time of its acquisition 11 months earlier. In September Paragon Bank bought specialist asset finance broker Premier Asset Finance to help expand the business. And during the first quarter of Paragon's 2017 financial year the asset finance operation made £56m of new loans, which represented 15 per cent of the total.

 

 

Acquisitions are also being used to grow the bank's second charge mortgage book (second loans secured against a property), which stood at £305m at the end of September. Organic new loans were £45m during the last financial year, up from £15m in 2015, and a further £13.6m was lent in the first quarter. At the financial year-end, average loan size was £57,000 and the average loan-to-value ratio stood at 69 per cent. A further £185m in second charge mortgages was acquired via Paragon's debt purchasing business, Idem Capital, late last year. At the end of September none of the second charge mortgages written by Paragon Bank were in arrears and just 5 per cent of the acquired loans were in arrears. This is compared with an industry average of 12 per cent, according to the Finance and Leasing Asociation.

Paragon Bank has been busy entering other areas of lending, too. Last year it started offering finance for small-scale property development, for builders that may not be able to gain credit from mainstream banks. It made £10m of such loans (2.7 per cent of the total) in the first quarter. It also provided £21m of car finance in the quarter. And the bank is planning to launch its residential mortgage product to a wider distribution network during the course of this year.

The funds used to back loans are being diversified, too, as Paragon funnels more business through its bank, in order to take advantage of the lower cost of funding available via retail deposits. This marks a switch away from financing its lending through the wholesale markets. At the end of 2016, retail deposits at Paragon Bank stood at £2bn, double where they started the year. This supported a fourfold increase in the bank's loan book last year to £1.69bn. Part of this growth reflects more buy-to-let business being channelled through the bank, with wholesale-funded Paragon Mortgages buy-to-let loans falling from £977m to £600m last year while the bank's buy-to-let lending jumped 60 per cent to £562m.

While buy-to-let is becoming a less important source of new lending, it is still significant for the group and accounts for around 90 per cent of outstanding loan balances. That means the increase in stamp duty on second properties has had an impact on investor sentiment as well as new loan volumes. Indeed, total buy-to-let mortgage sales declined by around £150m to £1.16bn last year. And while first-quarter lending of £185m was up on the previous three months, it was less than half the £400m achieved a year earlier when buyers were rushing to beat the tax changes. However, Paragon's focus on professional investors should help insulate it from the rule changes and the buy-to-let pipeline of business has been recovering strongly off summer lows. This stood at £640m at the end of December 2016, twice what it was at the end of September.

PARAGON GROUP OF COMPANIES (PAG)

ORD PRICE:411.9pMARKET VALUE:£1.14bn
TOUCH:411.8-411.9p12-MONTH HIGH:420pLOW: 225p
FORWARD DIVIDEND YIELD:3.9%FORWARD PE RATIO:9
NET ASSET VALUE:346LEVERAGE:15.5

Year to 31 DecTurnover (£m)Pre-tax profit (£m)*Earnings per share (p)*Dividend per share (p)
201419812230.59
201521213534.811
201624414740.913.5
2017*25614642.814.3
2018*27715647.815.9
% change+8+6+12+11

Normal market size: 5,000

Matched bargain trading

Beta: 0.48

*Shore Capital forecasts, adjusted EPS and PTP figures