Paragon stronger than investors think

Though it is was founded in 1985, Paragon is like the new generation of banks in that it does not offer customers day-to-day clearing services. Instead, it focuses on consumer and small business loans, with a bias towards buy-to-let (BTL) mortgage lending and fixed rate offer savings.

Mortgages still comprise most (around £12bn) of the £14bn total loan book. While this contributes the largest slice of total profits, mortgages’ net interest margin (NIM) is just 2.07 per cent – even if this is up from 1.69 per cent in 2019. But with mortgage rates now rising, and rising faster than deposit rates, the NIM should increase – albeit there is an inevitable lag in rising market rates flowing through to revenues because most loans are on a fixed-term, fixed-rate basis.

Slowly, the historic bias towards mortgages is shifting, and lowering the group’s reliance on a cyclical housing market. Commercial loans are just 12 per cent of the loan book, but advances here have grown by a third since June 2019 (versus 11 per cent in mortgages). Two-fifths of these are in development finance for real estate, with another third in general SME business loans, 15 per cent in motor finance and the rest in structured finance. All told, commercial lending generates a NIM of 6 per cent, which translates to net profits being around one-third the level of mortgages. The strategy is to continue growing this division at a faster rate than residential loans.

All loans require capital. However, an inherent problem for a small bank is that a relatively small balance sheet limits the amount of business it can write. Since becoming a bank and a deposit taker in 2014, the bulk of the funds available to Paragon come from savers’ deposits, as well as funds from the Bank of England. This balance will still need to be repaid and replaced before the end of 2025, and arguably should be done sooner as the interest cost on the funds equals the fast-ascending BoE base rate.

Another potential funding source is securitisation, whereby a collection of loans is bundled up and sold to external investors. While Paragon was once one of the big issuers of UK mortgage-backed securities, its reliance on issuance has sharply fallen in recent years.  

Mortgage market enters rough waters

After an unexpectedly bright couple of years, powered by tax breaks, an urban exodus, excess savings, benign borrowing conditions and the continuing transfer of intergenerational wealth, the UK mortgage market now faces a much trickier time. For lenders, negative forces include potentially falling demand, a tougher wholesale market and higher default risk.

Paragon should be able to handle each. Tighter household finances will more likely affect private buyers than renters, meaning landlords should benefit from higher rental demand. Higher wholesale costs should be mitigated by increased saver deposits. And lower loan-to-value (LTV) ratios should offset higher default risks: the average LTV across Paragon’s portfolio now sits at 57 per cent and just 1.6 per cent of the lender’s loans have an LTV rate of 80 per cent or higher.

Though BTL is unlikely to survive tighter market conditions unscathed, unreleased provisions taken against Covid risks mean Paragon’s balance sheet can absorb fresh distress in its core market.

BTL lives on

Reports of the death of the BTL market’s – made repeatedly since a series of tax changes started to be introduced in 2017 – are greatly exaggerated.

The changes in legislation mostly apply to the amateur end of the lettings market, or those who might be considered accidental landlords. These people, who are typically taxed through PAYE (where the tax changes have hit), are largely not Paragon’s customers. These are professional landlords who often own more than five rental units, usually through a company, meaning they are still allowed to offset loan interest as a corporate expense an incur small company tax rates of 19 per cent. This compares with, in most cases, tax at a marginal rate of 43.25 per cent or higher.

With the market’s attraction dimmed for many smaller investors – and following a stay of execution through a house price inflation surge – some BTL amateurs will be looking to exit. These units would be expected to end up either being taken on by first-time buyers or, and perhaps more likely, being absorbed by the larger, more professional landlords. So while the BTL market is at risk of shrinking, the scale of investment by Paragon’s customers could actually increase. Either that or the rental market shrinks, which ought to be a positive driver for rental levels. What might look to be a negative development through a private landlord’s lens appears more of a positive for Paragon.

A greater risk is in the shape of competition from the UK’s larger banks, which have historically tended to avoid BTL. Barclays’ recent purchase of Kensington Mortgages, and HSBC’s hints in recent analysts’ meetings at interest in the ‘non-standard’ market, both suggest the sands are shifting.

It is not hard to understand why. Nationwide, the UK’s largest mortgage lender, has a NIM of only 1.26 per cent, less than half that of Paragon and highlights the competitive (if not cut-throat) nature of mainstream mortgage lending. This could be a threat to margins, even it feels unlikely that these larger players will want to pull down returns – rather that they are looking to boost their margin mix. However, well-capitalised competition is never welcome.

A history of high returns

Paragon has a long history of returning surplus capital to shareholders. A CET 1 ratio (of core equity to risk weighted assets) of 15.4 per cent has been stable in recent years, and well above internal and regulatory minima. This has allowed a steady capital return programme split between dividends and share buy backs, which we prefer for their permanent boost to returns and equity valuations.

Since 2015, Paragon has redeemed £335mn of its equity and paid out £339mn in core dividends, giving a total distribution ratio of 40 per cent of net profits. In 2022, the plan is to buy in £75mn and Shore Capital expects at least another £50mn in both 2023 and 2024. For comparison, the group’s market capitalisation is just £1.25bn. So, the buy back offers investors a boost to total returns of around 6 per cent this year and the core yield offers additional income of around 5 per cent. It’s easy to see how total returns have averaged 8.75 per cent in each of the last five years.

The valuation basis for banks is the standard economic value-added model. This means that the extent to which a bank’s RoTE exceeds the market’s estimate of its weighted average cost of capital (WACC) should be the extent to which the share price exceeds the net asset value (NAV).

Larger banks have in the past decade struggled to make returns above their WACC and have, therefore, tended to trade below their NAV. Some more profitable challenger banks, by contrast, have traded closer to NAV. Currently, Paragon’s RoTE is around 14.5 to 15 per cent, and the market estimate of its WACC is around 11 per cent, suggesting the shares should trade at around 1.35x NAV.

However, they are closer to NAV, reflecting investor concerns about the company, its sector, and the housing market – and worries that the current level of RoTE reflects a now-ended benign wider economy and housing market, a rising WACC, market competition, falling house prices, or the risk that wholesale finance costs will rise faster than mortgage rates and begin to drag on the NIM.

The macroeconomic outlook now looks less certain, but there is a danger that investors are mapping outdated concerns onto a business that is better capitalised, more regulated, reactive and digitally enabled.

So, while it feels unlikely that investors will soon allow spur a 35 per cent premium to book value (implying a share price of around 675p), that does still look like a destination as the NAV rises (through retained profits, provision adjustments and share buybacks) to around 650p by September 2024. Throw in a 5 per cent dividend yield, and a moderate double digit annual return looks likely.

If the housing market lurches into reverse, this would be harder to achieve. But even allowing for a dip to house prices, threats to asset-backing do not look severe enough to cause large numbers of landlords to sell up. On balance, Paragon’s investment case looks positive.