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Diversifying Paragon too cheap

The challenger bank trades at a discount to peers despite growing its loan book at an impressive rate
September 21, 2017

Some Paragon (PAG) investors may have been concerned that last year’s hike in buy-to-let (BTL) stamp duty would pull the rug from under the specialist mortgage market. Solid lending growth, for more than a year since the new regime was introduced, indicates that these fears were overdone. The challenger bank is also diversifying revenue streams and funding channels to take advantage of growth in other sectors. But its shares trade at a discount to peers, which does not do justice to its prospects.

IC TIP: Buy at 410.2p
Tip style
Growth
Risk rating
Medium
Timescale
Medium Term
Bull points

Diversifying loan book

Cheaper cost of funding

Discount to rivals

Growing loan book

 

Bear points

Credit cycle risk

Housing market uncertain

There may have been a spike in buy-to-let mortgage applications prior to the stamp duty increase in April last year, but lending during the nine months to the end of July 2017 was the highest in recent years. The lender wrote £1.01bn of new buy-to-let business during the first three quarters of its 2017 financial year, up from £990m the same time in 2016. Its bias towards lending to professional landlords helps insulate it from any decline in the wider market. During the same period, professional customers accounted for 70 per cent of its pipeline, up from 62 per cent the same time the previous year. That pipeline stood at £700m at the end of June, compared with £339m the prior year, although that prior figure was affected by the market disruption.

Paragon's other business lines are growing at a faster rate than buy-to-let, albeit from a much lower base. During the six months to March, £107m in new asset finance loans were written – almost double that during the same time the previous year. It built on this during the third quarter, writing £59m in new asset finance business. In the nine months to June, a quarter of new lending came from non-buy-to-let sectors, up from 17 per cent in the previous comparable period.

Management has set a target of writing new asset finance loans of more than £200m by the end of the year, in addition to a combined £200m of new loans for its other business lines. These include development finance, aimed at small-scale property developers, and second-charge mortgages (additional loans secured against the value of a property). But, at a nervy time for consumer credit, this exposure remains limited. According to the Finance and Leasing Association, new business within the second charge mortgage market declined by £21m to £458m during the six months to March. While new business volumes increased at Paragon, second-charge mortgages stood at just 3 per cent of the overall loan book.      

However, the challenger bank is not only diversifying its revenue stream, but also its sources of funding. Retail deposits via Paragon Bank are now its largest source of monies for new lending. Deposit balances increased by 65 per cent year on year to £2.35bn at the end of March. Funnelling more business through Paragon Bank, rather than Paragon Mortgages, means it can take advantage of the lower cost of money via retail deposits; an alternative to using the wholesale markets to fund its lending. Paragon Mortgages wrote just 18 per cent of the total buy-to-let loans written by the group during its first half. However, this low cost of retail funding will rise when interest rates are eventually lifted.

PARAGON GROUP OF COMPANIES (PAG) 
ORD PRICE:410.2pMARKET VALUE:£1.09bn
TOUCH:410-410.3p12-MONTH HIGH:491pLOW: 299p
FORWARD DIVIDEND YIELD:3.9%FORWARD PE RATIO:9
NET ASSET VALUE:365pLEVERAGE:

14.9

Year to 30 SepTotal operating income (£m)Pre-tax profit (£m)Earnings per share (p)Dividend per share (p)
201419812230.59
201521213534.811
201624414740.913.5
2017*25714642.714.2
2018*28015947.415.8
% change+9+8+11+11
Normal market size:5,000   
Matched bargain trading    
Beta:0.52   
*Shore Capital forecasts, adjusted PTP and EPS figures