The UK’s major sub-prime instalment loan providers seem to be sitting in a sweet spot. The Financial Conduct Authority’s (FCA) price cap reduction in 2015 put the brakes on the rapidly expanding payday lending market, forcing those lenders out of business or – without the additional fees and interest from rolling over debt – trading at reduced margins. Meanwhile, the addressable market for non-standard credit, from those with poor credit ratings or a lack of credit history, is estimated to be between 10m and 12m adults in the UK.
Rising demand in that corner of the credit market is reflected in the rapid growth in customer numbers and lending by the major UK providers in recent years. The Finance and Leasing Association (FLA), which counts Provident Financial’s (PFG) motor finance business, Moneybarn, and Non-Standard Finance’s (NSF) Everyday Loans among its constituents, says its members wrote £96.2bn in new business last year, up 6 per cent on 2016. What’s more, concerns over a further regulatory clampdown that would put the squeeze on the major UK-listed providers seem unfounded. The FCA's recent review of ‘high-cost, short-term credit’ – defined as charging 100 per cent APR or more – decided against recommending the total cost cap be extended to the home credit market.
Yet taking advantage of demand has not been plain sailing for UK-listed providers. Provident Financial’s disastrous restructuring of its home credit business – together with a £172m settlement over the mis-selling of repayment option plans (ROP) by Vanquis Bank – forced it into a £344m pre-tax loss last year and a £300m emergency rights issue in February. Meanwhile, Non-Standard Finance has consistently underperformed market expectations since listing three years ago, with the cost of expansion pushing out profitability and leaving the shares down more than a third on the initial 100p placing price.
Boom time for sub-prime
With discretionary incomes shrinking and interest rates on the rise, there are concerns that traditional lenders may suffer rising impairments as borrowers that have overstretched themselves – encouraged by cheap debt – may struggle to meet repayments. That’s not to say conditions for sub-prime lenders haven’t been favourable in recent years, with stagnating real wages driving demand and low unemployment – which fell to an almost record low in June, or around 4 per cent – minimising widespread customer defaults. However, rising rates are slightly less relevant for sub-prime lenders, given that interest charges are not linked to the base rate, but the loan size and repayment time. “For example, a 52-week home credit product is priced at just under 300 per cent, so a 25 to 400 basis point increase is hardly going to shift the dial,” says Peel Hunt’s Anthony Da-Costa. Higher rates have also traditionally been associated with better economic activity that shouldn’t then affect such customers, in terms of impairments, he says.
However, while home credit seems relatively insensitive to further potential interest rate rises, those providers offering nearer-prime lending could be at greater risk of rising impairments. That’s because those customers are more likely to have access to other lending products that have a greater link to the base rate, such as mortgages. For example, the typical household income of customers of credit card provider Vanquis Bank is between £20,000 and £35,000, while borrowers are also more likely to be employed, according to the company. That’s compared with the typical home credit customer, who has an income of between £10,000 and £15,000 and is in part-time or casual employment. What’s more, around 75 per cent of the business’s customers are renting homes – implying the rest are homeowners. Berenberg analyst Donald Tait reckons that could make those types of customers more susceptible to rising rates directly. However, Mr Tait – who has Provident Financial on a ‘sell’ rating – also argues that Vanquis Bank’s high level of customer churn also makes it susceptible to margin contraction. During the first half Vanquis gained around 187,000 new customers, but increased overall customer numbers by just 44,000 to 1.76m.
A light touch?
Given the high levels of APR charged by sub-prime lenders, the rapid growth in the market and the vulnerability of some customers, it’s unsurprising that the sector has frequently come under regulatory scrutiny in recent years. Most recently, the FCA released proposals for tightening rules for the ‘high-cost, short-term’ credit market, which included introducing a price cap for the rent-to-own market sector and limiting fees on unarranged overdrafts.
However, when it came to the home-collected credit market, a substantial source of revenue for the major UK-listed sub-prime credit providers, the regulator’s recommendations were relatively tame. Rather than proposing a price cap – given its concerns centre on the costs of repeated use of home‑collected credit rather than the costs of any individual loan – the regulator recommended home credit providers should be banned from offering new products or refinancing when visiting clients without being explicitly asked. The FCA is also consulting on a rule mandating that lenders provide customers with the comparative costs of taking out another loan on top of an existing loan, so they can compare the costs of refinancing.
Given the large listed lenders already comply with the affordability and verification checks, they have already said that additional required disclosures to customers would be a simple implementation, which would not incur any significant operational expense. However, the FCA’s rules designed to reduce the incidence of persistent debt cycles for credit card users seem to have more bite. A customer under this kind of duress might, typically, over an 18-month period, pay more in interest, fees and charges than they have repaid of the principal amount borrowed. The FCA measures encourage borrowers to repay their debts more quickly when they can afford to by changing repayment plans and showing forbearance, such as interest rate reduction, where customers cannot afford increased repayments.
For Vanquis Bank that’s meant increasing the contractual minimum payments that customers are required to make monthly, while it is also rolling out recommended payment strategies and enhanced customer communication around repayment. Together with stricter affordability testing – following another FCA review into that topic matter last year – that contributed to the 20 per cent reduction in new customer bookings during the first half.
Favourites
Shares in Morses Club (MCL) have been one of the few among the sector to appreciate during the past months, up almost a quarter. The group may be less diversified than other lenders, focusing predominately on home-collected credit, but it has managed to grow the loan book without any sizeable uptick in the impairment rate (which typically accompanies new customer growth, given they are more likely to default on loans). Last year the loan book was up almost a fifth to £72.8m, while impairments as a proportion of revenue was 26.1 per cent. Admittedly, that was up from 24.4 per cent in the previous year, but it was within management's guidance range of between 22 and 27 per cent. At 154p, the shares are up on our buy tip (120p, 3 Nov 2016) and trade at 11 times Peel Hunt’s forecast earnings per share for 2019.
Outsiders
Admittedly, Non-Standard Finance managed to reduce impairments to 25.9 per cent of revenue during the first half, down 3 percentage points on the same time last year, while also growing the loan book more than a third. It also has a more diversified mix of lending streams via the home credit business, branch-based business Everyday Loans and guarantor lending business TrustTwo. The group’s strategy has been to acquire smaller lenders, which included its £54m purchase of guarantor lender George Banco last year, while hiring more agents at the home credit business. However, the cost of expansion has not come cheap, with the group reporting a £2.6m pre-tax loss during the first half, although that was down on the £4.2m loss in the prior year. It has also meant that the group has needed to raise more debt to fund organic and acquisitive growth. This month the group raised a further £70m of debt, taking total committed debt facilities to £330m to fund growth to 2020. At 64p, the shares are trading at 16 times house broker Shore Capital’s adjusted EPS forecast for 2018, a premium to the sub-prime sector.
