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Paragon primed for takeover

The challenger bank operates in a consolidating sector
April 4, 2019

Consolidation has been rife among UK-listed challenger banks during the past two years, as lenders combine forces to boost their funding sources. Following the recommended takeover of Charter Court (CCFS) by OneSavings Bank (OSB) in March, we think there is every chance rival Paragon Banking (PAG) could be next in line. The alternative lender’s solid loan book growth, rising return on tangible equity and expanding retail deposit base make it an attractive target for a would-be bidder.     

IC TIP: Buy at 434.4p
Tip style
Growth
Risk rating
High
Timescale
Medium Term
Bull points

Potential takeover target

Impressive lending growth

Diversifying funding sources

Conservative loan-to-value ratio

Bear points

Regulatory capital reduced

Buy-to-let skew

Paragon specialises in buy-to-let mortgages and commercial finance, with the former accounting for 85 per cent of the loan book at the end of September. New buy-to-let lending has held up despite the increase in stamp duty land tax on second homes in 2016 and the withdrawal of mortgage interest tax relief a year later. Paragon specialises in catering to professional landlords with multiple properties, which accounted for 79 per cent of buy-to-let completions in 2018 and 88 per cent of its pipeline.

The group’s focus on complex cases has helped it outperform the wider market, where completions rose just 2 per cent during the year to September, according to trade body UK Finance. However, Paragon wrote £1.5bn in new buy-to-let mortgages, up 7 per cent on the prior year. That momentum continued into the new financial year, with buy-to-let advances during the final three months of 2018 up by nearly a quarter on an annual basis to £425m. Loans more than three months in arrears are also below the industry average of 0.42 per cent, coming in at 0.11 per cent of buy-to-let accounts, although that was up on 0.08 per cent the prior year.   

Management is trying to diversify its lending streams via commercial finance products, which included acquiring residential development finance specialist Titlestone in July. That brought with it outstanding balances of £76m, although it also contributed to a decline in the group’s core tier one ratio to 13.8 per cent at the end of September, from 15.9 per cent the prior year. Nevertheless, that ratio is still comfortably ahead of management’s medium-term target of 13 per cent. Overall new commercial lending grew 82 per cent last year, doubling outstanding balances to £1.13bn. Together with debt purchasing business Idem Capital, non-buy-to-let lending accounted for 14 per cent of the book at the end of September, compared with 11 per cent the prior year and 10 per cent in 2016.

However, it is not just lending lines that are being diversified, but also funding sources. After restructuring the group in 2017, the banking operations subsumed the rest of the organisation to reflect a shift towards backing new loans with lower-cost retail deposits, rather than relying predominately on wholesale finance markets. The retail deposit base more than doubled to £5.3bn between 2016 and 2018. Admittedly, the low cost of retail funding will rise when interest rates are eventually lifted, but so too should the amount that can be charged for loans, and forecasts for rate rises remain very modest. Last year, the overall deposit book cost was relatively stable at 1.76 per cent, compared with 1.71 per cent in 2017.

Lending growth could soon receive another boost, as Paragon plans to apply to the Prudential Regulation Authority (PRA) to switch to using the internal ratings-based (IRB) approach – rather than the standardised method – for the purposes of calculating credit risk. The IRB method typically requires a lower level of capital to be held against loans, compared with the latter approach.

PARAGON BANKING (PAG)   
ORD PRICE:434.4pMARKET VALUE:£1.13bn
TOUCH:434.2-434.6p12-MONTH HIGH:559pLOW: 379p 
FORWARD DIVIDEND YIELD:5.5%FORWARD PE RATIO:7
NET ASSET VALUE:420pLEVERAGE:15
Year to 30 SepTotal operating income (£m)Pre-tax profit (£m)*Earnings per share (p)*Dividend per share (p)
201624414340.513.5
201725314543.115.7
201827618255.919.4
2019*31217453.321.2
2020*34619860.124.0
% change+11+14+13+13
Normal market size:5,000   
Beta:1.01   
*Investec Securities forecasts, adjusted PTP and EPS figures