It was not 5 weeks ago that I wrote my first piece on Secure Trust Bank (LSE:STB) (https://eddielloydcom.wordpress.com/2021/07/11/bargain-hunting-secure-trust-bank-plc-at-5-6x-fy22-p-e/), when I concluded that this was one of the best value opportunities I had seen in 2021. Since then, the share price has progressed from £10.30 to £13.90, a 35% increase, and with half year results released last week, now seemed like the time to reassess.
Though the long-term bull case for STB remains unchanged, half year results were well ahead of my expectations and, following revisions to my model, I’ve updated my personal target price from £18 to £19.50.
Prior to COVID-19 occurring STB had performed very strongly, with its high net interest margin strategy making it far less sensitive to the low interest rate environment which has proved difficult for most of the industry. During the COVID-19 pandemic BoE base rates were dropped to an all time low of 0.1%, however STB has continued to maintain a strong net interest margin throughout.
These fundamentals of the business are baked into my model, however the overarching premise of the conclusion which I drew in my previous piece was that the STB share price was being unduly depressed by temporary adversity which does not represent a challenge to long-term earning potential. In particular, I picked out three key factors which remain key to the bull case.
- Preservation of capital through COVID-19 period
For a lender such as STB, maintaining a strong capital base is essential for earning potential. Lenders such as STB are regulated by the PRA/FCA and are required to maintain capital adequacy levels in line with Basel III requirements. These capital requirements are determined as a function of the lending assets on the balance sheet (risk-weighted assets), and as such the amount of loans that can be held, and the amount of interest that can be earned, is constrained by the capital held.
The consequence of this is that in a period of stress, capital depletion can result in a permanent reduction in earning potential, so it is critical that this is maintained if this kind of company is to hold its value through a downturn.
Even under the severe credit loss scenario disclosed in the year-end accounts, STB would have been profitable in 2020, meaning no depletion in capital, with opportunity of future earnings remaining. In the half year results in 2021, STB announced a half-year profit after tax of £26m, maintaining a strong CET1 ratio of 14.2%, and the bank now has the largest capital base in its history from which to earn returns.
- Economic recovery providing runaway for continued growth
It’s no good having lots of capital around if poor lending conditions mean you can’t earn a return on it. This is why the recovery of the UK economy is another prerequisite for lenders to flourish. Despite this STB does have one advantage over larger banks, which is that its relative size means that it has an opportunity to find it’s niches and grow faster than the economy (as it has done over the last decade). It was already known that STBs lending levels had returned to pre-pandemic levels by the end of 2020, and half year results confirmed that this has continued into 2021.
Nevertheless, the success of the economy remains a key factor for STB, and I think it’s fair to say I’m optimistic in this regard. The UK vaccine rollout has been a strong success with all UK legal restrictions relating to COVID-19 ending in July. The UK economy grew by 4.8% in Q2 according to trading economics and the consensus shown in the forecasts below is that it is set to continue. Whilst vague concerns around Brexit continue to depress the mood, these are of wholly different magnitude to the impact of COVID, and following the deal agreed in 2019 this is not a major concern for me.
UK GDP
Nobody has a crystal ball however, especially when it comes to the economy, and there is a sense that only once furlough restrictions end in September and once the dynamics with inflation and central bank policy stabilise will we know where we stand. Only time will tell.
- Forward-looking credit loss accounting providing room for writebacks
For the last few years the International Financial Reporting Standards (‘IFRS’) has required banks to recognise credit losses on a forward looking basis, recognising not only incurred credit losses but also expected future losses. In the 2020 accounts an impairment charge of c. £50m was recognised reflecting the COVID-19 circumstances, however the vast majority of this had not crystallised and was based on future expected defaults.
As such in my previous piece I noted that a) the £50m charge should not be considered as a new ‘run rate’ for credit losses, and therefore long-term earning potential is not diminished, and b) improved economic outlook may even result in a writeback in impairment charge.
In the half year results STB announce and impairment credit of £1.1m, as compared to annual charges of c.£30m in 2018 and 2019, which was the key factor in the pre tax half year profit of £26m. However, as with the 2020 impairment charge, this should not be considered as a new normal, and this is why my model shows a slight dip in earnings in 2022 as the impairment charge normalises.
Model
DCF Model
I have updated my Dividend Discount Model (‘DDM’) using my own forecast considering historical metrics including leverage ratio, net interest margin, loans to deposits ratio, historical impairment losses, etc, which result in forecast earnings below. The majority of the earnings growth shown below comes from reinvestment of capital, with the payout ratio starting at 42.5% and trending to 100% in the terminal year, with good operating leverage achieved. These forecasts are broadly consistent with my previous model.
I’ve kept Ke constant at between 10% – 12.5% using the CAPM model, considering observed betas across the market, with the addition of a small market premium.
The resultant calculation gives an equity value range of between £341m and £464m, or between £18.30 and £24.90 per share, still significantly higher than the current price level of £13.90 per share. Moreover, my sensitivities show that the applied Ke would need to rise to 15.2% for the equity value of STB to be equal to the current share price.
I would note that the increase in the lower estimate results from a less conservative terminal growth assumption which I believe to be more appropriate (2% terminal growth in line with inflation).
Multiples
Up until the COVID-19 pandemic, STB traded at a premium to book value, reflecting its growth prospects and earning potential.
As shown above, my valuation results in an implied P/B ratio of between 1.2x – 1.6x, which is broadly consistent with the P/B ratio observed for the stock in the few years preceding COVID-19.
I would note that a depressed P/B ratio is not unique to STB, but for a bank that is profitable and with growth potential, a discount to book value does not appear reasonable.
Conclusion
My view is unchanged, and in fact I’d suggest that there were no real surprises in the half year results. As such, I’ll simply repeat my conclusion:
“In my view, the market is excessively overcompensating for the risks associated with COVID-19 and Brexit on the economy. A patient investor can wait for things to get back to normal and see STB profit from its undiminished capital base.
The bank itself has a business model which is well suited to cope with low interest rates and has sufficiently specialized areas of focus to effective manage risk whilst maintaining good yields, not to mention strong LTV levels across its secured lending.”
Target price: £19.50. Conclusion: still a bargain share.
Eddie Lloyd Investment Research 