Arbuthnot Banking Group Acquisition of Everyday Loans

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1 Arbuthnot Banking Group Acquisition of Everyday Loans Capitalising opportunities Financials In line with its stated strategy, Arbuthnot Banking Group s (ABG) 75.5% subsidiary Secure Trust Bank (STB) has announced the acquisition of Everyday Loans Holdings, a provider of unsecured loans to a customer base predominantly in lower income groups that operates through a national network of 25 offices. The loan book was 64m at end 2011 and the consideration 1, with a performance-related deferred consideration of up to 1.5m. In the four months to April 2012 Everyday Loans made pre-tax, pre-subordinated-loan-interest profits of 1.2m. 13 June 2012 Price 530p Market cap 81m Shares in issue 15.3m Free float 100% Code ARBB Year end Revenue ( m) PBT* ( m) EPS* (p) DPS (p) P/E (x) Yield (%) 12/ / /12e /13e Note: *PBT and EPS are normalised, excluding intangible amortisation and exceptional items. Primary exchange Other exchanges Share price performance LSE N/A Secure Trust: Strategy of acquisition STB is well funded and well capitalised. Part of its strategy is to acquire portfolios and businesses that may be more funding constrained and to use the balance sheet strength of STB to enhance profitability. This deal is exactly that type of opportunity. Everyday Loans was funded by 34m subordinated debt (principally held by Alchemy) and 37m of bank loans and this will be replaced by retail deposit funding. Financial implications Everyday Loans made an IFRS pre-tax, pre sub-debt interest profit of 2.8m in 2011 (accelerating to 1.2m in the four months to end April 2012). Including Everyday Loans will see a material increase in ABG s profits despite higher minority interests. The 2012/13 statutory numbers will be highly variable will be inflated by acquisition-related profits and 2013 depressed by acquisition-related amortisations. Funding a loan book of 64m will use about half the surplus deposits STB had at end 2011 (loans 155m, deposits 272m). We estimate the regulatory capital support for the loan book at c 8-9m and there will be some additional operational risk charge. This is well within existing capital and the accounting adjustments likely from this deal. Valuation: Value enhancing deal raises valuation ABG s stake in STB is worth c 112m, c 40% above ABG s market cap. While there are some central costs, there is also a private bank generating 2m in pre-tax profits; we discuss why this anomaly is inappropriate in more detail later. Our fundamental and peer group analysis indicates c 595p as fair value and we see a number of triggers for a share price re-rating. The uplift to valuation (from 580p) with this deal is modest as our sum of the parts includes STB based off a market valuation, and the impact on Gordon s growth via higher equity is small. % 1m 3m 12m Abs Rel (local) week high/low 530.0p 280.0p Business description Arbuthnot Banking Group is engaged in retail and private banking and other financial services. It owns 75.5% of Secure Trust Bank. It has a modest stake in the investment bank Westhouse Holdings plc. Next events Interim results 26 July 2012 Analysts Mark Thomas +44(0) Martyn King +44(0) financials@edisoninvestmentresearch.co.uk Edison profile page Arbuthnot Banking Group is a research client of Edison Investment Research Limited

2 Everyday Loans: Deal terms STB has acquired Everyday Loans for a consideration of 1. On acquisition STB immediately provided funding so that EDL can redeem the remaining circa 34m of subordinated debt principally held by Alchemy. A payment of up to a maximum of 1.5m will be made to the management team of EDL in March 2013, subject to achieving certain performance targets. Given STB management s own ambitious plans, we believe it will have assumed the whole consideration will become due. The deal did not require share holder approval and completed on 8 June, having previously obtained regulatory consent. Impact on financials Ongoing business Everyday Loans profit is growing strongly m pre tax pre subordinated loan interest rising to 1.2m for four months to April (we understand the latter may be regarded as a fair run-rate with any seasonal impacts being modest). We believe a loan book such as this will be charging substantial APRs and have assumed annual incremental net interest income of 23.7m (just over half accruing in 2012). We also assume that it will have annual costs (including centrals) of c 0.5m per branch, ie 12m pa and have annual credit losses of 12.5% of lending ( 8m pa): again around half assumed for Following the acquisition, we believe the business will be maintained as a separate distribution channel and brand partly to ensure clarity for establishing the performance-related deferred consideration. Accordingly we do not expect material savings from the branch network. There will be two largely offsetting interest effects. First STB will replace c 37m of bank financing with cheaper deposit financing. We understand the facility was negotiated before the impact of the credit crisis and at a spread well below that currently seen in the market. Any benefit from this will be largely offset by replacing the interest cost of funding the 34m subordinated loan repaid to Alchemy. STB will receive from Arbuthnot Banking Group (ABG) a subordinated loan of up to 5m at an interest cost of up to 200k. The current return on the surplus deposits used for funding the issues above, and which will be foregone in this deal, is minimal. Overall we assume the first four months run rate ( 3.6m annualised) will be the initial underlying contribution from this business. We have assumed a modest increase in deposits raised ( 30m in 2012, 50m in 2013) as STB manages down its surplus deposits but still maintains excellent liquidity. These assumptions raise our 2013 forecast adjusted EPS from 84p to 107.3p (noting that the statutory number could be depressed significantly below this level by the factors identified below). Accounting complications The statutory profits will reflect a number of accounting profits, which create a different P&L pattern from the underlying business we have identified above. In H112, the fair value adjustments on acquisition will be taken directly to profits and this could be a material positive number. At this stage we are unable to quantify the effect and believe more information will be available with the interim results due at the end of July. The adjustments are likely to include: 2

3 Fair value of the loan book is likely to see an uplift from the accounting currently adopted. Recognition of a deferred tax asset associated with start-up losses, which had not previously been recognised. Fair value of intangibles such as brand, repeat customer business, some IT historically written off. In H212 some of these factors (such as intangibles) will have to be amortised over their useful life (two to three years) and so negatively impact the P&L in that period. In addition, STB will be accruing the cost of the deferred consideration of up to 1.5m. With this payable March 2013 there will be a lesser effect in that year. In addition, under IFRS the amortisation of significant loan fees over the expected life of the loan (contractually typically three years but often repaid over two) defers profit recognition. STB will acquisition account for historically written loans and so will be effectively starting afresh with new loans. It will not see the benefit of prior years fees being amortised. Consequently, for two/three years profits will be depressed as loan fees are spread out, with the effect only neutralised when the benefits of prior year amortisations become meaningful. Impact on capital ratios The deal is complicated but we believe the key issues are: Addition of c 64m loans, which will require 8-9m of capital support. Positive fair value adjustments (negative goodwill), which could be material. As the fair value adjustments can only be included in capital when they have been agreed and signed off by auditors and regulators, ABG has agreed to a capital injection of up to 5m by way of subordinated loan to support capital ratios in the initial period. As the fair value adjustments are recognised the need for this support will reduce although strong organic growth may mean that the funding is left in place. From an ABG perspective this consolidates out at the group level. Valuation: Some upside The average of our absolute valuation methods is c 670p, although the peer relative approaches would suggest less upside. The sum of the parts is significantly driven by STB s market value, which was not materially affected by this deal (we believe value-added acquisitions were expected by the market). The increase in group equity was modest (before any deal value adjustments) and the earnings increase is diluted modestly by the higher minority charge. There remains the anomaly between ABG s market capitalisation (c 80m) and the value of its 75.5% stake in STB (c 112m). We believe it reflects a number of factors, each of which should moderate over time. Historic perceptions that ABG was a yield play, while STB is perceived as a value play. Clearly the growth in STB will feed through to ABG numbers so these should align. The fact central costs exceed the private bank profits so the residual group has a negative value. We believe this gap will reduce by a third over the next two years. The regular recurrence of exceptional profits and losses in ABG meaning that a long run track record of clean numbers is hard to establish was a transformational year and while we expect further entrepreneurship (and so some unusual profits and losses), we would be surprised if they were material for the next few years. 3

4 Peer valuations ABG lacks peers for its key retail division. Bank comparators are meaningless and Provident Financial and S&U as specialist lenders make comparisons fraught with difficulties. Other strong growth financials such as Hargreaves Lansdown or Brooks MacDonald trade on June 2012 P/Es of c 20x. Arbuthnot is trading on a similar 2013 P/E multiple to Close Brothers, although taking a wider group of wealth management peers (Brewin Dolphin, Rathbone Bros), it is at a discount. Exhibit 1: Peer comparators 2012 P/E 2013 P/E 2012 yield ABG % STB % Other growth financials Hargreaves Lansdown (June) Brooks MacDonald (June) Specialist lenders Provident Financial S&U (Jan 2013/2014) H&T Albermarle and Bond (June) Other Wealth Managers Brewin Dolphin Close Bros (July) Rathbone Brothers Source: Thompson, Edison Investment Research. Note: Prices as at 10 June Sum-of-the-parts model We take the market valuation of ABG s stake in STB discounted by 10% to conservatively allow for any placing discount for this majority stake. We recognise that if ABG sold its holding all together, a trade sale is most likely (and so would likely attract a bid premium), but at this stage we prefer to be conservative. The private bank multiple is conservative relative to peers (Close Brothers, Rathbone Brothers, Brewin Dolphin) typically on 13-14x 2012e. The international private banking multiple reflects a couple of years to resolve the strategic positioning of this unit. For the investment bank we have taken the market value of the holding in Westhouse Holdings and added the 350,000 convertible loan at par. Compared with previous valuations, the strong STB share price has increased this valuation approach. We have valued the gain on sale of Secure Trust shares at par and treated it as surplus capital. Clearly if it is held in cash for a sustained period the earnings on it would be below cost of capital and this would suggest a discount, but we will give the company some time to make this strategic decision before making this valuation adjustment. Exhibit 2: Sum of the parts 2012 estimates Pre-tax Post tax Post minority Multiple (x) UK private banking 3,414 2,287 2, ,449 Secure Trust (90% of market value of its 75.5% holding) N/A N/A N/A N/A 100,883 Stake in Westhouse Holdings plc - equity and convertible Adjustment re retail bank to Secure Trust (30) (20) (20) 3.0 (60) Group surplus capital N/A N/A N/A N/A 12,000 Centrals (6,637) (4,447) (4,447) 7.5 (33,351) Total 107,639 Per share ( ) 7.18 Source: Edison Investment Research Value 4

5 Gordon s growth model We use a group-wide Gordon s growth model. Sustainable ROE is forecast at 17.5%, which, with a 70% sustained payout ratio, generates growth of 5.3%. Non-deployment of surplus capital for an extended period may lead us to cut the long-term return assumption, but at present we have left it at 17.5%. The cost of equity is estimated at 11%. As a conservative, liquid and well capitalised bank, ABG may be expected to have a low cost of equity; this is offset as it is a small institution without any implicit government support. On these assumptions, the implied price to book is 2.1x, which, on the estimated 2012 NAV, generates a value of 622p (previously 589p). Exhibit 3: Gordon s growth model Base 1% ROE 1% g 1% COE ROE 17.5% 18.5% 17.5% 17.5% Growth 5.3% 5.3% 6.3% 6.3% COE 11.0% 11.0% 11.0% 12.0% P/B NAV E Implied target price Difference Source: Edison Investment research Forecasts We have amended our forecasts for Everyday and increased the minorities effect accordingly. Our net income attributable to equity holders in 2013 rises from 6.9m to 9.2m and normalised EPS from 46.1p to 61.1p. We note that the 2013 statutory earnings will be depressed by the deal related factors identified above and which are not included with the P&L and balance sheet forecast below. 5

6 Exhibit 4: Profit and loss account '000s Restated Year end 31 December e 2013e Gross interest income 29,325 39,233 63,000 86,250 Interest expense (7,955) (11,990) (14,000) (15,850) Net interest income 21,370 27,243 49,000 70,400 Fee & commission income 16,902 20,087 21,900 23,450 Fee & commission expense (364) (1,760) (650) (700) Gains less losses from dealing in securities (136) (112) 0 0 Net non interest income 16,402 18,215 21,250 22,750 Total operating income 37,772 45,458 70,250 93,150 Total G&A expenses (31,603) (34,525) (42,470) (52,117) Operating profit pre impairments & exceptionals 6,169 10,933 27,780 41,033 Impairment charges on loans (3,146) (6,813) (15,336) (23,336) Fair value movement on derivatives 0 (124) Other income 1,042 1, Pre tax profit (reported) 4,065 5,116 12,444 17,697 Tax (1,238) (1,817) (3,111) (4,424) Profit after tax (FRS3) 2,827 3,299 9,333 13,273 Discontinued business (Arbuthnot Securities post tax) 894 (10,249) (Loss)/profit for year 3,721 (6,950) 9,933 13,273 Other comprehensive income (270) (485) Minority interests 26 1,936 (3,036) (3,929) Net income attributable to equity shareholders 3,477 (5,499) 6,897 9,344 Dividends (3,289) (3,362) (3,502) (4,203) Retained profit 188 (8,861) 3,395 5,141 Average number of shares (m) EPS - FRS3 (p) 23.2 (36.7) Normalised EPS DPS (p) Dividend cover on adjusted EPS Dividend cover on reported EPS Source: ABG, Edison Investment Research 6

7 Exhibit 5: Balance sheet '000s Year end 31 December e 2013e Assets Cash and balances with central bank 73, , , ,183 Derivative financial instruments Interbank loans 12,080 66,961 66,961 66,961 Customer loans, gross 309, , , ,076 Less impairment provision (9,196) (11,250) (13,250) (15,250) Net customer loans 300, , , ,826 Debt securities 143,119 40,079 (321) 25,565 Trading positions 3, Assets classified as held for sale 0 3,674 3,674 3,674 Current tax asset Goodwill and other intangibles 2,915 3,561 4,000 4,500 Property, plant and equipment 5,903 5,214 5,475 5,748 Deferred tax and Other assets inc financial investments 23,837 12,447 12,447 12,447 Total Assets 565, , ,850 1,058,312 Liabilities Interbank deposits 3, ,000 4,000 Total customer deposits 503, , , ,302 Trading liabilities ,000 3,001 Debt securities in issue 12,630 12,256 12,256 12,256 Other liabilities 10,594 16,281 16,281 16,281 Subordinated debt issued Total liabilities 530, , , ,840 Minority interests 2,118 5,998 9,034 12,963 Equity shareholders interests Share capital Share premium 21,085 21,085 21,085 21,085 Retained earnings 12,142 21,571 24,966 30,107 Other reserves (1,347) (1,836) (1,836) (1,836) Book value of shareholders equity 32,030 40,973 44,368 49,509 Intangibles 2,915 3,561 4,000 4,500 Net asset value 29,115 37,412 40,368 45,009 Source: ABG, Edison Investment Research Companies mentioned in this report Secure Trust Bank (STB), Hargreaves Lansdown (HL.), Brooks MacDonald, Provident Financial (PFG), S&U (SUS), H&T (HAT), Albemarle and Bond, Brewin Dolphin (BRW), Close Brothers (CAY), Rathbone Brothers (RAT). EDISON INVESTMENT RESEARCH LIMITED Edison Investment Research is a leading international investment research company. It has won industry recognition, with awards both in Europe and internationally. The team of 90 includes over 55 analysts supported by a department of supervisory analysts, editors and assistants. Edison writes on more than 350 companies across every sector and works directly with corporates, fund managers, investment banks, brokers and other advisers. Edison s research is read by institutional investors, alternative funds and wealth managers in more than 100 countries. Edison, founded in 2003, has offices in London, New York and Sydney and is authorised and regulated by the Financial Services Authority ( DISCLAIMER Copyright 2012 Edison Investment Research Limited. All rights reserved. This report has been commissioned by Arbuthnot Banking Group and prepared and issued by Edison Investment Research Limited for publication in the United Kingdom. All information used in the publication of this report has been compiled from publicly available sources that are believed to be reliable, however we do not guarantee the accuracy or completeness of this report. Opinions contained in this report represent those of the research department of Edison Investment Research Limited at the time of publication. The research in this document is intended for professional advisers in the United Kingdom for use in their roles as advisers. It is not intended for retail investors. This is not a solicitation or inducement to buy, sell, subscribe, or underwrite securities or units. This document is provided for information purposes only and should not be construed as an offer or solicitation for investment. A marketing communication under FSA Rules, this document has not been prepared in accordance with the legal requirements designed to promote the independence of investment research and is not subject to any prohibition on dealing ahead of the dissemination of investment research. Edison Investment Research Limited has a restrictive policy relating to personal dealing. Edison Investment Research Limited is authorised and regulated by the Financial Services Authority for the conduct of investment business. The company does not hold any positions in the securities mentioned in this report. However, its directors, officers, employees and contractors may have a position in any or related securities mentioned in this report. Edison Investment Research Limited or its affiliates may perform services or solicit business from any of the companies mentioned in this report. The value of securities mentioned in this report can fall as well as rise and are subject to large and sudden swings. In addition it may be difficult or not possible to buy, sell or obtain accurate information about the value of securities mentioned in this report. Past performance is not necessarily a guide to future performance. This communication is intended for professional clients as defined in the FSA s Conduct of Business rules (COBs 3.5). Registered in England, number Edison Investment Research is authorised and regulated by the Financial Services Authority. London +44 (0) Lincoln House, High Holborn London, WC1V 7JH, UK New York Lexington Avenue, Suite 1724 NY 10168, New York, US Sydney +61 (0) Level 33, Australia Square, 264 George St, Sydney, NSW 2000, Australia 7