S&U. Positioning for sustainable growth. H119 results. Adapting to market background. Valuation: Maintained on slightly lower estimates.

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1 S&U Positioning for sustainable growth H119 results Financial services S&U s non-prime motor finance business has experienced a further increase in the rate of impairment as some of its customers have been pressured by real income constraints and use of newer short-term credit products. Tighter criteria have been adopted in response and should reverse this trend while the Aspen property bridging pilot, if given the go ahead, should provide a useful additional source of growth in a specialist market. 27 September 2018 Price 2,555p Market cap 307m Net debt ( m) end-july Shares in issue 12.0m Free float 26% Year end Revenue ( m) PBT* ( m) EPS* (p) DPS (p) P/E (x) Yield (%) 01/ / /19e /20e Note: *PBT and EPS are reported. Code Primary exchange Secondary exchange Share price performance SUS LSE N/A H119 results The interim figures showed further strong growth, with Advantage motor finance receivables up 16% from H118 at 264m and Aspen bridging finance loans up from 11m at the year-end to 16m; this pilot business has now moved into profit and the go ahead for further development appears likely in the second half. Receivables growth fed into revenue growth of 18% and 17% growth in pre-tax profit and EPS versus H118. The interim dividend was increased by 14% with the intention of moving to 2x cover. Impairments at Advantage have continued to rise (rolling 12- month impairments were 24.7% of revenues at end-july vs 21.9% at the year-end) and, in response to this, lending criteria have been tightened further, leading to a reduction in the percentage of applications approved and a 6% reduction in the number of new transactions compared with H118. There are early signs that this is bearing fruit in terms of repayment performance from new customers. Adapting to market background The motor finance business has a long track record of adapting to changing market conditions and the current tightening of credit criteria reflects both the experience of higher impairments than expected from parts of its customer base and uncertainties in the political and economic outlook. Having said this, the level of loan applications remains buoyant and the used car market has displayed greater stability than new car sales, so Advantage should still be able to achieve growth while being more selective. Aspen remains a pilot project but, assuming it is given the go ahead, appears capable of providing a useful alternative source of growth from a niche market. Valuation: Maintained on slightly lower estimates Our earnings estimates are reduced slightly (see page 5) to reflect the increased level of impairments reported in the first half and assumed slower growth for the full year in Advantage receivables. However, we are still looking for the return on equity to increase to over 17% and 19% for FY19 and FY20, so we retain our ROE/COE derived value of 3,060p. % 1m 3m 12m Abs Rel (local) week high/low p p Business description S&U s Advantage motor finance business lends on a simple hire-purchase basis to lower and middle income groups that may have impaired credit records that restrict their access to mainstream products. It has 58,000 customers. The pilot Aspen property bridging business is expanding its loan book (c 16m end-h119). Next event Q319 trading update 7 December 2018 Analysts Andrew Mitchell +44 (0) Martyn King +44 (0) financials@edisongroup.com Edison profile page S&U is a research client of Edison Investment Research Limited

2 H119 results S&U s first-half results showed group receivables up 22% to 279.8m compared with the same period last year. This reflected continued but more moderate growth in Advantage motor finance as lending criteria has been tightened and the stepping up in property bridging loans as the pilot operation gains momentum. Revenue growth of 18% was outpaced by impairments as Advantage experienced a further increase in the rate of impairment but the cost of sales was contained with the number of new loans at Advantage 6% lower than in H118. This allowed pre-tax profit and earnings to advance by 17%, while the first interim dividend was increased by 14% as cover is rebuilt towards the target level of two times. Exhibit 1: H119 results summary m unless indicated H118 H218 H119 H119/ H118 (%) Sequential change (%) Motor finance receivables Number of new loans (#) 12,542 11,976 11, Property bridging loans at period end Revenue Impairments (8.6) (10.9) (11.3) Other cost of sales (8.6) (8.7) (8.6) Administrative expenses (4.8) (4.9) (5.5) EBITDA Depreciation (0.1) (0.2) (0.2) Operating profit/loss Finance expense (1.2) (1.7) (2.1) Pre-tax profit Tax (2.8) (3.0) (3.2) Net profit EPS fully diluted (p) Dividend per share (p) Source: S&U, Edison Investment Research Advantage Finance Three points within the Advantage results merit further discussion: the slowing of growth in new loans; the increase in impairments; and changes in accounting following the adoption of IFRS9 and IFRS16. Advantage has a long track record with over 18 years of growth, and this experience and S&U s conservative approach, which looks to develop the business sustainably, has fed into a progressive tightening of credit criteria in response to the results of an earlier experimental loosening and the more recent evidence of pressure on some customer s real incomes. The company notes that it has recently further modified its own internal credit scoring to take account of the impact of new highcost, short-term credit products (typically six-month unsecured personal loans) that have gained traction following the regulatory pressure on pay-day lending. This has resulted in a modestly lower level of new loans by Advantage in the period. Demand remains robust with loan applications up 16% to 510,000 and an e-signature system has eased the process of signing up and slightly raised the proportion of approved applications that have been signed up. Greater selectivity has nevertheless meant that the transactions rate versus applications has fallen from 2.8% to 2.3%. The rise in impairments has lasted longer than the company expected but, as noted, credit scoring has been refined further and, subject to broader developments in the economy, the rate of impairment appears likely to stabilise and then reverse as tighter criteria progressively change the mix within the book of receivables. S&U indicates that very early evidence from repayments made by customers acquired during the first half does tend to support this expectation. S&U 27 September

3 % % The adoption of IFRS9 with its expected credit loss approach resulted in a net 2.5m opening reduction in equity; this was in line with the previously indicated level and was taken straight to the balance sheet. Prospective potential differences in profit and loss impairment charges of the new standard compared with IAS39 are not clear cut, but where loan growth is rapid the rate of provision is likely to be higher (as intended) and volatility in provision levels at turning points in the economic cycle may be accentuated as loans move in or out of the lifetime provisioning categories. Importantly, cash flows arising from the loan portfolio will be unaffected by the change. As part of the adoption of IFRS16, the grossing up of revenue and impairment charge by unpaid interest on impaired loans has been removed. For S&U, this was a small effect ( 1.2m) in the first half, but it does introduce some distortion in comparing impairment and revenue ratios with earlier periods. As a way of sidestepping this, S&U cites a rolling 12-month risk-adjusted yield (revenue less impairment charge/monthly average receivables) for Advantage as a performance indicator. This showed a figure for the year to July of 25.4%, compared with 26.7% for the 12 months to February. Aspen Bridging The property bridging pilot has continued to develop with net receivables at the period-end of 16.3m, compared with 10.8m at the year-end, while 61 bridging loan facilities have been arranged in the 18 months to end-july, of which 22 have been repaid. The average loan size is c 380,000, with an interest rate of just over 1% per month and an original term of between six and 12 months. Loans are made for refurbishment rather than rebuilding (avoiding risks related to timing and collateral value). Industry recognition of the business has grown, aiding origination of new business. The business achieved a profit of 0.28m, a swing of over 0.559m compared with last year s loss. Investment in Aspen will be restricted to 20m prior to a decision (in the second half) on continuation of the pilot. As things stand, it seems likely that S&U will decide to go ahead with development of the business. A return on capital of around 12% is expected and, while this is lower than the figure of over 15% earned by Advantage, it is still seen as attractive taking into account the different characteristics of the businesses. Property bridging is focused on the quality of collateral and has the aspiration of avoiding bad debts almost entirely, while Advantage focuses on the credit quality of borrowers rather than the partial collateral provided by the vehicles financed and operates with relatively high impairment rates serving non-prime borrowers. Background and outlook While there are uncertainties in the economic and political outlook, the current employment and consumer confidence background is generally benign for S&U (see Exhibits 2 and 3). Exhibit 2: UK redundancies and unemployment Unemployment Redundancies Source: ONS Exhibit 3: UK consumer confidence indicator Source: European Commission S&U 27 September

4 Sales volume in the new-car market has seen weakness ( 4.2% in the year to end-august: SMMT data), but volumes in the used-car market where Advantage operates have been more resilient (Exhibit 4).The volume and value of used-car finance, as reported by the Finance and Leasing Association, has continued to rise, although the pace of growth has recently been lower than in earlier years (Exhibit 5 used-car loan volume +7% in the 12 months to end-june). Exhibit 4: UK used-car market volume Exhibit 5: Used-car finance through dealerships bn m Q115 Q315 Q116 Q316 Q117 Q317 Q Q110 Q111 Q112 Q113 Q114 Q115 Q116 Q117 Q Used car market volume % change YoY (RHS) Used cars ( bn) Used cars (m) Source: SMMT Source: Finance and Leasing Association Used-car prices, captured by BCA s reports on auction prices, have remained broadly stable (Exhibit 6 showing fleet and lease and dealer part-exchange prices). In the event of an economic downturn, the used cars for which Advantage provides loans (average loan 6,157,H119) are likely to be less vulnerable to a softening in prices than new, higher-value vehicles. Exhibit 6: BCA auction prices ( ) 12,000 10,000 8,000 6,000 4,000 2,000 Dec-15 Mar-16 Jun-16 Sep-16 Dec-16 Mar-17 Jun-17 Sep-17 Dec-17 Mar-18 Jun-18 Fleet and lease Dealer part-exchange Source: BCA Absent a marked worsening in the macroeconomic background, Advantage should benefit from a progressive improvement in the level of impairments as the tightening of lending criteria feeds through into the book of receivables. The existing high level of demand, the company s relatively small market share and initiatives such as addressing the franchised dealership section of the market all suggest sufficient appetite for loans to allow Advantage to maintain or improve on the current growth rate without relaxing its credit standards. On regulation, the FCA is due to issue its final report on its review of motor finance. The FCA has been focusing on affordability, the basis of commission arrangements, the quality and transparency of information provided to customers, and exposure to falling residual values. S&U believes it is well placed in each of these areas, given its close attention to regulatory developments and welldeveloped credit assessment process. Advantage pays fixed commissions to brokers, prides itself on the clarity of information provided and, with no exposure to PCP contracts and a relatively low value of vehicles financed, is not overly sensitive to fluctuations in residual values. S&U 27 September

5 Turning to Aspen, the prospects here hinge on whether the board decides to move from a pilot project to developing the business further. As noted, the signs are positive and, if the go ahead is given, it seems likely that the board would wish to make sufficient investment in the activity to generate a material contribution for the group. This could mean a loan book rising to around 50m, generating a pre-tax profit of c 5m. For the moment, we have assumed the business will develop beyond the pilot stage, with a loan book of c 30m by the end of FY20. Financials Exhibit 7: Changes to estimates Taking into account the trends shown in the first-half results, including the moderation in receivables growth and increased impairments at Advantage together with progress at Aspen and its move into profitability, our adjusted estimates are modestly lower than previously. Small variations in assumptions could offset the reduction. Year end Revenue ( m) PBT ( m) EPS (p) DPS (p) January Old New Change (%) Old New Change (%) Old New Change (%) Old New Change (%) 2019e % % % % 2020e % % % % Source: Edison Investment Research. In Exhibit 8, we set out the cash flow analysis that S&U provides, giving details of cash flow within Advantage highlighting the tapering down of the level of new advances in the last two halves, and the resulting reduction in the overall outflow both at Advantage and for the group as a whole. Exhibit 8: Cash-flow analysis m H118 H218 H119 Motor finance Advances (77.8) (74.4) (72.8) Monthly collections Settlement/reloans Debt recovery Overheads/interest (14.4) (15.0) (15.8) Corporation tax (2.5) (2.9) (2.8) Dividend (5.8) (2.4) (7.5) Motor Finance outflow (27.2) (14.7) (9.5) Property bridging outflow (2.3) (8.9) (5.1) Other inflow/outflow Group inflow/outflow (31.5) (24.3) (16.4) Opening net debt Closing net debt Source: S&U, Edison Investment Research Closing net debt stood at 121.4m, giving a gearing ratio of 78% compared with 56% for H118. On our estimates, gearing would increase to 79% by year-end and 87% at end-fy20. More funding will be sought in due course to lengthen maturity and match the evolving asset profile, assuming Aspen is developed further. Valuation We have updated our comparative table (Exhibit 9) that includes a number of companies involved in non-standard lending or have motor finance as one of their activities. S&U trades on a belowaverage P/E and an above-average yield. The return on equity is noticeably above the group average, while the price-to-book is only moderately above the average value. S&U 27 September

6 While our estimates have been slightly reduced, as outlined above we still look for the return on equity to move to more than 17% and 19% for FY19 and FY20, respectively. On this basis, an ROE/COE calculation still supports a valuation of 3060p (unchanged with the assumption of ROE of 17%, long-term growth 5% and cost of equity 10%). Exhibit 9: Peer comparison Price (p) Market cap ( m) 2018 P/E (x) Yield (%) ROE (%) Price to book (x) S&U 2, PM Close Brothers 1, , Private and Commercial Finance Provident Financial , N/A 2.4 Secure Trust Bank 1, Average Source: Bloomberg, Edison Investment Research. Note: P/Es adjusted to CY18. Priced at 26 September S&U 27 September

7 Exhibit 10: Financial summary 000s e 2020e Year end 31 January IFRS IFRS IFRS IFRS IFRS PROFIT & LOSS Revenue 45,182 60,521 79,781 92, ,721 Impairments (7,611) (12,194) (19,596) (23,578) (25,389) Other cost of sales (8,980) (12,871) (17,284) (17,688) (20,597) Administration expenses (7,131) (8,332) (9,629) (11,216) (12,806) EBITDA 21,460 27,124 33,272 39,878 47,928 Depreciation (209) (253) (294) (359) (399) Op. profit (incl. share-based payouts pre-except.) 21,251 26,871 32,978 39,519 47,529 Exceptionals Non recurring items Investment revenues / finance expense (1,782) (1,668) (2,818) (4,473) (5,769) Profit before tax (FRS 3) 19,469 25,203 30,160 35,046 41,760 Profit before tax (norm) 19,469 25,203 30,160 35,046 41,760 Tax (3,583) (4,861) (5,746) (6,658) (7,934) Discontinued business after tax 53,299 Profit after tax (FRS 3) 69,185 20,342 24,414 28,389 33,825 Profit after tax (norm) 15,886 20,342 24,414 28,389 33,825 Average Number of Shares Outstanding (m) Diluted EPS (p) EPS - normalised (p) Dividend per share (p) EBITDA margin (%) 47.5% 44.8% 41.7% 43.2% 44.9% Operating margin (before GW and except.) (%) 47.0% 44.4% 41.3% 42.8% 44.5% Return on equity 15.2% 15.2% 16.7% 17.8% 19.3% BALANCE SHEET Non-current assets 103, , , , ,092 Current assets 61,903 57,763 84, , ,072 Total assets 165, , , , ,164 Current liabilities (6,850) (17,850) (7,927) (7,278) (7,720) Non current liabilities incpref (30,450) (38,450) (104,450) (131,202) (162,086) Net assets 128, , , , ,358 NAV per share (p) 1,084 1,177 1,276 1,385 1,548 CASH FLOW Operating cash flow (16,017) (27,431) (43,418) (12,106) (15,866) Net cash from investing activities 80,716 (308) (1,040) (588) (588) Dividends paid (23,090) (9,548) (11,377) (13,084) (14,576) Other financing (excluding change in borrowing) Net cash flow 41,664 (37,266) (55,823) (25,765) (31,030) Opening net (debt)/cash (53,565) (11,901) (49,167) (104,990) (130,771) Closing net (debt)/cash (11,901) (49,167) (104,990) (130,771) (161,817) Source: S&U, Edison Investment Research. Note: FY16 dividend per share includes exceptional payment of 125p. 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