Arbuthnot Banking Group Analyst Q&A: Transition appears both well-timed and well-positioned (LON:ARBB)

Arbuthnot Banking Group plc (LON:ARBB) is the topic of conversation when Hardman and Co’s Analyst Mark Thomas caught up with DirectorsTalk for an exclusive interview.

Q1: You called your recent note “2020 results in line; 2021 outlook: strong recovery?”. Can you give a short summary of your key findings?

A1: The key highlights from Arbuthnot Banking Group’s FY’20 results were a small loss (as expected), with breakeven excluding deal costs. Margin pressure (from base-rate cuts) and a £2m rise in impairments, despite there being zero higher-risk Stage 2/3 property exposures over 80% LTV (2019 over £30m), were the main drivers.

The 2021 outlook is for i) a strong recovery, driven by loan volume growth, ii) less pain from excess liquidity, iii) profits generated by Asset Alliance after acquisition (completed end-March, which will also see a £10m equity uplift, as it is being bought below book), iv) a gain on the sale of Tay mortgages, v) forecast lower impairments, and vi) a dividend from STB.

Q2: Taking last year first, what drove the fall in profits, so that ABG broke even only on an underlying basis?

A2: The cut in the base rate (from 0.75% to 0.1% in March 2020) had several effects during the year. ABG was not able to pass on the full reduction to its savers but, as most of its lending is variable rate, its interest income fell more than interest expense – a hit to earnings of ca.£6.7m. Given the uncertainty, ABG prudently increased surplus liquidity from ca.£400m to ca.£600m and, paying more for marginal deposits than it earned on cash reserves at the Bank of England, which fell with the base rate, this cost a further £3.6m. ABG has not simply sat on its hands facing this margin pressure, but has, as a consequence, lost over £10m in interest income.

COVID-19-related issues saw gross impairments rise by £2m, with ca.£1m in formulaic expected loss calculations on performing lending and the balance where there had been some deterioration in customers’ creditworthiness. Overall, credit quality was very robust, but ABG faced a specific issue from its lending to London taxi companies. Segregating the impact on revenue from COVID-19 is challenging. ABG tightened its lending criteria, reflecting operational uncertainty on borrowers and the practical difficulty in accurately assessing security, but also the prudent preservation of capital to take advantage of new opportunities that were likely to emerge post-pandemic.

Q3: You touched there on new opportunities, and the outlook sounds much more positive; you outlined some of the drivers a bit earlier, but can you give us some detail?

A3: Sure – the first real opportunity is in acquisitions. ABG’s strong capital and liquidity mean it can do value-enhancing deals – like the Asset Alliance deal. That completed on 31 March, and ABG is buying it £10m below the accounting fair value – an uplift that goes straight to equity – and because ABG has more certain, lower-cost funding, it should be immediately profitable. We estimate £900k in 2020 and £2.75m in 2021. Non-bank lenders are finding financing difficult, and ABG is a solution for them.  Second, we do not expect the same drag effects in 2021 as we saw in 2020, and so the franchise growth can feed through to profit. We are already seeing loan growth resume on better margins, and, given more confident margins, we expect less of a drag from excess liquidity. Third, the impairment outlook remains uncertain, but we expect a slightly lower charge in 2020, as we do not anticipate a repeat of the same scale of the formulaic charges. Fourth, it sold a small mortgage book, where servicing costs were making it uneconomical for ABG but, on the sale, it has generated a net gain of £2.2m. Fifth, it is controlling costs tightly – for example, by closing its Dubai office. Finally, STB (in which it now holds a near 6% stake) has declared a dividend, which is income for ABG.

Q4: And, looking further forward, what can you tell us about the strategic direction of the firm?

A4: For the first time, Arbuthnot Banking Group has outlined, in detail, how it sees its strategic future over the medium term. The core private bank becomes roughly a third of the group, from a position when, in 2016, following the disposal of Everyday Loans and STB, it accounted for almost the entire group. In summary, ABG is a diversified mix of small business finance companies, earning strong returns on capital (23%-33%).

The group has been transformed from a relatively stable private bank, with a high-return specialist personal lending business, into a stable private bank, with a high-return specialist SME business. Given trends in regulatory intervention and the dramatic impact of claims management companies in the personal space, this transition appears both well-timed and well-positioned.

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