Arbuthnot Banking Group progressing strategically towards its ‘Future State 2’ plan (LON:ARBB)

Arbuthnot Banking Group (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 ‘Trading update: taking ABG to the next level’, can you give a short summary of your key findings?

A1: In our view, the key takeaway from the recent 3Q trading statement is how Arbuthnot Banking Group is progressing strategically towards its “Future State 2” plan.

In particular, we note i) specialist SME finance divisions generating the ambitious balance sheet growth in the plan, ii) optimising the core relationship banking franchise, which, in this period, saw 7% deposit growth ‒ given the level of base rates, this is a profitable product for a relationship bank, and iii) continued investment, which, at times, requires a step change in cost rather than a gentle evolution.

To meet expected multi-year demand, ABG is increasing its central London HQ office space by 45% at an annual increase in cost of ca.£5m (with further dual running costs until October 2024 as it is refitted).

In terms of credit, the book continues to perform robustly despite the increased credit risk inherent in the current environment. This was a result of a conservative credit appetite, which was tightened over a year ago. At the interims, we detected the early signs of a gentle deterioration, and our loss expectations are unchanged.

Q2: So can you tell us first about the growth in the SME franchises?

A2: The company, in recent years, has invested in a number of specialist finance businesses, which are now reporting the strong growth inherent in the ambitious “Future State 2” plans.

These include: i) RAF finished the period with a loan book of £176m compared with £157m at the half-year, equating to a 33% increase since 31 December 2022; ii) Asset Alliance had Assets Available for Lease of £276m at 30 September 2023 compared with £259m at 30 June 2023 and £172m at 31 December 2022, and iii) despite the slow PE market activity, a major source of new business, Arbuthnot Commercial Asset Based Lending, maintained its loan book over the quarter to finish at £244m.

Q3: Optimising the core relationship banking franchise, what have they been doing there?

A3: In our previous notes, we have emphasised how they have built a relationship bank, which, in a period of rising interest rates, can offer competitive deposit products that are profitable to the bank. This suite has been the focus of marketing, given the interest rate outlook and its capital efficiency. It is encouraging that growth in the bank’s client base has continued in the third quarter, from the existing franchise as well as from new segments, with deposit growth of £218m, to £3.5bn, as at 30 September 2023.

Assuming no further changes in rates, the cost of funds is expected by the bank to stabilise at around 310bp (it was 291bp end September) as fixed rate accounts mature and re-price. As Arbuthnot places its surplus liquidity with the Bank of England this average cost of funds is well below the level of income it earns, making deposit-gathering a very low-risk and profitable business in its own right.

Q4: Can you tell us about the investment to take the business to the next level?

A4: Some costs, such as property, by their nature, can see step changes for a strongly growing business.

Following historical growth, the company has had multiple central London sites and the current lease on the main HQ was coming to an end. Given the strong demand it expects over the period of the “Future State 2” plan, and the need for high specification working space, client meeting and entertainment suites inherent in its relationship banking model, ABG has decided to take on 45% more central London space in a single site.

There will be dual running costs until October 2024 and the increased footprint and depreciation of the fit-out costs will increase the annual expenditure on premises by ca.£5m, on a steady-state basis. The new site is expected to meet demand for several years to come (the lease is for 15 years) and, given the current central London commercial real estate market, negotiating a large, single site is likely to have been on relatively favourable terms.

Q5: Any other notes of caution?

A5: Arbuthnot Banking Group is experiencing net interest margins that are higher than it expected over the longer term, as the repricing of deposits generally has a delay of up to 12 months as time deposits reach maturity.  

Also, the group is yet to see the full impact of the inflationary pressures on its cost base.

As always, there is macroeconomic uncertainty, and the political environment creates its own uncertainties too. Credit deterioration is an obvious risk but, as I mentioned, ABG has been conservative in new lending criteria and taking security which should reduce the probability of default and the loss in the event of default.

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