The Paragon Group of Companies 12 Dec 13

The lending pioneer

Revelations this week that inflation in the UK has tailed off somewhat recently has given further credence to the view that the Bank of England is still some way of in raising interest rates. This should also ensure that the resurgence in the housing market continues a while yet.

To date we have gained exposure to the revival in the UK housing market through a number of different angles, and we have also identified the Paragon Group of Companies (LSE, PAG) as another quality play. The group has carved out a niche as a specialist lender of buy-to-let mortgages to good effect, enabling it to bolster returns to shareholders and invest in new business growth, as mortgage demand in the UK has surged.  

With strong ongoing growth prospects, we are also attracted by the group’s modest valuation, and we are therefore recommending the stock as buy to all Members.


From a technical stand point, share price action is very supportive of further upside. The uptrend that commenced during the second half of 2012 has maintained its momentum for the past 18 months. Having found support at the technically important Fibonacci retracement of 38.2%, the share price has rotated higher, positioning itself just below resistance at 357p. In addition, the formation of an ascending triangle indicates that it won’t be long before a break out of the current trading range takes place.

Background

Paragon was established in 1985 and is a specialist (and the only independent) lender of buy-to-let mortgages in the UK which targets landlords and residential property investors as customers. The company also operates as a loan servicing provider for third parties, and seeks to acquire loan assets and portfolios. The company currently has around £10 billion of loan assets under management, which are continuing to grow at a rapid clip.

The company operates as a buy-to-let specialist lender through established brands Paragon Mortgages and Mortgage Trust. Paragon stands out in the lending market being one of the pioneers of buy to let finance, and in 2000 was the first to focus solely on this market

The company also has an investment division, Idem Capital, which seeks to acquire loan portfolios, including first and second mortgages, in addition to unsecured assets. The company also services loan portfolios for banks and other specialist lenders. Idem is one of the top consumer debt purchasers in the UK and has a book of around £3.5 billion of loans.



Results

With the renaissance in the UK property market over the past year it is no surprise that buy-to-let investors have been driven back to the market. Rental rates have been robust and the attraction of still low mortgages rates, and the prospect of further capital value increases, has boosted the allure here.

And as a niche lender in the sector, Paragon has benefited significantly, and this is borne out by recent results.

 

Source: Company Presentation

The company saw record profits in the year ending 30 September 2013, with profit before tax rising 10.4% to £105.4 million. Underlying earnings were 10.5% ahead at £104.1 million. Underlying profit in the buy to let lending business rose from £61.6 million to £64.4 million, while the consumer finance division saw profits rise from £32.6 million to £39.7 million. Underpinning momentum was robust growth in group loan assets.

A significant increase in lending volumes in an increasingly buoyant buy to let market propelled earnings out-performance. The company reported that buy to let loans increased by an impressive 90.5% over the course of the year to £359.8 million.

Source: Company Presentation

Overall volume growth had the impact of driving overall net interest income by 2.2% to £161.3 million. Cost control meanwhile was also impressive at the same time with an underling cost to income ratio of 30.9%, well below industry averages.

And looking ahead management advised that the outlook was also robust with the pipeline of loans at 30 September 2013 standing at £231.9 million, some 78.5% higher than the year before.

Importantly (and particularly for those with vivid memories of the GFC) the quality of new business lending has not been sacrificed, which has seen default rates continuing to trend down. This is as Paragon typically targets professional landlords making for a relatively high to loan to value ratio of 75% on average.

Source: Company Presentation

Paragon saw the buy-to-let portfolio reach £8,324.4 million, compared with £8,196.4 million a year earlier. And the company’s book has remained increasingly sticky with a redemption rate of just 2.5%, with Paragon’s buy to let specialist offering attractive compared to main street lenders.

Management reports that the percentage of loans three months or more in arrears stood at 0.35% at 30 September 2013. This compares highly favourably to the industry average of 1.16% as cited by the Council of Mortgage Lenders (CML). The impairment charge attributable to the First Mortgages unit decreased to £6.8 million for the year from £12.4 million the year previous.

 

Source: Company Presentation

Clearly a rising property market will help reduce impairments and defaults but it is a testament to the company’s credit control and lending tests in our view that the arrears rates are running at around 30% of the industry average.

Consumer Finance

The company’s consumer finance division also put in a steady if less spectacular performance last year. The total loans outstanding on the books were £399.7 million, compared with £399.0 million at 30 September 2012, with portfolio purchases offset by redemptions.  The book is split with £248.4 million in secured loans, and £151.3 million in unsecured loan, retail finance and car finance portfolios.

Idem Capital is the Group's investment division, investing in loan portfolios either as principal, or as a co-investor alongside other partners. Paragon’s two servicing units Moorgate Loan Servicing and Arden Credit Management are usually involved here which generates additional income. At the year-end 43.8% of accounts under management were managed on behalf of third parties.

During the year Idem Capital added £92.8 million of new investments and a further £13.5 million shortly after the year end. Idem purchased £71.9 million of unsecured loan assets and invested a further £20.9 million in loan portfolios as a co-investor. At year end the balance outstanding in respect of investments in portfolios was £193.7 million, up from £135.4 million in 2012.

Idem has also carved out a niche in the UK as a mainstream purchaser of consumer debt and is benefiting as a range of large institutions look to rationalise their balance sheets.  And Idem is benefitting as it tends to buy at deep discounts.  

Paragon is planning to give the consumer finance division a real shot in the arm though, with plans to start a new banking subsidiary. The company plans to set up a consumer lending entity, financed primarily by retail deposits, to make, initially, car and second mortgage loans. Subject to approvals this will be up and running in the first quarter and could provide a further boost to earnings, and an additional source of funding.

Cash Flows

Significant growth in the company’s loan book, and the low amount direct competition in the buy to let space, has not surprisingly seen a robust earnings performance flow through to the cash coffers.

‘Free’ cash balances were £170.8 million at year-end, up from £127.7 million the year before. This also adds to Paragon’s war chest to invest further in loan portfolios and other new lending.

 

Source: Company Presentation

Robust cash flows are also being used to reward shareholders with the company increasing the total dividend for the year by 20% to 7.2p per share. Management are looking to maintain a progressive dividend policy as earnings grow, with dividend cover maintained in the range 3.0 to 3.5 times.


Funding

Securing funding for buy to let mortgages was not surprisingly tight in the wake of the GFC but the tide certainly appears to have turned.

Paragon also lays claim to be one of the first companies in the UK to pioneer the securitisation of buy to let loans and is certainly finding this no problem at the moment. In September the company completed a £273 million deal here through Paragon Mortgages A substantial £238.1 million in AAA rated notes at margins of 115 over three month LIBOR was a clear reflection of the quality of the underlying assets.

Paragon also uses two warehouse facilities to originate mortgage loans, prior to arranging term funding. The company now has around £450.0 million in capacity and will possibly seek to up this as mortgage demand rises further.

The company also completed a retail bond offering during the year. The £60.0 million issue is set to mature in 2020 and is being invested in growth opportunities across Paragon Mortgages and Idem Capital.

Property Market Outlook

Paragon has delivered an impressive performance over the past year but a key determinant of whether it will continue as robustly is the property market.

It is no coincidence of course that the revival in the UK economy has occurred in tandem with a constant improvement in the housing market. And indeed this is a thematic we are seeing play out in many parts of the world post the GFC with housing wealth gains closely linked to overall increases in consumer and business confidence.  

A low interest rate environment has certainly helped bolster the housing market, and we think this support is likely to remain in place for the next year at the very least.

The Bank of England will continue to lend support in our view given that inflation and unemployment are some way below and above target respectively. It is therefore hard to see the Bank of England embarking on a tightening phase in the next 6- 12 months.

In any event if the unemployment rate fell meaningfully below target this would imply a much stronger economy. It would therefore be accompanied by new marginal housing demand and wage inflation to help offset any interest rate rise.

Given the interest rate outlook, and robust mortgage growth, we therefore see the housing market in the UK continuing to play a large part in the economic revival which is taking place. And this will also be equally true of the buy to let investment market in our view.

And with the recovering economy both consumer spending and borrowing will also continue to lift. Paragon will also be able to benefit in this regard from its consumer finance division and soon to be established bank.

A risk for Paragon of course is that the property market turns, likely due to rising interest rates, and that demand weakens and funding suddenly becomes an issue (again). However, we do not believe that interest rates are going to rise in the next year, and when they do it will likely be measured, particularly in light of the current inflation outlook.

Valuation and Summary

Currently Paragon trades on a forward price earnings multiple of 11.8 times which is undemanding given our expectation that the property market will continue to be robust.

With a niche position in lending to the buy to let sector Paragon is well placed if mortgage demand continues to rise which looks likely given housing demand.  Whilst rising interest rates will dampen the outlook at some juncture, we do not see this happening in the next 12 months, and rises when they do come will likely be fairly measured.

Accordingly, we recommend Paragon Group as a buy to all Members around current levels. 

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