Interactive Investor

Stockwatch: taking a stake in this challenger bank looks a good strategy

This company’s financials look very clean and show excellent margin and free cash flow. Analyst Edmond Jackson thinks the stock appears cheap if the UK avoids serious recession. 

8th December 2023 09:32

Edmond Jackson from interactive investor

Strong annual results to 30 September from Paragon Banking Group (LSE:PAG) - one of the UK’s so-called “challenger” banks – have sparked a jump in its share price from around 490p to around 550p. 

Its chart does look periodically jagged, and even a near £1.2 billion mid-cap company can have tight liquidity. But the market looks to have been taken by surprise by this, and a few other financial stocks reporting how underlying performance has been far more resilient than relentlessly declining charts through 2023 imply. Efficient markets, anyone? 

Bank shares: a conundrum in the current environment  

Their business models benefit from higher interest rates, but if recession strikes then bad debts multiply. Various banks are active mortgage lenders where demand has reportedly taken a hit. Moreover, Paragon is exposed to buy-to-let – where alarmist reports have suggested the economics are no longer viable and landlords are exiting. Amid plenty of talk in the media of a UK recession, it is hardly surprising investor sentiment towards banks has cooled.

Yet even after Paragon’s share price jump, and if management’s resilient outlook statement can be relied on, the consensus target for an advance in net profit from £154 million to £191 million in the current year to September 2024, implies is a forward price/earnings (PE) ratio of just over six times. With share buybacks continuing, it’s exactly six times in 2025. Similarly, the prospective dividend yield is 6.5%, rising to near 7% and covered 2.5 times by earnings if consensus is fair.  

Mind, various banks are rated modestly – for example Barclays (LSE:BARC) is on 12-month forward earnings of 4.5 times and yielding near 7%, Lloyds Banking Group (LSE:LLOY) is on six times earnings and near 7% yield, and “peer” challenger Metro Bank Holdings (LSE:MTRO) on 3.3 times (if projections are reliable here) but no yield.  

Paragon’s free cash flow per share was a humungous 428p in the last financial year, nearly five times management’s definition of normalised earnings per share (EPS). 

Additionally, and while Paragon appears to offer a classic “margin of safety”, being priced at 0.8 times book value, that ratio is 0.3 for Barclays, 0.8 at Lloyds and 0.3 at Metro. Implicitly, the market has tried to price in risk of write-downs if businesses fail and mortgage arrears multiply, and house prices (as collateral) fall. 

Paragon originated as the National Home Loans Corporation in 1985 and the banking operation was launched in 2014. An essential case for its equity would be that it’s a more focused UK operation than the big banks and better managed, yet its stock is affected by Metro’s serial fiascos tainting the reputation of challenger banks.  

Perhaps there is a contrarian case for Metro, unloved at around 40p in the wake of a rescue-refinancing, but the market probably will want firm evidence of turnaround.   

In terms of overall risk/reward, Paragon’s financial record shows excellent margin and free cash flow, conveying a sense of quality yield. On this valuation basis alone, the stock appears cheap if the UK avoids serious recession. 

Paragon Banking Group

year-end 30 Sep

2017

2018

2019

2020

2021

2022

2023

Turnover (£ million)

429

499

535

509

458

568

1,028

Operating margin (%)

33.7

36.4

29.7

23.3

46.7

73.6

19.5

Operating profit (£m)

145

182

159

118

214

418

200

Net profit (£m)

117

146

127

91.3

165

314

154

EPS - reported (p)

41.9

54.2

48.2

35.7

63.0

126

66.3

EPS - normalised (p)

41.9

54.2

48.2

35.7

63.0

126

66.3

Operating cashflow/share (p)

527

399

151

402

336

469

936

Capital expenditure/share (p)

0.9

0.9

1.2

1.1

1.7

1.2

1.4

Free cashflow/share (p)

526

398

150

401

334

468

935

Dividends per share (p)

15.7

19.4

21.2

14.4

26.1

28.6

37.4

Covered by earnings (x)

2.7

2.8

2.3

2.5

2.4

4.4

1.8

Return on total capital (%)

1.1

1.3

1.1

0.8

1.4

2.5

1.1

Cash (£m)

1,497

1,311

1,225

1,925

1,360

1,931

2994

Net debt (£m)

11,042

11,943

11,819

12,177

12,398

12,655

13,335

Net assets (£m)

1,009

1,074

1,108

1,156

1,242

1,417

1,411

Net assets per share (p)

380

412

432

451

496

596

651

Source: company accounts

Spectacular beats on most metrics versus other banks 

You would think by now that higher interest rates should have affected demand for mortgages and loans, while the cost-of-living crisis – with higher food and energy bills in the last year – has caused deposits to run down. 

But capable deposit service providers – offering decent interest – are in clover as customers shift money out of major bank current accounts. In its year to 30 September, Paragon enjoyed a 24% increase in retail deposits to £13.3 billion. This is important given savings deposits are the principal source for Paragon’s financing needs, hence its risk profile.  

Total new lending has slipped 6% to £3.0 billion albeit chiefly a 13% reduction in commercial lending advances to £1.13 billion, while mortgage advances were quite flat at around £1.9 billion. The overall loan book has still managed to grow nearly 5%, and a widening of the net interest margin to over 3% has helped the 25% underlying profits rise.  

A sceptical view would be that the chief shift of cash from bank current accounts to higher interest providers has happened. January 2024 onwards will be the real test of business confidence for commercial lending where Paragon makes its best margin. 

Yet on mortgages, unless unemployment rises the housing market has resisted most dire predictions. Paragon says its mortgage lending quality remains strong and significantly better than industry averages. 

Buy-to-let lending seems trickier, where media stories have proclaimed the buy-to-let bubble having burst and even experienced landlords are selling up. Paragon says its arrears in buy-to-let have more than doubled to 0.34% of total such lending, albeit “significantly below the industry average”. 

It is the group’s most mature division, but while the market has slowed this year, management says: “the more specialist sector in which the group operates has been materially more resilient.” 

Continued digitalisation has also helped. Paragon says: 

“The buy-to-let mortgage maturities portal introduced in 2022 underpinned a material improvement in customer retention, with over 80% of landlords with maturing fixed-rate accounts taking switch products at maturity, up from over 70% in 2022.”  

Similarly, a lending portal for small-to-medium-sized businesses, offering enhanced support, is described as “a catalyst for increased applications and more effective case handling.”  

Commercial lending is important for Paragon given it operates at wider margins than buy-to-let lending. 

Further digitalisation is scheduled this year, which I guess might assist growth if the economy allows; maybe not though, if UK political uncertainty tilts us into recession. 

As ever with financial stocks, you can go so far judging them according to management capability, but very significantly you are taking a macro view. 

Derivatives cause big disparity in reported profit 

In 2022, reported profit was boosted by £192 million of fair value net gains which became a £78 million loss this year.  

Note nine to the accounts clarifies this as “accounting volatility on derivative instruments which are matching risk exposures...generated requirements of accounting standard 39...losses and gains are primarily due to timing differences in income recognition between derivative instruments and hedged assets and liabilities”. 

Management reassures us that it does not affect cash flow and will reverse over time.  

Otherwise, Paragon’s financials look very clean. It has virtually no debt (where Lloyds’ net gearing has recently been over 60%), enabling the income statement to substantially reflect customer matters: £449 million net interest income split as £1,011 million interest receivable and £562 million interest payable.  

Even leasing arrangements have generated over £5 million net and are improving. 

Yes, impairments have risen 29% but only to £18 million, reflecting customers being hit from higher interest rates and inflation. So again, with that as a benchmark, take your view how worse the UK can get. 

Chart since 2008 reflects steady if volatile uptrend 

From 45p in December 2008, the stock was testing 600p last February, though has appeared in a volatile-sideways range the last two years. There was a sharp drop from around 630p to 430p in February/March 2022, and later that August/September it dropped from 580p to 340p, if significantly reflecting the UK “mini-budget” fiasco. You could still reckon to beware of macro events. 

Management contends that its focus on specialist products and margin maintenance has helped it prosper even in a high inflation/interest rate environment. That’s underlined by a 31% hike in the dividend to £37 million, despite £100 million spent buying back shares and a £50 million programme now embarked on.  

A pragmatic conclusion is to respect how Paragon’s relatively modest size, proven business model and capable management, should help it continue taking share from the main banks – hence its equity merits steady accumulation despite timing uncertainties. Buy.  

Edmond Jackson is a freelance contributor and not a direct employee of interactive investor. 

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