value and opportunity

Within my Handelsbanken mini series (part 1, part 2, part 3), I have identified their UK business as one of the potential value drivers. So it was a luck and coincidence that a few days ago, Aldermore PLc, a “start-up” UK Bank went public.

Aldermore itself was founded only in 2009 by a then out-of-job former Barclay’s Banker called Philip Monks. They tried to go public already last year but had to pull the IPO in October.

As I have mentioned a couple of times, an IPO prospectus is always a good opportunity to learn about business models in general and about competitors and the specific sector as well.

There are some interesting parts from the prospectus on the UK banking market:

A high number of mergers and acquisitions in the sector has resulted in sector consolidation (Lloyds’acquisition of HBOS being the largest as well as a number of smaller building society takeovers such as Santander’s acquisition of Alliance & Leicester and Nationwide’s acquisitions of Cheshire, Derbyshire and Dunfermline Building Societies). This has resulted in the UK banking sector becoming one of the most concentrated and least competitive in Europe according to a Treasury Select Committee report published in 2011.

The report concluded that the top five UK banks controlled 75 per cent. of total gross new lending in total mortgages, 85 per cent. of the personal current account market and 62 per cent. of the savings account market.

For a potential shareholder in a UK banking business stock, “most concentrated and least competitive” sound not that bad as it implies some pricing power.

Handelsbanken is mentioned as one of the few foreign players:

Although there are exceptions (e.g. Handelsbanken), more generally, foreign banks have exited or reduced their presence in the UK market. For example, ING exited their mortgages and savings business and stopped writing new business in Asset Finance towards the end of 2012 and the UK business banking subsidiaries of Irish banks have restricted lending.

Furthermore, UK banks have been forced to carry out major cost-cutting exercises, including centralising credit selection functions; in some cases, ring-fencing retail operations; and spending significant amounts to improve the performance and security of their IT platforms.

UK banks have also been significantly impacted by legacy issues arising from, for example, the mis-selling of PPI and swaps and from legacy and underinvested infrastructure. Since 2011, the total bill for litigation,fines and customer redress has been £28.5 billion, equivalent to two-thirds of the cumulative profits of the top five banks over this period

 Customer dissatisfaction in the UK banking sector has also risen. One effect of this, as discussed in a recent Oliver Wyman report, is an increased propensity of customers to review and switch banking provider

Similar to my argument for Handelsbanken, UK customers seem to be fed up with UK banks and are open for new entrants like Handelsbanken and Aldermore.

As a result of these factors, there have been a number of new entrants to the UK banking market. They have adopted a variety of models targeting different credit segments (i.e. retail, SME, corporate) and adopted different distribution models (i.e. branches, intermediary, direct). These include retail-focused branch-based banks such as Metro Bank and Virgin Money and required disposals under State Aid such as Williams & Glyn (currently part of RBS) and TSB (majority owned by Lloyds Banking Group). In addition, these are specialist lenders such as Close Brothers, Shawbrook, Bibby and Paragon, challenging the share of the UK banking market controlled by the incumbents in targeted lending segments.

Aldermore however has a complete different set up than Handelsbanken. They don’t run any branches:

Aldermore does not have a traditional branch network and as such does not have the significant costs associated with running such a branch network.

Instead they run Online/Broker/intermediary based business model, claim to avoid unnecessary costs for branches.

The Directors believe that Aldermore’s branch-free distribution model is better suited to the digital era,with the regional offices representing the physical footprint that Aldermore requires to service its SME customers. The absence of a large, under-utilised branch network enables Aldermore to distribute products and service customers more cost effectively

Interestingly, their actual cost income ratio 2014 is  60% vs. 53% at Handelsbanken. This might have to do with size (Handelbanken is 2-3 times bigger). So it is clearly not a “no brainer” to run an online bank only.

What I didn’t like about Aldermore:

– Intermediary model is not that easy. They don’t have direct client contact, clients are “owned” by brokers
– How do they cope in a downturn test if work outs are necessary and they don’t have client contact ?
– large potential bonuses for management
– targets for management are only EPS and Share price

They do state an explicit ROE ambition:

The Directors are targeting a return on equity of approximately 20 per cent. by the end of the financial year ending 31 December 2016.

Targeting is great, but having it included in compensation would be even better.

Could Aldermore be the same story like Admiral 10-15 years ago ?

I think that Aldermore differs in a very important way from Admiraml: It is not structured at as capital-light model, Aldermore keeps the risk on its balance sheet and will at some point in time need additional capital if they grow like this, which then will dilute shareholders.

Additionally, they are not active in the comparison space. I do think that in the long run will bite into their profitability as the comparison siteswill be able to charge them significant comissions for referals. In the insurance space, referral fees in many cases are already as expensive as sales commissions for agents.

A good reminder that not every new and online based financial company is “the next Admiral” is for instance Vardia, the Norwegian direct insurance newcomer. After explosive growth, out of the blue they had to announce a recapitalization recently. The stock price of course got hammered.

Summary:

Aldermore is clearly riding the wave of disgruntled UK bank clients, but I would not invest there. I don’t see a real competitive advantage,at least not for now.
Valuation wise, the company trades at around 2,5x book value and 15 times earnings which is OK but not cheap. The biggest risk in my opinion is that with their aggressive growth, the might attract a lot of bad risks. Their long-term underwriting abilities will be tested in the next down turn for sure. Anyway, the Aldermore IPO clearly shows that there is room for smaller players in the UK and that there is a good chance for Handelsbanken to grow for quite some time.

Additionally i would argue that the UK banking sector still looks attractive compared to other countries. In Germany for instance retail and commercial banking is dominated by Government backed banks (Sparkassen) which have a built-in advantage of extremely low funding cost. The local UK market in comparison looks much better, especially as interest rates are still positive…..