Paragon Banking Group PLC (LSE:PAG, Financial) is not a normal bank in that it does not offer customers day-to-day banking services. Its focus is on consumer and small business loans, skewed toward buy-to-let mortgage lending and fixed-rate savings.
The stock is fairly valued based on the GF Value Line and has a Piotroski F-Score of 8. Financial companies do not have Altman Z-Scores, but Paragon’s loan-to-value ratio on mortgages average is a conservative 57% across its portfolio.
Mortgages make up around 12 billion pounds ($14.64 billion) of the 14 billion-pound total loan book where the net interest margin is just 2.07%, but up from 1.69% in 2019. Now that mortgage rates are rising, and rising more quickly than deposit rates, the net interest margin will eventually increase, but there will be an inevitable lag in higher rates flowing through to revenue as most of its loans are on a fixed-term, fixed-rate basis.
This bias for mortgages is slowly reducing, which lessens the risk on the cyclical housing market. Commercial loans are currently 12% of its loan book, but this has increased by a third since June 2019 (with mortgages up 11% in this time) and 40% of these are for real estate development, with 33% for general small and medium-sized enterprise business loans and 15% in motor finance with the balance in structured finance. Commercial lending overall generates a net interest margin of 6%, so net profits come in at around a third of the level that mortgages produce. Management have stated its strategy is to continue to grow this division faster than the residential loans business.
Paragon became a bank and deposit-taker in 2014, with most of its funding coming from savers’ deposits and some funding from the Bank of England. The company also can use the securitization markets, where loans are packaged together and sold to external investors. Paragon was once one of the big issuers of U.K. mortgage-backed securities, though its reliance on MBS issuance has fallen sharply in recent years.
Mortgage market risks
The U.K. housing market has been strong in the last couple of years, but the near-term outlook could see falling demand, and potentially a tougher wholesale market and higher default risk.
However, Paragon is well placed to face this environment. Consumer-facing inflation and weaker purchasing power will impact house buyers more than renters, so landlords should benefit from sustained rental demand. Higher wholesale funding costs in the money and debt markets should be mitigated by higher saver deposits. Finally, lower loan-to-value ratios mean default risks are less likely in the mortgages that Paragon writes. The average LTV across its portfolio is currently at 57% and less than 2% of is loans have a higher risk LTV rate of 80% or more.
The buy-to-let market will not be unaffected, but Paragon’s unreleased provisions put in place for Covid-19 risks mean its balance sheet can stomach some distress in its core mortgage market.
Buy to let
Tax changes introduced since 2017 mostly apply to the amateur end of the market, or people who could be considered accidental landlords. Paragon’s customers are mostly professional landlords who tend to own multiple rental units, often via a company, so they can offset loan interest as a corporate expense to reduce their tax bill.
The tax changes impacting smaller investors means many buy-to-let amateurs will be wanting to exit. These units could go to first-time buyers, but will more likely get absorbed by the larger, more professional landlords, therefore potentially creating more business for Paragon. So what seems like a negative development on the surface should be more of a positive for the company.
Risks
Big U.K. banks have historically tended to avoid the buy-to-let space. Barclays’ (BCS, Financial) recent purchase of Kensington Mortgages and HSBC’s (HSBC, Financial) murmurings at interest in the "non-standard" market both suggest they could be entering. The reason is because their net interest margins are so low since mainstream mortgage lending is so competitive and low margin. If they enter the buy-to-let market, then Paragon’s net interest margins would probably be under threat somewhat, even if big banks where entering to capture higher margins in the first place.
Track record
Paragon has a good history of returning surplus capital to shareholders. A core equity-to-risk-weighted assets ratio of 15.4% has been pretty consistent in recent years, above regulatory minimums. This enabled a steady capital return program divided between dividends and share buybacks.
Since 2015, 6he company has bought back 335 million pounds' worth of its equity and paid out 339 million pounds in core dividends, equating to a total distribution ratio of 40% of net profits. In 2022, Paragon plans to buy back 75 million pounds' worth. The group’s market capitalization is just 1.25 billion pounds. This means total returns of about 6% this year and the core dividend yield is about 5%. With this kind of strategy, total returns have averaged 8.75% over the last five years.
Paragon’s return on tangible equity is a respectable 15%.
Even allowing for a fall in house prices, the asset-backed market should remain secure and Paragon’s customers are strong enough to avoid having to sell up. Therefore, the investment case looks positive.
