LON:OSB - OSB Group Plc

[Anglozurich]

OSB Group Plc (LON: OSB) is a small, rapidly growing UK-based specialist lending and retail savings bank. It was formed out of Kent Reliance building society after a capital injection by JC Flowers in 2010. It was awarded a banking license in 2011, listed on the LSE in 2014 and completed its acquisition of Charter Court Financial Services, a rival specialist lender, at the end of 2019.

 

OSB are a fast-growing prudent lender focused on specialist areas of the buy-to-let and residential mortgage market underserved by large and medium UK banking institutions. With a market capitalisation of £1.8bn representing a valuation of 7-8x P/E and  1.1x P/B, a rapidly growing loan book (£18bn), a well-capitalised balance sheet, a low-cost growing retail deposit base (£17bn) and impressive management team with skin in the game who have consistently delivered +20% return on equity, the stock is too cheap and is being temporarily weighed down by Brexit and a fear of Banking Credit Crisis Part II, a movie that is unlikely to play out.

 

The bank is well capitalised and has a growing retail deposit base and a good reputation with the regulator (PRA). OSB are benefiting from the Bank of England and PRA’s push to encourage competition from smaller challengers through offering low cost funding schemes to smaller banks such as OSB. A recent scheme of arrangement to form a holding company to make way for MREL planning is evidence that OSB will become a serious player in the future.  OSB have consistently delivered a return of tangible equity north of 20% and NIM of >2.7%. This is the result of targeting a niche buy-to-let sector that is growing rapidly with attractive risk-adjusted returns combined with a growing low cost stable retail deposit base complemented with low cost Bank of England term schemes. The bank has an industry leading cost-to-income ratio of 30% and utilises technology as oppose to branch rollouts. Its net income margin of 50% means it can and has consistently paid dividends.

 

Management are experienced and I like the insider ownership. Andrew Golding (CEO) has a very credible history at various building societies and is known for conservatism. He owns £6m of shares. Alan Cleary who came across from Charter also has a strong background and owns £8.4m of shares. The CFO has £3m of shares. JC Flowers cashed out at the IPO but large current shareholders are by no means cuddly. Paul Singer’s Elliot owns 17% and Merian Global, 15% and GLG hedge fund at 8%. Capital allocation is a tick for me.

 

OSB trades slightly above book with a market capitalisation of £1.8bn. It is expected to generate over £230m in net income in 2020 according to CapitalIQ estimates. A conservative lender with a conservative balance sheet, targeting a fast-growing part of the market at c.8x P/E is historically cheap. Paragon Banking Group is OSB’s nearest competitor and it trades at a similar multiple but its simply an inferior bank. Its funding base is quick money in form of higher cost mortgage and corporate bonds and whilst it survived the financial crisis, its back book is stodgy with a big variable book of low interest mortgages being kicked further down the road by landlords, preventing Paragon from generating the same return on equity as OSB. Larger banks such as Lloyds and NatWest generate 10% return on equity at best and have a huge task on their hands reducing their cost to income ratio down from 50% and cutting branches. They are increasingly shying away from growing their buy-to-let books due to the higher MREL capital requirements and have not been able to make inroads into the growing private rented sector (see below). They are fully focused on the resi market. Brexit is clearly weighing down on UK banks. My view is the British always muddle through. Alarmists with scars from 2008 are still shouting ‘the consumer is on fire’ and ‘credit crisis’ but this call has so far been proven wrong. UK house prices may cool in 2021 but they are up on 2019 and bank balance sheets are very well capitalised with low LTVs and the consumer is holding firm.

 

Across OSB and Charter, the loan book of £18bn comprises £13bn of buy-to-let mortgages, £4billion of residential mortgages and £1billion of commercial, residential development and bridging loans. The loan book has grown from £2.3bn in 2011 to £18bn in June 2020 (including the Charter merger). The buy-to-let book consists of loans provided to limited companies and individuals, secured on residential property held for investment purposes. OSB target experienced and professional landlords or high net worth individuals with established and extensive property portfolios.

 

This segment is called the Private Rented Sector (PRS), which has grown rapidly in the UK and continues to grow. Mom-and-pop landlords are exiting the market due to adverse tax changes on interest relief, higher stamp duty and higher deposit requirements for investment properties. Professional landlords in the form of institutional investors, pension funds, REITs, high net worth individuals and developers are providing millions of homes to an increasing pool of the population who through choice or circumstance are not ready to own a home. The PRS sector has been growing at a rapid clip and now represents over 20% of UK households up from 10% in 2001. The policy of promoting home ownership in the 1980s, to the detriment of all other housing forms, has become the victim of its own success in the UK, with more people than ever trying to buy their own home. However, demand for housing has outstripped supply. A recent VIC member wrote up Bellway (home builder) supporting this thesis. In the UK, it is estimated that 300,000 new homes are needed per year to cater for demand, but, on average, the UK build only around 125,000 each year. This has resulted in a housing shortage, which has now become a housing crisis. Build to rent (part of PRS) where professional investors fund the development of homes to rent will be important in order to fill this gap.

 

OSB’s underwriting quality is high and capital buffers are strong. This is partly due to a very experienced management (see below) who are veterans in the building society space and have lived through the 2008 crisis. Most of the book is first charge with LTVs lower than 75%. Whilst 40% of the book is in Greater London, they have stayed away from Zone 1 and 2 new build apartments and focused on older houses and flats further out in Greater London (think Chiswick over the Heron Tower as the CEO said on a recent call) where rental yields are higher and where landlords have a much higher rent cover on interest charges. All in all, and partly due to house prices staying firm in 2020, they have sailed through COVID. 

 

Funding: the bank is funded through retail savings originated through the long-established Kent Reliance and Charter Savings Bank brands. Retail deposits have grown from £2bn in 2011 to £17bn in June 2020 (including the Charter merger). The Bank of England are encouraging competition from smaller banks and are providing funding at the Bank of England base rate plus small admin costs. They will tap ILTR, TFS and TFSME schemes. OSB have a current funding balance of £2.6bn from the Bank of Englands Term Funding Scheme. 

 

Catalyst:

 

The private rent sector keeps growing

It becomes increasingly obvious that the UK needs more homes to keep up with household formation

Brexit and coronavirus sort themselves out over time

 

[samwise]

Thanks for the idea Anglozurich. I do have some stake in British banks (mainly LLOY).

 

Banking is a commodity industry, so its hard to understand why OSB can generate better NIMs at lower costs than LLOY. Surely other banks can compete in this sector as well, so why isn't this competed away? Or OSB is taking higher credit risk for higher NIMs?

 

The fate of most challenger banks hasn't been comforting, even when they came with great stories behind them.

[Anglozurich]

Samwise, Lloyds is a much larger bank with a legacy cost to income ratio of 50% vs OSB at 30% so it should be straightforward to see hence the higher net margin for OSB. I do own LLOY too and like the safety of the book, absence of PPI claims going forward, cost cutting strategy and its entrenchment in the UK banking market. I own NWG too. (LLOY, NWG and OSB)

 

I disagree with the premise that banks are just banks and anyone can enter compete. In the UK this has not proven to be the case hence why the PRA and BoE are scratching their heads and desperate to improve competition. Aside from stringent capital and liquidity requirements, investments in technology, systems,branches and staff....in order to scale loans and deposits the establishment of a trusted and reliable brand is important but even more importantly, underwriting quality and discipline has to be present. Look at the mess that Metro Bank have made. Lack of trust, higher cost branch network with too many staff (to underwrite more niche areas) and they have pissed off the regulator with a giant gaff on RWA, which could be the end of them.

 

OSB has low charge off rates. Underwriting quality is exceptionally high. They have restated many times that they refuse to reach for margin when the competition gets excited and present in certain areas. Its like saying insurance is a commodity. Through cycles, it just isnt. Short-term maybe because earnings and cash are recorded years apart from each other. Same with banks. Cost leadership and discipline shows up in the numbers over time and i think OSB's financials reflect that. Knowing when to compete and when to reign in the book are important. Also OSB are starting from an incredibly low base (£18bn of interest earning assets vs LLOY at £450bn) so you cant compare. I am not worried about runway. OSB trades like a legacy lender not a growing, nimble bank with good credit quality and high underwriting standards in their DNA

[samwise]

I was asking about NIM, which is just the interest costs of borrowing and lending. It comes before the bank’s other cost to operate. So I can imagine a new technology bank keeping costs low, but not the basic borrowing and lending rates. Unless it’s a feature of the niche they operate in.

 

You could like them because the business niche is great, or the management are great. From your reply it seems like you like the management.

[Anglozurich]

The impairment and provisions are below NIM. There is a great cost to NIM if the lending is reckless so net margin to me is more important. Regarding the PRS niche as the underlying sector they are focused on, i do like it yes for the reasons given.