Company snapshot

The business

PAG LN

6th June 2011

Paragon is the third largest lender in the UK buy-to-let (BTL) market offering a range of loan services such as property portfolio management, non-performing loans and arrears management, litigation services, property appraisals. The company also operates a consumer finance secured loans business through a network of dedicated brokers and is currently willing to increasingly rely on less capital intensive income streams such as advisory services within the mortgage market.

Paragon boasts a strong execution track record in the industry. Very attentive focus on borrowers credit quality rather than region-oriented indiscriminate lending and a precise asset-liability match (the lack of which has struck some competitors during the crisis) have provided PAG with a significant competitive advantage.

more in details The vast majority (95.5%) of PAG assets sits in mortgages which present lower delinquencies than consumer finance loans and offer higher return (1.85x). o Within the mortgage segment, only 1.65% of assets are owner related while the rest is entirely made of BLT. o The portion of consumer finance loans has been decreasing over the past quarters. o 394 mln assets of consumer finance loans, 362 mln are secured loans (backed by collateral).

Asset credit quality is much more solid than industry-wide average. The first chart shows the significantly lower BTL 3-month + arrears (missed or late payments for over 3 Months) compared to industry-wide and CML (Council of Mortgage Lenders) BLT mortgages. Although trends have progressively deteriorated over time since 2006, lower delinquencies can also be seen also for second charge mortgages: a mortgage that uses as collateral the house purchased through another mortgage (the first one).

Current ICR stands at 300% up from 170% at origination of BTL mortgage.

New income sources Company intends to seize opportunities offered by the abundance of non-core bank-held mortgage portfolios present in the market, by acquiring some of them. Pipeline of mortgage origination for 2H11 is strong. At Paragon new loans origination is centered on very strict standards and focused on experienced property investors. The typically targeted customers are professional landlords. Risk metrics adopted are significantly more prudent than the market average. LTV * (loan-to-value) stands at 68.0% vs. 75% and ICR (Interest Coverage Ratio) stands at 1.60x vs. 1.25x. Beside the acquisition of securitized loans portfolio, which offers the advantage of pocketing cash flows of real estate assets without having to book them, and mortgage originations, PAG management aims at diversifying its income stream with its portfolio of companies specializing in mortgages arrears collection, litigations, real estate properties portfolio management/appraisal, rent insurance/guarantee, risk-management and thirdparty loan servicing.

Strong drivers for landlords BTL mortgages demand Interest rates are very low and yields have already attained (over) two-year peak in Apr. at 6.2%, equaling Nov. 2010. o Rents in the UK increased by 4.4% y/y on average. o Property purchase demand lost ground in favor of property rental demand and not likely to see trend reversal in short/medium term.

Subdued number of first-time buyers (owners living in purchased property) thus hinting at higher rental demand.
LTV represents the loan nominal as percentage of the property value ICR shows by how much the rent expected on the purchased property will cover mortgage interest payments.

Market sentiment is robust; likewise, demand remains healthy and is expected to grow by both companies managements and landlords as supported by statistics in recent quarters. Polls suggest 64% of landlords see limited availability of rental property. The Association of Residential Letting Agents recently released a statistics of landlords survey pointing at sustained strong tenants demands in parallel with constrained rental accommodation supply (top chart) and peaking rents (bottom chart).

The head of the Council of Mortgage Lenders in the UK mentioned earlier this month: o o o Stable market, although witnessing low volumes (compared to historical average). Strong demand for rental property coupled with tight supply. Fair performance of buy-to-let mortgages.

Interest rates outlook and impact While interest rates look stuck at historic lows, they are poised to inevitably rise. Inflation pressures have increased in the UK, although the Bank of England said on multiple occasions it expects normalization from current levels. The interest rate aspect represents a double bladed sword. While low interest rates might encourage landlords to seek financing for more BLT mortgages, return on investments will be lower (narrower margins). On the other end, should interest rates go up margins would expand but such boost would be mitigated (if not offset) by higher delinquencies. Of course, the key to interest rate impact on companys profitability lies on the amplitude and rapidity of actions taken by policy makers. o A 1% interest rates increase will translate into additional 7 mln of net interest income, representing an 18.2% increase to current levels.

Some numbers Company has been steadily reducing debt since 2007 with a sharp reduction (about 10%) between 2009 and 2010. Revenues decreasing since 2008 but should stabilize this year and gain further strength in 2012 on the back of rental property demand and consequently increasing rents (thus higher mortgage payments at constant IRC). o Improved operating efficiency reduced costs by 20% DPS payment suffered a major cut in 2H07. It has been reinstated in 1H08 and has been progressively increased.

Recommendation The company first appeared in the World Opportunity Fund screenings. As the qualitative analysis confirmed the investment case, we have bought a position for the fund. While the Damocles sword of a weak employments market, public sectors cut, increased VAT and energy prices (inflation exceeded 4%) continues hanging over the Co.s head, recent developments have already been mostly priced in. Valuations are not demanding for a company with a strong cash flow generation and a very capable management which is willing to diversify the income stream with BLT services while remaining well positioned to benefit from favorable housing market trends. I would recommend starting with a small position (c.a. 0.5%).