More on Northern Rock
Northern Rock: H1 2006 results
Mortgage lender Northern Rock reported that statutory pre tax profits rose 13.3% to £293.9m in the half year to June 2006.
The company announced stellar volume growth: gross lending rose 28.3% to £14.8bn while net lending rose 22% to £7.3bn; something of a record for the bank. The cost:income ratio is also said to have improved slightly to 28.9% (2005: 29.8%).
Given the excellent volume growth and the improved cost:income ratio we would expect much stronger bottom line growth. The slow bottom line growth is due to a significant weakening of underlying interest margins – which have slipped to 0.89% from 0.97% in the same period last year. Rising interest rates, which have pushed costs for most banks as well as a more competitive market (particularly in commercial lending and unsecured loans) which has resulted in tighter pricing are the reasons for the slip in margins.
Given the outlook for UK interest rates, these broad trends are expected to continue and banks will find margins under constant pressure.
When we last looked at this stock we were concerned that the aggressive expansion in the lending portfolio (even as the market was slowing) would lead an increase in impairments or bad debts. Our concerns seem to have been justified: arrears in residential mortgages have risen from 0.35% of the book to 0.45% of the book and those in standalone unsecured lending have risen to 1.08% from 1.02%.
Northern Rock claims that its rates of arrears are better than the industry average, which is true but we would watch these figures carefully to see if they get any worse.
We noted above that the company’s cost:income ratio had improved. It is worth noting that the improvement was due to strong growth in income (which in turn was driven by aggressive lending). In absolute terms costs rose by an uncomfortable 13.5%. Unfortunately, there is no indication as to how much of this cost growth was in fixed costs. We expect variable costs to rise with levels of business but significant increases in fixed costs can lead to sharp declines in profits (and necessitate painful downsizing) should volumes stagnate.
The bank says it is on track to meet consensus estimates for the current year profits. The bank does admit that it expects both the economy and the housing market to slow in the medium term but is confident that its “low risk appetite” will serve it well in more difficult times. Our concern is precisely this, particularly when the bank seems confident of growing lending volumes by 20% +/- 5%.
The share trades at 1072.5p, on a prospective PE (2007 earnings) of 10.9x, within the sector range with a yield of 3.5%.
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