Description

Kensington (KGN.LN) is the leading provider of “non-conforming” mortgages in the U.K. Those of you who read and profited from kurran363’s write-ups on NCEN should be familiar with the upside potential of “non-conforming” mortgage lenders given the natural skepticism surrounding the industry. I believe that Kensington is quite similar to NCEN in its upside potential but is operating with a better management team and a lower risk profile in a less competitive environment (not to detract at all from the NCEN idea, which was obviously excellent). The valuation of KGN is similarly compelling, at 6x forward earnings which are growing at a 50% clip. Having looked at most of the subprime mortgage lenders in the U.S., I believe that the credit profile of Kensington’s customers is far superior. Moreover, Kensington is far less dependent on interest rates than its U.S. counterparts. While I use the term “non-conforming” to describe KGN throughout this write-up, it is not because using a euphemism for subprime makes me feel better about my investment. Rather, KGN is actually a mix between an Alt-A lender and a subprime lender—sort of a hybrid between NCEN’s and Greenpoint’s mortgage businesses in the U.S.

Kensington started the non-conforming business in the U.K. and is the largest player by a comfortable margin, with between 25% and 30% market share. The best estimate I have found is that the prime mortgage market in the UK is greater than ₤200 billion annually and the “non-conforming” market is approximately ₤8 billion in size. Due to the early-stage nature of the industry, the “non-conforming” market as a whole is expected to grow at about a 15% annual rate for the foreseeable future. KGN is taking share in the market and is poised to accelerate its growth over the next few years from the already rapid pace. The company’s penetration of mortgage brokers in the U.K. is still low (brokers account for 60% of KGN’s originations) but growing. KGN is also rapidly growing its national accounts business (currently a small portion of originations), whereby large conforming mortgage lenders refer the non-conforming loans to KGN. In 2002, KGN bought TML, a direct to consumer originator of loans. TML has been a strong contributor to growth as well, as direct to consumer lending will comprise 25% of the total originations in 2004.

Unlike most North American “non-conforming mortgage lenders”, KGN does not sell its originations into the secondary market for gains at the time of origination. KGN does not utilize gain on sale accounting either. Instead, KGN portfolios virtually all of its originations (a very small percentage were sold in 2003) using on-balance sheet securitizations. KGN is well known and received by the securitization market, as the company has completed more securitization transactions over the past five years than any other lender in Europe. As of year end 2003 (FY ended 11/03), KGN had a portfolio of ₤3.1 billion of loans, an increase of 60% over the prior year. There is zero interest rate risk in its portfolio, as both loans and securitization funding are floating off of 3 month libor. In 2003, 45% of KGN’s mortgages were made to purchase homes, while 55% were refinances of existing mortgages. Since all U.K. mortgages are floating rate over LIBOR, rates do not drive refinancing, and 80% of the refinance volume experienced by KGN is from borrowers who have moved up the credit spectrum and are no longer considered “non-conforming”. KGN is compensated for the loss of portfolio loans through refinancing, as all loans contain prepayment penalties.

The first question when investing in a consumer finance lender that focuses on a non-conforming customer base is obviously credit quality. KGN has a very strong management team and their focus on tight underwriting standards has resulted in exceptional credit quality. The average LTV on new loans is 78%, with less than 0.1% of new loans having an LTV greater than 90%. For comparison, NCEN’s highest credit quality borrowers (A+ rated) borrow up to a 95% LTV at the time of origination. Taking into account house price appreciation, the current market LTV of KGN’s portfolio is 68%. Of KGN’s total originations, 38% were low-risk, high credit quality in 2003, compared to approximately 5% for NCEN (NCEN’s Alt-A as a % of total). The average income of a KGN borrower is approximately ₤40K and the vast majority of properties are valued between ₤70K and ₤250K (over 94% of properties are valued at less than ₤250K). On average, KGN’s customers’ mortgage payment is less than 20% of their pre-tax income; assuming a 200 bps rise in rates, this ratio would expand to 25.5%. Again, for sake of comparison, NCEN’s debt service to income ratio is approximately 50%. Only 3% of the loan book is buy to let (rent), which is where the majority of the issues in mortgage lending in the U.K. have arisen in the past. KGN avoids areas of the U.K. that have experienced strong house price appreciation, as only 7% of loans are in Inner London, and the loan book is geographically dispersed.

Delinquency trends are very favorable, as less than 8% of the portfolio is greater than 30 days late on their current interest payment, and another 4% of the portfolio is paying their current interest payment in full, but is catching up on prior payments missed. Looking at the same statistic on a 90 day norm, less than 4% of the portfolio is late on their current interest payment, and another 1.5% is paying their current interest payment in full, but is catching up on prior payments missed. Delinquencies have trended sharply lower over the last few years, as management has focused on higher credit quality borrowers. Even when Kensington has foreclosed on borrowers, its losses have been minimal. For 2003, annualized losses were below 10 bps of loans under management. Management realistically expects that delinquencies and losses will increase with interest rates, as all loans are floating rate. However, management estimates that a 100 bps increase in rates is only likely to increase losses from 7-8 bps currently to approximately 10-15 bps. The current reserve is 50 bps (5-6x losses) and it can be increased if necessary without significantly compromising profitability.

Management is very comfortable with 35% growth in net (net of refinancings) new loan originations in 2004. This figure seems conservative (as management typically is when giving guidance) given the current monthly run-rate. The net interest margins should naturally expand over the next few years, as the portfolio has been growing very rapidly and there is a teaser rate on KGN mortgage loans that works out to be a 175 bps discount on the first year of the loan (the average product margin over LIBOR was 3.73% in 2003, yet the net interest margin of KGN was only 2.5% and its borrowing costs over LIBOR are approximately 30-40 bps). The effect of the teaser rates converting into fully indexed rates will be somewhat mitigated by the fact that KGN has shifted its portfolio to higher quality, lower margin loans over the past year. Fee income should grow strongly with the size of the portfolio and management is just beginning to experience operating leverage from its acquisition of TML, which was breakeven in 2003 but will be a strong contributor to profits in 2004. Fee income, which accounted for approximately 50% of KGN revenue in 2003, was comprised of: 53% early redemption charges, 35.8% TML fee income (mostly from selling the loans that KGN decides not to keep to other lenders), and 11% origination fees. Early redemption fees should be stable in all rate environments, given that 80% of refis are driven by borrowers moving up the credit spectrum. However, even if redemptions were to slow, these fees would simply be translated into higher net interest income as the duration of the average loan would extend.

The returns on equity for KGN are extremely high given the nominal amount of equity needed for KGN’s securitizations (4% equity—88% of bonds are AAA). Moreover, The company has positioned itself well in terms of liquidity. It has warehouse facilities for ₤1.5 billion including a new 3 year facility with Royal Bank of Scotland. In 2003, the company conducted a limited whole loan sale simply to gain the expertise in that funding source in case it desired to use it in the future. Finally, KGN management is very shareholder friendly, as large buybacks and dividend payments have returned all capital not needed for growth. Unlike most European management teams, when asked about buybacks, the CFO states that “anyone with a calculator can figure out that the math is quite attractive”.

In the near future, management expects to expand its business to other geographic areas (i.e. Ireland) and product areas (home equity). These market opportunities have not been considered in the projections detailed below.

Valuation/Upside

I believe that KGN can conservatively earn approximately 70-75 pence per share in the year ending November 2004. This level of profits is driven by 41% growth in net originations, a stable net interest margin (note that if this company ever stopped growing, its profitability would explode as the teaser rates would expand into fully indexed rates), and stable pre-tax profitability as a percentage of average mortgages under management (i.e., no operating leverage). For reference, the leading sell-side analyst, who is at Bear Stearns, recently published an estimate of 62.5 pence for 2004. For 2005, Bear Stearns is estimating 69.5 pence, which is absurdly low absent a credit disaster. I think eps in 2005 should conservatively be between 90 and 100 pence. Placing a 9x multiple on the low-end of my 2005 estimates gives a valuation of ₤8.1 per share, or 76% upside from currently levels. I believe that at least 10x for a business with this market opportunity and management is more reasonable, but you can see the upside even with conservative assumptions. It is important to note that KGN deserves a higher valuation than its U.S. peers for a number of reasons: 1) no whole loan sales, only securitizations so you are not paying a multiple of inflated cyclical earnings, 2) a less mature, less competitive market, 3) better credit quality, and 4) management that is trustworthy and concerned about increasing value for shareholders. KGN may also be an attractive acquisition candidate at some point in the near future for any of the other larger mortgage lenders that wishes to enter the “non-conforming” space. In the U.S., the leading conforming players such as WFC, CFC and WM, have successfully boosted returns by leveraging their capabilities into the “non-conforming” space.

Catalyst

1. earnings will exceed estimates by a wide margin in 2004
3. company continues showing strong credit quality in higher rate environment leading to a re-rating
2. potential acquisition candidate in near future