Close Brothers beefs up its balance sheet ahead of its brush with the regulator

“The acquisition of Novitas in 2017 has haunted Close Brothers ever since and the merchant bank now has another spectre at its shoulder, namely the Financial Conduct Authority’s investigation into discretionary commission arrangements (DCA) in the car financing market,” says AJ Bell investment director Russ Mould.

“Thankfully, the FTSE 250 member seems to be through the worst on Novitas, and the combination of February’s decision to cancel the dividend and the affirmation alongside the full-year results that it can further bolster its balance sheet looks to be offering some reassurance to investors that Close Brothers can withstand whatever regulatory penalty comes its way.

“Novitas was a specialist provider of finance to the legal sector. Close Brothers decided to withdraw and start running down the loan book in 2021, while supporting the remaining cases to the best of its ability. Provisions against losses of £73.2 million in 2021 and £60.7 million in 2022 did not prove enough and Novitas cost the firm another £115 million in the year to July 2023, with the result that annual pre-tax profit tumbled to £112 million from £233 million.

Source: Company accounts. Fiscal year to July

“The good news is that the interim results for fiscal 2024, which cover the six months to 31 January, reveal no further bad news from Novitas, and this is why pre-tax profit is rebounding to £93.8 million from £11.7 million for the period.

“The bad news is the bank now has the regulator on its tail regarding its car financing loan book, which currently comes to some £2 billion, or a fifth of the total.

“A DCA was a deal whereby some lenders allowed brokers and loan arrangers to adjust the interest rate offered to customers for car finance. The higher the rate, the more commission the broker earned. The FCA banned this in 2021 but it has received complaints from consumers who feel they were overcharged before this cut-off point and has begun investigating the period 2007-21 to see if finance providers acted unfairly and customers did indeed lose out.

“Finance providers vigorously deny any wrongdoing, but consumer champion Martin Lewis has said this could be the next Payment Protection Insurance (PPI) scandal in waiting. Investors will remember how that cost the banks the thick end of £50 billion over a decade. While DCA is unlikely to be as big, Lloyds Bank has already booked a £450 million provision in its 2023 results to cover potential costs and compensation.

“Close Brothers has not taken any such provisions in its interim results, but it has started to prepare itself. Back in February, the firm announced it would cancel dividend payments for fiscal 2024 and only review the prospect of cash returns to shareholders in 2025 once the FCA’s findings are known and their impact quantifiable.

Source: Company accounts. Fiscal year to July. *2024E based on management guidance from 15 February 2024

“The merchant bank already has a Common Equity Tier 1 capital of £1.35 billion, for a CET1 ratio of 13.3%. This is more than the regulator requires it to hold, in the event it suffers unexpected losses. Management is stressing that the cancellation of the dividend will add £200 million to CET1 capital, anticipated earnings another £100 million and internal measures and efficiencies a further £100 million, to take the total to £1.75 billion. The cost of this comes in the form of the dividend and less growth in risk-weighted assets and the loan book.

Source: Company accounts. Fiscal year to July

“Close Brothers’ share price was already under the cosh before the FCA investigation was made public in January, thanks to Novitas, as well as worries over the UK economic downturn and any associated bad debts, plus weak earnings from brokerage firm Winterflood, which has continued to suffer from the turgid performance of the UK stock market and the lack of new flotations.

“The regulatory intervention took an even bigger toll as investors fled amid the uncertainty of what the financial cost may be once the FCA published its findings.

“The only good news for investors is that the valuation of Close Brothers’ shares looks to be discounting a very bleak scenario indeed and this may be why the first-half results are giving them a boost. The company has tangible net assets per share of 920p and the share price is 375p. Such a massive discount means the market really does fear a very bad regulatory outcome, but it also suggests a lot of bad news may be in the price already.

“Cautious investors will likely prefer to wait and see what the FCA concludes before they get involved. But if Close Brothers has now put a lid on the Novitas disaster, they might one day choose to reassess the firm’s prospects in light of the strength of its asset management business, and how the banking arm tends to come into its own during tougher times, as it typically lends contra-cyclically, when mainstream lenders are running scared. This helps the bank to make the fat, 7.5% net interest margin generated in the first six months of the year to January 2024.”

Source: Company accounts. Fiscal year to July

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