A Paragon of Deep Value

10/20/2010 11:51 am EST

Focus: GLOBAL

Peter Shearlock

Editor, Growth Company Investor

This prudent UK lender to developers of rental flats is ready to rock again after surviving the financial crisis, writes Peter Shearlock in The IRS Report.

Britain’s buy-to-let property market is not the first place you would think of to go hunting for value stocks. When the financial crisis struck, the market came close to collapse. Lenders withdrew, mortgage costs rose sharply, and the price of city center flats in places of chronic oversupply fell sharply.

To make matters worse, rental values dropped as developers who were stuck with unsold apartment blocks offered them for rent instead. For Paragon Group (London: PAG), a specialist in buy-to-let finance, the crisis was almost terminal.

Fortunately, when the crisis broke, the great bulk of Paragon’s £10-billion book of loans had been securitized and was match-funded to maturity. But any further securitizations were impossible as the debt capital markets seized up. The company’s warehouse bank facility was closed to new business and, in accordance with its terms, converted into a £1.7-billion term loan maturing in 2050.

That left two other sources of finance. One was a corporate bond, not due to mature until 2017. The other was a £280-million bank line, which was called for repayment in February 2008. Paragon did the only thing it could—launch a deeply discounted rights issue. That raised £287 million, which got the bankers off its back.

Throughout the past two and a half years, Paragon has concentrated on keeping existing customers. The business has been profitable, has generated cash, and, since the rights issue, has paid rising dividends for shareholders.

Because Paragon always restricted the amount it lent on purpose-built city center developments, it avoided the worst of the downturn. Mortgage arrears have been consistently lower than the industry average, while margins have been strong.

Most importantly from a value perspective, Paragon has managed to maintain its net asset base. In the last profits statement, shareholders’ funds were shown at £665 million, or around 225 pence per share. That compares very favorably with a current share price of 158 pence.

For some months, the company has been making preparations for when it can put up the “business as normal” sign. The buy-to-let market has recovered strongly. With new mortgage availability limited, would-be buyers are renting instead. Tenant demand has grown sharply in the past year, while the supply of property to the private rented sector has fallen.

Last week, the group announced it has secured a four-year, £200-million warehouse facility from Macquarie Bank and is restarting new buy-to-let lending. This should get analysts looking ahead to a growing loan book and rising profits.

Even without this, Paragon looks as if it will lift underlying profits by about 45% this year. The shares are selling for a single-digit price/earnings ratio, and there is strong cash flow.

Importantly, competitors remain thin on the ground. Short of another financial crisis, the down side looks limited while the up side is considerable.

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