ADAM APPLEGARTH - NORTHERN ROCK - (LSE:NRK)
CEO Interview - published 04/09/01

DOCUMENT # MAB021

ADAM APPLEGARTH is Chief Executive of Northern Rock Plc. He joined Northern Rock in 1983 from Durham University as a management trainee. He was appointed General Manager in 1993 and became an Executive Director in 1996, responsible for lending, insurance, information techADAM APPLEGARTH is Chief Executive of Northern Rock Plc. He joined Northern Rock in 1983 from Durham University as a management trainee. He was appointed General Manager in 1993 and became an Executive Director in 1996, responsible for lending, insurance, information technology, marketing and corporate affairs. Mr Applegarth is a Trustee of the International Centre for Life Trust. nology, marketing and corporate affairs. Mr Applegarth is a Trustee of the International Centre for Life Trust.

Sector: Financial Services

TWST: Would you start us off with a quick corporate overview of Northern Rock, please: what is its main business?

Mr. Applegarth: Northern Rock’s main business is lending money, mainly to individuals, mainly for the purposes of buying their own homes. We raise the funds to lend from a variety of sources: partly through retail cash deposits, mostly in the UK, partly through treasury operations raising wholesale money all over the world, and partly through mortgage backed securities.

TWST: Could you recap the main corporate milestones in the company’s history?

Mr. Applegarth: The company is effectively 150 years old, and for 147 of those years we were a mutual building society within the United Kingdom. We converted and floated on the London Stock Exchange in October 1997.

TWST: What’s your analysis of the trends that will be important in the UK mortgage sector and more broadly in the finance industry over the next 12-24 months?

Mr. Applegarth: The mortgage market in the UK is a very large market — last year there was gross completions of GBP120 billion, and net lending of around GBP40 billion. There is no real alternative to home ownership within the United Kingdom. The private rented sector is pretty small, and the social sector — the local authority housing stock — is of poorer quality; and therefore home ownership within the United Kingdom is extremely prevalent with home ownership nudging towards the 75%-80% level of households within the UK. Mortgages are almost an essential commodity rather like bread and potatoes; and almost regardless of the economic cycle there is a strong mortgage market and housing market within the United Kingdom.

TWST: Take me through the key elements of your corporate strategy to exploit that market situation.

Mr. Applegarth: We only hold 3.4% of the outstanding stock of UK mortgages. Our share of the flow of new business however is somewhere in the 6%-7% region; so we tend to lend twice our share of stock. We’re able to do that because we’re the lowest cost providers in the industry. We are centred up in Newcastle-upon-Tyne in the Northeast of England, and we have a lower cost structure. We don’t have a very large number of branch outlets, which historically have been high fixed costs within the United Kingdom. So we have very efficient distribution; we’re focused on lending within the United Kingdom, so we’re not a diversified financial services arm. We’re not a bank assurer, nor are we a universal clearing bank. We’re a specialist mortgage lender who happens to have a banking licence, because of our retail deposit-taking activities. And therefore we use our low-cost advantage to attract mortgage business, because within the United Kingdom a large chunk of mortgage business is price-led, and that particular market segment is almost a commodity product. We trade on our low cost advantage to out-price the others which in turn drives down our unit costs.

TWST: There’s been some discussion in the financial columns about the autonomous future of independent mortgage providers. What’s your view?

Mr. Applegarth: If you have margins of banks coming under pressure they historically do two things: they consolidate in order to have costs to strip out, or they strip out their own costs. As regards Northern Rock, it only costs GBP130 million to run Northern Rock in its entirety — we are an extremely low-cost operation. And for somebody to want to take Northern Rock over in order to strip out costs, there really isn’t much in terms of cost to strip out. We are a GBP25 billion asset operation, our share of stock at 3% means that in terms of economies of scale we’re not on the radar screen for acquisition for that purpose. I would have thought that a more likely area for consolidation of the banking industry within the United Kingdom are those medium-sized players who have enough size to have critical mass but who are also relatively inefficient. I think there are a number of other candidates before Northern Rock.

TWST: I’d like to go through some of the business areas in which you operate more systematically and try and understand the key trends in more depth. For example, in the residential lending market, what’s the outlook now for the year 2001 and beyond?

Mr. Applegarth: I think the outlook for the residential housing market in the UK for the next couple of years is pretty solid. The UK economy has had a very good period the last three or four years; if it does slow down because of slow-downs elsewhere in the world, it’s likely to be a slow-down as opposed to a recession. We’re already in the situation of having relatively low interest rates by United Kingdom standards, and the likelihood is that interest rates are if anything going to ease, whether or not we join the Euro — that would merely reinforce that easing of interest rates, to bring us into line with the Euroland. But that means that even if there is a slow-down in the economy, people’s ability to afford mortgage repayments is considerably better than it was, say, a decade ago, and therefore the prospects of the housing market and thus the residential loan market remain pretty good over the next couple of years. I doubt we’ll see the high levels of market growth that we saw last year when the market was at one stage up by about 20% compared to 12 months before. I expect the market to grow somewhere between 5%-6% this year and next, which is reasonably healthy and sustainable growth.

TWST: You have plans to develop your lending in the secured commercial domain. Can you explain why this is and what you’ll be doing to achieve?

Mr. Applegarth: We’ve been in the commercial lending market for over a decade now. It is a relatively modest part of our operation; as I said, if we have a loan book of GBP25 billion, our commercial lending operation has about GBP1 billion of that, so it is still relatively small. All the commercial lending is secured on bricks and mortar — we don’t do any unsecured commercial lending. It is most risky when economies slow down and move into recession, and unsecured commercial lending takes place — we don’t do any of that. With regards to our commercial lending, half of it is under our regulators’ (the Financial Services Authority) definition as residential lending — it’s flats above shops, for example. Simply because of the way we operate we count that as commercial lending, but by the classical definitions for monetary reporting terms in the UK, it actually counts as residential lending, and therefore you can see our commercial lending operation is very conservative by scale and by type of lending.

TWST: Turning to distribution and processing, you’re developing a multi-channel distribution strategy: what does this mean in concrete terms?

Mr. Applegarth: One of the advantages of being small is that we can be relatively fleet of foot and therefore we’re able to match our distribution against what our customers want. We’re not starting from the position of having, say, 2,500 branch outlets and then having to find some way of getting an economic return out of them, because you’re starting with them. We’re not in that situation. We have 76 branches; we have another 12 or 15 mortgage sales centres; but we do a good amount of introduced business on the residential lending side through intermediaries, such as independent financial advisors, estate agents, solicitors, accountants and other professionals. We have a large direct operation, which is a telephone-based operation centred up in Newcastle, and last year we made a major improvement in this by launching automated online decision centres. When a customer phones up he’s on the phone for about 10-minutes. On the information that he’s given us we’ll be able to guarantee — provided he can substantiate that information — the loan, we will send out to him a pre-populated application form for him to verify, sign and send back with the substantiating information. That’s gone down very well, particularly with introducers, because it’s much easier for them to talk to somebody on the telephone and have the person at the other end fill in the application form rather than having to do it themselves, and that really has enhanced our telephone-based operation. We’ve then enhanced the telephone operation further by building in e-commerce activities as an integrated part of our business. We haven’t had to set up our e-commerce offerings under a separate brand name because of fear of cannibalising our existing balances. We only have 3% of the mortgage stock in the UK. We have about 1.5% of the share of retail deposits in the UK and therefore clearly we’re not worried about cannibalising the book. We’ve been able to build our e-commerce operations as part of our integrated distribution strategy; and that means that if a customer wants to do business with us through an introducer one day and the next day he wants to do it over the telephone, via the Internet, by post or walk into a branch, all the products are available to him by any of those distribution outlets.

TWST: Where do you source your new mortgage business?

Mr. Applegarth: The customers are sourced in line with the demographic spread within the UK; so although we are headquartered in Newcastle, which is the Northeast of England, our lending is exactly where the customers are. Half of national households are centred in the Southeast of England, and therefore unsurprisingly last year half our new lending was done down there. So our split of lending is very much where the customers are. In terms of the type of borrower, roughly a third of our borrowers last year were first-time buyers — people who were buying their homes for the first time; and the rest of the people were either people who were re-mortgaging from other institutions, or people who were moving home — next-time buyers.

TWST: What are your plans for expansion in continental Europe? You have an Irish funding arm: what other European activities have you? How will you be growing those activities?

Mr. Applegarth: We have no plans to expand lending operations outside the United Kingdom. As I said we only have 3% of the mortgage market, so there’s a huge swathe of mortgages to go at within the United Kingdom. Our personal secured lending, our credit card lending, our unsecured lending are all within the United Kingdom. However, to fund that we raise money from all over the world. In terms of retail deposits we have GBP2 billion of retail deposits that are handled through our Guernsey operation. Last year we launched an Ireland operation where we took a couple of hundred million pounds in a year, which took us to about 1% of the Irish market within a year. We’ve also recently opened an office in the Bahamas to pick up some US-dollar denominated cash deposits, mostly from investment trusts. We may well over the next 12 months open an operation similar to that we did in Ireland across in Holland, because it’s important for us to diversify by both product and geography to ensure that we have a consistent flow of retail funds. If we’re over-dependent on any one particular segment (and the UK cash deposit market has been extremely competitive with people cross subsidising from other parts of their diversified operations and effectively raising funds at uneconomic rates) we could have a margin squeeze. Our other two sources of funding, are first, mortgage backed securities — we’ve just done another GBP1.5 billion tranche of mortgage bank securities, and there was $1.5 billion within that, so we’ve done a large marketing exercise across in the States. The States is a very mature market for mortgage backed securities, much further advanced than the United Kingdom and even much further advanced than mainland Europe. We do raise large chunks of money for mortgage bank securities across in Euroland and also within the UK in sterling. Secondly, we borrow money from a huge number of banks and corporates all over the world, and that requires us to go across and do presentations both in the States and in Euroland. One major enhancement to both our mortgage bank securities programme and to our wholesale operations has been the acquisition of our SEC registration in July 2000.

TWST: Turning back to growth strategies and the dichotomy between organic and acquisition-led approaches, if you’re not going to be acquired, are you an active acquirer in the UK? Have you a programme of acquisition currently?

Mr. Applegarth: We’re an amalgam of 53 building societies and therefore we’ve clearly been acquisitive in the past. Since we floated we haven’t. We have looked at all the mortgage books or unsecured loan books that have come onto the market, but none of them have justified the premium for the quality of the loans. We’ve found it’s been a much better return on our capital to actually grow the business organically, particularly now we have securitisation that allows us to do additional lending we otherwise would not have been able to do. So in terms of the answer to your question, yes, I’m perfectly willing to consider acquisitions, but they have to be acquisitions at the right price, because we are a capital-lean operation and therefore we really do have to justify to our shareholders and our regulators that any acquisition is worth it. We don’t have capital to waste.

TWST: You’ve been Chief Executive since 1 March 2001. Can you take me through the list of items that you have on your agenda, the corporate objectives that you are setting now for the company?

Mr. Applegarth: You’re quite right, I’ve been Chief Executive since 1 March, but I’ve been with Northern Rock for 18 years, and before being Chief Executive I was effectively the Commercial Director, and therefore am a firm driver of the growth strategy that we’re following. Therefore what you’ll see under my period of stewardship as Chief Executive is a further enhancement of that. We will look to outgrow our share of stock; I expect our share of flow of business to be at least twice our share of stock of residential lending; but you will see us do it in slightly different and more efficient ways. I think the moves we’ve made over the last 12 months in terms of e-commerce as a way of generating business will be directed towards driving out transaction costs too. Last year e-commerce applications accounted for 10% of our total loan applications, which I’m quite pleased with. The corporate goals over the next two or three years are centred around our core strategy of using our cost advantage to grow the business, using our enhanced funding capabilities, particularly with securitisation to seek additional lending, and therefore additional profit streams for our shareholders.

TWST: Have there been any other important changes at the senior management level?

Mr. Applegarth: What you’re seeing is a re-organisation of our existing management team. It is very much the management team that people have known for the last five years here and continue to run the business. So my colleague who was the Operations Director has become the Chief Operating Officer — that is David Baker. Our Group Finance Director remains Bob Bennett; he was Group Finance Director before the changes. And those are our only three executive directors. We then have a substantial and very talented team underneath us, and they’re very much the same team as has been in place for the last five years. It’s quite a young management team, but a very experienced management team. If you look at the number of years that we have all worked for this company, let alone in this type of activity, there’s a lot of years clocked up.

TWST: For investors looking at the financial reports, what are the figures that should catch their eye?

Mr. Applegarth: The first figure should be return on equity. We’ve re-structured our business model to cope with 100 basis points spread, which is where we believe it will settle in the UK — I think we’re the only people to have done that. We’re still able to generate a return of equity between 18%-20%. With interest rates continuing to nudge down in the UK that’s a very effective return on equity, and we anticipate being able to sustain that on the back of our aggressive growth targets for the next two or three years. I would also look at the cost ratios, because that shows our clear advantage over our competitors. For example, if you compare us with the Halifax, who are the holders of the largest stock of residential mortgage in the UK, we have a 40% advantage over them in our cost-income ratio; and that is a substantial advantage that we can use to continue to attract business and to continue to maintain a good healthy return on equity for shareholders. So I would look at the cost ratios and I’d look at the profit figures, because that allows the return on equity. It’s a tight-run ship.

TWST: Asset quality: any concerns there?

Mr. Applegarth: Our concern is to make sure that we continue to have the best-quality loan book in the UK, which is what we have. One of the things that was put to me when we floated was, would it not have been better to have backed into somebody with a better credit rating than ourselves, because that would enable us to raise our wholesale money cheaper. I think securitisation has changed that argument. For the first time we can actually get advantage into our cost of funding from the quality of our loan book. I’m very proud of the last two tranches of securitisation where we’ve issued at prices inside the Abbey National, for example, who are a much bigger operation and again an operation with an SEC registration because of the quality of our loan book. If you look at the performance of our residential loan book in terms of three month-plus arrears, our arrears are half the industry average. We have a very good quality loan book; and therefore an essential factor for us is, as we use our competitive advantage in costs to price to attract loans, we attract loans that are better than the industry average. Some of the major enhancements we’ve made last year are to do with ensuring that we continue to do that. I’ve already talked about the decision call centre and that gives us a much greater control of the quality of loans coming in; but we’ve also introduced, for example, behavioural scoring; that enables us to effectively re-score our loan book on a monthly basis, which does two good things for you. The first thing is, it actually allows you to see how the quality of your loan book is increasing or decreasing, but it also allows you to target your arrears or delinquency management towards those customers who are the highest risk. At the end of the day I don’t think it particularly matters if a customer with a 20% loan to value loan misses one payment, but it’s a much higher risk if somebody who’s a 90% loan to value customer misses a payment; and you can actually target your arrears management to those cases that are a higher risk to the company.

TWST: Securitised assets represent 12% as at 31 December 2000 of your total mortgage portfolio. Where do you see that number going over the next couple of years?

Mr. Applegarth: We said at the start of last year that over the two years coming — so that was obviously last year and this year — that we would have a GBP5 billion securitisation programme, and that’s the number that we’re doing over the two years. We did just over GBP2 billion last year so you can work out what we’re doing this year. There is a natural limit to which you would want any one source of your funding to be at in that you don’t want to be overly dependent on any one particular funding source, in case there’s a problem — it’s not too long since we’ve had the Japanese banks repatriating all their lending in the early 1990s. You don’t want to become over dependent — whether it’s UK cash deposits or securitisation or whether it’s on wholesale monies from any particular country. You need to strategically manage your risk by keeping a balance between them all. Last year of the GBP4 billion we raised to lend, half was securitised, a quarter was wholesale, and a quarter was retail cash deposits. So for the next couple of years I’d anticipate that split being fairly similar.

TWST: What have analysts had to make of the story? What questions are they putting to you today? Do they buy into your specialist focus?

Mr. Applegarth: I think two years ago when we first announced securitisation and the way that we were going to use it for additional lending as opposed to a way of managing capital — because you can use securitisation for that purpose — their initial reaction wasn’t certain. It’s taken us some time of being able to show them that we’re going to do exactly what we said we were going to do (which is all to do with additional lending) for them to accept it. The more times we come to them with our performance being exactly what we said it was going to be, the more readily they accept it. I think there is a much warmer feeling now towards the strategy, and if you read through all the analysts’ comments, that’s held up in there.

TWST: Could you summarise the three to five year vision that you have for Northern Rock?

Mr. Applegarth: I think I see Northern Rock involved in all the areas of manufacturing loans process, all the way from manufacturing to origination to distribution. Because of the pressure on margins, I think the mortgage market in the UK faces the prospect of fragmenting, and it may well be, as the cheapest administrator within the United Kingdom, that we can actually pick up an additional income stream in doing third party administration for either secured loans or unsecured loans for other companies. As I said earlier, when financial institutions come under pressure they do two things. One is, they consolidate to get costs to strip out, and alternatively they strip out costs on their own. If we’re the lowest cost administrator — which we are — if we do administration well enough to get a triple A credit from Standard & Poors and Moodys, which we have to do for our securitisation, it would make sense for an institution who’s facing pressure on their cost base to actually reduce their costs by hiring us as an administrator. And therefore I can see the prospect of an additional income stream from administration of secured loans, and for unsecured loans.

TWST: Any evidence of that happening in the nearer term?

Mr. Applegarth: I think we’ve seen a touch of it, in that you’ve seen the Woolwich — who are now part of Barclays — tie up with Countrywide. You’ve seen Bradford & Bingley tie up with Alltel and I think they’re finding it a little harder than they thought, because the Americans are extremely efficient at mortgage administration, but it’s on a fairly narrow product range. The difference in the United Kingdom, because we don’t have the quasi-support from the Government for securitisation, is that we have a very diversified product range. For example, we have one product that combines a secured loan with an unsecured loan, and it’s a fully flexible product that allows daily rests, over payments etc, and that’s actually quite a difficult system to build for administration. We’ve been doing that for a long time, and it’s an essential part of our business. If we wanted to lend at twice our share of stock, we have to be product innovators, and we have to be right at the forefront of it; and therefore in hiring us as an administrator, they would get somebody who has to be at the forefront in order to keep their own operations going. I think we’ll need to see a bit more margin pressure before we some other contracts come in.

TWST: Any points that I’ve omitted to touch on and that you’d like to represent in the interview?

Mr. Applegarth: You find us in a buoyant state, because we’re doing exactly what we said we were going to do. We said two years ago we were changing the business model to be able to cope with margins of 100 basis points, that we believed that we would be able to do that and still have a return on equity between 18%-20%, and that’s exactly what we’re doing.

TWST: A summary statement for a potential investor: why should he buy the stock today?

Mr. Applegarth: He would be buying into just about the only growth story within the UK mortgage market, buying into a growth story predicated on an advanced view of where margins are going to be going to, so you’re not buying into somebody who’s growing today but will have to stop tomorrow. We’ve spent the last two years restructuring the company to be able to grow consistently going forward, because growth is only good if you can carry it out consistently. If you’re see-sawing around, in the years where you’re growing under-trend, then you’re relatively inefficient because you’ve over-resourced; if you’re over-trend growth then you’re inefficient because your customer service is poor and you’re going to lose your loyal customers. Therefore you’re buying into somebody who is able to deliver a consistent growth story and a consistent growth in profits.

TWST: Thank you. (OK)

ADAM APPLEGARTH
 Chief Executive
 Northern Rock Plc
 Northern Rock House
 Gosforth
 Newcastle upon Tyne NE3 4PL
 United Kingdom
 +44 (0)191 285 7191
 +44 (0)191 284 8470 – FAX
 www.northernrock.co.uk

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