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Morningstar | CYBG and Virgin Money Marriage Creates Attractive Opportunities. FVE GBX 280/AUD 4.90 Unchanged. See Updated Analyst Note from 17 Jan 2019

No-moat-rated, U.K. regional bank, CYBG Plc, completed the acquisition of Virgin Money Holdings (UK) plc in October 2018, with CYBG’s all share offer valuing Virgin Money at GBP 1.7 billion. CYBG issued 541 million shares with Virgin Money shareholders owning approximately 38% of the combined group. We have incorporated the CYBG share issue and our estimate of Virgin Money’s financials in our earnings forecasts and valuation. Our CYBG valuation of GBX 280, or AUD 4.90 per share, is unchanged. At the current price around AUD 3.30 per share, the stock is undervalued, trading 30% below our valuation. We will have a clearer picture of the merged entity when CYBG releases its first-quarter fiscal 2019 update on Feb. 6, 2019, including a trading update for the combined group as well as pro forma historic financial statements and an update on the IFRS merger accounting adjustments.

Based on CYBG management projections, the combined entity is well positioned to benefit from good earnings growth, but we are concerned by risks around merger integration, potentially overpaying and rebranding of the iconic establishment Clydesdale and Yorkshire brands to the more edgy Virgin Money brand. In addition to merger risks, CYBG’s share price has fallen sharply in the past six months, likely due to increased uncertainty surrounding the Brexit process, the third-quarter calendar 2018 global equity market sell off and the softening outlook for the U.K. economy.

Despite Brexit uncertainty, we are confident the cost synergies from the Virgin Money acquisition will drive CYBG’s earnings growth in the next few years. Earnings growth should see the share price move closer to our valuation. However, the likelihood of hard Brexit weighs on the outlook for the merged group. Management contends the cultures of the two organisations are “highly compatible,” but we are less certain, and believe it will take time before there is clear evidence supporting management’s positive position.

A key attraction of the merger is the expected EPS accretion and acceleration of CYBG’s progressive dividend policy to a 50% payout ratio. EPS accretion is derived from substantial cost synergies with estimated annual pretax cost synergies of GBP 120 million targeted by end fiscal 2021. We think the cost synergies are achievable and estimate underlying EPS upside of approximately 10% while we forecast an average 1% return on equity uplift during our five-year forecast period. The merger’s success hinges on saving costs without damaging the value of each business. The merger creates the largest midsize bank in the U.K. with approximately GBP 83 billion in assets, six million customers and a focus on the profitable retail and SME banking segments. We also expect additional upside from not proceeding with the planned Virgin Money digital bank project and unspecified revenue and funding cost savings.

Despite the disappointing recent share price performance, we don’t think investors fully appreciate the attractiveness of the Virgin Money merger, with CYBG’s market capitalisation currently around GBP 2.61 billion, about the same before the transaction completed. CYBG paid GBP 1.7 billion in stock for Virgin Money and at current prices, the market is not attributing any value to the business and the expected merger savings. Virgin Money, on a standalone basis, reported a net profit of GBP 195 million for the 12 months ended June 30, 2018 and we are confident of similar returns in future years.

Based on management guidance, we model GBP 35 million in productivity improvements and cost synergies in fiscal 2019. Our consolidated fiscal 2019 operating expense forecast is GBP 941 million in line with guidance of less than GBP 950 million. Total pretax annual cost synergies of approximately GBP 120 million by end fiscal 2021 are to be sourced 10% for network efficiency, 30% from organisational restructure, 30% from operational improvements and 30% reduction in centralised cost management. To achieve the GBP 120 million in annual estimated cost savings, the bank will spend GBP 240 million in one-off restructuring and project costs, broadly split one third in each of next three fiscal years. We forecast the cost/income ratio to average 55% during the next five years, with management guiding for 55-58% by end of fiscal 2019.

Net interest margin guidance for fiscal 2019 is a range of 1.60% to 1.70%, lower than a pro forma estimated combined margin of 1.78% in fiscal 2018 and 1.93% in fiscal 2017. CYBG’s estimated fiscal 2019 margin of 2.15% far exceeds Virgin Money’s margin estimate of 1.25%. We forecast net interest margins to average 1.66% during our five-year forecast period. Mortgage and deposit pricing remain under pressure due to higher funding costs and increased competition for high-quality borrowers and retail and SME deposit customers. The outlook for interest rates and economic activity continue to pressure demand for mortgage finance.

Based on preliminary estimates, we forecast total assets of the combined group at approximately GBP 83 billion including GBP 70 billion in loans. Mortgages account for approximately 83% of total loans, SME and corporate loans 11% and credit cards 5%. The combined funding position is diversified with 77% of the GBP 77 billion pro forma funding sourced from retail and SME customer deposits. The pro forma loan/deposit ratio is 117% within the midterm guidance range of less than 120%.

The estimated combined group pro forma common equity Tier 1 ratio is 15.2% at September 2018, providing a material 3.6% buffer to minimum regulatory capital requirements. The strong capital position and enhanced capital generation supports the bank’s progressive dividend targets. We forecast the payout ratio increasing from just 10% in fiscal 2018 to approximately 50% by fiscal 2021. We forecast strong dividend per share growth to fiscal 2023 due to the uplift in payout and robust earnings growth. In fiscal 2023, we forecast a GBX 22 per share dividend equivalent to AUD 41 cents per share and based on the current share price of GBX 186 and AUD 3.33, represents an impressive 11% unfranked dividend yield.