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Morningstar | CYBG Completes Acquisition of Virgin Money. FVE GBP 3.10/AUD 5.50 Unchanged. See Updated Analyst Note from 14 Oct 2018

No-moat-rated, U.K. regional bank, CYBG Plc, completed the acquisition of Virgin Money Holdings (UK) plc with the court approving the scheme of arrangement. The Boards of CYBG and Virgin Money, agreed to merger terms on June 16, 2018 with CYBG making an all share takeover offer valuing Virgin Money at GBP 1.7 billion. Virgin Money shareholders will receive 1.2125 new CYBG shares for each Virgin Money share held. Following completion, Virgin Money shareholders will own approximately 38% of the combined group on a fully diluted basis.

We have not yet incorporated the proposed CYBG share issue or Virgin Money acquisition in our earnings forecasts or valuation. CYBG’s financial year ended Sept. 30 with fiscal 2018 results due Nov. 20, 2018. The Virgin Money scheme of arrangement is effective Oct. 15, 2018 and will not impact fiscal 2018 results. We expect more detailed financial information, including the impact of the acquisition, to be available with the release of fiscal 2018 accounts. Our CYBG valuation of GBP 3.10 or AUD 5.50 per share, is unchanged and at current prices, the stock is fairly valued.

Based on CYBG management numbers, the combined entity is well positioned to benefit from strong earnings growth, but we are concerned with the increase in merger integration risks, the risks of overpaying and risks involved in the planned rebranding of the iconic establishment Clydesdale and Yorkshire brands to the more edgy Virgin Money brand. A key attraction is the expected EPS accretion and acceleration of CYBG’s progressive dividend policy to a 50% payout ratio. Management contend 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 this. Despite the potential for cultural clashes, we like the transaction with the combination of the complementary strengths of the two challenger banks creating a national competitor to the dominant U.K. major banks.

The combined CYBG group benefits from expanded capabilities, enlarged scale and a national distribution network. The full-service product range, innovative technology, Virgin Money’s iconic national brand and the focus on strong customer service attract. The growth strategy is based around technology, customer service, product innovation and the high-profile Virgin Money brand. The combined assets of the merged group are estimated to be GBP 83.5 billion. Based on CYBG’s successful track record of stripping out costs and improving productivity we are reasonably confident CYBG can deliver on its forecast GBP 120 million of annual run rate cost synergies by the target date of end fiscal 2021. Job cuts and branch closures feature in the expected cost savings with an estimated 1,500 jobs likely to disappear.

In April 2018, CYBG announced additional payment protection insurance provisions and we treated the net GBP 220 million as an above the line operating expense reducing our cash earnings forecast for fiscal 2018. We now treat the GBP 220 million of pretax conduct charges as non-recurring and remove from our cash earnings forecast. Our fiscal 2018 cash profit forecast increases to GBP 243 million from GBP 75 million previously, but our statutory NPAT forecast for fiscal 2018 of GBP 46 million is unchanged. Our underlying expense forecast for fiscal 2018 is now GBP 626 million compared with guidance of less than GBP 640 million.

Separately, CYBG received internal ratings-based, or IRB, accreditation from the U.K. regulator, the Prudential Regulation Authority, for its mortgage and SME/corporate loan portfolios. IRB accreditation is an important step for CYBG and satisfies one of the major commitments made when the bank demerged from National Australia Bank in early 2016. CYBG is now authorised to use its own risk models in determining risk weighted assets, resulting in a significant reduction in risk weighted assets for the two portfolios and thereby improving its capital position. As at June 30, 2018, total risk weighted assets would have been GBP 5.3 billion lower for the two portfolios under the IRB methodology, resulting in a pro forma increase in the bank’s common equity Tier 1 ratio of 390 basis points to approximately 15.3% compared with the reported ratio of 11.4%. Total group risk weighted assets were GBP 19.9 billion at March 31, 2018. Changes in risk weighted assets and other impacts of IRB accreditation will be included in the bank’s trading update for first quarter fiscal 2019 expected in late January 2019. CYBG continues to work with the financial regulator to progress its retail unsecured lending IRB application.

Future benefits of IRB accreditation include the ability to target segments of the lending market where previously the group’s higher capital requirements made it difficult to compete with other IRB accredited participants. CYBG is an institution subject to “bail-in” and as such the group expects to meet the regulatory requirement for “minimum requirement for own funds and eligible liabilities,” or MREL, from Jan. 1, 2020 of 18% of risk weighted assets. IRB accreditation results in a lower MREL debt issuance requirement by Jan. 1, 2020. A key benefit of IRB accreditation is better credit risk management that should result in lower future loan losses.