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Morningstar | CYBG’s 1Q19 Update Impresses, But Brexit Uncertainties Persist. FVE GBX 280/AUD 4.90 Unchanged

No-moat CYBG Plc, impressed with first-quarter fiscal 2019 trading update. Good volume growth, better than expected net interest margins, in line loan losses, and an uplift in expected cost savings stand out. The performance for the three months to Dec. 31, 2018 included Virgin Money from Oct. 1, 2018. Management confirmed good progress with the merger integration and boosted expected annual run rate cost synergies to GBP 150 million from previous forecast of GBP 120 million per year.

Despite the Brexit debacle, the regional bank is doing well with modestly improved margin guidance for fiscal 2019 of 165-170 basis points from previous guidance of 160-170 basis points. First-quarter annualised margin of 1.72% declined on prior periods, Virgin Money adjusted, due to intense pricing competition for U.K mortgages. Our fiscal 2019 forecast margin of 1.70% is unchanged. 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 more edgy Virgin Money brand. First-quarter fiscal 2019 asset quality was good with annualised loan impairments of 22 basis points in line with management expectations.

The U.K. political and economic outlook is uncertain, but the group is heavily focused on the Virgin Money integration. We are confident management can deliver on fiscal 2019 guidance, but longer-term targets are less clear. No change to our consolidated fiscal 2019 forecasts with cash earnings of GBP 358 million and a GBX 7 per share dividend. The positive trading update was welcomed by investors with ASX-listed stock up 20% on the day. Despite a strong share price gain, the stock still trades 22% below our unchanged fair value of AUD 4.90 per share. The LSE-listed securities increased 14% on the day and trade at a 27% discount to our unchanged valuation of GBX 280.

First-quarter volume growth impressed with mortgage growth of 1.5%, SME growth of 1.2% and retail unsecured lending growth of 0.4%. Overall lending growth of 1.4% outstripped the 0.2% increase in customer deposits. The increase in lending balances was partially funded by high levels of liquidity following he wholesale funding raised at the end of fourth-quarter fiscal 2018.

As expected, the annualised 22 basis points loan loss rate is higher than standalone CYBG’s fiscal 2018 outcome of 13 basis points due to higher losses in the Virgin Money business. In addition, SME loss rates increased, but importantly, mortgage loss rates remain at very low levels. The pro forma combined lending mix is 83% mortgages, 11% SME and corporate, 5% credit cards, and 1% other unsecured.

Strong levels of capital and balance sheet strength provide comfort if the U.K. economy suffers as a result of Brexit negotiations. Despite easing somewhat, the 14.5% common equity Tier 1 ratio is well above regulatory minimums. Combined group assets remain materially below systemic bank thresholds resulting in no required domestic systemic risk buffer. IFRS 3 accounting adjustments required on consolidation had a minimal effect on capital, with only GBP 12 million of goodwill recognised on the acquisition.

Guidance for fiscal 2019 underlying operating costs was confirmed with the bank on track to deliver total operating costs of less than GBP 950 million. We continue to forecast operating expenses of GBP 941 million for fiscal 2019. Run rate benefits from the final year of the standalone CYBG cost reduction program are being delivered as expected. Year 1 integration synergy benefits are on track. Despite the first quarter underlying cost/income ratio of below 60%, we maintain our full-year fiscal 2019 forecast of 61%. CYBG now expects to deliver a minimum of GBP 150 million of annual run rate cost outs by the end of fiscal 2021. At this stage, we maintain our forecast of annual cost outs of GBP 120 million by end fiscal 2021 due to concerns the integration may not be as smooth as management expects.

In contrast to the positive outcome for underlying operating expenses, the group is flagging GBP 261 million of exceptional items in fiscal 2019. Approximately GBP 161 million was incurred in the first quarter including GBP 48 million of Virgin Money acquisition costs, GBP 8 million of acquisition stamp duty, GBP 77 million due to the closure of CYBG’s VMDB project and GBP 17 million in integration spend. An additional GBP 100 million in further integration expenses is expected to be incurred during the remainder of fiscal 2019 on integration, rebranding, and restructuring costs.