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Morningstar | CYBG’s FY18 Result Disappoints and Earnings Pressure Builds. FVE Cut 10% to GBP 2.80/AUD 4.90

We were disappointed with no-moat-rated U.K. regional bank, CYBG Plc’s, messy fiscal 2018 result, despite underlying profit before tax increasing 13% to GBP 331 million. We did not like the massive increase in "below the line" exceptional costs to a whopping GBP 495 million pretax and the soft and uncertain outlook as Brexit remains a key risk. Our fiscal 2019 NPAT forecast for standalone CYBG of GBP 254 million is broadly in line with our previous forecast but we reduce outer year forecasts resulting in a 10% cut to our fair value estimate to GBP 2.80, or AUD 4.90 per share from GBP 3.10, or AUD 5.50 previously. At current prices, the stock is trading 26% below our reduced valuation. We have not yet incorporated Virgin Money in our forecasts as the merger accounting adjustments are not yet finalised. Our result commentary applies to CYBG standalone with the Virgin Money merger effective Oct. 15, 2018. We do expect a boost from the Virgin Money merger with the combined group boasting six million customers, an iconic brand, and national distribution providing a full range of retail and SME banking services.

The fiscal 2018 cash NPAT after preference distributions of GBP 269 million exceeded our forecast of GBP 243 million, but the composition disappointed with a significantly lower tax rate boosting aftertax returns. Importantly, the fiscal 2018 underlying profit before tax and distributions of GBP 331 million was 6% below our above-consensus forecast of GBP 351 million and the bank lurched to an embarrassing aftertax statutory loss of GBP 145 million from a statutory profit of GBP 211 million in fiscal 2017. Pretax exceptional items of GBP 495 million included GBP 396 million conduct provisions and other legacy conduct matters, GBP 38 million in restructuring charges, GBP 37 million in Virgin Money transaction costs, GBP 16 million in Royal Bank of Scotland alternative remedy package spend, and GBP 7 million in separation costs.

Negative surprises included the increase in PPI provisions by GBP 150 million in the second half to a full-year total of GBP 396 million in fiscal 2018 despite the weekly complaint volumes falling since July 2018. Net interest margin guidance for fiscal 2019 is softer with CYBG guidance reflecting a modest decline to approximately 2.15%, but Virgin Money margin guidance is for a sharper fall to 1.25% in fiscal 2019 from 1.42% in fiscal 2018. Consolidated margin guidance is for 1.60%-1.70% in fiscal 2019 down from a pro forma 1.78% in fiscal 2018.

The underlying tax rate was just 10% compared with our forecast of 23%, boosting the aftertax underlying profit. We maintain our long-term tax rate forecast of 21% including the bank tax, modestly above the U.K. statutory tax rate of 19%.

Low loan losses continue to impress with just GBP 41 million in net impairment charges or 0.12% of the loan book reported for fiscal 2018 down from GBP 48 million or 0.14% in fiscal 2017. As expected, mortgage loan losses are insignificant. The SME book also performed strongly with gross loan losses improving in the year.

As expected, underlying operating costs decreased to GBP 635 million in line with guidance of less than GBP 640 million. Run rate cost savings continue to provide hope for a better outcome in fiscal 2019 with a target of at least GBP 100 million in net cost savings in fiscal 2019. The improvement in the underlying cost/income ratio to 63% from 66% a year ago was a good effort and guidance of 55%-58% was confirmed by end of fiscal 2019. Our forecast cost/income ratio is higher than guidance at 60% as we are not yet convinced significant savings can be achieved while the complicated merger with Virgin Money takes place. Guidance for run rate cost synergy benefits of approximately GBP 120 million by end of fiscal 2021 was confirmed.

The bank benefited from good volume growth with above-system mortgage growth of 5% year on year to GBP 24.5 billion, core SME loans up 6% to GBP 7.2 billion and unsecured personal loans up 4% to GBP 1.2 billion. Customer deposit balances increased 4% to GBP 28.9 billion, with wholesale funding balances down 12% to GBP 8.1 billion. The Virgin Money merger does create a much larger bank and a national competitor to the banking status quo and we can see one of the benefits is sustainable customer growth. As expected, fiscal 2018 net interest margins declined to 2.17% from 2.27% in fiscal 2017 due to higher funding costs, but more so from intense competition for new lending and a changing loan and deposit mix.

Underlying returns on tangible equity of 10.8% in fiscal 2018 met double-digit guidance, but the positive performance was overshadowed by the GBP 495 million in below the line pretax "exceptional items" including GBP 396 million pretax in conduct provisions. The unfranked divided of GBX 3.1 per share exceeded our forecast of GBX 2.0, representing a payout of 10% of underlying EPS. Previously announced advances internal ratings based, or IRB, accreditation for the mortgage book and SME loans boosts pro forma common equity Tier 1 capital to 14.0% from the reported common equity Tier 1 ratio of 10.5% down from 12.4% at Sept. 30, 2017. Despite good organic capital generation, the GBP 396 million in conduct provisions detracted. Management contend the Virgin Money merger will add approximately 1.2% to the core capital ratio boosting to a pro forma 15.2% common equity Tier 1 ratio. The strong capital position provides comfort to the group’s ambitions to progressively increase the dividend payout to approximately 50%.