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Morningstar | CYBG 3Q18 Trading Update in Line with Expectations. GBP 3.10 FVE Retained

No major surprises in no-moat-rated CYBG Plc, or CYBG's, brief third-quarter fiscal 2018 trading update. Business outcomes are tracking to plan, albeit mortgage volumes are a little soft. Third-quarter earnings were unspecified and our fiscal 2018 earnings forecasts are unchanged. Fiscal 2018 guidance was maintained for net interest margins, or NIMs, around 2.2%, underlying costs of less than GBP 640 million, loan growth at the bottom end of the mid-single-digit percentage range and loan/deposit ratio of less than 120%. The Virgin Money merger continues to progress as planned and is expected to complete in fourth-quarter calendar 2018, subject to shareholder and regulatory approval. We are positive on the Virgin Money transaction as we see good EPS upside assuming successful completion.

No change to our GBP 3.10 (AUD 5.50) per share fair value estimate, and at current prices, the stock is modestly overvalued. Good progress continues to be made in transforming the U.K. regional bank into a digitally-enabled challenger bank. But uncertain economic conditions, tough competition for new business and some one-off mortgage processing set-backs saw growth momentum slow. The nine-month annualised mortgage growth rate declined to 3.8% from the six-month annualised growth of 5% at March 31, 2018. Annualised customer deposit growth declined modestly to 4.5% from 5% at March 31, 2018 and core SME lending grew an annualised 4.7% broadly in line with the annualised first-half growth rate.

NIMs are under pressure due to intense competition in the mortgage market and interest rate discounting for new home loans. The nine-month annualised margin of 2.18% is in line with the first-half and our full-year fiscal 2018 forecast. Improved SME margins in the quarter offset lower retail margins. NIMs have declined from 2.26% in first-half fiscal 2017 and 2.28% in second-half 2017. Asset quality continues to impress, with an annualised loan loss rate of just 0.12%.

Our positive longer-term view is based on a combination solid loan growth, broadly stable NIMs, and importantly, the success of the cost-out program. Our longer-term forecasts are based on annual average loan growth of 5.8%, NIMs averaging 2.18%, loan losses averaging 0.19% and the cost/income ratio averaging 59%.

Capital remains solid, with a common equity Tier 1 capital ratio of 11.4%, in line with March 31, 2018, supported by 0.15% of organic capital generation. Transition to advanced Basel III regulatory accreditation for the mortgage book is on track, with accreditation expected in October 2018. Significant progress has been made on the group's internal ratings based, or IRB, methodology application for SME lending with accreditation expected earlier than planned.

Shareholder documentation relating to the all-share Virgin Money merger is due to be published on July 31, 2018 with meetings scheduled for Sept. 10, 2018. We have not yet incorporated the proposed CYBG share issue or Virgin Money acquisition in our earnings forecasts or valuation. We like the complementary nature of the two challenger banks, with a dynamic growth strategy based around technology, customer service, product innovation, and the high-profile Virgin Money brand.

The annualised loan loss rate for the nine months to June 30, 2018 is comfortably below our fiscal 2018 forecast of 0.15%. We are forecasting higher bad debts over time, closing out fiscal 2022 with a loss rate of 0.20% up from 0.15% in fiscal 2017.

CYBG's existing medium-term targets remain, with mid-single-digit loan growth to fiscal 2019, a loan/deposit ratio of less than 120%, a cost/income ratio of 55%-58% by fiscal 2019, and a double-digit return on tangible capital by year-end fiscal 2019. Over time, CYBG is targeting a transition to a 50% dividend payout. Excluding the proposed Virgin Money merger, we are confident the medium-term targets can be achieved with the exception of the double-digit return on tangible equity. We forecast an average return on tangible equity around 9% during fiscal 2019-22, but a potential share buy program could boost returns into the double-digit range.

Payment Protection Insurance, or PPI, complaint volumes remain high but are trending in line with management's expectations. We expect to see a slowdown in complaint volumes in fiscal 2019 due to tighter government controls on fee caps and limits to cold calling for claims management companies. The PPI balance sheet provision was GBP 367 million at March 31, 2018 following the first-half GBP 220 million pretax top up. Based on management's expectations, the GBP 367 million provision is sufficient to meet current and future claims, but uncertainty continues to linger, and we would not be surprised to see higher provisions during the next few years.

We continue to highlight the importance of U.K. macroeconomic conditions to longer-term earnings quality. Risks increase as the U.K. works through the complex exit from the European Union. Downside risk is centred on the bank's exposure to the U.K. economy, with mortgages accounting for a very high 83% of the merged group's total loan portfolio and the core SME sector accounting for 11% at March 31, 2018.