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Morningstar | CYBG Remains Undervalued Despite Our Scepticism About Management’s Ambitious Targets

No-moat U.K. regional bank, CYBG Plc’s upbeat presentation at its 2019 investor day confirmed the expanded bank is on track to meet previously announced medium-term targets. The priority is on integrating the merger with Virgin Money, reinvigorating the mortgage and SME businesses, cutting costs, and increasing operational efficiency.

Management is optimistic on the bank’s prospects, despite challenges in the U.K. economy, and provided upgraded targets on profitability, asset growth, funding and capital. We see good upside potential for the merged CYBG/Virgin Money group with expanded distribution, enlarged scale, and integration progressing in line with plan. However, we question how management can deliver on its longer-dated goals like net interest margin, or NIM, improvements, above system lending growth and the ambitious GBP 200 million of annual run rate cost synergies by the end of fiscal 2022. Margin pressure continues to persist, the largest five banks continue to maintain an oligopoly with high customer inertia, and the Virgin Money integration may not be as smooth as expected.

We have adjusted our earnings forecasts in light of the updated guidance. Specifically, we have projected moderate improvements in lending and deposit growth and cost improvements offset by weaker NIM forecasts and higher loan loss rates. To this end, our fair value estimate of GBX 280/AUD 4.90 per share remains unchanged, implying a P/E multiple of 11.2 times our 2019 earnings estimate. The stock continues to screen as undervalued at current prices.

We believe CYBG’s initiatives are consistent with accelerating longer-term EPS growth. The strategy is based around customer service, gifting rewards, building relationships, and technological innovation. Of particular note are the renaming of the company to Virgin Money UK Plc by the end of 2019, rebrand all operations to the Virgin Money brand by 2021, and grow market share in business and unsecured consumer lending. There will be risks. The iconic Clydesdale and Yorkshire Bank brands resonate with customers in niche market segments, and a greater exposure towards business and unsecured lending increases the risk of higher loan losses.

Nonetheless, we think Virgin Money’s iconic national brand and proposition should help increase the customer base over time. The pivot towards higher-margin business and unsecured lending also makes strategic sense as the mortgage market has been under severe margin pressure due to low interest rates growing competition. We are confident the bank’s tight lending standards will help maintain reasonable loan loss rates. Three-month-plus arrears currently sit at 0.3%, well below the industry average of 0.8%.

Management’s short-term profitability targets were reaffirmed for fiscal 2019 with NIM in the 1.65% to 1.70% range and operating expenses of less than GBP 950 million. We assume a fiscal 2019 NIM of 1.70% and operating expenses of GBP 948 million. Management indicated the focus will be on improving productivity rather than volume growth, but their longer-term targets look optimistic to us.

First, management expect to achieve "above-system" lending growth, underpinned by market share gains in business and personal unsecured lending while maintaining its market share in mortgages. Second, a total of GBP 200 million of annual cost outs by fiscal 2022 (from previous forecast of GBP 150 million by fiscal 2021). Operating costs in fiscal 2022 are guided to be below GBP 780 million, with a cost-to-income ratio around mid-40%. Third, upward trending NIMs by fiscal 2022, supported by a mix shift towards higher margin business and personal lending, and initiatives to attract more deposit funding. Management expects "high-single-digit" annual growth on deposits.

The U.K. banking industry is highly concentrated, and regulatory efforts have done little to fuel competition. HSBC, Barclays, RBS and Lloyds continue to hold 80% of personal accounts and 85% of business accounts, and continue to pursue similar strategies of digitisation, cost reduction, acquiring disruptive startups, integrating operations and targeted growth in consumer finance. CYBG Management has a track record of stripping out costs, but to date only GBP 33 million out of the GBP 200 million annual run-rate cost synergies have been achieved, with the target date pushed back by a year to fiscal 2022. The prevalence of broker-led distribution reduces pricing power, while the major banks: i) have substantial surplus liquidity to deploy into the system; ii) have access to low-cost wholesale funding; and iii) enjoy customer inertia on deposits.

We think it is more likely for CYBG to achieve similar levels of lending growth as historically; achieve a similar cost/income ratio as the major banks; and continue to face NIM pressure. We forecast lending growth of 5% per year through to fiscal 2023, in line with the historical average. We remain sceptical on how an increasingly digitised lender can nurture strong customer relationships, especially with business lending. We forecast progressive cost savings, with a relatively low cost/income ratio of just below 50% by fiscal 2022, influenced by our concern the Virgin Money integration may not be as smooth as management expects.

We project NIM to decline over time to just below 1.65% in fiscal 2022. Industrywide competition are likely to constrain pricing power, with potentially higher wholesale funding costs from the refinancing of the Term Funding Scheme monies and meeting minimum requirement for own funds and eligible liabilities obligations. We also forecast deposits to increase by 7.5% a year, as customers generally deposit smaller portions of money with challenger banks. Finally, we project the loan loss rate to increase to 30 basis points by fiscal 2022, reflecting the lending book’s greater risk exposure.

Nonetheless, our forecasts on CYBG’s lending and deposit growth remain above those for the major banks. We expect strong EPS accretion averaging 13% per year from GBX 30 per share in fiscal 2018 to around GBX 55 per share in fiscal 2023. Encouragingly, there are no surprise legacy conduct charges with the deadline for lodging new cases/complaints fast approaching in August 2019. There is also potential upside from the RBS Incentivised Switching Scheme and a prospective improvement in interest rates, but we have not incorporated this in our forecasts.