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Morningstar | CYBG’s 1H19 Update Impresses, But Still a Long Way to Go. FVE GBX 280/AUD 4.90 Unchanged

No-moat U.K. regional bank, CYBG Plc, impressed with a solid first-half fiscal 2019 result with a pro forma pretax underlying profit of GBP 286 million, down 5% on a year ago. The pro forma profit assumes the Virgin Money acquisition took place effective Oct. 1, 2018 whereas the transaction completed Oct. 15, 2018. We liked the good volume growth, broadly stable net interest margins, and a reduction in the cost base improving the cost/income ratio. Loan losses are trending higher, but off a low base and we do not see any major problems in the underlying loan book. Management confirmed good progress with the merger integration and confirmed annual run rate cost synergies of GBP 150 million. Underlying return on tangible capital of 10.4% was modestly higher than six months ago. No interim dividend was paid.

The regional bank is doing well with guidance confirmed for net interest margin in the 1.65%-1.70% range. First-half annualised margin of 1.71% was in line with the six months to Sept. 30, 2018 despite intense pricing competition for U.K mortgages. Our fiscal 2019 forecast margin of 1.70% is unchanged. Based on CYBG management projections, the combined CYBG and Virgin Money group is well positioned to benefit from good earnings growth, but we remain concerned by risks in the merger integration, potentially overpaying and rebranding of the iconic establishment Clydesdale and Yorkshire brands to the Virgin Money brand. Asset quality was good but annualised loan impairments of 0.21% are up from 0.16% six months ago and 0.14% a year ago. The increase had been well flagged by management.

The impact of GBP 277 million in pretax exceptional items reduced the statutory NPAT to just GBP 29 million. The exceptional items were flagged at the first quarter fiscal 2019 trading update in February. Exceptional items included acquisition and integration costs of GBP 214 million, legacy conduct costs of GBP 33 million, restructuring and other costs of GBP 30 million.

The political and economic outlook in the U.K. remains uncertain, but CYBG 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. We make no change to our consolidated fiscal 2019 forecasts with cash earnings of GBP 358 million and a GBP 7 per share dividend. Despite a positive market response to the result, the stock still trades 28% below our unchanged fair value estimate of AUD 4.90 per share. The London Stock Exchange-listed securities trade at a 31% discount to our unchanged valuation of GBX 280.

First-half volume growth was solid with mortgage growth of 2.5%, SME growth of 1.1% and retail unsecured lending growth of 4.2% compared with September 2018. Overall lending growth of 2.4% outstripped the 1.2% increase in customer deposits and was partially funded by a 5.8% increase in wholesale funding.

As expected, the combined loan loss rate of 0.21% is higher than standalone CYBG’s fiscal 2018 outcome of 0.13% due to higher losses in the Virgin Money business. In addition, SME loss rates increased to 0.55%, but importantly mortgage loss rates remain at very low levels around just 0.01%. Unsecured loan losses increased to 3.17%. The combined lending mix is 83% mortgages, 11% SME and corporate, 5% credit cards, and 1% other unsecured. The increase in loan losses was due to the impact of the adoption of IFRS 9, a return to more normal levels in the SME book, and growth and seasoning in the credit card portfolio.

Strong levels of capital and balance sheet strength provide comfort if the U.K. economy suffers as a result of Brexit. Despite easing somewhat from the 15.1% at September 2018, the 14.5% common equity Tier 1 capital ratio at March 2019 is well above regulatory minimums. Combined group assets remain materially below systemic bank thresholds resulting in no required domestic systemic risk buffer. Risk-weighted asset growth, investment spend, acquisition and integration costs, legacy conduct costs and the payment of the fiscal 2018 final dividend detracted.

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 continue to be realised. Cost savings in first half amounted to GBP 25 million with second half costs guided to be less than GBP 470 million.

First year integration synergy benefits are on track with GBP 33 million of annualised cost synergies achieved. First-half underlying cost/income ratio improved to 57% from 60% for the previous six months to September 2018. CYBG expects to deliver approximately 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.