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Do you want to own a second-tier UK bank?

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By Paul Rickard

Do you want to own a second-tier UK bank? National Australia Bank (NAB) shareholders who were “gifted” shares in CYBG Plc, the holding company for the Clydesdale and Yorkshire Banks, should periodically ask themselves this question for two reasons. Firstly, because the shares are often in the “nuisance” category, and secondly, CYBG is really just a minnow in the UK banking market.

Back in February 2016, NAB decided to exit UK banking and their ownership of the Clydesdale and Yorkshire Banks. NAB shareholders were given one share in CYBG (quoted on the ASX under code: CYB) for every four shares they owned in NAB. For example, if you owned 1,000 shares in NAB which were then worth around $30,000, you received 250 CYB shares worth $1,000 (the exact cost price for each CYB share for CGT purposes was $4.01). In relative terms, the CYB shares were about 3% of their NAB investment - nuisance value for many shareholders.

Despite a share sale facility that saw 140,000 CYB shareholders with less than 100 shares exit in early July and receive $4.76 per CYB share, there are still some 240,000 Australian shareholders who have a holding of less than 5,000 CYB shares. Based on yesterday’s closing price of $4.72, shares worth less than $23,600.

They will be pleased to see that CYB has released an encouraging third-quarter trading update that shows it is on target to meet its FY17 fiscal and strategic objectives. However, the question remains that as CYB is a second-tier player in a foreign banking market, is there any strong reason for Australian shareholders to continue with their investment?

Image: Cash machine at a Clydesdale Bank's Piccadilly branch, London. Source: AAP.

CYB’s targets

CYB is a northern English and Scottish retail and small business bank, with 2.8m customers and £30.7bn in loans. Its strategy is to offer a differentiated customer experience delivered brilliantly through an omni-channel mix (digital, branches, contact centres and third party). Financially, this translates to the following medium term metrics:

By Australian standards, these aren’t particularly exciting or challenging targets. Australian Banks have ROEs (return on equity ratios) of around 14% (CBA is the highest at 16%, ANZ the lowest at 12.5%), while cost to income ratios for our majors are in the low 40’s (CBA’s retail bank is nearing 35%). For CYB, however, these targets are a long way off. In the first half of FY17, CYB had a cost to income ratio of 70% and the RoTE was just 6.3%!

The third-quarter update showed that CYB is nevertheless making solid progress. Mortgage growth of 5.8% with record application volumes in the third quarter, loans to small business up by 4.7%, a small increase in net interest margin (NIM), a CET1 capital ratio of 12.4%, and an efficiency program running ahead of guidance that should see operating costs for the full year of less than £680m compared to previous guidance of £690 - £700m. 

In the medium term, CYB’s strategy to improve shareholder returns involves an aggressive cost out plan which includes branch closures, head count reduction, business simplification, process re-design and organisational design, and digital transformation by leveraging their “market leading banking platform”. In regard to the former, they are running marginally ahead of schedule.

CYB’s “market leading banking platform” is known as iB, a set of microservices and APIs sitting over a core banking platform to manage interactions with customers and staff, and provide access to real time data and insights. While this digitization strategy should be an important enabler to positioning the Bank for future growth, caution is required as residual legacy issues from the core banking platform (which is not being changed) may limit the capability of what is offered. 

In the first half, the Bank reported an underlying profit of £123m, up 15% on the corresponding half in FY16. With the third-quarter results pointing to an improved cost outcome, broadly stable NIM and asset growth in line with the target, the Bank is on track to record an underlying profit of £250-£255m this year. The payment of an inaugural dividend has also been telegraphed.

What do the brokers say?

The major brokers who cover CYB are largely neutral on the stock, with one buy, two neutrals, and two sells. According to FNArena, the consensus target price for the stock is $4.93, a 4.4% premium to the last price. Individual recommendations are as follows:

On a multiple basis, the analysts have CYB earning 19 pence or 32.0 Aussie cents in FY17. This puts it on a multiple of 14.7 times FY17 earnings. Earnings for FY18 are forecast to rise to 37.6c, giving it a multiple of 12.5 times.

Bottom Line

The multiples aren’t cheap, but when a Bank has a RoTE of just 6.3% and a cost to income ratio of 70%, there has to be considerable upside opportunity. Then again, it is a second-tier bank operating largely in regional markets, and it is going to remain a second-tier bank.

If you don’t mind the nuisance value of the investment, hang on for the ride. Otherwise, look at one of the Australian majors.

Published: Thursday, August 03, 2017


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