Sizing Up NAB’s UK Spin-Off

This story features NATIONAL AUSTRALIA BANK LIMITED. For more info SHARE ANALYSIS: NAB

-Cost cutting opportunities
-Positive UK macro environment
-Upside potential longer term
 

By Eva Brocklehurst

The outlook is reasonably sunny for CYBG plc ((CYB)) , the former Clydesdale Bank from the wet part of the world spun off by National Australia Bank ((NAB)), but investors may need to be a little patient.

This UK banking franchise has a strong deposit book with 50% being current accounts, and if it delivers on its growth plans over the next 3-5 years Ord Minnett expects it to re-rate towards 1.0 times book value from 0.6 times presently. Low near-term profitability and dependence on rate rises in the UK leads the broker to initiate coverage with a Hold rating on a 12-month view with a $4.33 target.

Ord Minnett expects returns on tangible equity to decline to 3.8% in 2016 from 5.1% in 2015 because of a step up in costs as the franchise takes shape as an independent entity. Over the next five years the broker expects returns to increase to 10.3%, driven by loan growth and benefits from interest rates.

Given expectations for lower-for-longer interest rates in the UK, Ord Minnett believes that a move from revenue-based strategies to a mixed revenue/cost-based plan will be well received by the market. Opportunities for costs to be taken out exist, the broker maintains, as CYBG's cost base is similar to TSB which has almost three times the number of branches. It's also more than double Virgin Money, which has a similar sized balance sheet.

A surcharge impacting all UK banks and building societies came into effect on January 1, 2016 – flagged in the company's scheme booklet – and Bell Potter, while expecting some offsets will apply, opts for conservative assumptions. The net effect of all changes to forecasts is a 3-5% reduction in earnings estimates for 2016-2019.

The broker still considers the UK macro environment in terms of GDP, low unemployment and improving retail sentiment as positive for the bank's growth outlook and additional value should come from cost efficiencies. The broker, not one of the eight monitored daily on the FNArena database, retains a Buy rating with a $4.60 target.

Bell Potter likes the stock, with its 275 branches and 40 business centres located in England and Scotland. Its regional market share is strong. Moreover, the broker notes the balance sheet has been substantially de-risked by increasing CET1 capital and provisions and strengthening lending and funding quality.

CYBG's stability has been substantially underwritten by NAB prior to the de-merger and IPO, the broker adds. The bank is 84% customer-funded and it intends to pay a maiden dividend in 2017 with an eventual distribution of up to 50% of earnings.

The base case for gradual improvement in returns is largely priced into the stock, in Morgan Stanley's opinion, but upside is possible from the release of capital. Morgan Stanley has initiated local coverage with an Overweight rating and no target as yet.  The broker expects loan growth to drive improved operating leverage and models a growth rate of 6.5% over 2015-20, largely in line with management's targets.

Continued market share gains are expected in mortgage balances and a return to growth in small-medium enterprise lending. The bank is well capitalised and the broker models dividends commencing in FY17 and the pay-out rising to 50% by FY19.

The broker concedes the pathway to delivering returns above the cost of capital is long. Morgan Stanley also finds the relative valuation of the Australian listing more attractive so has an Equal-weight rating and 235p target for the London Stock Exchange listing.

CYBG has good prospects for medium-term efficiencies and upside potential for returns, Credit Suisse envisages. The broker considers the main risk include the challenges of execution for a newly formed management team and the prospect that achieving the targeted pay-out ratio could take longer than expected.

Credit Suisse notes, on the positive side, the re-basing of net interest margins and non-interest income appears to be over and asset quality has dramatically improved. On the negative side the broker observes the customer base is skewed towards the relatively less affluent areas of the UK and these customers are less penetrated from a product perspective. Moreover, CYBG lacks scale and is burdened by its relatively high cost to income ratio.

Natural owners of the stock are considered to be value investors that are willing to back a 1-2 year cost restructuring. The broker notes that in this early phase post IPO there is potential for share register realignment which could create some near-term volatility.

The investment case, therefore, rests on the realisation of improving returns on equity progressively over the medium term, which should lead to the achievement of higher book multiples. Credit Suisse initiates with a Hold rating and $4.75 target.
 

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