By Greg Peel

“The most interesting reporting season for several years looms,” said Citi last week. The broker believes large organisational restructures are nigh.

Westpac ((WBC)) will report first half earnings on Monday, ANZ Bank ((ANZ)) on Tuesday and National Bank ((NAB)) on Thursday. Commonwealth Bank ((CBA)) reported in February.

The good news, as far as Citi’s assessment goes, is that any clear change of strategic direction accompanying restructures will be a positive catalyst. The bad news is that the broker believes both ANZ and NAB will cut their dividends – ANZ as part of a broad, firm-wide restructure, and NAB due to a sharp rise in bad and doubtful debt (BDD) expense.

UBS expects the banks to look through the spike in BDD charges and hold their dividends. But if it transpires that the banks have not adequately provided for some recent high-profile corporate distress, and here we are talking Dick Smith, Slater & Gordon, Arrium, Peabody and others, the market is not going to like it, UBS warns.

Credit Suisse notes ANZ has already warned twice on BDDs heading into result season and Westpac has referred to a provision review, but NAB has been silent. Aside from specific corporate exposures, Credit Suisse also notes potential BDD issues related to the New Zealand dairy industry and to the mining & energy-exposed Australian states.

Macquarie notes ANZ and CBA are overweight loans to miners. CBA is overweight exposure to the WA economy. ANZ is overweight exposure to NZ dairy, as is CBA.

UBS suggests results this season will be “messy”. ANZ has been busy restructuring its international and institutional businesses, Westpac will be providing new divisional disclosures and NAB will be reporting pro-forma numbers for the spin-off of Clydesdale. Other than messy, UBS expects overall results to be relatively weak. The broker is forecasting a 4.1% fall in first half sector earnings.

Outside of bad debts, the two main areas of focus will be net interest margins (NIM) and tier one capital ratios. NIM expansion occurred as a result of mortgage repricing in the period but this will have been offset by higher funding costs, lower prevailing rates and competition, UBS suggests. Basel 4 international bank regulations are expected to be finalised later this year and APRA's definition of “unquestionably strong”, with regard to Australia’s bank capital positions, is due early in 2017.

CLSA has previously warned of all the major banks being forced into a second round of capital raisings as a result of regulatory requirements.

It all sounds very gloomy, but brokers note that bank share prices have taken quite a hit this year. There remains the possibility of upside share price spikes on less-bad-than-expected results, as was the case for US banks earlier in the month.

To that end, Macquarie further notes short positions in bank shares are currently at their highest levels since 2011. ASIC’s most recent data show ANZ on 2.9% shorted, NAB on 1.6% and Westpac on 2.7%. Short positions have risen 50% in 2016 as bank prices have fallen around 10%.

Macquarie sees upside share price risk in bank results given how negative market sentiment has become. Increased short positions are evidence of such sentiment, but also a source of share price upside were results to spark short-covering. The broker sees fundamental value in the sector at current levels. There is further near term upside risk on offer if the banks undertake another round of mortgage repricing after the July federal election, the broker suggests.

Macquarie also sees the downside as limited, were results not to be well received. Retail investors account for some 50% of bank share registries and were net buyers of banks in the March quarter. Retail investors are maintaining a strategy of buying the dips and the broker does not expect any change to this strategy, especially if dividend support remains in place.

The table below highlights ratings and forecasts from the eight major brokers in the FNArena database. The table corroborates analyst belief that bank share prices have already priced in weak sentiment and maybe too much of it.
 

On a net basis, the database brokers have set 13 Buy ratings, 17 Hold and only 2 Sell. Interestingly there are no Sells on CBA, which for eternity bank analysts have considered to be afforded too generous a premium over peers. Target prices are 4-9% above current trading prices.

Earnings forecasts have come down but so too have share prices, thus on 6-7% yields, fully-franked (at least for now), it’s hard to ignore such a return in a low interest rate world. Yields will nevertheless be under threat if dividends are cut and/or further capital raisings are required.
 

Technical limitations

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-Subdued earnings growth expected
-Advanced accreditation may help
-Volatility of Homesafe highlighted
 

By Eva Brocklehurst

Bendigo & Adelaide Bank ((BEN)) has provided some insight with its trading update into how it is positioned in the banking sector, highlighting a customer focus and omni-channel approach, particularly via its major distribution channel, the Community Bank network.

Yet, Deutsche Bank observes this network, while resonating strongly with customers, has struggled to generate the required return-on-equity benefits. Advanced accreditation may improve this situation in the future but, given the broker expects house price weakness will affect the bank's Homesafe income, there is little prospect envisaged for earnings growth over coming years.

Ord Minnett is also unsure. Until there is more clarity on the timing and move to an advanced accreditation the broker's current earnings estimates reflect a flat growth profile for the near term. The timing and quantum of advanced accreditation is up to the Australian Prudential Regulation Authority (APRA).

The bank considers its recent below-system growth is a result of the difference in capital requirements between standardised and advanced accredited banks. The bank believes its standardised status effectively makes it uneconomical to participate at current pricing.

The benefit for Bendigo & Adelaide of advanced accreditation would be a reduction in mortgage risks weights. The bank sits at 39% currently, versus the proposed 25% floor for the major banks. Ord Minnett calculates that a 10 basis points net capital release on the bank's $40bn mortgage book would equate to 3.0% per annum earnings growth over five years.

Outside of this, housing credit growth has been adversely affected by the run-off of the Investec book but the broker envisages improved growth trends are now emerging. Growth in business lending underwhelmed Ord Minnett, and is attributed to bank time being used to re-rate exposures for the transition to advanced accreditation rather than for clients.

Lending growth across the bank's three main areas of housing, business and agriculture has accelerated and Credit Suisse welcomes the trend after a flat first half. That said, the broker notes weak house price growth in the quarter, which created a $1.65m pre-tax loss in the Homesafe portfolio, has highlighted the volatility of this business.

Retail margins appear robust but emerging funding pressures will be instrumental in determining future outcomes, the broker maintains. Further on that subject the broker observes the bank's ability to maintain its net interest margin appears to be unique, in that it is not a symptom of the shift in the competitive environment. The bank flagged the fact that front book pricing pressures continue and competition is heightened for term deposit funding.

The stock is inexpensive compared with the major banks and Bank of Queensland ((BOQ)) but Credit Suisse prefers Bank of Queensland at this juncture.

Macquarie agrees it is hard to overlook the potential downside risk from falling house prices and the near-term earnings uncertainty, despite the fact the stock looks oversold on a fundamental basis. The relationship model remains core to the bank's strategy, but in the broker's view this is a higher cost although potentially higher revenue model, yet achieving the latter has proved challenging.

The bank is looking to strengthen its relationships, particularly in regional Australia, by growing its mobile banking and deepening its penetration of small business communities to selectively build partnerships.

While having completed its core banking system upgrade, Macquarie notes the company still needs to finalise its customer interface which, until that occurs, may hold back its acquisition of younger customers. The broker also questions the merits of a strategic push into non core markets such as NSW. Macquarie also notes that attaining advanced accreditation is critical and worth around 10% in valuation upside. Meanwhile the bank will have to rely on dilutive DRPs to maintain its current dividend payout ratio, given its capital position.

While many may overstate their “customer focus” UBS tends to agree with Bendigo & Adelaide that this is a competitive advantage and a point of differentiation from its peers. Over time the broker expects the bank will be able to generate higher margins, although the cost to serve is likely to remain elevated and be a barrier to higher returns.

The broker also acknowledges that while there is further evidence of more stable interest margins, house price movements do have a substantial impact on earnings via Homesafe.

Morgan Stanley envisages downside risk stemming from ongoing home loan competition, lower interest rates and higher funding costs. The broker also expects loan losses to rise 10 basis points in the second half, with residual risk stemming from the Great Southern portfolio, where the run off failed to accelerate despite the finalisation of legal proceedings.

The bank has one Buy rating (Citi), four Hold and two Sell on FNArena's database. The consensus price target is $9.78, which compares with $9.94 ahead of the update and signals 11.4% upside to the last share price. The dividend yield on FY16 and FY17 forecasts is 7.8% and 7.7% respectively.
 

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-Structural growth intact
-UK referendum uncertainty
-Upside catalyst in US funds
 

By Eva Brocklehurst

BT Investment Management ((BTT)) is poised to deliver further diversified growth in its funds under management (FUM), suggesting to brokers the business is resilient in the face of volatile markets.

Inflows to the company's UK business, JO Hambro, offset the minor outflows that occurred from local operations in the March quarter. Net inflows for BT Investment Management totalled $1.0bn, exceeding the $500m raised in the December quarter. Australian inflows in the wholesale channel were more than offset by outflows in legacy retail products.

Hence, JO Hambro remains a meaningful driver of earnings for the stock. Given this, the declining British pound has undermined recent share price performance, Ord Minnett observes, along with volatile equity markets and the pending regulatory reviews in the UK.

JO Hambro performance fees were $73.2m for 2015, generated by 11 funds and the 50% of the FUM in this division that generates such performance fees. This is materially higher than the $37.6m in the prior year. Also, the broker notes a global shift in asset allocation to value stocks from growth stocks has weighed on the performance generally.

While the stock has de-rated for several reasons over the past couple of months and is trading around 10% below a target of $10.50, Ord Minnett finds better value elsewhere in the sector and maintains a Hold rating.

While mindful of the risks to industry flows, Morgan Stanley considers the company well placed to manage the challenges given its earnings diversity, global distribution and cost flexibility. JO Hambro funds are considered well able to win share in higher margin US mutual funds.

Revenue margins are strong and the broker targets expansion to 54 basis points in FY18, supported by flows into the higher margin JO Hambro products and a positive mix shift in Australia.

The main attraction for Morgan Stanley, who has an Overweight rating, is product diversity – around 70 – and global distribution. Upside catalysts are a successful move into the US and greater-than-expected margin expansion.

Macquarie downgrades earnings estimates for FY16 by 8.9%, largely because of the FX impact, but retains an Outperform rating, finding the capacity and performance attractive from an operational perspective.

The main uncertainty for BT Investment is the issue over Britain's exit or otherwise from the European Union. Predominantly, the risks lie with the currency, Morgans maintains. The upcoming referendum in Britain on whether to leave the EU poses a short-term uncertainty, especially for the direction of the GBP.

That said, the broker believes that JO Hambro will not be materially affected from an operational perspective regardless of the outcome. Longer term, the momentum in FUM, despite a very volatile quarter, confirms the structural growth path is intact.

Once the referendum is out of the way on June 23, the stock can re-rate towards its price target of $10.95. Morgans upgrades to Add from Hold, taking a 12-month view. Upside risks include higher realised performance fees, favourable currency movements and a meaningful acquisition, in the broker's opinion.

Currency may have been a headwind but Credit Suisse was encouraged by the continuation of positive flows. While suggesting it deserves a premium, the broker is cautious about paying too much for the stock because of the skew to earnings from the UK, as well as the FY16 cycling of high performance fees and the less recurring transactional revenue.

Nevertheless, the stock deserves its 27% price/earnings premium to UK peers given strong fund flows, margin expansion and innovative products. The UK market experienced net outflows from equity products in both retail and institutional markets in January and February 2016 and Credit Suisse notes commentary from peer Henderson Group ((HGG)) also indicated European flows were weak.

The broker suspects both BT Investment and Henderson benefitted from inflows into US products, as the US market rotated into active equity strategies in Jan-Feb 2016 and into global equities from US equities.

There are three Buy ratings, two Hold and one Sell (UBS) on FNArena's database. The consensus target is $10.11, suggesting 4.6% upside to the last share price. The dividend yield on FY16 and FY17 estimates is 4.3% and 4.9% respectively.
 

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-Margin concerns shift to liabilities
-Increased geographic diversity
-Portfolio de-risked but outlook subdued
 

By Eva Brocklehurst

Issues for Bank of Queensland ((BOQ)) are taking another tack after the company's first half result release, as the bank flags a re-pricing of its mortgage book. Heightened concerns regarding margin pressure have abated somewhat, as margins were flat in the half, and this latest round of re-pricing should provide support. Most brokers were disappointed at the headline numberss, nevertheless, with revenue growth lower than expected.

The challenge now, as Credit Suisse defines it, is to convert mortgage re-pricing into margin expansion, without losing lending growth momentum.

The re-pricing – up 12 basis points for variable rate mortgages for owner occupiers and 25 basis points for investors – should keep the bank competitive from an acquisition and retention perspective and the new rate on a $500,000 ClearPath owner occupier mortgage will still be three basis points below the average of the major and regional banks, Goldman Sachs points out.

Concerns about margin erosion from recent housing volume growth have now shifted to the liability side of the balance sheet – funding/hedging costs and low rates, the broker adds. On the other hand, asset quality was broadly stable and the result should alleviate concerns on this front from the bank's overweight position in Queensland. Goldman Sachs, not one of the eight brokers monitored daily on the FNArena database, has a Buy rating and $12.99 target.

The re-pricing allows margins to remain stable in the second half but easing volumes and expense growth, such as the Virgin brand development, as well as a discounted dividend reinvestment plan, make the earnings growth outlook less compelling for Ord Minnett.

While the re-pricing is beneficial to near-term earnings, Macquarie suspects some risks are forming from the direction of the bank's major peers. Depending on the timing and extent of the ultimate response from the other banks, the broker suspects Bank of Queensland will likely lose its growth momentum in the mortgage book.

Further levelling of the field in mortgages remains a key area of upside for regional banks and Macquarie envisages the 4-13% valuation upside from Bank of Queensland's risk weights on mortgages will converge with the majors. One interesting development the broker flags is the bank's diversification geographically, with 62% of settlements in the loan portfolio originating from outside of Queensland compared with 52% of portfolio balances.

Upside to margins from improvement in deposit spreads is still likely, the broker asserts, as the bank continues to offer sector-leading rates to attract deposits. Countering this now is sector-leading mortgage rates, which could impinge on growth momentum.

The bank may need to offer higher discounts to attract business, which would become permanently embedded in the back book. Moreover, given the ClearPath product – the subject of the hike in variable mortgage rates – does not come with an option to discount, the elevated pricing may deter customers from a flagship product that the bank has built up over the years, Macquarie suggests.

The stock remains Morgan Stanley's pick in the sector, given re-pricing benefits, cost savings and a relatively strong capital position. The broker acknowledges its forecasts were too optimistic and housing loan growth of 1.6 times system in the first half is too aggressive. This is expected to drop sharply to just 0.8 times.

The flat margin is a credible result, given the market conditions, so Morgan Stanley believes the decision to lift home loan variable rates is prudent. Despite three new single name exposures, which accounted for around 30% of new impaired loans, loan losses fell half on half. Management has materially de-risked the portfolio, in the broker’s view, but the soft economic outlook warrants caution.

The bank's garnering of mortgage share over the last 18 months has come from its broker channel and the Investec acquisition. These channels now represent 46% of flows, UBS observes. Managing distribution is the challenge, as the broker notes the bank was hit by a large volume of broker loans earlier this year which reduced net interest margins and offset much of its back book re-pricing.

UBS also believes, given political pressure on the major banks at present, it is unlikely they will follow Bank of Queensland in the near term. This would leave the bank’s back book out of the market and risks additional customer churn.

Bell Potter, not one of the brokers monitored on the database, had upgraded the stock to Buy with a target of $13.50 earlier, given expectations of a stronger underlying earnings outlook for 2016. The broker is now frustrated this is not the case, with headwinds to non-interest income and operating expenses and a higher effective tax rate.

This broker hopes there is some “noise”in the results and, all else being equal, expects the re-pricing initiatives should offset the higher funding/hedging costs and ensure more stable margins over the next few years. The broker's rating is downgraded to Hold and the target to $12.25.

FNArena's database shows two Buy ratings and five Hold. The consensus target is $12.76, suggesting 11.4% upside to the last share price. The dividend yield on FY16 and FY17 forecasts is 6.7% and 6.9% respectively.
 

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-Re-pricing probably offset by costs, competition
-Focus on mining/Queensland exposures
-Growth still likely to be above peers
 

By Eva Brocklehurst

Tomorrow's interim financial results release from Bank of Queensland ((BOQ)) will be scrutinised for margin pressure the bank pointed to earlier in the year.

Ord Minnett expects first half FY16 cash earnings to be $187m with an interim dividend of 36c, representing a 72% pay-out ratio. The broker expects the outlook for margins will be a key area of focus, considering the potential for re-pricing initiatives to be offset by larger front-book mortgage discounts, competitive business credit pricing and widening wholesale funding costs.

The broker's first half margin forecast of 1.97% is flat versus the prior half, as investor and owner occupier re-pricing initiatives are offset by rising funding costs and elevated competition for housing and business credit. Ord Minnett will also be looking for guidance on the exposure to mining related equipment finance, which has recently experienced a rise in impairments.

Credit Suisse bases its earnings forecasts of $191m on modest revenue growth, lower non-interest income and a flat net interest margin. The broker is also keen to look at asset quality trends, particularly within the mining exposed states, and obtain an update on cost re-structuring, including branch consolidation.

The bank has flagged a move to a more conventional dividend profile and a more conservative first half dividend. This implies a skew towards the final dividend, in Credit Suisse's opinion. The broker factors in a 38c interim dividend.

The bank expects non-interest income growth will be flat to low, targeting a cost to income ratio over the longer term in the low 40% range. The broker notes upward cost pressures and a rising balance of intangible assets which leads, in turn, to higher amortisation expenses.

Deutsche Bank observes loan growth has picked up as a result of the bank's channel diversification strategy but the first half result is likely to be subdued, because of the one-off cost investment flagged in February. This broker also expects underlying margin pressure to largely offset the mortgage re-pricing benefits.

A first half profit of $181m, down 5.0%, is forecast, driven by elevated cost growth more than offsetting revenue growth. Deutsche Bank expects more than half of this cost growth will be driven by the bank's investment program.

On the revenue front, the broker expects 2.0% growth in net interest income on flat margins. Deutsche Bank remains attracted to the bank's medium-term growth prospects but is well aware that the margin outlook is uncertain, with management having twice issued cautions in this area.

The broker also ponders whether the bank is growing too quickly given the current funding environment, and will be on the hunt for evidence of any deterioration in asset quality in Queensland and mining exposures. The downside risks in Deutsche Bank's view are higher bad debts, competition for retail deposits and potential for higher cost growth.

Morgan Stanley also envisages modest downside risk to forecasts. Still, the stock remains the broker's preferred bank because of its relatively strong capital position. While it trades at a discount to the major banks, Bank of Queensland offers stronger earnings and dividend growth.

Morgan Stanley envisages scope for more home loan re-pricing in 2016 and more favourable outcomes for credit quality, with less impact from higher capital requirements. The broker expects the bank to generate above-peer earnings growth of 4.5% versus an average decline of 0.5% for the major banks.

An interim dividend of 38c is forecast, with the broker noting this would end the 2c per share progressive dividend trend. A flat CET-1 capital ratio of 8.9% is also forecast, around 190 basis points above the regulatory minimum.

FNArena's database shows two Buy ratings and five Hold for Bank of Queensland. The consensus target is $13.17, suggesting 14.4% upside to the last share price. Targets range from $11.95 (UBS) to $15.40 (Citi). The dividend yield on FY16 and FY17 forecasts is 6.8% and 7.1% respectively.

See also, Is Bank of Queensland Vulnerable To Margin Pressure? on February 10 2016.
 

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-Single party resource exposures dominate
-ANZ likely to accelerate Asian pull-back
-Confidence in ANZ dented
 

By Eva Brocklehurst

ANZ Banking Group ((ANZ)) has stirred the pot on credit risk with a further increase in bad debt charges, provoking renewed negativity surrounding the banking sector.

Just five weeks after its first quarter trading update signalled a hike in bad debts, recent individual company credit events have been added. Coal Miner Peabody Energy Australia missed an interest payment last week and Arrium ((ARI)), in announcing a recapitalisation plan late February has, Ord Minnett suspects, caused ANZ to take a provisioning top up.

ANZ is not alone in these exposures but Peabody missing its payment is considered the likely catalyst for the bank announcing an additional $100m exposure, which adds to its earlier guidance of charges being a little above $800m.

Ord Minnett observes both Westpac ((WBC)) and National Australia Bank ((NAB)) hold exposures of similar magnitude. While recent refinancing from Glencore and a recovering share price for Noble Mining are positive international aspects in the current resources malaise, Ord Minnett expects further pressures from domestic exposures.

Aurizon ((AZJ)) is likely to endure some pressure on its debt provisions as a consequence of the problems with Peabody. The broker notes each of the major banks hold $50m in exposure to Aurizon's $490m debt tranche maturing in 2021. NAB has further exposure to failed retailer Dick Smith Holdings, while, along with Westpac, NAB is among five other lenders in a syndicate to troubled law firm Slater & Gordon ((SGH)). Ord Minnett expects the sector's share prices will be under pressure heading into reporting season in May.

Westpac also delivered an update in its consumer and business bank briefing and signalled bad debt charges were rising. Credit Suisse notes some asset quality deterioration in automotive finance but believes the pressures continue to reflect the usual “hot spots”. Westpac has highlighted rising arrears in Western Australia and suggested five single name exposures could present losses for the sector.

Goldman Sachs, at this stage, believes the deterioration in asset quality is largely isolated to specific resource exposures, but nevertheless is not exclusive to just Westpac and ANZ. Larger domestic resource syndicated loans usually have at least three major banks participating. The broker suspects the market is pricing the deterioration as an ANZ-specific issue, and Westpac's announcement suggests this is not the case.

ANZ remains the broker's preferred bank stock, with a Buy rating. Goldman Sachs, not one of the eight stockbrokers monitored daily on FNArena's database, retains an Neutral rating for the other major banks.

Brokers note that Westpac does have an advantage in the current environment with its heavy exposure to NSW and Victorian mortgages, as these states are currently enjoying the strongest economies. Westpac expects consumer bad debt charges should be 10% or $24m higher than the previous corresponding period, which is lower than UBS expected.

Both UBS and Deutsche Bank are a little more concerned about ANZ's update as this is not the first time in the last 18 months that the bank has underestimated the bad debt charge and been forced to revise estimates. UBS expects the charges will stay around current levels over the second half and 2017 but could be materially higher if Asia experiences a hard landing.

The broker expects ANZ will accelerate its pull-back in Asia, with a base case of $30bn in additional institutional business being exited by FY18. The revenue impact is expected to be largely offset by a significant cost cutting program.

Maintaining a steady dividend is becoming increasingly challenging and any further signs of asset stress or economic deterioration would likely force the board to cut its dividend, the broker suspects. The stock does not appear expensive but UBS finds few catalysts for outperformance until ANZ can demonstrate both a stabilising of bad debts and a successful pull-back in Asia.

Despite the fact this is about single names rather than a worsening credit environment, Deutsche Bank believes it suggests both limited visibility on bad debt and potential for further charges given ANZ's overweight position in resources and institutions. The prospect of the bank closing the valuation discount to its peers in the short term is low, the broker believes.

Deutsche Bank downgrades ANZ to Hold from Buy. Ordinarily, the broker believes. the news would not be a huge cause for concern as the provision represents just 1.0% of post tax profit but ANZ has surprised several times on its bad debts, and this is an environment where companies that disappoint are dealt with harshly.

ANZ has overweight exposures in several areas such as NZ dairy, Asia and Western Australia's housing portfolio and should two more more of these categories deteriorate simultaneously it could mean more downside risk to earnings, the broker maintains.

Macquarie is also concerned that ANZ's guidance changed over a relatively short period, despite the overall credit environment being broadly stable. The broker expects the market will continue to question the bank's differentiation in terms of credit quality to that of its peers.

While the issues for ANZ are likely to be company specific, ongoing commodity price weakness is expected to translate into higher losses for the sector, with Macquarie observing ANZ and Commonwealth Bank ((CBA)) are most exposed.

Macquarie's syndicated loan data suggests that ANZ and CBA have lower quality institutional exposure relative to peers, partly from higher exposure to energy and resources. This appears to counter Goldman Sachs' observations, which estimate ANZ has the largest at-risk exposure to resource syndicated loans and CBA the smallest.

Morgan Stanley believes ANZ's new CEO, Shayne Elliott, should cut the dividend and strengthen the balance sheet as priority. The bank is in an earnings downgrade cycle driven by loan losses and the broker lowers forecasts by a further 2.0%. ANZ has the highest risk profile of the major banks because of its business mix, rate of growth and risk appetite in Australian non-housing loans, and its broad Asian institutional lending exposure, in Morgan Stanley's view.

ANZ has four Buy ratings, three Hold and one Sell (Morgan Stanley) on FNArena's database. The consensus target is $26.44, suggesting 12.6% upside to the last share price. This compares with $26.72 ahead of the announcement. Targets range from $22.50 (Morgan Stanley) to $32.75 (Citi).
 

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-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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