By Ian Smith

,
10 February 2016

A year ago, demerging and floating your UK banking operations no doubt appeared a fairly safe prospect. The market was enjoying a strengthening domestic economy and looking forward to increases in interest rates. TSB had made steady progress since its flotation as challenger banks flourished. By March, TSB would be snapped up by Spanish lender Banco de Sabadell at a price equivalent to its book value.

But with banking stocks now crashing around investors’ ears, things have changed. National Australia Bank set a price range for the flotation of its CYBG (CYBG) operation – comprising the Clydesdale and Yorkshire bank brands – at 175p to 235p a share, which represented a price to net tangible assets ratio of 0.56 to 0.76 times. The stock is now trading at 193p. Why so cheap?

(Full, albeit odd, disclosure: my father, also called Iain Smith, was chief financial officer of NAB’s UK business between 2004 and 2011. The current finance director is an entirely unrelated Ian Smith.)

It wasn’t a great start. CYBG had to delay its IPO by 24 hours after Moody’s reassessed and subsequently downgraded its long-term deposit rating. The bank was keen to emphasise this had no material impact on its ability to raise funding, and nor did it increase its cost of funding. But to understand the discount, we have to consider the bank’s underlying return on tangible equity, which expresses profit after tax and distributions as a proportion of average tangible equity. This sat at just 5.1 per cent in the year to the end of September 2015. That is sluggish compared with rival
Virgin Money
(VM.) on 10.2 per cent – looking ahead, CYBG’s own target is in double digits.

Currently weighing down the profit side of that equation are the bank’s costs, as it makes up for a lack of investment by its erstwhile parent company in customer-facing initiatives. “We have pushed ahead quite strongly in digital investment,” says the current Mr Smith of investment during FY2015. Since November, for example, customers have been able to open accounts online. As a result of this expenditure, the bank’s underlying cost to income ratio sits at 75 per cent, up five basis points on the 2014 financial year. Costs are not expected to return to normal until FY2017.

The other part of improving that cost-to-income ratio is growing the loan book. Having expanded too aggressively, in management’s view, into commercial real estate at the end of the last decade, CYBG transferred this loss-making book to its parent company in 2012. CYBG has now rebooted its small- and medium-sized business lending franchise with a mixture of overdrafts, asset finance and invoice finance, as well as starting to make small-scale, low-risk commercial property loans. CYBG expects 4 per cent annual growth in its SME lending, and 8 per cent in its mortgage book.

Underwriting standards are remaining tight – the average mortgage last year was 2.66 times the recipient’s income, compared with 2.65 times in FY2014. And CYBG’s strong retail funding base allows it to get more out of those loans. Its net interest margin – that is, net interest income divided by interest-earning assets – sits at 220 basis points. Virgin Money looks worse off this time at 165bp.

Could further expected payouts for payment protection insurance and an expected hit to book value explain part of the discount? Not likely: the bank has an indemnity from NAB against a further £1.1bn in PPI claims and other compensation, on top of nearly £1bn in unused provisions.

Part of the discount is explained by the general market bearishness. “We all just need to look out of the window and see what has happened to bank stocks over the last six weeks,” says Mr Smith. Even the more highly rated of the lenders such as
Lloyds Banking Group
(LLOY), whose shares had sustained a premium to book value throughout 2015, has been brought back down to earth with a bump.

But in the end, CYBG’s challenge is arguably one of size. It has the branch network and the compliance costs of a large-scale banking operation without the loan book to provide a compelling return on equity for shareholders. The departure of NAB and the work done to rationalise the business arguably makes a takeover or merger more likely, but Mr Smith points out that for all the talk of consolidation, the Sabadell-TSB deal is all that the market has delivered.

Private shareholders who are not convinced that CYBG is as likely a target as TSB presented (the former is certainly less expensive) will have to decide whether the discount is too harsh to the growth story the management team is keen to tell.