Clydesdale Bank CYBG LN
March 18, 2016 - 11:10am EST by
hawkeye901
2016 2017
Price: 2.08 EPS 0.13 0.23
Shares Out. (in M): 879 P/E 16.2 8.9
Market Cap (in M): 1,833 P/FCF N/A N/A
Net Debt (in M): 0 EBIT 0 0
TEV: 0 TEV/EBIT N/A N/A

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  • Spin-Off
  • Financial services
  • Regional Bank
  • Banks
  • United Kingdom
 

Description

We believe Clydesdale Bank (CYBG LN or CYB AU) is a classically undervalued spin-off with the potential to more than double in value in the next two to three years.  Prior to its IPO last month, Clydesdale had been a small and neglected subsidiary of National Australia Bank (NAB AU), a large Australian bank located more than 10,000 miles away.  Due to legacy issues at Clydesdale, regulatory pressures to simplify operations at NAB and the nuisance value of managing a UK operation that contributed just 3-4% of total group earnings, we believe that NAB was a price insensitive seller, resulting in an IPO valuation of just 58% of tangible book value.  At the current share price of £2.08 per share, Clydesdale trades at 67% of tangible book, an attractive valuation for a bank with strong (and likely excess) capital levels that should reach double digit ROEs over the next 4-5 years.

 

Further, we believe the Clydesdale investment opportunity has a number of exciting drivers and upside levers, including 1) a high caliber new CEO who has already successfully executed the Clydesdale playbook while he ran Allied Irish Bank (AIB) from 2011-2015, 2) meaningful cost reduction opportunities, 3) potential for excess capital equal to ~60% of the current market cap as Clydesdale moves to advanced risk weightings for the calculation of its capital ratios, 4) earnings upside from higher interest rates and 5) the potential to be acquired.  Importantly, the financial impact of any legacy conduct issues has been de-risked through substantial indemnification from NAB.

 

Brief Background on the Bank and Spin-off

Clydesdale is a mid-sized UK bank that operates primarily in northern England and Scotland.  It operates under two local bank brands, Clydesdale and Yorkshire banks, and is a relatively plain-vanilla mortgage, credit card and small business lender.  Clydesdale has 2.6 million retail customers and 179,000 small/medium-sized business customers.  In its core regions, it has strong market shares of 9% of personal checking accounts and 8% of business lending.  In addition, 78% of its retail current accounts and 54% of its business current accounts have been customers for more than 10 years.  With a high-quality/sticky and heavily current account-oriented deposit base, Clydesdale has a lower cost of deposits than other "challenger" banks in the UK including Virgin Money and TSB, and has lower deposit costs than even large incumbents like Lloyds and Santander UK.

 

After decades of ownership by NAB, Clydesdale became a standalone public company in February 2016 through the IPO of a 25% stake (listed in London) and the subsequent distribution of the remaining 75% of shares (listed in Australia) to NAB's shareholders.  The stock currently trades in both the UK and Australia.

 

New CEO Has a Proven Track Record

To give some context on the historical management of Clydesdale by NAB, the current COO is one of the few legacy senior executives.  She has been with the bank for 17 years and in that time has seen 14 different CEOs.  During the IPO process, management described past management of the bank as "a revolving door of expat talent" that resulted in a "confusion of the strategy and a short-term approach."  In anticipation of Clydesdale's IPO, current CEO David Duffy joined the bank in June 2015.  He had previously been CEO of Allied Irish Bank (AIB) from December 2011 to May 2015. At AIB, Mr. Duffy led an impressive turnaround effort that was centered on the delivery of significant cost savings through workforce reductions and branch closures.  We believe he plans to replicate the AIB playbook at Clydesdale over the next few years.

 

Duffy accomplished quite a bit in his three and a half years at AIB.  Prior to him joining AIB, the company had a total of 446 branches and commercial centers, 14,501 full time employees and a cost/income ratio of 96%.  Duffy outlined an initial plan to reduce the workforce by 2,500 and to achieve a cost/income ratio of 60-65% by 2014. Throughout his tenure at AIB, those goals were consistently proven to be conservative as the bank over-delivered on the initial plan.  By the time he left AIB in May 2015, the company's branch network had been reduced by 30% to 316 locations, headcount had been reduced by 3,900 (or 27% in total) and more than €350 million of costs had been eliminated (>20% of the cost base).  The end result was a marked improvement in the bank's cost/income ratio to 52% in the first half of 2015, well below the initial targets of 60-65%.

 

As a result, we are highly confident in Duffy’s ability to deliver on Clydesdale’s 5-year plan outlined at the time of the IPO for a cost/income ratio below 60% and double digit returns on tangible equity by 2020.  However, in our discussions with management, it also became clear that the 5-year plan was developed by NAB prior to Duffy’s arrival and his own evaluation of the appropriate cost structure for the business.  Duffy and his team plan to complete their review of the cost opportunities and update the company's targets over time.  As will be discussed further below, we would expect the cost and return targets to be ratcheted higher over time, similar to what happened at AIB.

 

Upside Lever:  Significant Cost Reduction Opportunity Beyond Stated 5-Year Plan

Prior to the spin-off, NAB set a target for Clydesdale to reduce its cost/income ratio from 75% to below 60% over five years.  Given that Mr. Duffy was able to achieve a reduction in AIB's cost/income ratio from 96% to 52% in three and a half years driven predominantly by cost reductions, we believe the company’s current targets are conservative.

 

First, management has guided to £762 million in total FY 2016 operating expenses, of which ~£150 million represents regulatory and IT investments that should fall by at least £50 million in FY 2017 as some of the investment projects conclude.  Further, the bank has 2,834 employees in its 275 branches out of a total of 7,247 employees.  We believe the remaining ~4,400 employees outside of the branch network represent a significant cost opportunity for management to attack.  In addition, they plan to rationalize the branch network in a meaningful way.  During the IPO roadshow, management indicated it would like to get the branch network closer to 200 branches from the current 275 (>25% reduction from current).  Over the past year, they have closed 24 branches and according to the CFO, they saw no decay in deposit performance where they closed branches.

 

To give some further context, Lloyds has ~20x the asset base of Clydesdale but just 10x the employee count.  And Virgin Money, another "challenger," has ~20% fewer assets than Clydesdale but 60% fewer employees.  We believe the planned reduction in regulatory/IT spending, the potential closure of ~25% of the branch network and the significant non-branch level headcount provide management with material cost reduction opportunities.

 

 

Clydesdale vs. UK-Focused Banks

 

Clydesdale

 

Virgin Money

Lloyds

OneSavings

Aldermore

Shawbrook

 

 

 

 

 

 

 

 

Tangible Equity (mm)

£2,728

 

£1,276

£37,380

£247

£510

£313

 

 

 

 

 

 

 

 

Net Interest Margin

2.20%

 

1.65%

2.63%

3.05%

3.60%

6.10%

Cost/Income Ratio

75%

 

62%

49%

30%

53%

49%

 

 

 

 

 

 

 

 

Current ROE

5%

 

10%

15%

31%

19%

25%

Target ROE

"double digit"

 

"mid-teens"

13.5 - 15%

> 25%

~21%

~25%

 

 

 

 

 

 

 

 

Total Assets

£38,705

 

£30,229

£806,688

£4,937

£7,009

£4,000

Total Employees

7,247

 

3,058

75,306

419

876

414

Assets per Employee

5.3x

 

9.9x

10.7x

11.8x

8.0x

9.7x

 

 

Upside Lever:  Capital Release From Move To Advanced Risk Weightings

Clydesdale's current leverage ratio (Tier 1 Capital / Total Assets) stands at 7.1%. By comparison, the large incumbent UK banks have ratios of 4.5-5.6% and Virgin Money has a leverage ratio of just 4.1%.  By that metric, Clydesdale appears to have significant excess capital relative to its UK bank peers.  However, on a CET1 basis, Clydesdale's ratio stands at 13.2%, slightly above the large banks at ~13% but below Virgin Money at 18.7%.

 

The disconnect between leverage and CET1 ratios is due to the fact that Clydesdale currently uses a standard approach to calculating risk-weighted assets.  By comparison, the big UK banks and Virgin Money are all on internal ratings-based (IRB) risk-based capital formulas for their risk-weighted asset calculations.  To put the comparison in perspective, total risk-weighted assets to total assets at Clydesdale is 47% vs Virgin Money at 20%.

 

 

Clydesdale Capital Ratios vs Peers on Advanced Risk Weightings

 

Clydesdale

 

Virgin Money

Lloyds

RBS

Barclays

 

 

 

 

 

 

 

Leverage Ratio

7.1%

 

4.1%

4.8%

5.6%

4.5%

CET1 Ratio

13.2%

 

18.7%

13.0%

15.5%

11.4%

 

 

 

 

 

 

 

Total Assets

38,705

 

30,229

806,688

815,408

1,120,012

RWAs

18,227

 

6,110

222,845

242,600

358,376

RWA/Assets

47%

 

20%

28%

30%

32%

 

  

In order to get on advanced risk weightings Clydesdale needs to demonstrate its ability to accurately predict losses using its risk models.  This process takes time and is not factored into our base case or management's plan, but management is confident that they can get there over time for at least a large portion of the bank's portfolio, if not the entire bank.  In our discussions with the company, they highlighted that they have a long history of reliable data for mortgages and have been running models as part of NAB’s IRB program in the past, so they aren’t starting from scratch.  By management's own estimation, a move to advanced risk weightings could result in up to a £1 billion capital benefit, which represents ~60% of Clydesdale's current market cap and could be returned to shareholders or used to grow the business.

 

Upside Lever:  Higher Interest Rates

With a large, low-cost deposit base of ~50% current accounts, Clydesdale would be a significant beneficiary of higher rates as they would continue to effectively pay nothing on half of their deposit base even in a higher interest rate environment. While today it might seem hard to imagine a return to higher interest rates, it represents a free upside option to a Clydesdale investment.

 

Upside Lever:  M&A Potential

Over time, we believe Clydesdale could be an attractive acquisition target.  As an example, TSB (TSB LN) was spun out of Lloyds in June 2014 at ~80% of tangible book and was subsequently acquired by Spanish bank Sabadell (SAB SM) in 2015 for 1.0x tangible book.  Compared to Clydesdale, TSB had a higher cost structure (with a cost/income ratio of 80%+), lower capital levels (5.3% leverage ratio) as it was on advanced risk-weightings, a similar ROE and a higher starting valuation than Clydesdale today.

 

Legacy Conduct Issues Largely De-Risked 

As those who have followed UK financials will know, most banks have been dealing with legacy conduct issues, particularly PPI (Payment Protection Insurance).  This was a product that was supposed to help consumers ensure the repayment of loans if the borrower became ill or disabled.  PPI was historically sold in a misleading way and customer redress has become an expensive issue.  Clydesdale has been dealing with this and other past conduct issues, but the financial cost of the redress has been mitigated by NAB as part of the separation process. 

 

Prior to the spin-off, NAB provided Clydesdale with significant unutilized provisions of £986 million relating to all of the outstanding conduct issues.  In addition, NAB has provided an incremental £1.1 billion indemnity to provide additional coverage if needed.  So in aggregate, Clydesdale has £2.1 billion in total provisions and indemnities, which management is confident will be sufficient.  To give you further background regarding how the size of the mitigation package was developed, it's important to remember that the UK regulators had to bless the separation of Clydesdale from NAB.  Therefore, based on our understanding, the regulator had NAB run stress tests of the expected ultimate exposure, to which they added a multiplier to ensure that it was extremely unlikely that the ultimate costs would exceed the NAB indemnity.  From the regulator's standpoint, the last thing they want is to let a deep-pocketed foreign bank off the hook and then have Clydesdale run into trouble later.  From NAB's perspective, it seems to have been desperate enough to complete the separation that they were willing to agree to such a large number (including posting the £1.1 billion indemnity in escrow with the Bank of England).  Therefore, while continuing to be a distraction, we don't expect the economic impact of these legacy items to be meaningful for Clydesdale.

 

Summary Clydesdale Financials

 

Clydesdale:  Summary Financial Projections (September FY)

 

2015A

2016E

2017E

2018E

2019E

2020E

 

 

 

 

 

 

 

Average Earning Assets

£35,780

£37,149

£39,137

£40,850

£42,621

£44,400

Net Interest Margin

2.20%

2.20%

2.23%

2.26%

2.29%

2.32%

Net Interest Income

£787

£817

£873

£923

£976

£1,030

 

 

 

 

 

 

 

Cost/Income Ratio

75%

75%

63%

58%

52%

48%

Net Income

£139

£87

£190

£252

£319

£373

 

 

 

 

 

 

 

Adjusted EPS

£0.16

£0.10

£0.22

£0.29

£0.36

£0.42

Dividends Per Share

£0.00

£0.00

£0.00

£0.10

£0.16

£0.21

Payout Ratio

0%

0%

0%

35%

45%

50%

 

 

 

 

 

 

 

Tangible Book Value/Share

£3.10

£3.20

£3.42

£3.60

£3.80

£4.02

 

 

 

 

 

 

 

ROTE

5.1%

3.1%

6.5%

8.2%

9.8%

10.8%

 

 

 

 

 

 

 

Capital Ratios

 

 

 

 

 

 

CET 1 Ratio

13.2%

13.3%

13.8%

14.2%

14.5%

14.9%

Leverage ratio

7.1%

7.1%

7.2%

7.4%

7.5%

7.7%

 

 

Clydesdale Comps

 

UK-Focused Banks:  Valuation Comparison

 

Clydesdale

 

Virgin Money

Lloyds

OneSavings

Aldermore

Shawbrook

 

Comps Median

 

 

 

 

 

 

 

 

 

 

Share Price

£2.08

 

£3.68

£0.71

£3.11

£2.32

£3.00

 

 

Market Cap (mm)

£1,833

 

£1,637

£50,376

£756

£799

£752

 

 

 

 

 

 

 

 

 

 

 

 

Tangible Equity

£2,728

 

£1,276

£37,380

£247

£510

£313

 

 

Tangible Book (£/sh)

£3.10

 

£2.89

£0.52

£1.02

£1.48

£1.25

 

 

 

 

 

 

 

 

 

 

 

 

P / Tangible Book

0.67x

 

1.28x

1.35x

3.06x

1.57x

2.40x

 

1.57x

 

 

 

 

 

 

 

 

 

 

EPS (Calendar)

 

 

 

 

 

 

 

 

 

2016

0.13

 

0.32

0.08

0.38

0.26

0.32

 

 

2017

0.23

 

0.42

0.08

0.42

0.30

0.40

 

 

2018

0.31

 

0.49

0.08

0.44

0.33

0.46

 

 

 

 

 

 

 

 

 

 

 

 

P/E (Calendar)

 

 

 

 

 

 

 

 

 

2016

16.2x

 

11.6x

9.3x

8.3x

9.0x

9.3x

 

9.3x

2017

8.9x

 

8.8x

9.2x

7.5x

7.7x

7.6x

 

7.7x

2018

6.8x

 

7.6x

9.3x

7.0x

7.0x

6.5x

 

7.0x

 

 

Conclusion

We believe that in its fiscal year ending September 2019 Clydesdale can achieve a 52% cost/income ratio and earn an ROE of ~10%, while still posting a 7.5% leverage ratio and a 14.5% CET1 ratio.  Assuming the stock trades at 12x forward earnings and 1.2x tangible book value, Clydesdale would be worth ~£4.50 per share including dividends in ~2.5 years, which represents more than a double from the current share price.  And that valuation target ignores the fact that you could have an incremental £1.00+ per share in excess capital (50-60% of additional value on the current share price) if they can move to advanced risk-weightings.

 

I do not hold a position with the issuer such as employment, directorship, or consultancy.
I and/or others I advise hold a material investment in the issuer's securities.

Catalyst

  • Management outlining and executing on sizable cost opportunity 
  • Move to advanced risk weightings
  • Investor awareness and index inclusion
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    Description

    We believe Clydesdale Bank (CYBG LN or CYB AU) is a classically undervalued spin-off with the potential to more than double in value in the next two to three years.  Prior to its IPO last month, Clydesdale had been a small and neglected subsidiary of National Australia Bank (NAB AU), a large Australian bank located more than 10,000 miles away.  Due to legacy issues at Clydesdale, regulatory pressures to simplify operations at NAB and the nuisance value of managing a UK operation that contributed just 3-4% of total group earnings, we believe that NAB was a price insensitive seller, resulting in an IPO valuation of just 58% of tangible book value.  At the current share price of £2.08 per share, Clydesdale trades at 67% of tangible book, an attractive valuation for a bank with strong (and likely excess) capital levels that should reach double digit ROEs over the next 4-5 years.

     

    Further, we believe the Clydesdale investment opportunity has a number of exciting drivers and upside levers, including 1) a high caliber new CEO who has already successfully executed the Clydesdale playbook while he ran Allied Irish Bank (AIB) from 2011-2015, 2) meaningful cost reduction opportunities, 3) potential for excess capital equal to ~60% of the current market cap as Clydesdale moves to advanced risk weightings for the calculation of its capital ratios, 4) earnings upside from higher interest rates and 5) the potential to be acquired.  Importantly, the financial impact of any legacy conduct issues has been de-risked through substantial indemnification from NAB.

     

    Brief Background on the Bank and Spin-off

    Clydesdale is a mid-sized UK bank that operates primarily in northern England and Scotland.  It operates under two local bank brands, Clydesdale and Yorkshire banks, and is a relatively plain-vanilla mortgage, credit card and small business lender.  Clydesdale has 2.6 million retail customers and 179,000 small/medium-sized business customers.  In its core regions, it has strong market shares of 9% of personal checking accounts and 8% of business lending.  In addition, 78% of its retail current accounts and 54% of its business current accounts have been customers for more than 10 years.  With a high-quality/sticky and heavily current account-oriented deposit base, Clydesdale has a lower cost of deposits than other "challenger" banks in the UK including Virgin Money and TSB, and has lower deposit costs than even large incumbents like Lloyds and Santander UK.

     

    After decades of ownership by NAB, Clydesdale became a standalone public company in February 2016 through the IPO of a 25% stake (listed in London) and the subsequent distribution of the remaining 75% of shares (listed in Australia) to NAB's shareholders.  The stock currently trades in both the UK and Australia.

     

    New CEO Has a Proven Track Record

    To give some context on the historical management of Clydesdale by NAB, the current COO is one of the few legacy senior executives.  She has been with the bank for 17 years and in that time has seen 14 different CEOs.  During the IPO process, management described past management of the bank as "a revolving door of expat talent" that resulted in a "confusion of the strategy and a short-term approach."  In anticipation of Clydesdale's IPO, current CEO David Duffy joined the bank in June 2015.  He had previously been CEO of Allied Irish Bank (AIB) from December 2011 to May 2015. At AIB, Mr. Duffy led an impressive turnaround effort that was centered on the delivery of significant cost savings through workforce reductions and branch closures.  We believe he plans to replicate the AIB playbook at Clydesdale over the next few years.

     

    Duffy accomplished quite a bit in his three and a half years at AIB.  Prior to him joining AIB, the company had a total of 446 branches and commercial centers, 14,501 full time employees and a cost/income ratio of 96%.  Duffy outlined an initial plan to reduce the workforce by 2,500 and to achieve a cost/income ratio of 60-65% by 2014. Throughout his tenure at AIB, those goals were consistently proven to be conservative as the bank over-delivered on the initial plan.  By the time he left AIB in May 2015, the company's branch network had been reduced by 30% to 316 locations, headcount had been reduced by 3,900 (or 27% in total) and more than €350 million of costs had been eliminated (>20% of the cost base).  The end result was a marked improvement in the bank's cost/income ratio to 52% in the first half of 2015, well below the initial targets of 60-65%.

     

    As a result, we are highly confident in Duffy’s ability to deliver on Clydesdale’s 5-year plan outlined at the time of the IPO for a cost/income ratio below 60% and double digit returns on tangible equity by 2020.  However, in our discussions with management, it also became clear that the 5-year plan was developed by NAB prior to Duffy’s arrival and his own evaluation of the appropriate cost structure for the business.  Duffy and his team plan to complete their review of the cost opportunities and update the company's targets over time.  As will be discussed further below, we would expect the cost and return targets to be ratcheted higher over time, similar to what happened at AIB.

     

    Upside Lever:  Significant Cost Reduction Opportunity Beyond Stated 5-Year Plan

    Prior to the spin-off, NAB set a target for Clydesdale to reduce its cost/income ratio from 75% to below 60% over five years.  Given that Mr. Duffy was able to achieve a reduction in AIB's cost/income ratio from 96% to 52% in three and a half years driven predominantly by cost reductions, we believe the company’s current targets are conservative.

     

    First, management has guided to £762 million in total FY 2016 operating expenses, of which ~£150 million represents regulatory and IT investments that should fall by at least £50 million in FY 2017 as some of the investment projects conclude.  Further, the bank has 2,834 employees in its 275 branches out of a total of 7,247 employees.  We believe the remaining ~4,400 employees outside of the branch network represent a significant cost opportunity for management to attack.  In addition, they plan to rationalize the branch network in a meaningful way.  During the IPO roadshow, management indicated it would like to get the branch network closer to 200 branches from the current 275 (>25% reduction from current).  Over the past year, they have closed 24 branches and according to the CFO, they saw no decay in deposit performance where they closed branches.

     

    To give some further context, Lloyds has ~20x the asset base of Clydesdale but just 10x the employee count.  And Virgin Money, another "challenger," has ~20% fewer assets than Clydesdale but 60% fewer employees.  We believe the planned reduction in regulatory/IT spending, the potential closure of ~25% of the branch network and the significant non-branch level headcount provide management with material cost reduction opportunities.

     

     

    Clydesdale vs. UK-Focused Banks

     

    Clydesdale

     

    Virgin Money

    Lloyds

    OneSavings

    Aldermore

    Shawbrook

     

     

     

     

     

     

     

     

    Tangible Equity (mm)

    £2,728

     

    £1,276

    £37,380

    £247

    £510

    £313

     

     

     

     

     

     

     

     

    Net Interest Margin

    2.20%

     

    1.65%

    2.63%

    3.05%

    3.60%

    6.10%

    Cost/Income Ratio

    75%

     

    62%

    49%

    30%

    53%

    49%

     

     

     

     

     

     

     

     

    Current ROE

    5%

     

    10%

    15%

    31%

    19%

    25%

    Target ROE

    "double digit"

     

    "mid-teens"

    13.5 - 15%

    > 25%

    ~21%

    ~25%

     

     

     

     

     

     

     

     

    Total Assets

    £38,705

     

    £30,229

    £806,688

    £4,937

    £7,009

    £4,000

    Total Employees

    7,247

     

    3,058

    75,306

    419

    876

    414

    Assets per Employee

    5.3x

     

    9.9x

    10.7x

    11.8x

    8.0x

    9.7x

     

     

    Upside Lever:  Capital Release From Move To Advanced Risk Weightings

    Clydesdale's current leverage ratio (Tier 1 Capital / Total Assets) stands at 7.1%. By comparison, the large incumbent UK banks have ratios of 4.5-5.6% and Virgin Money has a leverage ratio of just 4.1%.  By that metric, Clydesdale appears to have significant excess capital relative to its UK bank peers.  However, on a CET1 basis, Clydesdale's ratio stands at 13.2%, slightly above the large banks at ~13% but below Virgin Money at 18.7%.

     

    The disconnect between leverage and CET1 ratios is due to the fact that Clydesdale currently uses a standard approach to calculating risk-weighted assets.  By comparison, the big UK banks and Virgin Money are all on internal ratings-based (IRB) risk-based capital formulas for their risk-weighted asset calculations.  To put the comparison in perspective, total risk-weighted assets to total assets at Clydesdale is 47% vs Virgin Money at 20%.

     

     

    Clydesdale Capital Ratios vs Peers on Advanced Risk Weightings

     

    Clydesdale

     

    Virgin Money

    Lloyds

    RBS

    Barclays

     

     

     

     

     

     

     

    Leverage Ratio

    7.1%

     

    4.1%

    4.8%

    5.6%

    4.5%

    CET1 Ratio

    13.2%

     

    18.7%

    13.0%

    15.5%

    11.4%

     

     

     

     

     

     

     

    Total Assets

    38,705

     

    30,229

    806,688

    815,408

    1,120,012

    RWAs

    18,227

     

    6,110

    222,845

    242,600

    358,376

    RWA/Assets

    47%

     

    20%

    28%

    30%

    32%

     

      

    In order to get on advanced risk weightings Clydesdale needs to demonstrate its ability to accurately predict losses using its risk models.  This process takes time and is not factored into our base case or management's plan, but management is confident that they can get there over time for at least a large portion of the bank's portfolio, if not the entire bank.  In our discussions with the company, they highlighted that they have a long history of reliable data for mortgages and have been running models as part of NAB’s IRB program in the past, so they aren’t starting from scratch.  By management's own estimation, a move to advanced risk weightings could result in up to a £1 billion capital benefit, which represents ~60% of Clydesdale's current market cap and could be returned to shareholders or used to grow the business.

     

    Upside Lever:  Higher Interest Rates

    With a large, low-cost deposit base of ~50% current accounts, Clydesdale would be a significant beneficiary of higher rates as they would continue to effectively pay nothing on half of their deposit base even in a higher interest rate environment. While today it might seem hard to imagine a return to higher interest rates, it represents a free upside option to a Clydesdale investment.

     

    Upside Lever:  M&A Potential

    Over time, we believe Clydesdale could be an attractive acquisition target.  As an example, TSB (TSB LN) was spun out of Lloyds in June 2014 at ~80% of tangible book and was subsequently acquired by Spanish bank Sabadell (SAB SM) in 2015 for 1.0x tangible book.  Compared to Clydesdale, TSB had a higher cost structure (with a cost/income ratio of 80%+), lower capital levels (5.3% leverage ratio) as it was on advanced risk-weightings, a similar ROE and a higher starting valuation than Clydesdale today.

     

    Legacy Conduct Issues Largely De-Risked 

    As those who have followed UK financials will know, most banks have been dealing with legacy conduct issues, particularly PPI (Payment Protection Insurance).  This was a product that was supposed to help consumers ensure the repayment of loans if the borrower became ill or disabled.  PPI was historically sold in a misleading way and customer redress has become an expensive issue.  Clydesdale has been dealing with this and other past conduct issues, but the financial cost of the redress has been mitigated by NAB as part of the separation process. 

     

    Prior to the spin-off, NAB provided Clydesdale with significant unutilized provisions of £986 million relating to all of the outstanding conduct issues.  In addition, NAB has provided an incremental £1.1 billion indemnity to provide additional coverage if needed.  So in aggregate, Clydesdale has £2.1 billion in total provisions and indemnities, which management is confident will be sufficient.  To give you further background regarding how the size of the mitigation package was developed, it's important to remember that the UK regulators had to bless the separation of Clydesdale from NAB.  Therefore, based on our understanding, the regulator had NAB run stress tests of the expected ultimate exposure, to which they added a multiplier to ensure that it was extremely unlikely that the ultimate costs would exceed the NAB indemnity.  From the regulator's standpoint, the last thing they want is to let a deep-pocketed foreign bank off the hook and then have Clydesdale run into trouble later.  From NAB's perspective, it seems to have been desperate enough to complete the separation that they were willing to agree to such a large number (including posting the £1.1 billion indemnity in escrow with the Bank of England).  Therefore, while continuing to be a distraction, we don't expect the economic impact of these legacy items to be meaningful for Clydesdale.

     

    Summary Clydesdale Financials

     

    Clydesdale:  Summary Financial Projections (September FY)

     

    2015A

    2016E

    2017E

    2018E

    2019E

    2020E

     

     

     

     

     

     

     

    Average Earning Assets

    £35,780

    £37,149

    £39,137

    £40,850

    £42,621

    £44,400

    Net Interest Margin

    2.20%

    2.20%

    2.23%

    2.26%

    2.29%

    2.32%

    Net Interest Income

    £787

    £817

    £873

    £923

    £976

    £1,030

     

     

     

     

     

     

     

    Cost/Income Ratio

    75%

    75%

    63%

    58%

    52%

    48%

    Net Income

    £139

    £87

    £190

    £252

    £319

    £373

     

     

     

     

     

     

     

    Adjusted EPS

    £0.16

    £0.10

    £0.22

    £0.29

    £0.36

    £0.42

    Dividends Per Share

    £0.00

    £0.00

    £0.00

    £0.10

    £0.16

    £0.21

    Payout Ratio

    0%

    0%

    0%

    35%

    45%

    50%

     

     

     

     

     

     

     

    Tangible Book Value/Share

    £3.10

    £3.20

    £3.42

    £3.60

    £3.80

    £4.02

     

     

     

     

     

     

     

    ROTE

    5.1%

    3.1%

    6.5%

    8.2%

    9.8%

    10.8%

     

     

     

     

     

     

     

    Capital Ratios

     

     

     

     

     

     

    CET 1 Ratio

    13.2%

    13.3%

    13.8%

    14.2%

    14.5%

    14.9%

    Leverage ratio

    7.1%

    7.1%

    7.2%

    7.4%

    7.5%

    7.7%

     

     

    Clydesdale Comps

     

    UK-Focused Banks:  Valuation Comparison

     

    Clydesdale

     

    Virgin Money

    Lloyds

    OneSavings

    Aldermore

    Shawbrook

     

    Comps Median

     

     

     

     

     

     

     

     

     

     

    Share Price

    £2.08

     

    £3.68

    £0.71

    £3.11

    £2.32

    £3.00

     

     

    Market Cap (mm)

    £1,833

     

    £1,637

    £50,376

    £756

    £799

    £752

     

     

     

     

     

     

     

     

     

     

     

     

    Tangible Equity

    £2,728

     

    £1,276

    £37,380

    £247

    £510

    £313

     

     

    Tangible Book (£/sh)

    £3.10

     

    £2.89

    £0.52

    £1.02

    £1.48

    £1.25

     

     

     

     

     

     

     

     

     

     

     

     

    P / Tangible Book

    0.67x

     

    1.28x

    1.35x

    3.06x

    1.57x

    2.40x

     

    1.57x

     

     

     

     

     

     

     

     

     

     

    EPS (Calendar)

     

     

     

     

     

     

     

     

     

    2016

    0.13

     

    0.32

    0.08

    0.38

    0.26

    0.32

     

     

    2017

    0.23

     

    0.42

    0.08

    0.42

    0.30

    0.40

     

     

    2018

    0.31

     

    0.49

    0.08

    0.44

    0.33

    0.46

     

     

     

     

     

     

     

     

     

     

     

     

    P/E (Calendar)

     

     

     

     

     

     

     

     

     

    2016

    16.2x

     

    11.6x

    9.3x

    8.3x

    9.0x

    9.3x

     

    9.3x

    2017

    8.9x

     

    8.8x

    9.2x

    7.5x

    7.7x

    7.6x

     

    7.7x

    2018

    6.8x

     

    7.6x

    9.3x

    7.0x

    7.0x

    6.5x

     

    7.0x

     

     

    Conclusion

    We believe that in its fiscal year ending September 2019 Clydesdale can achieve a 52% cost/income ratio and earn an ROE of ~10%, while still posting a 7.5% leverage ratio and a 14.5% CET1 ratio.  Assuming the stock trades at 12x forward earnings and 1.2x tangible book value, Clydesdale would be worth ~£4.50 per share including dividends in ~2.5 years, which represents more than a double from the current share price.  And that valuation target ignores the fact that you could have an incremental £1.00+ per share in excess capital (50-60% of additional value on the current share price) if they can move to advanced risk-weightings.

     

    I do not hold a position with the issuer such as employment, directorship, or consultancy.
    I and/or others I advise hold a material investment in the issuer's securities.

    Catalyst

    Messages


    SubjectRe: Costs
    Entry03/21/2016 11:08 AM
    Memberhawkeye901

    Thank you for the question.  Here are our responses:

     

    Cost Reduction

    The company has guided to total FY16 costs of £762mm which is higher than the £727mm of expenses in FY15 mainly due to standalone costs and increased technology investments.  The disconnect between our numbers and the street in the out-years is simple:  consensus assumes opex remains at these elevated levels for the very basic fact that management hasn't yet detailed any meaningful cost reduction opportunities.  During the IPO, management targeted a 60% cost/income ratio based primarily on topline growth, so no analyst is willing to model anything beyond that yet.  We think this gives patient investors a significant opportunity given the high probability, in our view, that management can/will be much more aggressive on the expense side.

     

    Based on several discussions with management and as we detailed in the write up, we believe the original five year plan is conservative and that there are meaningful cost reduction opportunities around 1) headcount and 2) reducing the branch network from 275 to 200 over time.  Personnel-related costs account for ~40% of total operating costs and the potential branch network reduction could reduce the footprint by more than 25% in the coming years.  If management can execute on these two areas, we think it's clear this would result in meaningful reductions to overall operating expenses.

     

    Last, we believe the investment spending should tail off, in line with what was communicated by management during the IPO process.  While some of the spending is expensed and some is capitalized, we don't have the exact split.  With a total of £150mm in annual investment spend currently, it still represents a meaningful operating expense item to attack.

     

    Importantly, we would also highlight that we believe Clydesdale offers significant downside protection to the extent we are wrong and the cost opportunity doesn't come to fruition as we would hope.  If we assume that costs do not come down in-line with our expectations and instead the company generates a 60% cost/income ratio in FY2019, our earnings estimate is 0.28 per share.  At 10.5x FY2019 earnings (82% of 2018 tangible book), the stock would still be worth £3.00 per share, more than 40% above the current price and a 15% IRR over the next 2.5 years.

     

    AIB Example

    I think the relevant takeaway from the AIB example is that this is a CEO who has managed a much larger bank, set aggressive cost reduction goals centered around branch closures and layoffs and most importantly, over-achieved on those targets.  So while we could debate whether AIB is a perfect comparison with Clydesdale today, the playbook is very similar and in talking to Duffy it's clear he wants to get the cost/income ratio much lower than the 60%.

     

    Comps

    We acknowledge that the other publicly-listed UK banks are not perfect comps to Clydesdale.  What we are trying to highlight is that these are all UK financial institutions, they all have much better cost/income ratios than Clydesdale and they all trade at healthy premiums to book value (vs Clydesdale at a significant discount).

     

    We agree that TSB would be the best comp for Clydesdale, but is no longer public.  TSB had ~8,400 employees and 631 branches at year end 2014.  Clydesdale employs on average 10 people per branch across its 275 branches (leaving ~4,400 employees outside of the branch network).  If we assume that TSB has a similar number of employees per branch, it would imply that TSB has just 1,900 employees outside of the branch network compared to Clydesdale at ~4,400.  And TSB supports a branch network that is more than twice the size of Clydesdale's.  Further, TSB was guiding to "no more than £720mm" in total 2015 operating costs despite having a higher employee count and a larger branch network than Clydesdale.  And again, from a valuation standpoint, TSB spent its public life trading at a higher valuation than Clydesdale and was ultimately acquired at 1x book, which would imply 48% upside to Clydesdale's current share price.

     

    We think Metro is a bad comp.  The bank has just 40 branches, isn't profitable (141% cost/income ratio in 2015) and holds a large portion of its assets in securities as opposed to traditional lending operations.  And yet Metro trades at 2.1x tangible book.  Given that Metro currently generates negative ROEs (-13% in 2015) and trades at over 2x tangible book, we think Clydesdale compares very favorably given its highly discounted valuation, positive earnings and multiple upside levers outlined in our write-up.

     

    IPO Process

    We think the heavy Australian participation in the deal was due to the fact that Clydesdale gave Australian investors the opportunity to own a bank stock that 1) trades at a big discount to Australian banks, 2) is listed in Australia and included in the local indices and 3) has no exposure to the frothy Australian housing market (diversification benefits).

     

    On the UK side, we don't have any particular insight other than to note that at the time of the IPO, markets were quite choppy.  We think it is likely that many investors just didn't want to risk getting involved in a new issue with a restructuring story and mid-single digit ROE at a time when European financial stocks were under tremendous pressure.


    SubjectRe: Re: Costs
    Entry03/29/2016 02:54 PM
    Memberblaueskobalt

    Shouldn't this bank require more branch costs than average?  It has a more rural footprint with a core customer that is older and less affluent...


    SubjectRe: Re: Re: Costs
    Entry03/30/2016 08:57 AM
    Memberhawkeye901

    Your assessment of Clydesdale's footprint/customer base is generally correct. However, our argument on the cost side simply centers around two key points:  1) they have too many branches (as mentioned, management would like to reduce the footprint from 275 to closer to 200 branches over time) and 2) they have too much overhead and non-branch costs (a point on which management also agrees). 

     

     

    It’s important to note that we are not saying that Clydesdale will do better than its average UK peer on its cost/income ratio or that it will have the highest ROEs in the UK banking sector.  Our thesis is that the current cost/income ratio gap between Clydesdale and any UK bank peer is significantly beyond what can be explained by structural differences. The fact that Clydesdale is being run by a management team highly focused on cutting costs and with a track record of successfully doing so, gives us confidence that they can achieve real improvements in the cost structure. While Clydesdale’s peers are targeting ROEs ranging from mid-teens to ~25%, we are simply outlining a case in which Clydesdale ultimately achieves ROEs of 10-11%, which at the current discounted valuation, should result in attractive returns over the next few years.


    SubjectRe: Buy-to-let rules
    Entry03/31/2016 12:25 PM
    Memberhawkeye901

    We don't think the impact is disproportionate given some of the comps we outlined in the write-up are even more focused on the buy-to-let market than Clydesdale (namely OSB LN, ALD LN, and SHAW LN).  That being said, buy-to-let has been a driver for CYBG over the past 4 years as it has been for the UK market as a whole.  Buy-to-let mortgages account for ~17% of the mortgage stock in the UK and 31% for Clydesdale (CYBG has indicated it will look to limit its overall buy-to-let exposure at around 35%).  From a loan quality standpoint, Clydesdale positions its focus as being on "medium net worth" clients who are looking to diversify investments, not career landlords.  The average income of Clydesdale's buy-to-let buyers is £104k per year and the bank estimates that 74% of their borrowers could afford the mortgage payments even if there were no rental income whatsoever from the property.

     

    Clydesdale has grown its owner-occupied mortgage book at a 4.7% CAGR since 2012 and its buy-to-let book by 27.4% for a total CAGR of 10.1% in the mortgage book.  Our model assumes mortgage book growth from 2015-2020 slows to a 6.4% CAGR.  If we assume the owner-occupied book grows by the same 4.7% over the next 5 years, the implied growth in the buy-to-let book would be a 9.8% CAGR over the period, a significant slowdown from what the bank has seen and below the expected growth rates outlined in the article you referenced, which indicates that the proposed changes may slow the growth in buy-to-let to +17% p.a. vs current projections of +20% p.a.  Importantly, the consultation paper that was published specifically states that the "buy-to-let market is expected to continue growing after the implementation of the proposals set out." 

     

    If you are concerned about the potential impact of any slowdown in the buy-to-let market, you could consider hedging a long CYBG position with the more buy-to-let focused lenders.  To put the relative valuation gap into perspective, the combined market caps of OSB + ALD + SHAW = £2,270mm with combined book equity of £1,070mm for an aggregate price / book of 2.1x.  By comparison, Clydesdale's market cap is £1,842mm while the book equity is £2,728mm.  So OSB + ALD + SHAW have a combined market cap 23% greater than Clydesdale but have a combined book value over 60% less in aggregate than Clydesdale.  They are currently generating strong NIMs and ROEs vs Clydesdale, but the valuation gap is extraordinary.


    Subjectbrexit
    Entry06/16/2016 03:32 PM
    Memberskierholic

    what are your thoughts on brexit on Clydesdale Bank given its largely local / retail clients?

    And any operational update would be appreciated

    Thanks!


    SubjectRe: brexit
    Entry06/17/2016 12:58 PM
    Memberhawkeye901

    Thank you for the question.  Brexit would likely be a short-term negative economic event for the UK and therefore a negative for Clydesdale, but as you mention, we think Clydesdale's focus on local retail and small business lending should largely insulate them from significant impacts.  We recently met with the CEO and CFO and they believe the major impact for Clydesdale would be lower loan growth as individuals and small businesses remain hesitant due to the added economic uncertainty.  In that case, management indicated they will "run harder" on costs to offset any topline slowdown.

    In terms of the operational update, Clydesdale reported strong H1 2016 results on May 24. Underlying profit before taxes exceeded consensus estimates by ~20%. The main driver of the better results was management’s initial cost reduction efforts, highlighted by the CFO who stated on the call that "costs aren't going up from here."  They updated 2016 cost guidance, lowering full year cost expectations by 4%, but based on H1 results, it appears that even this updated guidance will likely prove conservative.

    Most importantly in our view, the longer-term cost transformation appears on track with our thesis.  First, they announced further headcount reductions through year-end and will close ~10% of the bank's branches in the second half of this year.  None of those cost benefits will flow through until 2017, providing a meaningful earnings tailwind into next year.  Second, they are targeting what they describe as "significant" third party spending and are reviewing all contracts to reduce costs.  Last, they are undertaking a significant "de-layering" exercise to try and simplify the organization and reduce the cost structure.  Here is how the CEO put it on the call:  "...in most organizations, there's sort of a middle layer, sticky little layer of high cost, low productivity, we're tackling those areas... We will be ruthless in how we take those [costs] out."  We expect all of these efforts to be more clearly outlined in management's September investor day, which they brought forward by two months given their confidence in how things are progressing.

    We think the investment case is on track and based on our discussions with management, they appear very upbeat about the opportunity at Clydesdale.


    SubjectRe: Re: brexit
    Entry06/18/2016 02:11 PM
    Memberskierholic

    Thank you for the reply!

    Agree with most of your points and it is indeed as David Duffy calls it "an execution investment story".

    In an interview with David Duffy in 2015, he called Clydesdale Bank an interesting player in a consolidating UK banking sector. From your work, do you give any credence to the consolidation story?


    SubjectInvestor Day Update
    Entry09/14/2016 12:50 PM
    Memberhawkeye901

    CYBG hosted its first investor day yesterday and provided an updated long-term plan.  Management has based its plan on conservative assumptions regarding the UK economy and interest rates.  Most importantly, management provided its initial view on the cost opportunity and is targeting FY 2019 opex to be below £630 million.  For comparison, at IPO, FY 2016 opex was guided to be £762 million, so management expects to reduce costs by 17% from the 2016 starting point over the next 3 years while also growing the loan book by mid-single digits p.a.  The cost reductions will be driven mainly by further branch closures, headcount reductions and the rationalization of third party spending.  Management expressed a high degree of confidence in achieving this target, saying they have a "clear line of sight" on the cost reductions in their 2019 plan and will continue to work on further reductions from there.  Given management's past track record and the cost reductions delivered in 2016 to date, we think it is likely that the 2019 target will prove conservative.

     

    Additionally, management outlined its expectations to transition to IRB (advanced risk-weighting methodology) to free up excess capital that would then be returned to shareholders or deployed into accretive acquisitions. Management now expects to transition CYBG’s mortgage portfolio to advanced methodology at the beginning of 2019 and expects to transition the entire bank to IRB in 2020.  Their internal modeling indicates that they can reduce risk-weighted assets (RWAs) by £5 billion.  At their targeted 12.5% CET1 ratio, they would have ~£750 million in excess capital on the current asset base or ~£0.85 per share (34% of the current market cap).  Further, their plan appears conservative as the implied risk-weightings on their book would still be well above peers.  We believe that if they fully reached peer risk-weights on the current book, it would imply ~£1.2 billion or ~£1.35 per share in excess capital (over 50% of the current share price).

     

    Overall, we believe the investor day was supportive of our original thesis and importantly, significantly reduces the range of outcomes at CYBG from an operational standpoint.  While several months ago, there was no clear commitment from management around costs and much of the sellside assumed a flattish to growing cost base, we now have clear confirmation that the opportunity exists to right-size and restructure the business.  Therefore, we continue to think the skew is very attractive today with the stock trading at 79% of tangible book, having significant excess capital, a strong management team and double digit ROEs in 3 years.  At 1.15x our FY 2018 estimate of book value (and 12.5x forward earnings), the stock would be worth ~£4.10 per share or 65% upside in just over 2 years.

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