CYBG PLC, owner of the Clydesdale and Yorkshire Bank brands, demerged from National Australian Bank (ASX code: NAB) in February 2016, subsequently listing on the London Stock Exchange under the ticker CYBG and via CDIs on the Australian Stock Exchange under the ticker CYB. CYBG is the 6th largest UK bank by loans, with a 2% share of the UK lending market.
At the time of the demerger and IPO, the business was generating a relatively paltry return on tangible equity of 4.5% and was consequently trading at a little over half its book value (0.6x). Management set out a credible path to growing the return on tangible equity to at least 10% by 2020. This strategy was based on growing revenues, principally by growing the mortgage book, while managing expenses to reduce the cost to income ratio from 72% to below 60% (which compares to the average for UK retail banks of 53%). Achieving this reduction in the cost to income ratio from 72% to 60% corresponds with a lift in the operating profit margin from 28% to 40% and translates to a 43% increase in profit for CYBG before any revenue growth.
Over the past 18 months, CYBG management has executed successfully on this strategy. In the most recent half year result, operating costs were 7% lower than the prior year and revenues were up 1%, with 4% loan growth in the last six months. This resulted in a reduction in the cost to income ratio to 70% and a marked improvement in the return on tangible equity from 4.5% to 6.3%. Net interest margins were maintained and bad debt charges were low and stable. The bank is also well capitalised, with a common equity tier 1 ratio in the middle of management’s target 12-13% range.
This improvement in the business’ operational fitness has not gone unnoticed. Since IPO, the London Stock Exchange listed shares have risen from £1.80 to £2.83 at the time of writing, an impressive 57% return in just over 18 months. However, the GBP has depreciated by 20% relative to the Australian dollar over this time, leaving Australian investors with an attractive yet less spectacular return of 25%. It is also worth noting that the bulk of this return was delivered in the first 8 months following the demerger and the stock has effectively tracked sideways since. This may be seen in the below chart.
Figure 1. CYB.ASX price since listing in February 2016
Source: CBG Asset Management & IRESS
It is reasonable to ask whether the market is already giving the CYBG much of the credit for the strategic turnaround story, based on the price to book value expanding from 0.6x at IPO to 0.9x currently. CYBG’s domestic banking peers in the UK, including Barclays, Lloyds, RBS and Virgin Money, are forecast to generate an average return on tangible equity this financial year of 11.3% and they are trading on an average price to book value of 1.0x. Based on equivalent peer group price to book value multiples, this does not leave much upside for CYBG from its current 0.9x, considering the not insignificant further work needed to lift the return on equity from 6.3% currently up closer to these UK peers.
For those who prefer to think in PE multiple terms, CYBG is currently trading on 12.5x 2017 financial year earnings, compared to a UK peer average of 9.3x, which reflects the anticipated growth in earnings as CYBG moves towards its target double digit return on tangible equity by 2020.
Other factors we believe Australian investors need to consider are that
- CYBG has limited ability to pay (what will be unfranked) dividends given its current profitability.
- Based on earnings generated in GBP, the share price will also be sensitive to any change in the GBPAUD exchange rate, and finally
- the bank has incurred significant conduct related fines in recent times – as have UK peers – while any future fines should be wholly or largely covered by an indemnity from National Australia Bank.
CYBG has markedly improved its operational fitness since listing. This hasn’t gone unnoticed by investors. We continue to monitor the management team’s progress in executing their strategic turnaround plan and evaluate the opportunity this may present to deliver strong risk-adjusted returns.