Australia | Jul 31 2019
CYBG is underperforming a weak UK banking sector, as redemptions and margin pressures take their toll. Then there is Brexit.
-Changing mix in total loans increasing credit risk profile
-Net interest margins likely to contract over the near term
-Brexit pall likely to keep UK rates lower for longer
By Eva Brocklehurst
Risks to margins dominated the third quarter performance of CYBG ((CYB)), reflecting challenging conditions in UK banking. The bank has guided to a new target for its asset mix, moving to higher margin products such as business, credit cards and other personal loans.
The bank is underperforming a weak UK sector because of heavy legacy Virgin redemptions and, given the large decline in net interest margins was attributed to this refinancing, Shaw and Partners believes this is unlikely to be the end of the story.
The company's average mortgage rate was 2.6% in the first half but Virgin Money is now offering new mortgages at rates that are -80 basis points lower. Mortgages represent 70% of the company's interest-earning assets in the first half and if all are ultimately priced -80 basis points lower more declines can be expected in net interest margins.
Morgans was disappointed with the trading update as the mortgage book contracted by -0.2% over the third quarter. The broker was expecting subdued mortgage growth because of the significant redemptions but this was worse than expected.
Business lending growth was also underwhelming, with growth of only 0.5%, attributed to a subdued market. At the same time CYBG is indicating the new lending pipeline is strong and unsecured personal lending experienced strong growth of 5.7%. Morgans assesses the changing mix of the total loan book is increasing the credit risk profile.
To offset the impact on income, loans need to increase by 7%, Shaw and Partners calculates. Should this rate of growth fail to be achieved then net interest income will decline in FY20 and, the broker asserts, this is not a pretty outlook. Shaw and Partners has a Sell rating and $3 target for CYBG.
The deadline for complaints regarding mis-selling Payment Protection Insurance (PPI) is approaching. CYBG has confirmed a substantial increase in PPI information requests ahead of the August 29 2019 complaint deadline. The bank asserts, while the uphold rate relating to these requests is low, it is not possible yet to determine just how many valid complaints will surface. At this stage, Morgans continues to forecast a provision charge for PPI of GBP45m in the second half.
Macquarie envisages longer-term fundamental value in the stock but reduces forecasts to reflect the tough market conditions. Margins are expected to remain under pressure, given the current outlook for interest rates.
Margins
The bank is sticking with its guidance for net interest margins for FY19 of 165-170 basis points, albeit now expecting the lower end of this range. Morgans continues to expect net interest margins to contract and reduces its forecast for the outer years.
At current rates, mortgage profitability is approaching the cost of capital and, while trends should improve over the next 6-12 months, in the short term, Macquarie acknowledges this will affect bank margins. The broker expects margins to contract by -17 basis points by FY22, and a large share of this decline will be captured in FY19 exit margins. Meanwhile, changes in the lending mix should boost margins by around 12 basis points.
Following recent changes in interest-rate expectations, any upside to margins has now been largely eliminated, a material driver of earnings downgrades, and Macquarie also has a -25% discount in its valuation to capture the uncertain economic outlook resulting from Brexit and risks associated with integration.
The bank retains a CET1 ratio of 14.6% and the broker believes the capital position will decline to around 12.5% when restructuring costs, amortisation and conduct-related charges are taken into account. Still, with an improved returns outlook there is scope to increase the pay-out ratio over time and for CYBG to potentially buyback around GBP150m.
This can only take place when management and the regulator have clearer visibility on the progress of integration and Macquarie does not expect a buyback before FY21. The broker, which retains an Outperform rating and $4.10 target, expects CYBG to achieve a sustainable 11% return on equity over the course of the next three years.
The main downside risk Morgans envisages for the bank is a disorderly Brexit as well as the legal action in relation to fixed-rate tailored business loans. Morgans maintains a Hold rating and $3.16 target.
Brexit
Political ambiguity may result in UK interest rates remaining lower for longer, in Macquarie's view. New UK Prime Minister, Boris Johnson, intends to take the UK out of the European Union on or before the end of October 2019. If he fails to find get Brexit through the UK Parliament it may be necessary to call a general election.
Macquarie points out the governor of the Bank of England has indicated he would be likely to act in the event of disruption around the time of the scheduled date for Brexit. This, Macquarie surmises, would probably involve lowering UK interest rates by -25 basis points from the current level of 75 basis points and a reduction of this size has been largely priced into the yield curve.
In turn, this would exert margin pressure on the UK banking sector, including CYBG, at a point when credit losses are likely to increase because of deteriorating macro conditions.
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