So much for economic predictions. In the aftermath of the Brexit vote there was talk of imminent economic collapse in the UK and CYBG plc's shares fell by a third in the space of two weeks. Yet UK retail sales in April were up 4% year-on-year compared to a year ago and unemployment has fallen to its lowest since 1975. As the US economist Edgar Fielder said: 'He who lives by the crystal ball soon learns to eat ground glass.'
Of course the UK isn't out of the woods yet. With inflation picking up, real wage growth is lacking and arguably the real challenges with Brexit lie ahead. But we don't like the taste of ground glass, so we'll refrain from making predictions. CYBG's management, though, run a bank so they have little choice, and they continue to expect low growth and low interest rates.
That's probably just as well, because they have plenty of work to do improving the business they've already got. So far they've done a great job of that, with the clearest example being on costs.
Cost cuts continue
Revenue rising more slowly
Inaugural dividend forecast for 2017
With NAB head office being halfway around the world in Australia, it’s no surprise that there have been a lot of costs to cut. That the Clydesdale and Yorkshire banks that make up CYBG were such a small part of the wider NAB group also meant head office attention was likely directed at more pressing and material concerns.
Either way, CYBG management has wasted no time cutting costs. Since 2011 the number of customers using their branch for day-to-day banking transactions across the UK has fallen by one third as the rise of digital and online banking reduces the need to do so.
As such, 26 CYBG branches were closed in the first half and another 79 are to close in the second, saving £31m annually. Headcount declined by 223 with further fall of 810 expected in the second half.
Underlying costs fell £5m, to £348m, helping push the underlying cost-to-income ratio down from 72% to 70% (it was 75% at the time of the spin-off from NAB). Further planned cost cuts mean CYBG expects to achieve an underlying cost-to-income ratio of 55–58% in 2019.
CYBG has replaced the lost distribution from branch closures with heavy investment in its digital banking products – which allow customers to open accounts and obtain loans online – while also installing more than 100 smart ATMs across its network.
As well as cutting costs, this has allowed CYBG to attract a younger demographic, which is important given the tendency of customers to stick with their existing bank. Currently only around 3% of personal and 4% of business customers switch banks each year in the UK.
Of course, its competitors aren't standing still but the reducing competitive advantage of a large branch network as distribution moves online benefits the smaller, ‘challenger’ banks such as CYBG compared to their larger competitors such as Lloyds and RBS.
Challenger banks should also benefit once the UK implements its Open Banking scheme in 2018, which will make it easier for customers to switch banks.
Revenue more difficult
Things are proving more difficult on the revenue front, though, not least because the Bank of England reduced its base rate to 0.25% following the Brexit vote. As 46% of the bank’s lending portfolio is on a variable rate, this flowed through to the interest rates charged on CYBG’s housing and business loans, with mortgage competition also a factor.
|Six months to March||2017||2016|| /(–)
|Net interest income (£m)||411||400||3|
|Non-interest income (£m)||86||91||(5)|
|Net op. income (£m)||497||491||1|
|Op. expenses (£m)||348||353||(1)|
|PBT before impairments (£m)||149||138||8|
|Cash earnings (£m)||94||86||9|
|Cash EPS (£)||0.106||0.097||9|
|Note: underlying results|
Nevertheless, loan growth of 4% partially compensated: mortgages grew 5% on an annualised basis, with 64% of new mortgages being to owner-occupiers rather than investors, up from 58% in the prior corresponding period.
While there are obvious principal-agency risks from using brokers, this is another reason why fewer branches are required to distribute CYBG products. 79% of these new mortgages were sourced via brokers in the half.
With CYBG historically being focused on northern England and Scotland, the use of brokers has allowed it to expand its exposure to the wealthier south of England. 78% of new mortgages sourced via brokers were in Greater London and other parts of the south compared to 54% of its total mortgages at 31 March 2017. Although with house prices generally more elevated in London and other areas of the south, this doesn’t come without added risk.
‘Core’ loans to small and medium-sized businesses – the bank also has some ‘non-core’ loans which it is winding down – also rose 7%, to £6.4bn.
Overall, with income rising 1.2% and costs falling, the bank reported ‘positive jaws’ (of revenues rising faster than costs), which is catnip for banking analysts.
Reduced funding costs
Moreover, CYBG was able to offset the decline in the average yield on its assets, from 3.06% to 2.90%, via falling funding costs.
While underlying deposit balances remained stable, at £26.3bn, the bank continued to replace higher cost term deposits and savings accounts with less expensive current accounts.
It also took out £1.9bn in loans via the Bank of England’s Term Funding Scheme, which helped compensate for the central bank’s base rate reduction. As a result, CYBG’s average cost of funding fell 0.21%, to 0.82%, helping its net interest margin rise slightly to 2.26%.
With house prices generally rising and interest rates at historically low levels, impairments remain near cyclical lows, falling from 0.19% to 0.15% of average customer loans.
However, CYBG was forced to raise its PPI ‘conduct’ provisions (see NAB gets shot of CYBG (almost)) after regulatory guidance was released. With total cover of £1.1bn including the unutilised portion of NAB’s indemnity, management is confident this is adequate to cover additional costs for its legacy conduct issues but we will wait and see.
Return on tangible equity (ROTE) jumped 4.5% to 6.3%, on an underlying basis, and management maintained its guidance for it to reach double digits by 2019. It will be assisted in this goal by likely being granted ‘advanced’ status by the Bank of England's Prudential Regulatory Authority (PRA), which will reduce the risk-weights on its assets, especially mortgages, and hence its required capital. (For those who need help falling asleep at night, Taking a regional (bank) tour – part one has more on ‘advanced’ status, risk weights and bank capital requirements.)
Underlying earnings per share rose 25%, to 9p, and CYBG plans to announce a modest inaugural dividend along with its 2017 full-year result.
With the stock up 28% since its post-Brexit low, it's now trading close to tangible book value. We'd need to see plenty of value to encourage us to buy a bank on the other side of the world, so we're keeping our Buy price at $3.50. However, for those that didn't follow our recommendation to Sell in CYBG: Interim Result 2016 (Sell – $5.24), in recognition of the progress made we’re further bumping up our Sell price from $5.50 to $6. HOLD.