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.

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%.

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 Comps

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.

Catalyst

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