Description

Business Description: Metro Bank is a UK “challenger” bank founded in 2010 by Vernon Hill, who successfully ran Commerce Bank in the U.S. from 1973-2007, growing it from $1.5M of capital to 470 “stores” and $46Bn of deposits by the time of its sale to TD Bank in 2007 for $8.5Bn. Hill compounded Commerce shareholder value at a CAGR of ~23%/year for 34 years. Metro was the first new high street bank to be founded in the UK in >100 years and entered a market with far lower levels of competition than Commerce faced in the U.S., with the top 5 incumbents enjoying ~85% current account share. Metro has 55 stores (vs. 1.2K branches on average for the big 5 incumbents) and has ~55bps share of total UK deposits. Two thirds of Metro’s loan book is retail (mainly residential mortgages) and the remainder is largely commercial loans.

The Strategy: “We’re a growth retailer that happens to be a bank.” Like Commerce, Metro is run a) with a deposit-first mindset (i.e. focus on attracting customers and low-cost deposits first vs. a focus on the loan side of the balance sheet) and b) as if it were a retailer (focus heavily on the customer experience, make stores attractive/inviting, and place them in highly-visible locations). Hill recognized that customers care about more than just “price” (i.e. interest rate) and are willing to pay for better customer service. Commerce’s model involved higher upfront and operating costs than competitors, but Commerce was ultimately able to gather more deposits per store at a significantly lower cost than competitors and benefited from high operating leverage. Metro is following the same playbook in the UK. Metro is attracting consumers who want better service and, given the high operating leverage, is already producing “mature” store ROEs >30% before corporate overhead.

Investment Thesis: We believe Metro Bank is Commerce Bank 2.0, a 10+ year 20% compounder. It took Commerce ~25 years to get to $5Bn (USD) deposits vs. ~5 years for Metro. The customer service orientation is the same, but a) long-term 4-wall economics at Metro are superior due to higher operating leverage (much higher deposits per store), b) the UK competitive environment is much more apt for disruption, and c) the rate of store and deposit/store growth is much higher. The business is very early in its penetration of a large and inefficient market. Given the expected duration of our investment and the company's short track record, owning Metro is largely a leap of faith on management..

The Analog: Vernon Hill founded Commerce in 1973. His primary focus was on the "deposit" side of the bank, whereas the traditional banks focused more attention on achieving the highest returns from lending. "We believe the value of a bank is not its loan base," Hill explained, "but rather the deposit base, what we call core deposits. Those are deposits that come to you for non-rate reasons. We are generally the lowest ratepayers in every market."  Commerce's deposit rates were often half a percent lower than those of competitors. Hill built a bank modeled more after a "power retailer" than a typical bank - calling branches "stores" and focusing heavily on the in-store customer experience. Commerce prided itself on opening branches in prime locations, long hours (eventually Commerce was open 7 days per week), customer friendly initiatives (focused on creating "fans not customers"), and a positive attitude among employees who were encouraged to think on-the-spot about the best way to serve customers ("No stupid rules"). Commerce’s deep-rooted cult-like culture proved a formidable barrier to competition and allowed Commerce to sustain very healthy 4-wall economics.

Operating & Share Price Performance: A shareholder who invested $10K in Commerce in 1973 would have turned that amount into $4.7M by 2007 when Commerce was sold to TD Bank for $8.5Bn. Commerce ultimately expanded organically (vs. virtually all peers who relied on M&A during this period) to a total of 470 stores across NJ, PA, and NYC. Commerce's last 10 years saw the bank grow from 66 stores and $3.4Bn deposits to 470 stores and $46Bn in deposits (30% 10 year CAGR). From '97-'07 Commerce enjoyed average ROE, P/BV, and NTM P/E of 17%, 3.3x, and 19x, respectively.

Valuation: We are underwriting a low-20s IRR for the next 5 and 10 years. We value the business on EPS. On our #s this corresponds to low-3sx book. Commerce traded at 3.3x and 19x NTM during its last decade as a public company. One way to look at it is we assume exit at 0.2x deposits vs. the company currently trades at 0.25x deposits. Commerce traded at 0.2x deposits on average from 1995 to 2007. Our best guess is deposits increase 15-25x from current levels over time (…a long time). The long-term return CAGR can roughly be decomposed as the deposit CAGR minus multiple compression CAGR.

Variant Perception: Metro is arguably a variant perception-light investment.

Unit Economics: >35% "mature store-level" ROEs. We are focused on Metro's 4-wall economics, whereas the market is somewhat focused on '17-'21 earnings and book value. The market is focused on consolidated metrics vs. peeling back the onion to understand the unit economics. Over the past two years, revenue has increased by 135% while opex has grown by 61% (1H ’15 -> 1H ’17). Sell-side analysts don't seem to recognize that (inefficient) competitors have been earning healthy returns on their commercial and residential banking businesses.

Moat: Durable and deep culture-based competitive barrier. We believe that Metro has a very difficult to replicate culture-based competitive advantage akin to the Danaher Business System. Competition is concentrated with five bloated incumbents built via M&A and to meet the needs of a past world. Customer service is poor. Branch counts are way too high and will take many years to right-size. IT systems are antiquated and upgrading will be expensive and time-consuming. Long-term strategic decisions are being hampered by investor focus on maintenance of dividends. Despite all these inefficiencies incumbents earn very healthy returns in their retail and commercial banking businesses. We are not naive enough to underwrite the current competitive environment persisting forever; our very long term forecasts assume some TBD competitive force puts a cap on Metro's returns.

Investment Time Horizon: Ample room for above-market growth post-2025. In addition to allotting higher odds to management hitting its announced targets, we believe the business will have a very long growth runway post-2020 vs. the market assuming growth settles closer to inflationary levels at that point. We model Metro with only 2.6% deposit share in 2025 vs. long-term of 6-10% & Big 5 incumbents at ~12% each on average. For comparison, Commerce enjoyed 7-14% share of deposits at maturity in much more competitive U.S. markets. Sell-side analysts tend to assume GDP-like growth beyond 2020 or the early 2020s.

The Street is hung up on Metro's branch-based growth strategy given other banks are closing branches and foot traffic to banks is in decline. Our view = Metro has 55 stores vs. incumbents with >1K each. When Metro's expansion is finished (10+ years from now), they will still have a fraction of the incumbent branch count. Important transactions are still completed in-store. In fact, the move of low-value transactions to mobile likely improves the 4-wall brick & mortar economics as there is more capacity/store for higher value transactions.

Risks:

Business Quality:  There is a limit to how sustainably differentiated a commercial & retail bank can be! There is only so much you can do to differentiate on the asset side of the balance sheet. Bank returns through the last cycle – which coincided with massive rate compression – have not been good. Macro matters more for banks than other industries/companies.

Optical Valuation: Expensive on near and medium term consolidated numbers…substantial mark-to-market risk. We do not have a good sense for where Metro will trade going forward. Metro’s low-to-no growth peers trade at 9-11x NTM earnings. Commerce traded at ~19x NTM EPS from 1997 to 2007. We assume Metro garners an 18x NTM EPS multiple @ YE’20 in our base case (>3x book value…there is a limit to how comfortable one can be owning a bank at 3x book value). 

Leap of faith…on management and market:  We are predicting 2025 ROEs! A lot can happen over the next 10-15 years. A recession is highly likely to occur during this time period. Maintaining a cult-like customer service oriented culture on the right side and staying extremely disciplined on the left side of the balance sheet will require an obsessive leadership team. In addition, foot traffic to stores is declining and those declines are reportedly accelerating. It is possible consumer behavior changes too fast for Metro to truly get the word-of-mouth flywheel rolling.

Macro-sensitivity: High sensitivity to Brexit outcome and yield curve. Two key macro risks: Hard Brexit and inverted yield curve. Brexit could reduce the size of the UK market as well as impact real estate values in the UK, particularly in London. The latter risk is more concerning given Metro’s low market share but high London RE exposure. Reflexivity risk in a severe downturn.

Regulatory: Banking is a highly regulated industry, and is only becoming increasingly so. Metro's entry has been positively received by UK media. Metro has received a lot of free press. Potentially as a result, regulators have also been supportive of other new entrants. Metro is subject to significant capital and liquidity requirements.

We and our affiliates are long Metro Bank (MTRO) and may buy additional shares or sell some or all of our securities, at any time. We have no obligation to inform anybody of any changes in our views of MTRO. This is not a recommendation to buy or sell securities. Our research should not be taken for certainty. Please conduct your own research and reach your own conclusion.

Catalyst

This is a compounder. Time is on your side, but there is not single catalyst for which we are playing