Description

Jon64 posted a good high-level summary of the investment case earlier in the year but I think I can add greater detail around incremental returns on capital, why the business is currently mispriced, and why the model is difficult to replicate.

Summary

At ~250x 2017 earnings and a <1% ROE, Metro Bank does not screen well and has low liquidity for its size (trades ~$6 million/day vs market cap of $3.5 billion). However, current earnings are severly depressed due to investments for future growth (deposits growing 40%+ YoY) and ROEs are further depressed by the excess capital held to support that growth. I estimate Metro Bank trades at a more reasonable 15x steady state earnings, which I define as earnings if management decided to stop growing the branch count and used the existing excess capital to grow deposits at the existing branches for two years. I estimate that mature branches built 5 years ago are earning ROEs near 20% and are still growing deposits 20%+ YoY. The incremental ROE of supporting an additional £1 of deposits at an existing branch is ~35%. 

I expect Metro Bank to be worth 4x the current price in 5-7 years.

Management

Vernon Hill compounded shareholder capital at ~23% per year for 34 years as CEO of Commerce Bank, a Philly / New York based bank. Through Metro Bank, he is replicating the Commerce Bank business model in the UK. Metro Bank is in its ninth year and is still growing deposits 40% YoY off a £13.7 billion base. The UK market is even better than New York for the Commerce Bank model; it’s a much bigger market that is ~80% controlled by five big legacy banks that are almost universally hated by their customers, with net promoter scores near 0 compared to Metro Banks’ +82. So far, Hill has compounded shareholder capital at ~17%/year through Metro Bank since the first capital raise in 2010 and he owns a personal stake in the business worth ~$180 million.

The Business Model

The Commerce / Metro Bank model targets customers willing to trade price (lower interest on deposits) for exceptional service and convenience. Metro Bank branches are located in the best locations in the best areas and open almost twice as many hours per week as competitor branches, including long operating hours every Saturday and Sunday and most holidays. The busiest day of the week at Metro Bank is Sunday, when most competitors are closed. Hill brags about how many pens they give away every year (28 million in his last year at Commerce Bank) while competitors chain theirs to the table, offers free coin counting to anyone that walks into a branch (regardless of whether or not they’re a customer), and welcomes dogs in the branches. As another example, Hill doesn’t put security glass in any of the branches and says “Do you build a bank for the one in 10,000 people who are going to rob you or to give a better experience to the 9,999 who come in every day?” He is obsessed with creating a culture that gives customers an incredible experience, requiring two employees to say no to a customer request and only one to say yes (exception being lending). You can read his book “Fans not Customers” for a more in-depth overview of the culture (it's very brief and worth the read). There was also a Harvard case study written on Commerce Bank that is worth reading. While the vast majority of banking customers probably don’t care about this higher level of service (I don't…), a subset of customers love it. And while it may seem to most observers that banking is moving online, in the UK, 9% of customers still visit their branch at least once per week. Another 11% of customers visit their branch 2-3 times per month, and another 19% visit their branch at least once a month. The average account at Metro Bank holds £9,661. For many of these customers who value the branch experience, 50 bps lower interest on deposits (£48/year) is worth the quality of service that Metro Bank offers. This customer base is large enough to be worth targeting, but small enough that the big banks can’t change their business model to accommodate its needs. As a result, Metro Bank has a rapidly growing, very low cost deposit base (32% non-interest bearing, twice the UK average) that allows it to lend conservatively while generating high returns on equity. No proprietary trading, no derivatives, no wholesale funding, no development lending; just deposit funded, low-risk loans to customers and high-quality (mostly AAA) liquid residential mortgage backed securities. 

Returns on Incremental Capital

Management has disclosed the P&L’s of two locations, Ealing & Chiswick, which are more or less representative of all branches, and they show that the expense base at the store level is almost 100% fixed. Chiswick operating expenses didn’t change at all from Y1 (£24MM of deposits) to Y5 (£263MM of deposits). Ealing operating expenses were marginally higher (11%) from Y1 (£45MM of deposits) to Y5 (£402MM of deposits). This is why current earnings look so bad, branches lose money for the first couple years, but as store-level operating leverage kicks in, they become very profitable in years 4+. 

The disclosed P&Ls don’t include an allocation for corporate overhead though, which is partially a variable expense, so to get a true picture of incremental returns on equity we need to estimate what portion of corporate overhead is variable. If we use the Ealing P&L as a proxy for the average store, operating expenses at the store level are around £1.8MM per year. With 56 stores open, that’s £101MM of store-level expenses. Operating expenses + depreciation run-rate in H1 2018 was £323MM annualized. That leaves us with an estimated £222MM of overhead expenses. Management has stated that technology spend is running at a £70MM pace. Technology spend is very unlikely to change based on the level of deposits. Management also estimated 25% of the overhead was related to preparing for future growth, i.e., rent for stores under construction, employees in training, excess call-center capacity, excess compliance officers, etc. That seems reasonable to me given the rapid growth (40%+ YoY). You can’t grow at those rates without building quite a bit of track ahead of you. Using that assumption, and assuming ~£70MM spent on technology, we get ~£97MM remaining for quasi-variable overhead spent on credit risk, operational risk, compliance, call-centers, senior management, etc. For my analysis, I assume that these costs are not scalable at all, i.e., a doubling of deposits would double these costs. This is a very conservative assumption. With £13.7B of deposits, that implies overhead should increase by 0.71% of deposit growth. 

So adding the overhead cost in to the disclosed Ealing P&L, and assuming a £3.5 million build cost per store + 4% leverage ratio, we can estimate the after-tax ROIC for a new location and the IRR on that investment. The returns are very attractive:

This branch is not a cherry-picked example, management discloses store cohort growth rates and it is very clear that each cohort of stores are opening bigger and growing faster, evidence of network effects in the business. The more branches near you, the greater the value, and the more customers, the more word of mouth advertising.

Also important to note that these returns assume the current NIM, which should rise over time as (a) 32% of deposits are non-interest bearing, providing leverage to rising rates, (b) loans-to-deposits will creep up towards 90% from 86%, and (c) the loan mix will shift more towards commercial lending as they continue to build relationships with commercial clients. The company is targting NIM + Fees of 3.00% vs. current 2.68%.

Additionally, the ROE continues to grow over time at the branch level because the incremental returns on capital associated with supporting an additional £1 of deposits at an existing store are ~35%:

   2.68%       Current NIM + Fees

-  0.71%       Less Estimated Incremental Overhead

-  0.11%       Less Current Cost of Risk

   1.86%

x (1-25%)    Less Taxes

    1.40%

/   4.00%      Leverage Ratio

      35%       Existing Store Incremental ROIC  

At 0.5% market share, the runway for growth is extremely long. Currently, the average Metro Bank branch has £245 million of deposits, compared to the UK average of ~£160 million, and is growing by £75 million/year. And Metro Bank only has 56 branches compared to managements estimated TAM of 200-250.

Moat

Banks that earn that kind of return on equity should attract competition. However, I think Metro Bank has a defensible business model.

First, the branch level economics show that the market for customers that are willing to sacrifice 50bps of interest in exchange for the high level of service that Metro Bank offers is a niche that is large enough to support one Metro Bank branch in a given neighborhood, but not two. Offering early til late hours 362 days a year in the best locations with a highly trained staff is not cheap. You need deposit density in order to support those costs and still achieve an attractive effiency ratio. If you look at the store-level P&L above, you’ll see that the branch would earn a ~0% ROE if it held the same level of deposits as an average UK branch, and would earn a 3-4% ROE if deposits were cut in half. So while Metro Banks Ealing branch earns an attractive ROE, if a competitor opened up with an identical model across the street and stole half of Metro Bank's clients (absolute best case scenario for the entrant), it would not earn an attractive ROE. 

Second, even if you disagreed with the above, there are economies of scale in banking and it has taken Metro Bank £1.7 billion and and nine years to turn its first small profit. It is very difficult for a start up to get that kind of patient capital to deploy in what is generally viewed as a commodity business without Vernon Hill’s reputation.

Third, even if you disagreed with the above, culture is not always easy to replicate. Commerce Bank operated for 34 years and as far as I know, there were no successful copy cats. Hiring for attitude and training thousands of employees to put the customer first is not easy.

Valuation – Steady State Earnings

At 250x earnings, this looks absurdly overpriced, even if there are major growth opportunities ahead. But what if management just stopped opening new branches?   

In Q2 2018, Metro Bank was annualizing £35MM in net income if I adjust to factor in the full cost of the recently raised debt capital. With its existing capital, I estimate Metro Bank can support an additional £10.6 billion in deposits while still maintaining its target CET1^{*(see risks)} ratio of >12%. It could capture those additional deposits by the end of 2020, with no new stores, at the current same-store growth rate of £6.2MM/month/store (on 56 existing stores). At the same 2.68% NIM + fees earned in Q2 2018, assuming store level operating expenses are flat and overhead grows by 0.71% of deposits (no economies of scale), that would yield an additional £148MM of after-tax profits, yielding “steady-state” earnings of £183MM and an ROE of ~13%. In other words, if Metro never opened another branch (despite only having 56 branches when management thinks the country can support 200-250 branches) but simply grew its deposit base organically to a level supported by existing capital, it would be trading at ~15x earnings 2.5 years out, at which point it will still be growing deposits rapidly with an opportunity to reinvest the majority of its earnings at ~35% incremental returns on capital to support same-store deposit growth. That strikes me as a very reasonable price to pay and I should note it doesn't include any add back for the £55MM of growth related overhead.

Longer term, management is targeting £55 billion in deposits by 2023, up from £13.7 billion as of June 30^th 2018, which would be ~2% UK market share. I think this is very achievable; remember, last quarter Metro Bank grew deposits 40% YoY and SSS growth for even 3+ year old stores is 36%/year. And for more perspective, Commerce Bank captured 3.2% market share in the New York metro area only seven years after launching in Manhattan (and was still growing rapidly) and captured almost 6% market share in Philadelphia, its original market, before being acquired by TD Bank. Hill’s rule of thumb is that the bank is worth 20% of deposits. Commerce Bank was taken out by TD Bank at 19% of deposits. If you earn a 20% ROE with a 4% leverage ratio you should earn 0.8% of deposits. So paying 20% of deposits implies a multiple of ~25x earnings which at this point is reasonable given the growth potential. Looking out 10+ years, I’d probably use a number closer to 15% of deposits. Using the 20% rule of thumb, the bank would be worth £11Bn in 2023 if management hits its targets, compared to a market cap of £2.7Bn today. That would be a 30% CAGR. After the most recent equity raise, Metro should be able to build the necessary capital to support that target organically; but that doesn’t mean they won’t raise some equity capital earlier than needed to support future growth. 

Risks:

AIRB Waiver – Careful readers would have noticed the * next to CET1 in my valuation section. That is because under the standardized approach, banks have to apply a 35% risk-weighting to residential mortgages when calculating their CET1 Ratio; however, under the internal ratings based approach, banks can apply internal modeling, so long as they meet certain strict criteria, to risk-weight their residential mortgages. As a result, the average risk-weight of an average LTV mortgage in the UK is only 9%, because all of the big banks use the internal ratings based approach. But to date, Metro Bank has used the standardized approach because it is a start-up and hasn't had much in the way of historical loss data required by regulators to justify internal modeling. Metro Bank has already filed a waiver with the Prudential Regulation Authority (PRA) and expects sometime in the second half of 2019 to get substantial relief in the risk weighting it can apply to residential mortgages. I assume they are able to risk-weight their residential mortgage portfolio at 17.5% within two years. This should be a layup; the PRA has publicly recognized the competitive disadvantage the standardized approach creates for new banks and the disconnect between the risk weights and actual risk for residential mortgages, and they created a process to provide this relief. However, in the unlikely event Metro Bank is not able to get relief in this area, it would be a very material negative.

Online Banking - 9% of UK customers visit their branch at least once per week. A lot of the market will probably move online and not need a branch experience, but when you're talking about growing 0.5% market share to 2%, you've got a lot of room for share to shift online and still do well. 

Credit Risk – Growing deposits at 40% YoY means you also need to grow lending at 40% YoY, which doesn’t come without risks. With that said, most of Metro’s lending is ~60% avg. LTV residential mortgages. It’s tough (but not impossible) to lend stupidly in this space, especially with a cost of funds advantage (i.e., no incentive to stretch for yield). And Metro Banks loan-to-deposit ratio is only 85-90% compared to 115-120% for Virgin Money. 

Catalyst

1) Receipt of AIRB waiver.

2) Time & continued deposit growth.

3) Earnings inflection as mature stores become a greater proportion of store base.

4) Williams & Glyn bid success. A long delayed part of RBS' bailout during the crisis was a provision to help foster competition in the SME business banking sector. Starting in February 2019, RBS will literally be paying £775 million to a handful of challenger banks (Metro Bank included) to take 240,000 RBS customers. This has the potential to more than double Metro Banks' commercial account growth in 2019.