Description

Long Metro Bank common equity – target of £4.80 per share in two years (0.8x 2024 TBV)

 This writeup is a follow-up to the long Metro bonds pitch that we made in October of last year, although this time we are pitching the equity of the company. We would refer anyone interested in the background of this situation to last year’s writeup, as it contains a fair amount of information regarding the history of the underlying business. While the bonds have appreciated since last October, we think they still offer good upside potential, particularly the LT2 issue. However, this writeup will focus on the prospects for the common stock which we would classify as a special situation-type investment offering very high reward (4x invested capital) albeit with significantly more complexity than average.

Metro Bank equity trades at distressed valuation levels of ~0.18x forward tangible book due to the widespread belief by market participants that the bank will continue to generate losses for the indefinite future, culminating in an eventual dilutive rights offering / capital raise. We disagree with that assessment and think that Metro is likely to post income statement profits as soon as 12 months from now (2H’22 financials). We do think that the bank will issue senior unsecured bonds (MREL) in 2H’22 after it reaches profitability, but at much lower rates than the yields on offer in the market today.  While the assertion that senior unsecured yields will fall once the bank reaches sustainable profitability is relatively uncontroversial, most market participants and publishing analysts would dispute that Metro will reach profitability in a timely manner – hence the latter point is the focus of this note. If we are correct on profitability, both the bonds and the equity will certainly perform well. If we are wrong, then the bank will likely keep selling portfolios of assets as needed to remain in MREL compliance before either regaining profitability eventually or selling itself to a competitor. The ability to sell low LTV residential mortgages buys time for the bank to remix the portfolio and/or receive AIRB approval* without needing to resort to an equity raise, let alone a resolution process – even in a downside case. Our thesis is that the bank is poised to benefit from a post-Covid rebound in consumer spending (via personal loan growth) and higher UK base rates, yet it still trades at an extremely discounted valuation, creating the opportunity. 

Here are the assertions: revenue is growing, costs are falling, reserve releases are coming, and the company can bridge the gap to profitability in 2H’22 without raising equity. We believe that core profitability for the bank bottomed in 1H’21.

Revenue is growing: 

Metro obviously needs to grow net interest income to cover its operating expenses. The commonly cited concern is that growing net new loans will grow net risk weighted assets (RWA) and further deplete capital levels – thereby necessitating an equity raise or “forced issuance” of MREL bonds or both. What this argument misses is that Metro's standardized risk weighting model allows them to increase the return on their RWA without increasing the size of the balance sheet. For example, Metro is generating 5-6% yielding personal loans via its acquired fintech origination platform, Ratesetter, at 75% risk density. Meanwhile, it is running off a £3bn commercial loan portfolio with 3.5% yields and 100% risk density at the rate of ~20% per year. With £600mm annual commercial loan runoff Metro can originate £800mm of RateSetter loans (65mm monthly) at capital neutral levels while adding an additional £23mm in pre-tax pre-provision profits (PPP) each year. Over three years this dynamic is significantly accretive for earnings and valuation on a cumulative basis considering the bank’s market cap is only ~£185mm. Furthermore, the most recent Bank of England credit conditions survey illustrates a large uptick in demand for personal loans after the covid-driven deleveraging. As the UK consumer has recently been stress tested after last year’s economic shock, the current environment is a much better than average time to be a consumer lender – not only is systemwide loan demand increasing, but lenders also have a good sense of borrower willingness and ability to pay based upon who required payment deferrals in 2020. As shown below, monthly unsecured originations for RateSetter have picked up significantly and further accelerated after June 2021.

Source: Metro 1H’21 results presentation

Metro also has around £5bn in low LTV residential mortgages earning <2% yields at 35% risk density given standardized risk weights.  Metro is originating "specialist" mortgages with 3%+ yields including fees also at 35% risk density. Simply replacing one portfolio with another generates an additional £50mm in pre-tax, pre-provision (PPP) income at no burden to the CET1 or MREL ratio. Obviously replacing one portfolio with another is not as simple as flipping a light switch, but we would argue that the market for selling their low LTV book is deep and liquid. The trick is growing specialist mortgage originations (read: self-employed borrowers that require manual / human underwriting rather than a fully automated credit scorecard) at good risk adjusted returns, and the team they hired last year from Kensington has a strong track record of doing just that. The bank is originating £2bn per year in mortgage loans, of which the overwhelming majority would be considered “specialist”. The impact of this team’s originations is already visible from the 1H yield on mortgage completions per the chart below:

Source: Metro 1H’21 results presentation

The bank has also £5bn in cash earning 0.1% and the UK rate futures market implies rate hikes to the 0.8% - 1.0% context by the end of 2022. Reinvesting that cash in securities, swaps, or simply receiving interest at the BoE overnight rate is significantly accretive to PPP as well. Given massive excess liquidity in the UK deposit market, deposit costs are unlikely to rise much in the first several rate hikes and this will highlight the value of the company’s deposit-led business model. As a side note, deposit betas are generally correlated with the amount of excess liquidity present in a monetary system, which itself is a function of the quantum of QE on a cumulative basis. JPM, among others, notes that actual quantitative tightening is required to begin pushing funding costs up, as opposed to the simple cessation of QE or the beginning of rate hikes. Hence we’d expect very low deposit betas (on the order of <20%) for 100bps of rate hikes in the UK for the whole system including Metro. Metro also has a £4.3bn securities portfolio earning ~0.6% (primarily short-dated covered bonds) which will reprice higher on reinvestment, further increasing profits. Metro’s disclosed interest rate sensitivity in its annual report is very modest, but that is because in that disclosure the bank assumes an extremely high deposit beta, no reinvestment of securities at higher rates, no remixing of cash balances into securities, and no deposit growth (and associated deposit margin). We believe the economic sensitivity of the bank to higher BoE rates is extremely high over a 12-24 month period, which corresponds naturally to the deposit-led model the bank historically pursued (i.e. deposit led banks should be rate sensitive).

Metro’s fee income has been depressed by UK lockdowns & Covid. Metro should see an uptick in fee income just as a function of the rebound in consumer activity post-Covid (e.g. higher interchange, FX/travel, bancassurance sales). Barclays card data from October 2021 shows UK consumer spending up double digits from 2019 levels

Finally, Metro’s deposit costs are continuing to fall with front book rates well below 10bps vs the ~30bps average cost reported in 1H. Metro has specifically been running off the higher cost term deposits while growing checking/transaction accounts at 0% rates.

Costs are falling: Metro’s income statement is currently depressed by growth investments that are being expensed rather than capitalized (i.e.“change the bank costs”). They have spent £200mm through 1H’21 of a planned £250-300mm total. On the most recent earnings call the company noted that 2H’21 investments would be 50-60mm, implying a very limited pace of investment opex thereafter and most likely none by 2H’22. This leads total reported opex to drop from ~£550mm in 221 to ~£470mm in 2024 including cumulative inflation and increased software amortization. CEO Dan Frumkin has a background in restructuring and operational cost cutting, and in our view the bank has room to reduce costs lower than our estimate of £470mm. 

Reserve releases: Unlike every other UK bank, Metro has not released Covid-related reserve builds from 2020. This is not due to Metro having worse credit, but rather management deciding to take a cautious stance on topics such as UK home prices. There are £56mm of post-model overlays (30% of market cap) in the balance sheet which are arguably unnecessary, in addition to conservative assumptions within the expected loss model itself. Much of the overlay relates to uncertainty around COVID19, which should be released as the economy continues to reopen. Even specific reserves on commercial lending in the hospitality sector have room to be released as borrowers like restaurants and hotels migrate from forbearance instituted during lockdown and return to full P&I payments.

Optionality on AIRB approval: we obviously do not have a specific prediction on regulatory timelines for something as complicated and long-standing as Metro’s AIRB approval process. Having said that, Metro has been working on this process for a number of years and we believe they would have stopped some time ago if there was no prospect of approval. Regulatory approval is something that could happen at any point in time and would immediately generate a significant boost to capital ratios and put the capitalization risk concern to bed. We do not have any special insight into this process, but would observe that some positive signals have emerged recently – notably comments on specific post-AIRB risk density levels for their mortgage portfolio made at an August 2021 sellside briefing (per the Goodbody note on 8-13-21) which could signal that management are far enough along in the process to have received that level of granularity. Also the mere fact that Metro is proceeding with the full £50-60mm of discretionary change-the-bank opex investment in 2H’21 is a sign of management’s confidence in ultimate capital levels, which could be related to AIRB. It is highly implausible to assert that management is proceeding with £30mm (for example) of nice-to-have software development in the current period while knowing that they would need to do something as punitive as a rights offering to fund it; if they were really worried they would have just delayed the final tranche of opex investment.

Management incentives are aligned with shareholders: In 2021 Metro for the first time instituted a long-term incentive plan for management based on hitting financial targets from 2021-2024, which happens to be the timeline for the turnaround process. The previous management team prior to restructuring did not have one. The financial measures include total shareholder return relative to the FTSE 250, statutory return on tangible equity, and meeting certain risk and regulatory hurdles. The actual ROTE hurdle has not yet been disclosed, but likely will be as soon as management provides updated guidance; the most obvious occasion for updated guidance being the full year results in February. Suffice to say we think management is highly motivated financially to prevent the occurrence of something as dilutive to total shareholder return or ROTE as a rights issue.

Valuation: The company’s target of achieving 8.5% ROTCE in 2024 actually seems reasonable in light of higher NIM, falling costs, and higher base rates. Given the slightly more esoteric asset mix, a 0.8x TBV multiple for an 8.5% ROTCE is a fair mark, implying around a 9.5x P/E ratio. In our opinion this is not a particularly demanding absolute valuation level, but we acknowledge that it is a full one on a relative basis in light of where UK bank trade at this moment. However, 1) all UK banks will likely trade up if rates increase by the amount contemplated by the futures, and 2) Metro will likely trade closer to specialist lender PAG LN (1.0x book, 10x P/E) than Lloyds given its mix of business, absence of underfunded pension obligation, takeout optionality, and the fact that it doesn’t need to compete in the hypercompetitive mainstream mortgage market given its size.

Conclusion: Metro’s current trading levels assume a near certainty of continued losses and a dilutive capital raise. In fact, there is a decent short position in the stock seemingly predicated on covering into a rights issue. We do not think an equity offering will occur, which will be obvious by the time the bank post the profits that no one believes are possible. In order for Metro to post a profit, revenue growth needs to occur, and for that to happen the bank needs to originate RateSetter loans and specialist mortgages. Fortunately we already have evidence that this is occurring, and the overall market for continued consumer loan growth is quite favorable in the UK on the back of COVID reopening and a cyclical rebound in the economy. In short, we think that the stock has been left for dead by the market but the company for the first time is facing positive tailwinds on all levels (consumer loan growth, higher base rates, provision release) which can turbocharge returns from here. 

Common objections:

“The bank will be below the interim MREL level of 20.5% in January 2022, so really bad things are going to happen”: It is safe to say that the regulator (the PRA) is already extremely aware of this situation, if only because of the incessant and highly visible fixation by all parties on this topic. We think it’s important to note that the issue at play is operating “within a capital buffer” on an interim deadline for a brand-new regulatory standard for senior unsecured debt, rather than a continuing violation of a red-line rule like CET1 ratios. For clarity, the actual regulatory requirement for MREL is 18% of RWA (with which Metro will be in compliance) but the issue is that Metro is operating within its capital buffers of 2.5% at which point the regulator gets involved by design. In any capital adequacy discussion, the PRA’s process is to start with asking management for their remediation plans and timeline for compliance. In some cases, like Co-op bank a few years ago, the shortfall is so significant and prospects of remedy so daunting that remedial action is required (rights issues, M&A). In Metro’s case, the remedy would be to issue senior unsecured bonds (MREL) at some point during calendar 2022. Obviously, the coupon on such issuance would be dramatically lower if the bank reaches profitability than if it were to issue today. If we had to speculate, the PRA probably granted Metro time to hit near term profit forecasts so the argument becomes one about profit outlook rather than capital raising per se. It’s important to note that there are a couple of levers within management’s control to manage the situation in case things don’t proceed according to the plan laid out above. The first is that management can simply sell portfolios of residential mortgages (most likely at a gain) to boost capital ratios to buy additional time as they did in 2020. Secondly, management can simply delay any further change-the-bank investments which increase long-term efficiency at an upfront cost. As noted previously, the fact that management appears to be moving forward with these investments anyway speaks more to their confidence in the underlying bank’s performance than a cavalier damn-the-torpedoes attitude in our opinion. Finally, the same regulator tasked with overseeing Metro’s efforts to cure a MREL deficiency also oversees Metro’s AIRB application; they are very aware that they themselves can approve AIRB and “solve” the MREL issue at any point in time. It’s not lost on anyone that the fact that they have kept Metro as the only high street bank operating at standardized risk weighting has been a major factor behind Metro’s current difficulties in the first place. Hence, we believe that they are primarily focused on progress in Metro’s business plan rather MREL ratio “foot faults”, and are inclined to give the new management team time to work through the turnaround.

“Maybe the bank makes it past 12 months but tight capital ratios really constrain longer term growth so terminal multiples should still be low”: Firstly, we would note that the mere event of the bank not raising additional common equity as expected by the overwhelming majority of market participants would likely cause the share price to double from current distressed levels. Secondly, as Metro’s sustained profitability lowers their funding yields, they can accelerate their growth in the future by issuing AT1 bonds rather than common equity at some point in 2023 or 2024. Their T1 requirement of 9.3% is currently being met entirely by common equity, and AT1 issuance can support specialist mortgage and RateSetter loan growth. The actual CET1 required ratio is lower at ~7.6% which is in no danger of being breached. Of course, this discussion is contingent on the bank reaching profitability in the first place, but it’s an argument in favor of using a normal P/TBV multiple in the out years.

“Growing personal loans will cause credit issues down the line”: Possibly; with any consumer lending story it is impossible to rule out future credit issues by definition (although the fintech BNPL crowd would appear to disagree). But it’s important to note that the type of personal loans being originated by Metro are closer in quality to American Express prime card loans, rather than 2006-era subprime balance transfer lending. Furthermore, RateSetter is growing loans into an economic rebound 12 months after a credit shock, so it’s a better than average time to be expanding volume. Given that the credit seasoning curve for personal loans is ~24 months anyway, there won’t be evidence of problems until the bank is well into profitability – if there are any at all.

*AIRB means “Advanced Internal Ratings Based” approach to risk weightings for regulatory capital purposes, as distinct from the standardized approach. Capital ratios are the ratio of regulatory capital / risk weighted assets (RWA). For Metro, RWA are driven by credit risk, which means the risk of default on loans outstanding. For a UK residential mortgage under the standardized approach, the RWA on £100 in loans outstanding is £35, for a risk density of 35%. Given that the risk density is the same for any UK mortgage loan, the approach implicitly assumes that all residential mortgages in the portfolio have the same credit riskiness. This is obviously not true in practice, as differences in LTV, payment/income ratio, customer payment history, etc mean that some mortgages are much less risky than others. AIRB is a data statistics exercise where banks “prove” to the regulator that their internal credit rating models can accurately capture the riskiness of a loan, based on how the credit ratings correlated in history with actual, realized defaults. This allows banks on AIRB models to use lower risk densities – about 15% on average for the banks with whom Metro competes. AIRB also enables Metro’s competitors to earn a higher return on equity because they hold less regulatory capital per £ of loan outstanding. A bank has to get regulatory approval to use AIRB, and Metro has been working on its application for 4+ years at this point. Receiving AIRB approval from the regulators would instantly solve Metro’s MREL capital ratio deficiency by reducing RWA on its current balance sheet and is purely at the discretion of Metro’s regulators. The last public commentary from the company to investors was not to expect model approval “before 2021”. AIRB model approvals are granted on a portfolio by portfolio basis, and Metro has applied for approval on the residential mortgage portfolio – in other words not the commercial or buy-to-let loans which were the source of controversy under prior management. The bank has reportedly spent as much as £50mm on consultants and data scientists over time to check every box on the application.  We would note that all of Metro’s larger competitors already have AIRB approval, so this exercise is about leveling a currently unfair playing field rather than granting Metro some leniency or advantage.

Catalyst

2022 earnings