Description

Summary 

In March 2016, we posted our thesis on Clydesdale Bank (CYBG LN at the time), a U.K. bank IPO/spin-off that we felt was dramatically undervalued at below 60% of tangible book.  In the following 18 months, the stock performed well, rising by over 75% and trading above tangible book.  The company has since renamed itself Virgin Money (following an acquisition), and the stock has been beset by concerns ranging from Brexit to low interest rates to Covid to a looming global recession.  Today, the stock’s valuation sits at just 43% of tangible book despite the company having significant excess capital, being on track to generate double-digit returns on equity and recently launching and aggressively executing an inaugural share repurchase (buying back double digit percentages of volume in recent days).  At just over 1x book and 9x earnings, we see the stock worth over £4.00 in a little over one year for more than 200% upside.

Situation Overview

In 2016, we viewed the company to be a classically-undervalued special situation.  The transaction was executed in two stages, with an IPO and then a spin-off by its former large Australian bank parent company, and the bank was valued at what we believed was a very discounted multiple below 60% of tangible book value.  Further, our thesis was mainly driven by our belief that new management could turn a formerly mismanaged and neglected business with a high cost structure into a competitive U.K. financial institution with attractive returns on equity.  Leading this transformation was CEO David Duffy, who had joined the company from Allied Irish Bank, where he led an impressive turnaround and cost reduction effort.

Shortly after the IPO, management held an investor day where it outlined a plan to cut costs and reach double-digit returns on equity by 2019 (up from roughly 5% at the time of the IPO).  Over the course of 2017 and 2018, management consistently exceeded its targets, over-delivering on cost savings and reaching its ROE target one year earlier than the initial plan.  The company then announced the acquisition of rival U.K. lender Virgin Money (taking on its name in the process), which was completed in 2018, with excitement around the deal ultimately pushing the stock to a peak of over £3.50 per share.

However, since that time, the stock has faced a series of headwinds.  First, immediately after closing the acquisition, management’s guidance for 2019 net interest margin was disappointing.  Second, a legacy liability from a product called Payment Protection Insurance (PPI) was closed out at a greater cost than anticipated (an issue faced by virtually all U.K. banks), which drove several charges in 2018-19 but is now entirely resolved.  Then, just as the stock was starting to rebound from the prior issues, Covid hit in March 2020, driving the stock down roughly 70% from the start of 2020 to the lows in late March 2020.  While the stock has recovered somewhat, the general malaise around European financials and concerns around a likely recession have caused Virgin to languish at 43% of book and 4x earnings.  We think investors are overly pessimistic and are ignoring the strong balance sheet and upside from higher U.K. interest rates, combined with accretive share repurchases of a deeply discounted stock.

Management’s Financial Targets

Last November, management hosted an investor day, where they outlined the company’s new digital strategy and financial targets for 2024.  At the time, they announced a double-digit ROE target for 2024, which we viewed as quite conservative based on the key drivers outlined.  Management was effectively assuming no rate increases (one rate hike at the end of the three-year period while the Bank of England has already hiked a total of 115bps since management gave these targets).  Higher rate assumptions, combined with better cost performance (we believe management was similarly conservative on its 2024 cost-to-income ratio targets) and more shareholder-friendly capital management can drive 2024 ROEs to more than 12%.

What We Think It’s Worth

With an improving interest rate backdrop, excess capital of more than £425mm (almost 25% of the current market cap), a deeply discounted valuation and a clear path to a solid ROE, we think the current stock price will prove to be an incredible bargain.  Assuming the stock trades at 9x our fiscal year 2024 adjusted earnings estimate of £0.45 per share and just over 1x tangible book value, Virgin Money would be worth £4.10 including dividends in one and a half years, more than double the current share price.

Why Now?

While Virgin is clearly a cheap stock, we also think that this is a particularly timely opportunity for two key reasons.  First, the latest digital strategy contemplated front-loading investments this year such that expenses are increasing year-on-year (originally a big surprise to the market when announced).  However, we are now passing the peak investment phase with expenses expected to fall in each of the next two years, creating a unique set-up in a sector facing widespread cost inflation.  Combined with the benefit of higher rates, we forecast a large improvement in profitability in the coming years toward best-in-class levels.

Second, on June 30th, the company announced a surprise buyback program which we believe represents a key inflection point in capital return.  Virgin has long had excess capital, and yet management always found a reason to kick the can down the road on share repurchases while other U.K. banks pressed ahead.  As recently as May, management was suggesting that a buyback was unlikely to happen this fiscal year.  Out of the blue, just one month later, management announced a £75 million repurchase program to be completed before the end of 2022.  Based on our conversation with the company, we believe that this amount is just the start of a new perspective on consistent capital return.  Therefore, we see the potential for further capital return announcements as soon as the company’s fiscal year results presentation in late November of this year.  Not only do we think this shows management’s confidence in the business (particularly notable for a fairly conservative management team), but we also think that repurchases at levels so far below book can drive substantial value.    

Catalyst

Continued execution and meaningful share repurchases.