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UK Challenger Bank Focus List

challenger-banks-image

2017 likely positive for “Challengers”

Higher UK gilt yields suggest higher market interest rates in 2017 (even if Base Rates take longer). This is positive for bank margins. How/ why has this occurred so soon:-

 

 

  1. The “Trump effect” ie expectations of higher US budget deficits (increase global interest rates) – the 30YR yield has moved up to 3.08% from 2.4% pre- 8th November election.
  2. Likely rises in US Federal Funds money market interest rates in 2017
  3. The Bank of England increased 2017 inflation forecasts. It expects 2.7% in 2017 from 1% in 2016 due to the inflationary impact of the devaluation.

Post the June 23rd vote, UK “challenger” bank shares (Aldermore, Shawbrook, OSB, Virgin) halved on “Brexit”/ slowing property values. Investors overlooked inherent competitive advantages for the challengers relative to the High Street banks.

  1. Little, no “legacy” issues linked to PPI/ complex assets etc
  2. Smaller branch networks/ lower people & property costs
  3. Specialist lending i.e. catering to specific niches in “buy to let”, “commercial” lending offering customer faster decision making.

The “challengers” create competitive forces, by growing market share in key areas such as current accounts, mortgages, cards, savings products. They also provide a platform for foreign banks wanting to acquire UK market share quickly such as the TSB/ Sabadell merger in 2015. The Bank of England reported in July that 20 new banks are in talks to obtain a licence, with 14 receiving authorization since 2013.

Recent challenger updates have been positive;

  1. OneSavings Bank- Q3 (2 Nov) Interest earning assets £5.6bn +£0.46bn. “Margins on £510m of organic origination (new loan margins) strong”.
  2. Shawbrook Q3 (3 Nov) organic origination (new loans agreed) up 23%. Brexit “minimal impact”.
  3. Aldermore Q3 (11 Nov) net interest margin stable, new lending up 20% year to date.

With the caveat of stable property markets, credit demand is strong going into 2017. The sector will tap the Bank of England’s FLS scheme in 2017 hence lower cost of funds.

There are certainly risk factors in declining landlord profitability and low impairment provisions. Most have never experienced a downturn with high levels of repossessions and credit losses. The business model is dependent on IT security, an important issue that can derail an IT sensitive operation (Talk Talk).

The challengers face challengers, from “fintech” and digital/ online banks. One new addition “Atom Bank” received its banking licence in November 2015 and launched its deposits mobile app in April. “Monzo” received a restricted banking licence in August and is testing its IT to ensure new customers can open an account in under 1 minute.

OneSavings Bank – FTSE 250 – BUY

OneSavings Bank (OSB) is a specialist lender offering residential, buy to let and commercial mortgages via Kent Reliance Building Society, Prestige Finance and Reliance Property Loans. The sourcing of new business takes place via an IFA / specialist broker network. The co was the subject of an IPO in May 2014. The Kent Reliance business was rescued by New York private equity firm, JC Flowers who remains majority shareholder holding 53.78%.

OSB has tapped the Bank’s new Funding for Lending (FLS) scheme drawing down £626m at 0.25% for the first time. This is likely to enhance interest margins from H1 2016 levels of 3.07% providing a cheap cost of funds for new lending.

Consensus profit estimates; OneSavings Bank
Year End Total Income (£m) PBT (£m) EPS (P) DPS (P) P/E (x) Yield (%) Share Price (p)
Dec-16 196.8 139.1 40.7 9.6 8.55 2.75 348
Dec-17 218.1 138.3 42.3 11.0 8.26 3.16
Dec-18 237.5 147.6 44.7 12.5 7.80 3.59

Source: Bloomberg

The consensus forecasts envisage EPS growth over FY17 and FY18. We note the low level of forward PE (8.5x) normally suggests low growth contrary to expectations. Current book value per share at 155.2p.

Company OSB

Key Catalysts

Ahead of preliminary results for FY17 expected on 17th March 2017 we expect continued growth in deposits (H1 +10%) and loans (H1 +25%) and excellent ongoing cost control (cost income 27%) is likely to drive profit growth in 2017.

Expectations of higher base rates, given higher market rates could boost lending volumes significantly in Q1 2017 as lenders rush to lock in rates.

OSB’s valuation at 2.27x book value (155.2p) is forward looking

Share Price 348p
Target Price 450p
52 Week Hi/Low 380p/176p
Shares O/S 243m
Market Capitalisation £849m
Avg. Daily Volume 0.72m
Dividend Yield 2.75%

Source: Fidessa

Key Risks to Price Target

  1. Competitive conditions in deposit/ loan markets could intensify in 2017
  2. Sensitive to growth trends/ volumes in residential / commercial mortgages and regulatory conditions on new lending
  3. Exposed to landlord profitability/ “buy to let” conditions likely to be weaker in 2017.
  4. JC Flowers could reduce their shareholding via market sales, which would reduce the OSB share price.

Virgin Money – FTSE 250 – BUY

UK challenger bank Virgin Money is a UK retail / consumer facing financial services business offering savings, (ISAs, Insurance, Pensions), loan (mortgages, credit cards) and currency products (international transfers, travel money). Virgin floated on LSE in November 2014 at 283p per share.

Virgin Money bought Northern Rock in November 2011. That business comprised 75 branches, 1m customers, a £14bn mortgage book, and £16bn retail deposits. The mortgage book is now £28b.9n (2.1% of the UK mortgage market) with significant growth in credit cards, Virgin has a 3.4% market share in UK credit cards.

The board reported strong growth in Q3 new mortgage lending (+19%) to £6.5bn and credit card balances (+41%) to £2.2bn. Deposits jumped 12% to £28.3bn up £3.2bn. Virgin is on track to hit its £3bn credit card balance target by end 2017.

Consensus profit estimates; Virgin Money
Year End Total Income (£m) PBT (£m) EPS (p) DPS (p) P/E (x) Yield (%) Share Price (p)
Dec-16 586.6 199.7 30.9 4.7 9.5 1.60 294
Dec-17 654.9 229.0 33.5 5.0 8.7 1.70
Dec-18 716.0 257.0 38.1 6.0 7.7 2.04

Source: Bloomberg

The consensus forecasts appear conservative if growth in interest earning assets continues at Q3 levels.

Company VM.

Key Catalysts

Post the Nov 18th sale of a 12% stake in Virgin Money (owned by Wilbur Ross) the transaction (53.6m at 320p) has hit the shares knocking them back from 346p. The placing shares have created an opportunity for long term investors and ending a share overhang.

We are expecting a strong response for the “All Round Credit Card” launched in November – its APR at 19.9% undercuts rivals Vanquis, Barclaycard & AMEX.

Virgin will join the BoE “Funding Scheme” enabling it to obtain liquidity at just 0.25% below current interbank lending rates.

Share Price 296p
Target Price 375p
52 Week Hi/Low 386p/205p
Shares O/S 444.66m
Market Capitalisation £1.31bn
Avg. Daily Volume 2m
Dividend Yield 1.59%

Source: Fidessa plc

Key Risks to Price Target

  1. Growth in Virgin credit card market share may slow in 2017.
  2. Highly competitive UK market for financial services.
  3. Bad debts / impairments/ costs are likely to rise as lending levels grow.

(NB. “PBT”- profit before tax, “EPS” earnings per share, “DPS” dividend per share, “P/E” price to earnings)

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Key to Material Interests:

Please be aware that the following disclosures of Material Interests are relevant to this research note:

OneSavings Bank     Relevant disclosures:   <2>

Virgin Money            Relevant disclosures:   <2>

  1. The analyst has a personal holding in the securities issued by the company or of derivatives linked to the price of the company’s securities.
  2. Collins Sarri Statham Investments Ltd has clients who hold either shares or CFD positions in this security.

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