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CYBG's Virgin bid highlights challengers' plight

Both banking groups have struggled in a highly competitive retail market
May 10, 2018

CYBG (CYBG) may be about to bag itself a bargain. The Clydesdale and Yorkshire bank-owner's preliminary approach for Virgin Money (VM.) values the target at just over £1.6bn or 359p a share, a 15 per cent premium to Friday’s closing price. Under the terms of the bid, Virgin Money shareholders would receive 1.1297 new CYBG shares per Virgin share. That would give Virgin’s shareholders a 36.5 per cent stake in the combined group.

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CYBG said it recognised “the strength and appeal of the Virgin Money brand” and that a combination “would create the UK's leading challenger bank offering both personal and SME customers a genuine alternative to the large incumbent banks”. Virgin said it was in the process of reviewing the proposed offer.

Shares in Virgin and CYBG closed trading 10 per cent and 1 per cent up, respectively, on the day of the announcement. With concerns over rising funding costs and competition leaving the former trading at a near post-referendum low at the end of April, it’s hard not to view the timing of this approach as opportunistic, or even a touch miserly. At 359p, it represents a premium of just 17 per cent to Virgin's net tangible assets per share at the end of 2017, or an 11 per cent premium to Investec’s forecast net tangible assets at the end of this year.

That compares with South African lender First Rand’s 313p a share offer for Aldermore last year, which was equivalent to a 47 per cent premium to its net tangible book value at the end of June 2017. It’s also below the offer fellow challenger Shawbrook received from private equity group Pollen Street Capital in June last year, which amounted to a 56 per cent premium to its net tangible assets at the end of December 2016. Admittedly, Virgin has been enduring more growing pains than that pair, which could explain the relative lack of generosity.

In fact, both CYBG and Virgin have been trying to grow their loan books in highly competitive areas of retail banking, where mainstream lenders’ stranglehold on the current account and mortgage markets has afforded the larger players scale benefits. A merger makes some strategic sense and could be mutually beneficial.   

Virgin has had no problem attracting new borrowers, outstripping CYBG’s loan book growth during the past three years (see chart). It grew its customer loans 12 per cent to £37.1bn last year. What’s more, most of its mortgage balances are in prime residential. That’s the type CYBG is trying to build up, while lowering its proportion of buy-to-let lending, which accounted for 30 per cent of new mortgages last year.

 

 

It’s also more agile than CYBG, with a much lower branch network and free of the legacy issues that have dragged on its would-be acquirer’s returns on equity and capital levels. RBC Capital analyst Robert Noble estimates that Virgin Money has loans per branch of £454m, compared with £153m for CYBG. Meanwhile, the former’s return on equity was 14 per cent last year, compared with 6.1 per cent at the latter.    

Where Virgin has struggled is in maintaining its net interest margin, which it expects to come in at the lower end of its 165 to 170 basis point range this year. In the low rate environment, that’s been a challenge for most mainstream and challenger banks. However, Virgin has lacked the access to cheap retail and business deposits for funding – something a merger with CYBG could facilitate. Admittedly, that’s the reason it’s been investing in its digital banking operations, in the hope of competing with incumbents for lower cost current account balances and primary savings deposits. Yet with the closure of the Bank of England’s Term Funding Scheme in February, organic deposit growth could become tougher, with competition for customer deposits likely to increase among lenders. In contrast, CYBG had £28.7m in deposits at the end of December, up 15 per cent on the prior year, and backing a £31.7m loan book.