Another Misunderstood Spin-Off, page-18

@Captain Blood,

I'm not really inclined to be dispensing Target Prices, because I think that starts to border on the provision of investment advice, which I'm not in a position to offer.

But what I will say is that I think the intrinsic value of this business - assuming the new management team is adequately successful in achieving their strategic targets - will be materially higher than the current share price (the is a bit of a nothing statement, because if that was not the case, I sure wouldn't be buying the stock today).

What might be useful for you in deriving your own sense of what this little regional bank might be able to achieve in terms of improved financial performance, is a bit of a benchmarking exercise with some of its peers on some salient metrics:

Starting with Return on Equity (ROE):

CURRENT ROE
ANZ = 12.4%
BEN = 8.9%
BOQ = 11.0%
CBA = 17.4%
NAB = 13.3%
WBC = 15.1%
CYB = 5.1%


And then the very important issue of adequacy of capitalisation, Common Equity Tier 1 Ratio (CET1)

CURRENT CET1
ANZ = 10.9%
BEN = 10.8%
BOQ = 10.4%
CBA = 12.3%
NAB = 11.4%
WBC = 11.2%
CYB = 13.2%

(Now, it needs to be qualified that there might be a degree of comparing apples with oranges here, in that the CET1 ratios quoted here for the Australian banks are formulated by APRA, whereas CYB's is not. Sometimes the major banks, in their presentations, provide an alternative, "ïnternationally hamonised" CET1 ratios, and these are typically 100bp to 150bp higher than the APRA-based rates. So this not meant to be a prescriptive exercise; rather it it meant to indicate that, even if these capitalisation rates were to be normalised for international-vs-domestic definitions, that CYB is still in the very top tier in terms of CET1 ratios. Clearly, NAB have set CYB free with a very strong balance sheet in order to avoid any reputational contamination that would arise if NAB's mum 'n dad investors (those that didn't sell CYB) ended up having been sold a lemon.)


Next, and this metric is the most telling in relation to an investment in CYB, the Cost-to- Income Ratio:

CURRENT COST-TO-INCOME
ANZ = 45%
BEN = 56%
BOQ = 44%
CBA = 42%
NAB = 43%
WBC = 40%
CYB = 75% (!)...In 2014 it was 70%, but there has been an acceleration in the significant investment in IT and systems upgrades and process automation in 2015, some of which will continue into the current year (more on this later)

In terms of conventional banking valuation metrics, CYB is clearly priced at a discount to other banking stocks:

PRICE-TO-BOOK VALUE
ANZ = 1.3
BEN = 0.9
BOQ = 1.2
CBA = 2.0
NAB = 1.5
WBC = 1.8
CYB = 0.57


P/E MULTIPLES
ANZ = 10.3
BEN = 9.8
BOQ = 11.6
CBA = 13.5
NAB = 10.9
WBC = 12.7
CYB = 13.5 (*)

(*) Note: this higher-than-average valuation multiple is on current earnings that have been depressed due to a significant expenditure in IT upgrades and automation, the benefits from which will materialise in subsequent financial periods.


Now with all of the above at backdrop, let's plot some sort of potential financial path forward for the stock.

Starting with Operating Profit Before Impairments:

In 2014 Operating Profit Before Impairments was 296m pounds, and in 2015 it fell to 237m pounds.

This reduction was principally due to a 45m pound additional investment in IT systems, moving to a digital platform and automating certain back office functions.

CYB's biggest asset is its 29bn pound loan book, but my sense is that the Clydesdale business - being the "ugly stepchild" in the very large NAB family of businesses - was always starved of the capital and the management attention it needed to grow.

As a result, the company is not very efficient and there is still a significant labour intensity in what Clydesdale does. Which is why the "normalised" underlying Cost-to-Income Ratio (CTI) is probably in the 65% to 70% range (the "modernisation" expenditure is what pushed it up to 75% in 2015, and it will probably be above 70% again in 2016 as this programme is completed).

Management has been quite courageous in setting a CTI target of 60% once the upgrade benefits start to accrue and some of the marketing efforts and the organic growth initiatives start to come through. (I say "courageous" but 60% CTI is still high by industry standards, so its not as if they are promising the world to investors here.)

For context, assuming that CTI does get to 60%, over the next 5 years, and that Income growth of just a mere 5%pa is achieved over that period [*], then Operating Profits Before Impairments will be close to 500m pounds at the end of that period, which is more than double today's level.

Assuming impairments remain relatively unchanged at 30bp of the loan book (last year it was 27bp), then Operating Profits After Impairments will have risen from 159m pounds last year, to 380m pounds, an increase of 240%.

Net Profit After Tax will be a little over 300m pounds, compared to 127m pounds in 2015. In terms of compound annual growth rates, that translates into CAGR of almost 20%pa for a period of 5 years.

(And bear in mind that the current year will be a relatively flat growth year, because it includes the finishing of the upgrade investment expenditure. If the underlying growth rate is assessed for the period when CYB is in pure benefit harvesting mode, i.e., from next year, then the underlying growth rate is closer to 24% pa.)

I can't think of many companies that will be able to generate that sort of organically driven growth. Especially not a commercial bank operating in a developing economy!


So what does this mean for investment returns?

Well, assuming a range of steady-state P/E multiples for CYB, from say 10x to 12x, the following stock price performance over the next 4 years would result:

@ 10.0x P/E: 66% share price appreciation (or 14%pa CAGR)
@ 11.0x P/E: 83% share price appreciation (16% pa CAGR)
@ 12.0x P/E: 100% share price appreciation (19%pa CAGR)

And, at the company's intended 50% dividend payout policy, the average dividend yield would be around 6%pa, meaning Total investment returns of between 19%pa and 25%pa, depending on the exit P/E multiples assumed (10.0x to 12x, respectively)


So that's the way I assessed the investment opportunity on offer from an investment in CYB and which formed the basis for my investment in the stock. I hope that provides some rough analytical context.

However, I do stress that given the long-dated nature of the investment thesis, it is somewhat fraught with forecast risks. So, as an exercise, it is not meant for one second to be prescriptive, but rather far more indicative.

Tactically, I have initiated a position in the stock (currently 3% if my invested capital), and over the next 12 months I will monitor progress and management's articulation of how the business is progressing towards achieving the strategic objectives. If the thesis remains intact at various update points, I will duly add to my holdings.


[*]
Note that I have assumed 5% pa Income growth, which translates into total Income growth of 28% over the forecast period. CYB management have put out far more aggressive targets, namely 40% to 50% growth in the mortgage book (which is currently 70% of the company's current loan book) and 40% to 50% growth in retail lending, and 15% to 25% growth in SME lending