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TSB Banking Group Plc – Assigning Price Target; 20 November 2014

Company Overview

Following a state bailout during the financial crisis, EU regulations have forced Lloyds Banking Group (LBG) to slim down as a business. This has led to a number of disposals over the years, with the most recent being 631 of the group’s high street branches that have formed a new challenger bank under the brand of a Lloyds subsidiary, TSB.

The original TSB was formed more than 200 years ago by Reverend Henry Duncan, who, during a time of economic hardship, wanted to create an institution that would cater exclusively for the poor people of Scotland. The reverend’s model proved a success and within five years had led to a proliferation of similar organisations across the UK.

TSB Bank began operating as a separate entity to the parent during 2013 and is expected to devolve fully from Lloyds’s ownership over time. The first initial public offering of shares is set to take place this month, in June 2014, which will see the stake of LBG reduced by 25%.

Index FTSE 250 Ticker TSB.L Latest Close 273.00
52 Week High 300.25 52 Week Low 243.66 P/E (F) 12.10
Dividend Yield % N/A Dividend Cover N/A CEO: Paul Pester
CFO: Darren Pope Price Target 230.00

 

The Good – TSB posts some positive numbers

The close of October saw TSB Bank Group Plc reporting Q3 results following its first six months of life as a listed company.

In detail, profit for the period increased by 28.9% when compared with the second quarter while management also reported another strong performance in terms of customer acquisition, with the bank attracting 9.7% of all new current account business during the period.

In addition to this, the all important net interest margin from TSB’s own book held steady at 3.61% during the quarter, while management also remain confident that the eagerly awaited mortgage intermediary platform will be delivered on time in Q1 2015.

This is expected to enable TSB to bid for mortgage business from a national network of brokers in the UK, which should provide a positive boost to net lending and earnings figures in subsequent periods.

The shares responded well to the update, leading to gains of just over 6% in the month since 24 October. However, and despite that TSB has printed some good headline numbers across several key metrics, the interim update has yielded no real change to our negative outlook for the shares.

TSB Bank Group Plc Shares // Hourly Intervals

TSBBANKENDNOVEMBER

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The Bad – earnings will be markedly lower next year, pushing the valuation out to 32X consensus EPS estimates for 2015

While we have written extensively about our reservations over TSB Bank, an increasing number of analysts and observers are now beginning to release forward earnings expectations for the group going into 2015.

The growing number of estimates confirm to us our own earlier expectations, in that one off credits to the income statement in the first half are likely to have distorted the full year performance for 2014 and that after this time, earnings are likely to be somewhat lower.

Consensus EPS estimates from four major brokerages suggest 22.70 pence per share for 2014, with the same measure falling to just 8.55 pence per share for 2015.

This threatens to extend TSB’s forward valuation from the current 12.10 X 2014 earnings, out to 32.12 X earnings in 2015; implying that without a substantial upward revision to the outlook for the group the shares could struggle to keep their head above water once into the new year.

The consensus takes into account estimates from Berenberg Bank (26.2, 11.0), Investec Securities (24.51, 7.62) , Numis Securities Ltd (18.70, 8.00) and Canaccord Genuity Ltd (21.40, 7.6.).

In addition to the above, we continue to see TSB’s growth strategy as presenting risks to the business and do not believe that aggressive expansion into a softening mortgage market and competitive current account space will provide stable foundations for the business over the longer term.

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The Ugly – impairment charges for TSB’s own book are greater than profits from TSB’s own book

We see it as a fair observation to say that TSB is racing against time to meet the demands of its inherited cost base before the LBG assistance measures begin to expire in 2016.

We are concerned that the aggressive lending targets arising from this growth pressure are likely to increase the risk profile of its asset base over the medium term, which presents an additional threat to the shares and holds negative connotations for the valuation.

In this regard, we note that in the third quarter the mortgage enhancement (ME -borrowed book) accounted for 50.2% of profits for the group and that this income will need to be replaced by 2018 when the economic benefit of £220 million will have been realised from the ME.

Furthermore, when the positive impact of mortgage enhancement profits is stripped out from TSB’s Q3 results, the remaining balance of profits generated from its own book is just £20.7 million, or 49.8% of the total. This is while impairment charges arising from the bank’s own book for the period came to a total of £23.0 million.  

While the bank was always going to face an uphill journey toward profitability, we see this as highlighted the true gradient at which the climb must be undertaken.

We also believe that other indications of such loan growth & asset quality risks building are already present and can be seen in comments made at the interim update, a quote of which is included below.

“Loans and advances to customers decreased by 2.1 per cent, or £477 million compared to June 2014. While retail secured and unsecured markets remained competitive this reduction primarily reflected a continuation of recent trends where repayments on the Franchise mortgage portfolio, which was originated through both direct and intermediary channels, continued to exceed new loan origination which is currently limited to sales from direct channels”.

In short, the group is faced with having to make a substantial amount of business, personal and mortgage loans over the coming years whatever the cost. This denotes a higher degree of risk within the business and in our view, warrants greater scrutiny of the valuation.  

While eventual changes in UK interest rates may help the group to boost margins and income in some areas, this will also be likely to result in reduced activity within the mortgage market; which could lead to further compromises on loan quality.

In addition to higher risks and lower earnings than in the current year, we also see competitive efforts as likely to hinder the group’s ability to improve margins and therefore, returns on equity over the medium term .

While it is not possible to rule out eventual success for the bank or the shares, we believe there are sufficient grounds to believe that the valuation is overextended and that investors hopes are too high for the time being.

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Summary

We see scope for the financial sector to benefit from an evolving monetary policy environment as rates rise, net interest incomes increase, and volatility returns to financial markets in greater doses.

This could lift valuations across the sector however, it is likely to require time for these to make notable headway.

Despite this, and in relation to TSB; we believe that expectations of the group over the near term are too high.

The H1 update earlier in August only served to exacerbate this conundrum in that TSB’s withdrawal from the LBG defined benefit pension scheme led to a significant one off credit to the income statement which artificially enhanced the performance of the group.

Going forward into 2015, TSB is expected to launch its mortgage intermediary function which will enable it to bid for mortgage business through a network of UK brokers. This will be positive for loan book expansion and could lead to higher earnings expectations.

Therefore, it is possible that the shares will continue to a premium valuation relative to the banking sector for a longer period of time.

However, once into the new year investor attention will be likely to focus more intently upon earnings expectations for the current and immediately subsequent year. This will see the group’s forward price to earnings valuation (32.12X) for the 2015 year coming under close scrutiny.

While it is possible that the addition of a mortgage intermediary function and the potential for further developments in relation to monetary policy may drive earnings expectations toward an upward revision, we are skeptical of whether any upward revision could be significant enough to warrant the implied valuation of current estimates and current prices.

In addition to this, we are also concerned at the fixation of investors upon the current discount to book value of 20% which is attached to the shares. In this regard, we note that all UK listed banks have traded at a discount to book persistently since the days of the financial crisis and that the 0.8X attached to TSB is broadly in line with the wider sector.

We consider this to understate the risks attached to the business, given the group’s aggressive lending plan and the current pressure to cover costs ahead of the time when LBG assistance measures expire

While we do not expect any notable increase in concern among investors over the group’s book valuation, we do feel that a wider focus upon earnings expectations for 2015 and subsequent years could prove to be the catalyst for a substantial re-rating to the downside once into the new year.

In relation to price targets, we believe that the shares are unlikely to see too many “better days” over the near term and for this reason, further upside for TSB Group will likely remain capped at the 285.00 pence level for the time being.

While we expect that a rerating to the downside in the new year should see the valuation begin to reduce meaningfully from thereon, we assign an initial price target today of 230.00 pence, which implies just over 15% downside for the shares and a minor closing of the valuation gap between TSB and its peer group.

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