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TSB Bank Group Plc Full Year Update – 11 March 2015

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 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 243.66
52 Week High 342.70 52 Week Low 243.66 P/E 12.10
Dividend Yield % N/A Dividend Cover N/A CEO: Paul Pester
CFO: Darren Pope Previous Price Target 230.00 Current Price Target 230.00

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TSB shares spend much of the second half drifting lower

Since our last update in November, TSB shares have spent much of the intermittent period trading aimlessly. This trend also continued into March, despite the release of full year results at the end of February. However, the middle of March saw the shares jump sharply higher in response to rumours that the bank may soon be on the receiving end of a takeover offer from one of Spain’s largest lenders, Banco Sabadell SA.

Below we outline the particulars of the potential offer, along with our own view relating to its prospects for success, before providing an overview of the group’s performance throughout the second half of the 2014 year.

We also explain why, in the absence of a successful bid from Banco Sabadell SA, we maintain our existing call on TSB Bank Group Plc, as well as our price target of 230.00 pence for the shares.

TSB Bank Group Plc Share Price / 8 Hour Intervals

TSBBANKINMARCH

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Overview: Banco Sabadell takeover interest

As many will now know, mid March saw TSB and Lloyds announce that there have been talks with the Spanish lender Banco Sabadell regarding a potential takeover offer. According to the information made available by the pair, any potential offer will be for 340.00 pence in cash, which is expected to be funded by reserves and a rights issue from Banco Sabadell.

This represents a minor premium of about 4% upon TSB’s net asset, or book value, per share (326.8 pence) and an instant return of 30% upon TSB’s February share price.

Our view of the potential for a deal to go through is one of cautious scepticism. While Lloyds is legally obliged to sell the shares under European Union rules on state aid, we are doubtful as to whether or not management teams from the two banks will be able to come to an agreement which both parties find mutually acceptable.

This is because, at present Lloyds provides a number of lifelines to the fledgling bank, including its IT infrastructure and the economic benefits of a £3 billion bundle of mortgages. These lifelines are supposed to give the bank a head-start in life on its own and currently represent the difference between TSB being a profit making institution, and one that is wallowing in losses.

Therefore, one of the core reasons behind our scepticism is that we do not envisage Lloyds being willing to provide the same level of financial and technical support to TSB if the bank were to come under the wing of another much larger and more threatening organisation.

Although it is not clear whether or not Banco Sabadell would actually expect such support to continue after a takeover, we not not envisage Lloyds Banking Group Plc being willing to provide it in any case and if such support measures do happen to be a necessity to any deal, then it could result in Banco Sabadell refraining from making a formal offer.

Furthermore, we also believe that the competition argument surrounding any potential offer is hanging in the balance. This is because on the one hand, the entrance of a large foreign entity into the market could mean more effective competition with the dominant incumbents.

However, on the other hand, it could also serve to consolidate the grip of power over UK financial services into the hands of large international institutions who are all under intense pressure from shareholders to improve profitability. Such consolidation could raise further barriers to entry for the numerous emerging “challengers” which are currently attempting to establish a foothold within the UK market. 

While it is difficult to predict which of the above views the competition authorities will prefer to take, in light of the ongoing Competition and Markets Authority enquiry into barriers to entry, we view a regulatory veto as a viable risk to any potential deal. 

 

Financials: Strong growth in net interest income for TSB although, full year results are uninspiring

In terms of full year financials, TSB’s net interest income was 66.1% higher for the period at £787.1 million which reflects strong deposit growth during the period and the additional benefit reaped from the Lloyds Mortgage Enhancement (LMH). Impairments were also lower in the second half  at £46.5 million, down from £51.1 million in H1, although for the full year they increased by 21.5%.

At the bottom line, post tax profit for the period was down 27.3% from £185.0 million in 2013 to £134.5 million in 2014, reflecting the increase in costs born by the bank as a result of its spin off from Lloyds ownership.

In line with our earlier expectations, profits in the second half of the year were also considerably lower than in H1 2014 due to the effects of a one off credit to income statement in H1 (pension credit). The exact breakdown was for a post tax profit of £101.8 million in the first half and just £32.7 million in the second half.

“While the mortgage enhancement will provide additional income to TSB for some time to come, the bank will not benefit from further pension-related credits. This means that without further improvements, earnings for H2 are likely to be substantially lower than during the last six months.” – Stockatonia Research, 14 August 2014

In addition to the drop in profits for the period, management also announced that they would be willing to consider both inorganic as well as organic growth in future periods. 

This was a concern for some shareholders as it marked what some analysts have called a worrying U-turn on strategy, which could indicate an elevated degree of concern among management as to whether or not TSB will actually be able to pull off its “local banking” strategy.

 

Maintaining our call on TSB shares, headwinds to earnings growth remain significant

In the full year results management also referenced increasing competition within the industry (new entrants) and a prolonged period of low rates as being among the main reasons for why the group will be operating in a tougher environment during 2015 than it did in 2014.

While we wouldn’t disagree that these factors will pose a challenge, we see the real headwinds to growth at the group coming later on in 2017 & 2018, although we do note that the presence of a one-off £63.7 million pension credit in the income statement for 2014 will also mean that the group is running uphill from the very beginning in 2015.

When we speak about future headwinds to growth we of course mean the expiration of the Transitional Services Agreement (provided by Lloyds) in 2017 which, among other things, currently sees TSB supplied with the costly and complicated IT systems necessary for the operation of a financial institution. The expiration of this agreement in 2017 will add £100 million of annual costs to TSB’s P&L.

In addition to this the likely expiration of the Mortgage Enhancement portfolio in 2018, which accounted for 53% of pre-tax profits in 2014, means that the bank will need to grow earnings significantly during the years ahead just to keep bottom line income on a par with its 2014 level.

Although this is not impossible, it should provide an indication of just how hard the group will need to fight if it is to demonstrate any real form of earnings growth over the period.

 

Balance sheet, dividend and valuation update

In terms of the balance sheet, gearing at TSB remains low as the group has issued very little debt to date, while all of the available information continues to suggest that cash returns to shareholders, in the form of dividends, are not yet on the horizon.

Despite that that TSB often trades at a discount to net assets, in relative terms, the group’s earnings multiples are often found a considerable distance ahead of the wider industry. Given the challenges that the bank will face in terms of earnings growth during the years ahead, we continue to see TSB Bank Group Plc as being expensive from a valuation perspective.

Many investors are of the view that, given the bank is free from the legacy issues which plague many of its competitors and its prospects for growth in terms of returns on equity are also higher than across the sector, a premium valuation is warranted. we accept that some form of premium valuation is likely to be warranted. 

However, we believe that this premium is more than accommodated by our pre-existing price target for the shares, which implies a 12.4X historical (franchise) earnings multiple and a 19.5X  forward multiple for the shares (Consensus EPS 11.8 pence).

 

The takeaway

In short, we continue to believe that TSB Bank Group Plc will face many headwinds in its attempts to grow earnings during the years ahead, which we do not feel are fully priced into the shares at present, or even recent levels. In our view the mixture of challenges outlined earlier in this report will likely lead to disappoints when it comes to growth at TSB over the coming years. 

For this reason, we also believe that it is only a matter of time before investors are forced to reconsider whether or not the shares are going to be able to produce the returns expected of them within a reasonable time-frame.

In terms of the potential takeover by Banco Sabadell, we are sceptical of whether or not Lloyds and Sabadell will be able to come to an agreement which both parties find mutually acceptable, while we also believe the intended purchase would be a poor move on behalf of Sabadell shareholders. There is also the presence of a regulatory minefield between Sabadell in its current form and Sabadell as the parent of Lloyds. This minefield contatins issues such as competition concerns as well as prudential rules relating to capital strength, any of which could scupper a potential deal.

However, our scepticism may prove to be misplaced as there are no legal impediments to the deal, Lloyds is legally obliged to sell the shares as soon as possible and TSB management cannot avoid recommending to shareholders that they take up the offer. Only time will tell whether or not there is a deal to be made.

Despite this, and in the absence of a successful takeover, we maintain our price target for the shares at 230.00 pence each.

The next scheduled event of note will be the release of the Q1 interim management statement on 29 April. In regards to the takeover, Banco Sabadell are obliged to make a formal offer for the shares within one month of the earlier announcement, which means that we will have more information as whether or not the deal will go ahead by early April.

To view our earlier coverage of TSB Bank Group Plc, please see the below links; 

TSB Bank Initial Thoughts – 25th of April

TSB Bank – Part 2, Initial thoughts revisited and continued

Why We Are Still Not Feeling TSB Bank Group Plc – 04 August 2014

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

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IMPORTANT:
The contents of this report and the Stockatonia website (https://www.stockatonia.co.uk/) have been prepared to provide general information only, and as such, the specific needs, investment objectives or financial situation of any particular user have not been taken into consideration. Please always remember that the value of investments may fall as well as rise. Investing in securities, and any other products associated with them, carries a high degree of risk and may not be suitable for all investors. For advice or guidance related to investing in securities markets, please consult with your own financial adviser. 

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