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 TSB Bank; Part 2 – 12 June 2014

(To be read in conjunction with Part 1 – TSB Bank)

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’s 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.

The new spin-off has proved the most politically palatable means through which LBG can satisfy EU regulatory instructions to reduce its own scale, while forming a new “local banking” entity to help increase competition within the UK financial sector. The primary business of the bank is in serving retail and business banking customers with mortgage loans, personal current accounts and savings products, household insurance services and a wide array of business banking services.

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%.

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Recap:

In our first report on TSB Bank, back in April, we stated that we held a number of concerns over the bank and the investment prospects of the shares. The most prominent among these were soured consumer sentiment following the forced switching of accounts from Lloyds to TSB, a lack of competitive edge and the group’s vulnerability to a slowdown in the UK economy.

Also of equal prominence was the need for the bank to invest heavily in its infrastructure over the years ahead, most notably in IT systems, so that it can guarantee security and become suitably equipped to handle the evolution of the way in which banking services are delivered.

Each of the above had an influence on our decision to remain cautious on TSB shares, despite increasing levels of excitement surrounding the proposed IPO. Now with the prospectus for the share offer available online, we have chosen to look once more at the shares before confirming our outlook.

To view our original report, please click here …. TSB Bank: Initial thoughts

 

The Offer

The offer for which the June prospectus relates will see Lloyds Banking Group offload a 25% stake in TSB at a price that is expected to be toward the lower end of the 220.00 – 290.00 pence range.

A float at the midpoint of the range will provide TSB with a market cap of £1,275 million, which implies a discount to book value of nearly 15%. TSB is not expected to earn any income from the share sale as all proceeds are due to the selling shareholder, Lloyds Banking Group.

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TSB Bank: Performance, Valuation and Dividend Information

During the year ended 31 March 2014, TSB reported total income attributable to the franchise of £766 million. In addition to this, the group logged a profit of £32 million earned from a portfolio of residential mortgages which are known as the Mortgage Enhancement*.  The two create a combined income of £798 million which enabled the bank to report a profit for the year of £172 million, equating to earnings per share of 34.00 pence.

From a valuation perspective, the group’s financial data and offer information implies a multiple of 7.5 X 2013 earnings at the middle of the proposed price range. This compares well with other banks such as Barclays and HSBC which each trade on multiples of 14.4 X and 12.3 X 2013 earnings respectively.

Despite what seems, at first glance, to be a significant discount, we believe the price and earnings multiple to be fair at best. In our view, an assumption that the shares are due to float at anything like a true discount would be to overlook a number of material differences between TSB and its industry compatriots, as well as the challenges which the bank is set to face along the road ahead.

Given that TSB’s area of focus is concentrated on a narrow array of product lines and a single geographic area, it lacks the diversification of geographies that both Barclays and HSBC benefit from.

In addition to this, it also lacks the benefits of a more diverse product and service offering which could aid the group in weathering any downturn in demand for consumer credit, mortgages, commercial credit and personal as well as business banking extras.

Further from here, we are cautious of market expectations for earnings growth at TSB. This is because the group needs to generate earnings growth of roughly 4.65% per annum through till 2018 in order to ensure that its overall profits and EPS remain flat with their current levels. This is given that the Mortgage Enhancement* is expected to expire in 2018.

In relation to dividends, management are targeting a progressive policy which will eventually see between 40 and 60% of earnings returned to shareholders. In the short term and given the journey ahead of the bank, management do not envisage the return of any cash to shareholders until the 2017 year, which leaves short to medium term investors reliant upon capital appreciation of the share price in order to make a return.

Given the constraint upon earnings growth, and that this is traditionally a key driver behind the share price appreciation which TSB investors will depend on, we see a fair offer price for long term investors as being at or below the lower end of the offer price range.

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About the Mortgage Enhancement*

The Mortgage Enhancement is a portfolio of residential mortgages which were previously owned by Bank of Scotland. The economic benefit of the portfolio has been assigned to TSB by Lloyds so that the bank receives the economic benefit of the mortgages but does not have to bear the burden or cost of administering.

TSB is set to receive the mortgage enhancement payments for four years from, and including 2014, until such a time as the economic benefit of approximately £220 million has been earned. Once this has been achieved, Bank of Scotland is expected to re-assume the economic benefit of the mortgages.

Present estimates suggest that the enhancement income is responsible for nearly 18% of the group’s overall profit for the year. The remainder of the group’s income is earned through its retail and business banking operations.

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TSB Initial Thoughts Updated; Switching Process Leads to Customer Defection

In our earlier report on TSB, one of our key concerns was the importance of the bank’s customer-focused image and how this, among its existing client base, may have been damaged during the non-negotiable migration of Lloyds accounts to TSB.

Based upon the information available at the time, soured sentiment arising from the switch was believed to be a leading cause behind TSB’s award as the Worst Bank for Customer Service by moneysupermarket.com in late 2013.

When the switch of customers took place, the group claimed to have 4.7 million retail account holders and 127,000 business banking customers. Now on the other side of the New Year, and with the release of the share offer prospectus having taken place, a more reliable view of TSB’s starting position has been provided in up-to-date customer numbers.

At 31 March 2014, the bank reported 4.5 million retail account holders and 119,000 business banking customers, indicating a reduction of 5 and 6% respectively throughout the period between September 2013 and March 2014.

Despite the decline in account numbers, the bank’s helping hand has placed it in a strong starting position ahead of its introduction to life as a listed company. With £23.3 billion in customer deposits and a modest post-tax profit already reported, the group is in no immediate danger of making a loss, which is more than can be said for some UK-focused banks.

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TSB Initial Thoughts Updated; Front Runners of the Recovery, Switching Activity and the Road Ahead

While financial businesses have benefited greatly from the turn in consumer and investor confidence over the last 18 months, sentiment toward earnings prospects has now cooled. In our view, the softer sentiment is, in many respects, warranted.

While lower volatility across financial markets has already led to reduced trading activity and a decline in commission income for banks with broker dealer divisions, we believe that the greater threat to near term earnings growth for UK banks comes from an anticipated slowdown in mortgage lending and still muted demand for both consumer and corporate credit. TSB is at particular risk from this slowdown given its reliance upon mortgage lending, personal credit and corporate loans.

For information relating to our UK mortgage and property outlook, please see our UK Property report. Parts 1 and 2 are available through the online members section

On a slightly more positive note and despite a decline in overall account holders, TSB has managed to tempt more of its retail customers into trying its personal current account offering which has partially offset the decline in savings customers and deposits.

While a larger savings business would be better for overall deposits, the Personal Current Account is, at the industry level, more profitable. This is given the increased frequency of expense-related charges and a lower number of qualifying interest payments which are made to customers at less attractive rates.

Should the recent take up of PCAs among existing customers develop into a persistent trend, then over the longer term the impact is likely to be positive for TSB earnings. Having said this, and on the subject of account numbers, competition for external accounts remains a barrier to progress.

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Risks

In relation to risk, the most significant threat to the near term profitability of TSB comes from the anticipated slowdown in UK mortgage lending due to the implementation of new Mortgage Market Review regulations. Given TSB’s exclusive focus upon the UK, the consequent impact upon revenues and profits growth to the group has the potential to be significant.

Mortgages are the TSB Franchise’s largest asset portfolio and have a significant impact on its overall financial performance. TSB Prospectus, June 2014

In addition to reducing numbers of qualifying applicants for new mortgages, the group also has an above average exposure to credit risk within its loan book. This is because, according to the group’s prospectus, close to 50% of TSB’s mortgage loan book is comprised of interest only mortgages which, traditionally, are riskier than straightforward repayment mortgages.

Further from here, TSB is also exposed to reputational and brand risk. Given that the sole USP of the bank’s offering is a “local banking” image and the consumer centric service it offers, a shift for the worse in consumer perception could inflict lasting damage upon the bank’s ability to grow. Although the risk of this cannot be completely discounted, it has been mitigated to some degree by an indemnity agreement between TSB and Lloyds, which enables the bank to avoid liability for any past misconduct or legacy issues.

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Summary

In short, the June 2014 issue of prospectus yields no material change to our outlook for TSB Bank. While over the ultra long-term the bank may be able to carve out a home for itself within Britain’s concentrated banking sector, we remain cautious of TSB’s growth prospects over the foreseeable future.  

Low switching volumes in the personal current account market, a slowdown in mortgage lending, the side effects of rising interest rates and the need to invest heavily in the business are just some of the challenges that the group will face along the road ahead.

In addition to this, TSB must generate a high level of earnings growth over the coming four years just to keep profits and EPS at par with their present (IPO) levels. Despite this, there seems to be a great deal of excitement among the investor community over the anticipated flotation which may provide early investors with an opportunity to book a quick profit.

Nevertheless, we see a long road ahead to sustainable progress and earnings growth for TSB, indicating that the shares are best suited to those with an above average time frame, which is likely to far exceed what would normally be considered as long-term in the retail investment community.