Within the Australian equity component of investor accounts, we have bought Clydesdale Bank (ASX: CYB), the UK based full-service bank focused on consumers and small and medium-sized enterprises (SMEs).

We are positive on the medium-term outlook for CYB for the following reasons:

• The merger with Virgin Money in the UK we view as complementary – the combination of a traditional bank with a large customer base and branch network with a mostly digital neo-bank results in an attractive end-state business with national coverage, a strong brand and product breadth;
• It has significant ‘self-help’ potential with opportunity for further cost out and simplification benefits – targeted net cost reductions of £150m represent approximately 15% of total operating and admin expenses;
• The complete rebranding to Virgin Money better allows management to pursue its strategic plan of increasing the net interest margin earned by improving the mix of assets. This means growing market share in the higher margin SME and personal lending portfolios, while maintaining share in the lower margin mortgage market;
• Short term uncertainty regarding the economic implications of Brexit has created a significant discount to what we believe to be the intrinsic valuation of the business – it currently trades well below book value; and
• It is well positioned to grow its loan and deposit book due to structural tailwinds for UK challenger banks, reductions in its capital requirements, and its ability to source deposits at costs lower than other challenger banks;

As with all equity investment, the purchase is not without risk. While the strategic rationale behind the Virgin Money merger is sound, there is the possibility that the merger synergies may be overestimated. Also, the additional provisions recently guided to as a result of the significant unexpected spike in payment protection insurance claims has resulted in a one-off capital hit, raising concerns that a dilutive capital raising may be required for management to stick to their strategic growth plans. We think this unlikely but acknowledge the risk of a possible dividend cut if needed.

The purchase was funded from the sale of Caltex Australia Limited (CTX.ASX). While we still feel that CTX is a quality business operating in an attractive market with high barriers to entry (infrastructure, location & scale), the rebasing of expectations around the rollout of the new convenience format has led us to moderate our growth forecasts for the company.

For more information refer to the Clydesdale Bank Company Snapshot.