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UK banks move into Virgin territory

By Blog, Portfolio

The stock in focus this month is CYBG (CYB). CYBG is a full service UK bank previously owned by NAB. After years of underperformance CYB was demerged in 2016.

It operates under the brands Clydesdale Bank, Yorkshire Bank and more recently B Brands. Despite serving nearly three million customers and having a branch network of over 200 branches and business banking centres, CYB struggled to grow its footprint nationally and has been largely confined to Scotland and the north and midlands of England.

This led to a major strategy shake-up. In June 2018 CYB purchased Virgin Money, an iconic brand with strong credit card and mass mortgage product capability in different geographical markets. The combination with CYB’s retail and SME customer base made strong strategic sense.

The complementary nature of the business means that substantial cost savings are targeted with expectations of annual net cost savings of 200 million pounds by 2022, enabling the Bank to significantly reduce their cost to income ratio.

The other exciting opportunity for management is to lever the other aspects of the Virgin group to enhance the experience for Bank customers and to begin to build an ecosystem which incorporates the other Virgin brands that UK consumers are using including Virgin Atlantic, Virgin Mobile and Virgin Media.

However, in the short term there are macro factors impacting the UK economy, specifically regarding Brexit and the political and economic uncertainty this is creating.

After talking to CYB and other UK focused firms, most businesses in the UK are in a holding pattern until this situation is resolved. With the new PM in place, this resolution, while still unknown, is closer to happening.

While any solution will probably lead to short term volatility, the long runway for the process means that authorities and policy makers are prepared to provide the support the system needs to overcome these short term issues. We therefore see this as an opportunity to purchase businesses at a good level for the longer term.

Quick Snapshot

  • CYB will change its name and branding to Virgin Money from late 2019.
  • The newly combined entity will have 9 billion pounds of deposits and 7 billion pounds of lending.
  • The flagship product, the Virgin Money personal account, will launch in the third quarter of this financial year.

Are Term Deposits Defensive?

By Blog, Uncategorized

By Leon De Wet – Elston Portfolio Manager

At first glance the answer may seem obvious, but is it? That depends on what an investor is looking to protect against. There is no doubt that term deposits offer capital stability and given the government deposit guarantee, are virtually risk-free. So, through the lens of protecting the capital value of one’s investment, they are undoubtedly defensive.

Should the question however be framed in the context of providing income, the answer is quite different. According to data from the Reserve Bank of Australia, over the past 10 years the average rate on a 1-year retail term deposit has more than halved from 3.70% to 1.80% at the end of June 2019. For a retiree seeking a stable income stream, term deposits have not been defensive.

In contrast, the dividend yield on the S&P ASX200 Index at 4.55% (before franking credits), is broadly in-line with the average yield over the past 10 years and near the middle of the 4.0-5.0% dividend yield range. In essence, over the past decade the interest derived from term deposits has been more unpredictable, and lower, than the dividends derived from a broadly diversified portfolio of Australian companies.

This does not imply that term deposits should be avoided. They may well be justified in a diversified portfolio. Careful consideration however needs to be given to the role they are intended to serve, and the possible unintended consequences of being defensive, particularly in the context of longevity risk.

Are grocery shop owners off their trolley?

By Blog, Uncategorized

With the rise of e-commerce, you might be tempted to think that the traditional grocery shop is on the way out. But is it? While certainly facing a competitive threat, bricks and mortar grocery stores also have a couple of important advantages over the pure online retailer.

  1. Margins – grocery retailing is fundamentally a low margin business making cost control critically important. Running an online business is however typically costlier, mainly due to increased distribution costs and depreciation of the capital investment needed in IT systems and logistics.
  2. Fractionalisation of costs – physical stores tend to incur a greater proportion of fixed costs, primarily due to the rents paid. This means that brick & mortar grocers can increase their profit by more from every additional dollar of revenue generated than online grocers which incur a greater proportion of variable costs.

To help overcome these challenges a pure online grocer can of course levy an annual subscription and/or add a delivery fee, but in doing so it is likely to eliminate a pool of potential customers. Given that the delivery economics however work best if drivers spend the bulk of their time bringing groceries into homes from trucks rather than driving kilometers between homes, the loss of potential customers is clearly something best avoided.

Purchase of Westpac Banking Corporation

By Portfolio

Across the Australian Equity component of investor accounts we have bought Westpac Banking Corporation (WBC). Westpac Banking Corporation is Australia’s oldest banking and financial services group, with branches and operations throughout Australia, New Zealand and the near Pacific region as well as offices in key cities around the world. This purchase has been funded from the sale of Commonwealth Bank of Australia (CBA).

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

  • It has a relatively low risk business mix with overweight exposure to retail banking, as represented by peer group leading impairments performance;
  • Operating expenses are being well managed and the ongoing efficiency program is delivering consistent annual savings;
  • The balance sheet is strong with ongoing organic capital generation positioning it well for expected increases in core tier 1 capital requirements. Along with its peers it is amongst the best capitalised banks in the world;
  • With bond yields low Westpac (and the banking industry generally), will continue to find support from retail investors given their attractive fully franked dividend yield.

As with all investments it is not without risks which include increased pressure on Bank margins from lower interest rates and cost pressures, exposure to the domestic housing market and ongoing regulatory scrutiny following the recent Hayne Royal Commission.

The purchase was funded from the sale of CBA. While their businesses are largely the same, there is a large valuation differential between WBC and CBA, beyond the historic premium that CBA has been afforded (with WBC at 1.5 times price to book value and CBA 2.1 times). This in conjunction with the fact that CBA has just gone ex-dividend for its FY19 final dividend, we believe WBC offers greater income and has greater valuation support over the medium term.

Download Westpac Factsheet

If you have any queries, please contact SB Wealth

Purchase of Clydesdale Bank

By Portfolio

Across clients accounts, we have bought Clydesdale Bank, 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:

  • 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;
  • The business has significant balance sheet capacity to fund growth and should be able to increase its dividend payout ratio;
  • Merger with Virgin Money in the UK we see as complementary to the existing business and product lines while also providing opportunity for further cost out and simplification benefits;
  • CYB will be completely rebranded to Virgin Money which strategically enables management to improve the mix of assets by growing market share in the higher-margin business and personal lending portfolios while maintaining market share in the more competitive UK mortgage market;
  • Strength in combination of CYB, a traditional bank with a large customer base, network and strong capital position with a mostly digital neo-bank in Virgin Money; and
  • 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.

We have funded the purchase through the sale of Ansell. ANN is a well-run business but at current valuations we see it as close to fully valued compared with the relative value in CYB. The positive catalysts in CYB flowing from the Virgin Money (VMA) acquisition and rebrand strategy mean that we see CYB as a more attractive proposition.

As with all equity investment, CYB is not without risk. While the strategic rationale behind the VMA merger is sound, as with all mergers, there remains the risk that the value of merger synergies (e.g. economies of scale, best practice, the sharing of capabilities and opportunities) may be overestimated.

Download Clydesdale Bank Factsheet

If you have any queries, please contact SB Wealth

Purchase of Origin Energy

By Portfolio

Across client accounts we have bought Origin Energy (ORG), a vertically integrated energy company with operations including oil & gas exploration and production, power generation and retailing. This purchase has been funded from the sale of AGL.

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

  • ORG owns 37.5% of APLNG, a global low-cost, long life LNG producer backed by long term contracts. Due to its position on the cost curve, it should be cash profitable throughout the economic cycle.
  • ORG also has a portfolio of strategically attractive electricity generation assets, which includes a mix of gas, modern coal and renewables. Not only does this provide generation flexibility depending on demand, but it also enables the company to divert gas between the spot gas and electricity markets to maximise value.
  • ORG has restored the strength of its balance sheet with gearing heading to the bottom of management’s target range. This combined with increased cash distributions from APLNG provides scope for a more progressive dividend policy from next financial year and may lead to other capital management initiatives in the medium term;
  • The LNG market is currently undersupplied from 2023-2025. During this period, prices are likely to increase significantly.

As with all investments it is not without risks which include being exposed to declining energy demand due to increased energy efficiency initiatives and changes in industry regulation. With its interest in APLNG there is the risk to dividends and debt reduction if oil prices fall significantly for an extended period.

As AGL has a similar business with the generation and sale of energy, it is exposed to similar risks that ORG. However, it lacks the level of vertical integration which ORG enjoys, and given the increasing cash distributions from APLNG we see more potential upside for both income and capital appreciation from ORG.

If you have any queries, please contact SB Wealth

Download Origin Energy Snapshot

Purchase of Clydesdale Bank

By Portfolio

Across investor accounts, we have bought Clydesdale Bank (CYB), the UK based full-service bank focused on consumers and small and medium-sized enterprises (SMEs). The purchase was funded via the sale of Bank of Queensland (BOQ.ASX).

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

  • CYB is well positioned to grow its loan and deposit book due to structural tailwinds for UK challenger banks, reductions in its capital requirements, its ability to source deposits at costs that are in line with larger incumbents; and leveraging opportunities arising from the recent Virgin Money merger
  • The UK government is looking to increase competition in the system. They are introducing a variety of incentives to help customers switch to smaller challenger banks;
  • CYB recently gained IRB (internal ratings-based approach) accreditation significantly reducing the capital intensity of the business as it reducing the risk weighting of loans. This means going forward it requires less capital to fund growth;
  • Deposit funding costs of the existing bank are broadly in line with large incumbents and well below other challenger banks meaning CYBG should have a pricing advantage vs competitors and should also be able to improve the profitability
  • CYB has significant balance sheet capacity to fund growth and should be able to increase its dividend payout ratio

We have funded the purchase through the sale of BOQ. BOQ’s recent result highlighted the pressures that increased funding costs and competitive lending environments are having on regional banks and we expect earnings to remain under pressure in the near term. The positive catalysts in CYB flowing from the Virgin Money (VMA) acquisition mean that we see CYB as a more attractive proposition.

As with all equity investment, CYB is not without risk. While the strategic rationale behind the VMA merger is sound, as with all mergers, there remains the risk that the value of merger synergies (e.g. economies of scale, best practice, the sharing of capabilities and opportunities) may be overestimated.

For more information refer to the CYB Company Snapshot attached.

If you have any queries, please contact SB Wealth

Download Company Snapshot – Clydesdale Bank

Purchase of Pendal Group Limited

By Portfolio

Across client accounts Elston have bought Pendal Group Limited (ASX: PDL formerly BT Investment Management Limited), an Australian based fund management business with approximately $100B under management across various strategies. Pendal Group operates under two brands; Pendal in Australia and JO Hambro Capital Management (JOHCM) internationally. Pendal is a well-managed business, with a strong balance sheet and a clear growth strategy.

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

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

  • Excellent track record of developing new products and extension strategies;
  • Capital-light nature of the business means they can grow sustainably and maintain an extremely high dividend payout;
  • Longer term increase in asset values underwrites growth in FUM and revenues;
  • Demonstrated ability to attract, retain and reward investment and distribution talent;
  • Disciplined capacity management to preserve investment performance and management fee income;
  • A strong balance sheet and solid cash generation means the group is well placed to provide seed capital for the launch of new products and strategies which will help drive future growth; and
  • Excellent diversification across asset class and geography. High fixed costs do provide a barrier to deter new entrants.

As with all funds management companies’, business risks include the loss of key investment staff and sustained market weakness which both impact the level of funds under management (FUM) and hence revenue. Furthermore, revenues would be negatively impacted by a material deterioration in investment returns leading to lower performance fees as a source of revenue.

The purchase was funded from the sale of Perpetual Limited (PPT), also a funds management business. While valuation on the stock appears undemanding and the dividend yield is attractive, the combination of poor relative performance versus peers, depressed fund flows, a less diversified product offering and uncertainty over strategic direction with a new incoming CEO leads us to the view that the medium term prospects for Pendal are more positive.

If you have any queries, please contact SB Wealth

Purchase of CSR

By Portfolio

Across client accounts, we have bought CSR, the company behind some of Australia and New Zealand’s most trusted and recognised building products for construction of homes and commercial buildings. It is also a joint venture participant in the Tomago aluminium smelter located near Newcastle and generates additional earnings from its Property division which focuses on maximising financial returns by developing surplus former manufacturing sites and industrial land for sale.

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

  • The longer-term drivers of housing demand remain positive;
  • The backlog of work already approved is likely to sustain activity levels over the next 12 months;
  • CSR is well positioned to invest in further growth initiatives and/or ongoing capital management
  • Earnings volatility from the aluminium business is partially mitigated by hedging;
  • The property pipeline offers the potential to realise a number of valuable opportunities; and
  • Valuation support and an attractive dividend yield should limit downside from here

As long-term investors we are prepared to tolerate the cyclicality of the company’s earnings, and accept that the stock may struggle to outperform materially over the next few months in the face of weaker residential macro data. Should credit conditions tighten substantially and/or house prices decline more than forecast, there is however the risk that CSR’s earnings profile proves less resilient than expected resulting in further share price weakness.

If you have any queries, please contact SB Wealth

Purchase of Fortescue Metals Group

By Portfolio

Across client accounts, we have bought Fortescue Metals Group (FMG). FMG is a low-cost producer of iron ore with assets located in the Pilbara region of Western Australia. In addition to its iron ore assets, FMG owns and operates its own rail and port facilities, capable of exporting more than 170 mtpa of iron ore.

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

  • As one of the lowest cost producers of iron ore globally with long life, quality assets located close to key markets FMG is in a strong position to continue its strong operational performance and generate strong free cash flow through the cycle.
  • Following significant debt reduction in recent years FMG’s balance sheet is now in a strong position giving the company flexibility to invest in growth options such as exploration or other value enhancing growth projects such as Eliwana or increase shareholder returns.
  • The recent focus on pollution controls in the vital Chinese market has seen the continued decline of high cost, low quality Chinese production, which should provide medium term support for iron ore prices.
  • Ownership of key infrastructure assets such as rail, power and shipping not only provides FMG with higher control over key cost inputs but puts them in a strong position within the region.

As with all investments it is not without risks which include FMG’s exposure as a single resource producer to volatility in the iron ore price, a slowdown in the iron ore demand from its key market in China and more general risks to production common to all resource companies.

If you have any queries, please contact SB Wealth