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You can’t bank on NatWest delivering stellar returns

The Times

If the government presses ahead with returning NatWest to private ownership, investors should expect a discounted offer. But a lower price would not necessarily make the lender an appealing prospect.

NatWest had a clear advantage over other mainstream lenders in capitalising on rising rates: a greater base of customer deposits, a cheaper source of funding than the wholesale market. Yet the easy boost from the rapid rise in interest rates is fading.

The bank’s net interest margin peaked in the first quarter of this year. By the third quarter the margin, the difference between what a bank earns on loans and pays out in interest on customer deposits, had fallen to 2.94 per cent.

Customers are moving their cash from current accounts to fixed-term products that pay a higher rate of interest. Guidance for the full year was weakened to a margin of above 3 per cent, compared with about 3.15 per cent. Competition within the mortgage market has also increased. Growth in the loan book is harder. Net loan growth slowed to £800 million in its core retail banking business during the third quarter, or less than 1 per cent.

The lender maintained guidance for a return on equity of 14 to 16 per cent this year, which sits above its peers, but the investment bank RBC Capital forecasts a reduction to 11.8 per cent next year, a cut from its previous forecast of 13 per cent.

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The shares’ discount has widened since the start of the year to almost 30 per cent versus the tangible book value forecast for the lender in 12 months’ time. The debacle surrounding Coutts, NatWest’s private banking business, which dropped Nigel Farage, the former Ukip leader, as a customer, has not helped. The episode led to the resignation of Dame Alison Rose, who has been replaced in the interim by Paul Thwaite, a bank insider.

Ample capital returns have been a big bull point for NatWest. Analysts have forecast a dividend of 16.82p a share this year, which would leave the shares offering a potential yield of 7.7 per cent. In July the group announced a fresh £500 million share buyback programme, in addition to £800 million in purchases announced alongside its last annual results, but income expectations have also been downgraded. Regulatory changes to the way risk-weighted assets (RWA) are calculated are expected to inflate NatWest’s RWAs to £200 billion by 2025, higher than analysts had expected. That is potentially bad news for shareholder returns.

Higher RWAs weigh on a bank’s common equity tier one ratio. That means less capital available to be handed back to shareholders, over and above management and regulatory targets. Analysts at RBC Capital reduced forecasts for share buybacks between this year and 2025 from about £7 billion to £4.6 billion.

NatWest is not short of capital. The bank’s common equity tier one ratio sits at 13.5 per cent, above target and a regulatory minimum of 9.5 per cent and at the midpoint of management’s target range.

Its liquidity coverage ratio is a solid 145 per cent, compared with a regulatory minimum of 100 per cent. Such ratios are designed to ensure that banks hold a sufficient reserve of high-quality liquid assets to survive a period of significant stress, namely customers pulling deposits, lasting for 30 days.

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The government’s “Tell Sid”-style push to offload the remainder of its near-38 per cent stake in the lender to retail investors is part of a target to return the lender to private ownership by 2026. All the NatWest disposals so far have resulted in a loss for the taxpayer. Ridding the state of the rest of the stock is likely to require the shares to be offered at a discount to the prevailing share price. That is another overhang to the stock.

Making the case for the bank’s growth potential was already getting tougher, now the income case is also getting harder.

Advice: Hold
Why: The dividend is appealing but closing the discount might be challenging

Frontier Developments

Frontier Developments has a big credibility problem. The flop of the video game developer’s latest release forced the group to warn for a second time this year on profits, but also raises questions over its ability to deliver another hit.

Weaker sales of Warhammer Age of Sigmar: Realms of Ruin in the run-up to Christmas are a repeat of the disappointment of the F1 Manager 2023 game after it was released in July. Revenue guidance has been cut to between £80 million and £95 million for the 12 months to May next year, down from £108 million, and an adjusted loss before interest, taxes and other deductions of £9 million. Breakeven is targeted for 2025.

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Analysts at Shore Capital cut forecasts for revenue generated by Warhammer this year to £5 million, from £23 million and also reduced the contribution it expects from the F1 title, anticipating more discounting to shift units. The brokerage has forecast a return to profitability a year later than management has guided, in 2026.

A business publishing titles for third parties has been scrapped, along with diversions into new genres, and the focus shifted back to so-called creative management simulation games, the type behind its previous success, including Planet Zoo and Jurassic World Evolution.

A cost-cutting programme aimed at reducing operating expenses by about a fifth by 2025 will help to repair the bottom line but ultimately achieving breakeven in the next financial year depends on demand holding firm for those existing franchises as well as the success of a new release due that year. The former looks more assured than the latter. The video games market is highly competitive, made tougher by pressures on consumer wallets. The group’s recent history is not reassuring.

The value destruction for shareholders has been epic. The shares have plunged 87 per cent in value since the start of this year alone. The market capitalisation, which at its 2021 peak stood above £1 billion, has sunk to below £50 million.

In its corner, Frontier has a net cash balance of just over £20 million, although that has been depleting fast. In May that pile stood at £28 million and it was almost £39 million a year earlier.

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The UK video game industry was a shopping ground for overseas buyers before interest rates began rapidly rising. David Braben, Frontier’s founder, retains just over a third of its stock, which could present another complication to any takeover.

Advice: Avoid
Why: Another profit warning seems likely

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