British banks have struggled to win the trust of investors, but Virgin Money UK, the country’s sixth largest lender, has a bigger credibility problem than most. The bank’s shares are valued at less than half the value of its tangible assets, a greater discount than those attached to its London-listed peers. An ample capital pile and fatter margins indicate that the stock’s beaten-up valuation is too harsh.
Higher interest rates gave an easy kick to pre-tax profits, which beat expectations over the 12 months to the end of September and were 43 per cent higher than the previous year. The net interest margin, the difference between what the bank pays out on customer deposits and what it earns on loans, expanded to 1.85 per cent, from 1.62 per cent the year before, and is expected to increase again to up to 1.9 per cent this year, assuming that the Bank of England base rate peaks at 4.5 per cent next year. Crucially, impairments were much lower than feared at only £52 million, or 0.07 per cent of average customer loans.
A regulatory capital ratio of 15 per cent not only was ahead of consensus but also the medium-term target. That implies £375 million in surplus equity against the top of the company’s target of a ratio of between 13 per cent and 13.5 per cent. The result? Another £50 million in share buybacks, on top of the £75 million announced in June. That is in addition to the dividend of 10p a share, better than expected, which equates to a dividend yield of 6.1 per cent at the present share price. The company plans to increase the capital ratio to more than 14 per cent for the present financial year, a meatier buffer reflecting a worsening wider economic situation. Even that would still leave the lender with a maximum of £250 million in surplus capital, compared with the level at the end of September.
Further buybacks are not expected until after the end of the latest financial year in March, but analysts at Shore Capital reckon Virgin will need to make chunky shareholder returns over the next two years to return the regulatory capital ratio back within the 13 per cent to 13.5 per cent range, as the bank intends.
Attention will focus now on how likely it is that Virgin can achieve a target of generating an 11 per cent return on tangible equity from 2024, compared with 10.3 per cent last year and above the 8 per cent expected by analysts prior to the release of the latest trading figures. Hedges against fluctuating rates gave a boost of about £700 million to the tangible net asset value last year, according to estimates by Shore Capital. The unwinding of those hedges will provide an easy fillip to the returns Virgin can make on its assets.
The risks to returns? A sharper than anticipated increase in bad debts is one of the biggest threats to Virgin pushing returns higher. So, too, is an overrun on the £275 million in restructuring charges the lender expects to incur by 2024 as part of plans to digitise more of its operations and close more branches. The balance of those costs, about £190 million, is set to be incurred during the present financial year.
Last year, the cost-to-income ratio fell to 52 per cent, closer towards a target to reduce the ratio below 50 per cent by 2024. That was the result of a rise in income rather than progress on operating costs, which rose marginally, partly on the back of inflation. Then there is the question of how easy it is to lift mortgage lending, which accounts for roughly 80 per cent of Virgin’s loan book, in what is a highly competitive market.
The scale of the discount deeply embedded within Virgin’s market value compensates enough for the risks ahead.
ADVICE Hold
WHY The shares trade at a significant discount to tangible asset value, which accounts for macroeconomic risks
Telecom Plus
Soaring wholesale energy costs have given Telecom Plus its best chance yet of competing with the “goliaths” with “nothing to differentiate themselves”. Offering customers a cheaper deal by bundling services together means that the energy price cap has not proven to be a barrier to convincing consumers to switch providers, as it has done for the energy sector’s powerhouses.
The FTSE 250 utility provider, which trades as Utility Warehouse, has raised its profit guidance for the fifth time in a year, on the back of a jump in the annual rate of customer growth — 24 per cent — and higher energy prices over the six months to the end of September. Adjusted pre-tax profit this financial year is expected to be £95 million, which would represent an increase of more than 50 per cent on last year.
The shares have risen to a record high, but still don’t look overpriced. Consistent profit upgrades mean that a price-to-earnings ratio of just over 22 is still broadly in line with the five-year average multiple.
In June, the company unveiled a target to add a million more customers to its books over the next four to five years. Telecom Plus has only a 3 per cent share of the energy market, so there is room to take a bigger slice in near term. But achieving the million-strong target also requires the rate of customer growth to remain ahead of historic levels at almost 19 per cent a year. Whether that is achievable once energy price inflation settles is under greater question.
Bad debts should be watched closely. Arrears edged up to only 1.5 per cent of revenues over the first half of the financial year, from 1.4 per cent the same time last year, but the winter months will place more pressure on household budgets.
A capital-light business model means that the utility supplier has a record of generous cash returns. Higher earnings this year are expected to deliver a dividend of at least 80p a share, which would be equivalent to a yield of about 3.3 per cent at the present share price. Decent income and the prospect of further earnings upgrades over the next 12 months mean that there could be still further for the shares to run.
ADVICE Buy
WHY More earnings upgrades could send the shares higher
