The Clydesdale Bank (CYB), a key holding for the AIM Global High Conviction Fund released a solid third quarter trading update on Monday (this followed the solid trading update from Virgin Money earlier in the week).

While I remain cautious on the big four Australian banks due to regulatory risk, margin pressure, falling residential property prices and a potential change of Australian government that will lower the value of franking credits, the ASX-listed bank I am highest conviction on has absolutely nothing to do with Australia, other than it was once owned by National Australia Bank.

Global banking sector

At the macro level, bond yields are rising and yield curves are steepening as the central banks end QE and start raising interest rates. That sets a positive backdrop for the global banking sector and I do expect global banks to outperform in a steepening yield curve environment in the second half of this year. Global banks underperformed in the first half of 2018 and I believe that is reversing. Valuations remain cheap, and I think it’s prudent to increase weightings to global banks. Clydesdale Bank is one way of doing that and below I will run through the catalysts for further CYB share price gains. Interestingly, Lloyds reported better-than-expected earnings last night in the UK, confirming the trends CYB reported on Monday.

CYB NIM (net interest margin) of 218 basis points was roughly in line with market expectations and they reiterated circa 220 basis points guidance for FY18. This is pleasing, given the current competitive mortgage pricing environment.

Core SME growth was strong at 4.7% annualised, while mortgage growth came in at 3.8% annualised. The slowdown in mortgage growth (6% annualised in first half 2018) came from the on-shoring of mortgage processing, which resulted in servicing delays and lower applications in the second quarter, and subsequently lower drawdowns in the third quarter. As such, the full year mortgage growth is expected to be at the bottom end of the 4-6% range. Asset quality was strong and slightly better than expected with net cost of risk at 12 basis points versus 13 basis points annualised in the first half of 2018.

There are several near-term catalysts which we believe are positive for CYB.

Internal Ratings Based (IRB) Ruling and Capital Release

In their Q3 release this week, Clydesdale Bank reiterated that mortgage IRB accreditation is still expected in October and pleasingly the SME accreditation is also well ahead of schedule. For the mortgage book, Clydesdale Bank has pointed to a 20% mortgage risk weighting going forward (down from approximately 37% currently). This should equate to drop in Risk Weighted Assets of around £5 billion (GBP24.5 billion x (37% – 20%) = ~GBP 5 billion). Assuming a Target Core Tier 1 Ratio of 12.5%, this equates to a capital release of over GBP500 million or GBP0.61 per share.  We believe these numbers are likely to be conservative, given Virgin Money’s recent Bank of England Prudential Regulation Authority approved mortgage risk weighting was 12.9% (not 20%).  Any change to SME lending risk weightings will be incremental to this.

Whilst not all of this excess capital will be returned to shareholders, we believe that a meaningful portion is likely to be returned via special dividend, whilst the remainder will be invested in growth.

Virgin Money acquisition

The Virgin Money acquisition remains attractive to us given the highly strategic nature and earnings accretion. Effectively, the merger will see Clydesdale Bank rebrand itself as Virgin Money and will establish it as the largest challenger bank in the UK. The merger is scheduled to complete in early quarter four with the Scheme Meetings and shareholder votes to be held on 10 September. We estimate EPS accretion to be greater than 10%. CYB flagged £120 million of cost synergies from network efficiency, organisational design, operational efficiency and central cost management. This is around 34% of Clydesdale Bank’s cost base. CYB is strong in the North of England, whereas Virgin Money is the key player in Southern England so it makes geographical sense to become the next UK challenger bank.

Initiatives to boost banking competition

There are several UK initiatives focused on increasing banking competition and we are hopeful that the new combined entity will be a key beneficiary of this.  Clydesdale Bank will be able to apply for the Capability & Innovation Fund Pool A and the Incentivised Switching Scheme, both with awards announced in February 2019. As Clydesdale Bank is the biggest challenger SME bank, it has a very good chance at winning one of the main grants from the Capability & Innovation Fund Pool A (there is a £120 million, £100 million and £60 million grant available). Clydesdale Bank will also be a favourite to pick up a significant portion of the 120,000 customers using the Incentivised Switching Scheme – this is a total of £200 million revenue.

Although there is some macro uncertainty around Brexit and the UK economy, we remain confident that Clydesdale Bank will continue its organic growth and cost-out story, whilst successfully integrating with Virgin to create the UK’s most attractive challenger bank.  Finally, we believe that it is well positioned to return excess capital to shareholders in the coming years.

Spin-offs from large companies generally prove wonderful stand-alone investments. Clydesdale Bank is a classic spin-off and is performing as such. I think it will continue. On 12 times earnings offering 31% EPS growth, Clydesdale Bank remains undervalued.

Important: This content has been prepared without taking account of the objectives, financial situation or needs of any particular individual. It does not constitute formal advice. Consider the appropriateness of the information in regard to your circumstances.