Clydesdale Bank (CYBG) is a British retail bank which spun-out of the National Australia Bank in 2016. Pursuant to an announcement on May 7th, the company has proposed to acquire fellow UK challenger bank Virgin Money. At the present moment, investors don’t know whether they are buying CYBG’s “old pitch” of standalone operational improvement, organic growth and excess capital deployment; or the “new” Virgin Money M&A-driven synergy story.

In our view, both scenarios will drive a meaningful upside from the current share price, and we expect further clarity around the acquisition to emerge in the coming weeks. Based on current earnings expectations, CYBG is only slightly undervalued, however the company has several levers available (not only the Virgin Money acquisition) to increase return on equity:

1) Government initiative to increase business banking competition. Currently the UK government is focused on improving competition within the small/medium sized business banking market. As a result, Williams & Glynn (owned by RBS) is being forced to introduce its customers to competitors, including CYBG. As one of the largest UK “challenger” business banks, CYBG is hopeful that it will be a primary beneficiary of this process. The potential prize could be an upfront payment of c. GBP100m (4% of the company market cap) and incremental assets and liabilities that should contribute c. 5% to earnings.

2) The company’s efficiency should improve. The company was not efficiently managed under National Australia Bank. Benchmarking exercises suggest that the cost/income ratio of the bank should fall well below 60%, providing another 10% uplift to earnings vs. current expectations.

3) There is excess capital which should be released this year. CYBG has the capacity to reduce the regulatory capital it is required to hold by obtaining advanced internal model approval for its lending portfolios. This will liberate capital within the business and enable the company to return capital to shareholders or accelerate growth. We believe neither of these scenarios are captured in consensus earnings forecasts, and that the possible capital release could be as much as 20% of the company’s market capitalization (although there are likely to be offsets which may reduce this number to 12-17%).

4) Merger with Virgin Money could be highly accretive. The preliminary approach released by CYBG has suggested there is a substantial synergy potential, where our valuation estimates the deal could be 10%-30% accretive to CYBG’s EPS.  The potential synergies could be the following:

- Both banks have been heavily investing in their digital platform, going forward only one platform is required.

- Increased market share across locations (CYBG has a strong presence in Scotland & North of England where Virgin dominates the South of England) and across both business/retail banking (CYBG is recognised for its business banking franchise where Virgin is known for its retail banking brand).

5) UK banking margins appear to be stabilising. Recent data from the Bank of England suggests the mortgage lending margin pressure that has characterised the UK market for the last three years appears to be settling. Also, the Bank of England has started to raise interest rates, which is a positive for banks’ margins.

Considering these five factors, our valuation suggests CYBG has at least 30% upside. The downside risk for CYBG is another increase in the capital provision required to fund customers’ payment protection insurance claims. The company recently announced an additional GBP200m of requirements for PPI payments, and there is a possibility that provisions are increased again as the 29 August 2019 claims cut-off date approaches. Our analysis suggests any additional provision is likely to be lower than the GBP200m recently announced and our c. 30% upside target implies more than GBP800m of additional market cap for CYBG.  Overall, we believe there is an adequate buffer in the valuation for PPI payments.