By Paul Rickard 

NAB shareholders haven’t enjoyed a lot of love over the last couple of months.

Since announcing a very underwhelming set of full year results in October, which showed that the net interest margin in its business bank had been slashed from 2.43% to 2.33%, NAB shares have underperformed. In fact, it has become a case of the Sydney banks versus the Melbourne banks, with ANZ also marked down due to its confused Asian strategy.

As the following table shows, since 23 October (a date following the announcement of all capital raisings, but prior to the banks’ annual results), NAB has underperformed Westpac by approximately 12% - it has lost 7.7%, while Westpac has added 4.5%.

With NAB shares starting to look cheap, this may be about to change as investors consider relative pricing and trading multiples. Further, NAB’s demerger of its UK banks, Clydesdale and Yorkshire, might start to be viewed as a positive for NAB, and perhaps even a late Christmas gift to NAB shareholders.

The demerger

In the coming days, NAB shareholders will have their letter box stuffed with a 595 page scheme booklet explaining the proposed demerger. They will be asked to vote in favour of the proposal to separate from the NAB the Clydesdale and Yorkshire Bank operations, and house these in a new entity, CYBG PLC. NAB shareholders will own 75% of the new entity, with the remaining 25% divested under an institutional offer, with the sale proceeds going back to the NAB.

NAB shareholders will receive 1 share in CYBG PLC for every 4 NAB shares they own. For example, if you own 1,000 NAB shares, you will get 250 CYBG PLC shares.

Shareholders will first need to approve the demerger, with a vote scheduled on 27 January. Assuming this is passed, the institutional offer is scheduled to conclude by 2 February, with listing on the ASX on 3 February.

Small shareholders with 2,000 or less NAB shares who don’t want to own CYBG shares can elect to sell their CYBG entitlement via a special share sale facility. Sale proceeds will be paid by 4 April.

If you do decide to keep your CYBG shares, these will be listed on the ASX as CHESS Depositary Interests (CDIs) under stock code CYG. This effectively means that Australian shareholders can trade their shares on the ASX like any other share. Although the company will have its primary listing on the London Stock Exchange, the Australian CDIs can be converted at any time into UK based CYBG shares, meaning that that the two instruments should trade at or about the same price. NAB says that it expects the shares to be included in both the ASX 100 and FTSE 250 indices.

From a tax point of view, the demerger will not be treated as an assessable distribution - so no tax to pay. However, the cost base of your NAB shares will be reduced by the value of the effective distribution, which will be advised after CYBG shares have been trading for a week.

CYBG PLC

CYBG is a mid-sized UK retail and SME bank. Headquartered in Glasgow, it has 275 retail branches, 121 under the Clydesdale Bank brand in Scotland, and 154 under the Yorkshire Bank brand in northern England. It has 2.8 million retail and business customers, and a £29bn loan portfolio of which £20.5bn is housing loans, and the balance in loans to small business.

Although the new bank will be well capitalised with a Common Equity Tier 1 ratio of 13.2% and a leverage ratio of 7.1%, financially, it is a basket case. A return on tangible equity of just 5.1% pa, and a cost to income ratio of 75%! By comparison, Australian banks operate with ROTEs around 14% to 17%, and cost to income ratios in the low 40s.

Despite what many of us might think about Australian banks, they are “light years” ahead of the retail banks in the UK and those data points above say it all. The UK economy, although now recovering, suffered more from the GFC. There has also been an unholy mess about conduct provisions relating to the sale of interest rate hedging products and fixed rate business loans. With NAB providing a £1.15bn risk share and unutilised provisions of £1.0bn, CYBG will have £2.1bn on hand to absorb future losses, which it says has been sized after appropriate stress tests.

CYBG says that it has a strategy to deliver growth and improve shareholder returns. It says that it is targeting in the medium term a double digit ROTE, a cost to income ratio below 60%, and positive jaws - income growing at a faster rate than expense growth. It plans to grow its mortgage book by 40% to 50% over the next 5 years, its SME lending book by 15% to 25%, and maintain margins.

Whether it achieves these targets or not will in the main come down to two important factors - the calibre of the management team, and the flexibility and agility of its technology platform. The last factor shouldn’t be underestimated, because CYGB it is still a subscale bank. Slashing the cost to income ratio without compromising customer service and balance sheet growth will depend almost entirely on the ability to apply technology.

From 10,000 miles away, it is impossible to pass judgement on these points. However, it is largely a new management team with a new strategy, and optimistically, you can probably conclude that it can’t do any worse than the previous owners.

NAB benefits

NAB has comprehensively demonstrated, over many years, that it can’t manage these UK banks, so divestment must be a good thing. More politely, this is described as “facilitates strong focus on core Australian and New Zealand franchises”.  

In financial terms, NAB says that it will record a book loss on the deal of around $1.7bn to $4.7bn. This includes $262m of transaction costs in FY16, with $93m already occurred in FY15. However, it says that its return on equity will improve by 1.6% to 14.6%, its banking cost to income ratio will drop from 44.8% to 41.1% and its tier one capital ratio, after adjusting for FY16 impacts, will be around 9.45% - comfortably above its target operating range of 8.75% to 9.25%.

How to play

With a unanimous “yes” recommendation from the Board and an expert report from Grant Samuel saying that “the demerger is in the best interests of NAB shareholders”, this deal will be supported.

What to do with your shares? While you won’t need to make a decision until late January (the cut-off date for the share sale facility is 3 February), if you end up with a pesky little shareholding in CYBG worth a few hundred dollars or less, you probably sell and focus on more rewarding investment ideas. However, if you think there might be some upside that comes when the shackles are removed and a new team comes on board, as I do, then hang onto your CYBG shares and see how they go. Perhaps a belated Christmas present, but whether you sell or hold, probably not going to make a huge difference to your portfolio.