XYZ Group Plc. September 17, 2014
Neutral (Initiation) Moody’s: A3 (Negative) S&P: - A- (Negative) Fitch: A (Stable) Investment Case XYZ Plc, one of UK’s largest banks, is a dominant player in the retail and commercial banking market. XYZ’s outlook reflects its resilient earnings performance owing to proactive cost management and low impairment charges, improved asset quality, solid liquidity and improved funding profile. The Group’s diverse revenue profile enables it to stabilize overall performance as volatile contributions from its Investment Banking (IB) business are mirrored by predictable earnings from other business segments. The operating profile, however, continues to be affected by increased provisions towards legacy issues such as the Payment Protection Scheme and other conduct & litigation expenses. With large restructuring undertaken by the Group that aims at focusing on core operations, reliance on the IB business is expected to decline, with the management aiming to reduce exposure to no more than 30% of RWAs by 2016. However, one needs to have a very cautious approach on XYZ’s progress in the medium term as the management team is unproven in the light of the restructuring plan (spanning over 2-3 years) in terms of delivering returns and the possibility of further changes to its IB franchise remains in the wake of regulatory developments. While capital position and leverage have improved to meet stringent Basel 3 norms and the leverage ratio set by the Prudential Regulatory Authority (PRA) on the back of the Transform Plan, the Group still lags compared to peers. Sovereign exposures to the PIIGS economies have reduced significantly and remain manageable, but net derivative and risky credit exposures remain high and pose a threat in the event of any deterioration in capital markets. Other generic concerns involve impending risks from regulations in the UK such as the ring-fencing proposal, Scottish referendum, increased uncertainty related to litigation risks and challenging macroeconomic environment.
Risks Risks to the central case scenario include inability to meet targets as per its 2016 business plan and execution risk of the restructuring plan, headwinds from the UK’s regulatory environment and negative implications from increased litigation expenses.
Operating Profile XYZ is a major global financial services provider engaged in personal banking, credit cards, corporate and investment banking and wealth and investment management with an extensive international presence in Europe, the US, Africa and Asia. XYZ’s PBT increased by 49.1% y/y to £2.5bn in H1’14 (H1’13: £1.7bn), reflecting improved performance across majority of the businesses, partly offset by reduction in IB profit. However, PBT after adjusting for own credit gains of £52mn and PPI provisions of £900mn, declined by 6.7% y/y to £3.3bn. Adjusted total income declined by 11.5% to £13.3bn mainly impacted by lower trading income which fell by 43.7% to £2.6bn as well as lower fee income (-3.2% y/y) and lower investment income (-14.6% y/y). Total income was positively impacted by higher NII which witnessed 9.1% increase to £6.1bn. Adjusted operating expenses declined by 9.2% y/y including £494mn of costs incurred towards the Transform Plan implementation and litigation and conduct charges of £211mn, reflecting savings on the Transform Plan and favourable currency movements. C/I ratio stood at 67% (H1’13: 65%). Impairment charges improved significantly to £1.1bn, down 33.4% y/y reflecting the positive impact of improving economic environment on majority of retail and wholesale portfolios in the UK and lower impairment charges in Africa Banking mortgages. Segmental Performance: In May’14, XYZ reorganised its segments into Core business and Non-Core business. A) Core Business: PBT declined by 9.9% y/y to £3.8bn on the back of 6.3% y/y decline in total income due to lower performance in the IB business, supported by lower impairment charges (-12.8% y/y) and operating expenses (-4.6% y/y). o Personal & Corporate Banking (PCB) business comprises personal banking, mortgages, wealth & investment management and corporate banking. The segments witnessed 22.6% y/y increase in PBT to £1.5bn in H1’14 on the back of higher NII (+6.9% y/y to £3.1bn) driven by strong savings and mortgage growth and lower impairment charges (-23.0% y/y) and decline in operating expenses (-6.2% y/y). o XYZ‘s PBT witnessed 24.0% y/y increase, mainly driven by higher total income and lower operating expenses. Total income increased by 5.2% y/y to £2.1bn, driven by improved performance in the UK card portfolios backed by continued net lending growth as well as higher customer asset balances in the US and Germany. Impairment charges remained stable at £537mn. o Africa Banking business is managed under three primary businesses – Retail & Business Banking (RBB), Wealth, Investment Management & Insurance (WIMI) and Corporate & Investment Banking (CIB). The division witnessed 13.7% y/y decline in its total income to £1.7bn which led to 11.5% decline in PBT, partly offset by lower expenses and impairment charges. o IB business continues to be the largest contributor to the Group’s revenues. In H1’14, PBT declined by 45.8% y/y to £1.1bn as total income declined by 18.5% to £4.3bn as markets income decreased by 16% due to decline in FICC revenues and lower performance in equities (-16%), supported by £26mn of impairment recovery, albeit lower than £38mn released in H1’13; and 2.5% improvement in operating expenses. B) Non-Core Business: The Group comprises assets and businesses that are unfit to XYZ’s strategy under three broad categories – businesses including all of Europe Retail, securities and loans including IB portfolio assets and UK corporate long term loan portfolio and derivatives including the pre-CRD IV rates portfolio. Total income more than halved to £658mn in H1’14 from £1.5bn in H1’13 as income across all the categories declined on the back of reduced retail income, asset disposals and risk reductions. Loss before tax improved to £491mn from £673mn in H1’13 on the back of lower operating expenses and improvement in impairment charge. Asset quality expressed through the CRL (credit risk loans) coverage ratios decreased to 54.0% (2013: 54.6%) reflecting a modest decrease in the ratio for wholesale portfolios while retail portfolios remained flat. Non-performing customer loan ratio decreased to 2.6% at H1’14 from 2.8% at 2013 end and 3.5% at 2012 end. XYZ’s robust asset quality is further demonstrated by the bank's improved LTVs on the back of house price appreciation in the UK and South Africa that led to balances with >100% LTV decline to £910mn in the UK and £442mn in South Africa as compared to £1.6bn and £540mn, respectively in Dec’13. At Jun’14 end, the bank's £125bn UK mortgage book had an average LTV of 42%, lower than peers, and its exposure to UK commercial real estate - £11bn at 2013 end, while vulnerable to further impairments, is a smaller proportion of its Group loan book than some of its peers (around 2%). Global property and construction exposures accounted at cost were stable at £24bn representing ~ 37% of shareholders' equity.
XYZ Group Plc.
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Financial Profile The Group has made good progress on key balance sheet metrics, albeit the capital position still remains lower than most peers. On a fully loaded basis, the Group’s common equity tier 1 ratio increased by 80bps to 9.9% (Dec’13: 9.1%) while tier 1 ratio and total capital stood at 11.0% and 15.0%, respectively. The increase is mainly supported by 7.1% decline in RWAs and capital accretive earnings of £0.5bn (adjusted for dividend payments). RWAs at H1’14 end stood at £411.0bn (£442.5bn) driven by business activity risk reductions. On transitional basis, the Group’s common equity tier 1 ratio increased by 70bps to 9.8% (9.1%) and tier 1 ratio increased to 12.7% (11.3%). Total capital ratio stood at 16.0% (15.0%). XYZ issued fixed rate resetting perpetual subordinated contingent convertible securities (AT1 compliant) as part of an exchange of £1.5bn preference shares and £0.6bn Tier 1 notes and Reserve capital instruments. Loan to Deposit Ratio stood at 92% (Dec’13: 91%). At the end of H1’14, wholesale funding declined to £179bn (£186bn) of which 48.0% matures in less than one year while the average maturity is >80 months (excl wholesale funding of liquidity pool). The Group issues ~£15bn of term funding in H1’2014 of which £6bn were raised through participation in the BoE’s FLS Scheme. Term funding maturities for the remainder of 2014 amount to £12bn (total for 2014: £24bn; for 2015: £24bn). XYZ reported liquidity pool of £134bn (2013: £127bn) comprising mainly of cash and deposits with central bank (31%) and Government bonds (52%). XYZ’s Liquidity Coverage Ratio was 107% (as per CRD IV rules) at the end of H1’14 equivalent to a surplus of £9bn vs. 96% and shortfall of £6bn at 2013 end. Net Stable Funding Ratio stood at 98% (2013: 95%). XYZ’s net balance sheet exposure to the GIIPS nations and Cyprus declined 10.6% to £47.4bn in H1’14 (€53.0bn) due to lower financial institutions exposure on the back of loan repayments and decline in residential mortgage exposure due to lower volumes of new lending. The exposure includes £29.3bn towards mortgages and £5.0bn towards other retail loans. Corporate exposure stood at £6.3bn, sovereign at £2.3bn and financial institutions at £4.5bn as of Jun’14. The maximum government bond exposure was in Italy at £1.9bn while government debt exposure in the other economies remained very manageable at £371mn only. XYZ announced the disposal of the majority of its Spanish assets at Aug’14 end to CaixaBank for £623mn which is a further positive development. XYZ announced its interim dividend of 1.0p per share for Q2’14 (H1’13: 1.0p per share) bringing the total dividend for H1’2014 to 2.0p per share. This remains very low given its historical standards.
Management Strategy XYZ has undergone significant changes in the past 24 months with respect to business practices and culture, elements of business profiles including management changes in addition to strategy implementation and restructuring. In line with the same, in May’14, the management reorganised the Group into a simpler and more focused and balanced structure. o IB business to be appropriately sized for the Group as a whole utilising no more than 30% of RWAs and £400bn of leverage exposure o A non-core unit was created to focus on accelerated exit from strategically un-fit businesses as well as creation of a new integrated personal & corporate banking business segment o Capital to be reallocated towards the growth businesses o Reduce cost base with a target for core costs of <£14.5bn XYZ in its Transform Plan set out clear financial commitments to be achieved by 2016, which include: o to deliver RoE in its core business in excess of 12.0% while estimated drag on the RoE from the non-core business is estimated to be less than 3.0% o to achieve total cost base reduction to £16.3bn in 2015, including interim cost estimates of £17.0bn in 2014, thereby delivering a Group cost to income ratio in the mid 50s. Further reduction of cost base to less than £14.5bn by 2016 o common equity tier 1 ratio of 11.0% on a fully loaded basis o progressive dividend policy, targeting a payout ratio of 45-50% over time albeit expected to remain at 40% until the Group reached its 10.5% core equity tier 1 ratio by 2015 XYZ’s bottom line, however, continues to be affected by legacy issues related to the PPI and other litigation expenses. XYZ has been investing its huge liquidity pool in certain select government bonds to improve the liquidity portfolio yield. The PRA, in Jun’13, indicated that, by 2013 end, major UK banks and building societies should hold capital resources equivalent to at least 7% of RWAs and meet the leverage ratio, after adjustments, of no less than 3% by the end of Jun’14. XYZ’s leverage ratio at the end of H1’14 stood at 3.4%, reflecting reduction in PRA leverage exposure of £99.0bn to £1.3tn and increase in eligible PRA adjusted Tier 1 capital to £43.2bn on the back of exchange of existing T1 instruments into £2.3bn new AT1 securities. The Group remains on track towards 2016 target of >4.0%. With the European authorities taking steps to increase the resolvability of banks and requiring creditors rather than taxpayers to bear the burden of the costs of failure, potential extraordinary government support for European banks will likely decrease going forward and also lead to ratings downgrade by credit rating agencies. From Jan’16, however, the EU Bank Recovery and Resolution Directive (BRRD) is set to introduce the mandatory bail-in of a minimum amount of eligible liabilities, potentially including certain senior unsecured obligations, before governments could provide solvency support.
SWOT Analysis Strengths/ Opportunities XYZ’s position as an established leader in the UK banking sector is underpinned by its leading position in its core markets (10-15% market share in retail products and 15-20% in commercial and corporate banking) and a well diversified revenue base by business and geography. In addition, the Group boasts of higher likelihood of support from the UK Government considering its high systemic importance in the UK. Change in the Group’s structure is credit positive. Greater focus upon its typically more predictable retail and commercial banking activities could potentially be a positive development for the Group’s business position assessment in the medium-term, given the Group’s aim to shrink its IB arm to no more than 30% of RWAs from the 50% levels at 2013 end. XYZ’s strong operating profile is reflected in its resilient earnings performance despite difficult economic and market conditions with impressive results under its Core business operations as well as controlled costs and low impairment charges. Credit impairment charges have gradually reduced (£1.1bn in H1’14 vs. £8.1bn in 2009) reflecting improvements across business, notably in XYZ non-core business, Africa Banking and PCB. XYZ’s funding profile remains strong with high quality liquid assets totalling £134bn and its loan to deposit ratio at 92% with a strong deposit base. All of the business segments except IB activities are largely funded by customer deposits with the balance covered by funding secured against customer loans and advances. XYZ’s capital position has been steadily improving with common equity tier 1 ratio of 9.9% largely owing to organic growth and close management of the balance sheet. In line with its plan, XYZ has been successful to increase its leverage ratio above 3% by Jun’14 which now stood at 3.4%. XYZ has been reducing its exposure to the euro zone periphery countries (£47.4bn). The Group continues to reduce local funding mismatches in order to mitigate redenomination risks. Weaknesses/ Threats While the Group has undergone significant restructuring, dependence on the IB segment still remains high (albeit reduced) at 31.8% of Group income and ~30.5% of Group RWAs at H1’14 end, exposing Group earnings to market volatility on the back of low interest rates and extended period of quantitative easing in addition to the execution of the Transform Plan on the back of legacy issues related to PPI redressal. XYZ’s gross derivative asset exposure of ~£332bn in a balance sheet of £1.3tr, though declining, remains high and could be a drag if markets were to face the postLehman sort of systemic risk in future. XYZ will have to price its products higher particularly in the UK to keep its NIM margins intact given the high cost of funding now and in future (post ring fencing). XYZ, like other large UK banks, faces the challenge to adapt its business model to the changing regulatory environment. Regulatory reforms like Basel III, PRA’s leverage ratio, retail ring fencing (XYZ’s estimated cost to be ~£1bn) and UK bank and FSCS Levies continue to impact bank earnings and put pressure on the UK banking sector. Uncertainty related to the outcome of the Scottish referendum is nevertheless credit negative for XYZ. The short-term risks following an affirmative referendum outcome are mainly liquidity, funding and operational risks, which while largely mitigated, longer-term risks related to impact on the bank’s operating profile due to lack of clarity on the adoption of currency still persist
XYZ Group Plc.
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Financials
£ mn; YE December 31 Net Revenues Net Interest income NIM margins PBT Pre-tax Margin Expense Ratio Deposits / (Deposits+Debt) Transitional Common Equity Tier 1 Ratio Transitional Tier 1 Ratio Transitional Total Capital Ratio
2010 31,708.0 12,523.0 1.3%
2011 32,292.0 12,201.0 1.2%
2012 25,009.0 11,654.0 1.2%
2013 27,935.0 11,600.0 1.3%
H1’2013 15,157.0 5,577.0 1.1%
H1’2014 13,384.0 6,082.0 1.3%
LTM’2014 27,392.0 11,102.0 1.1%
6,065.0 19.1% 58.3% 50.8% -
5,770.0 17.9% 56.4% 55.8% -
797.0 3.2% 69.8% 54.7% -
2,868.0 10.3% 67.2% 61.3% 9.1% 11.3% 15.0%
1,677.0 11.1% 64.5% 58.3% -
2,501.0 18.7% 66.3% 64.6% 9.8% 12.7% 16.0%
1,603.0 5.9% 64.7% 64.6% 9.8% 12.7% 16.0%
Segmental Analysis £ mn; YE December 31
2013 Revenue
Core Personal & Corporate Banking
PBT
H1'2013 %
Revenue
LTM’2014
H1'2014
PBT
%
Revenue
PBT
%
Revenue
PBT
%
8,102.0
2,233.0
27.6%
4,006.0
1,197.0
29.9%
4,131.0
1,468.0
35.5%
8,227.0
2,504.0
30.4%
Credit Card
3,007.0
1,183.0
39.3%
1,479.0
616.0
41.6%
1,587.0
764.0
48.1%
3,115.0
1,331.0
42.7%
Africa Banking
3,560.0
1,049.0
29.5%
1,781.0
547.0
30.7%
1,577.0
484.0
30.7%
3,356.0
986.0
29.4%
Investment Bank
8,877.0
2,279.0
25.7%
5,260.0
1,951.0
37.1%
4,283.0
1,058.0
24.7%
7,900.0
1,386.0
17.5%
NM
159.0
66.0
41.5%
308.0
98.0
31.8%
34.1%
11,737.0
3,840.0
32.7%
22,906.0
NM
509.0
NM
984.0
Head Office Total Non-Core
145.0
(15.0)
23,691.0
6,729.0
1,393.0
(1,562.0)
NM
(4.0)
28.4%
12,522.0
NM
918.0
(47.0) 4,264.0 (673.0)
(491.0)
6,305.0 (1,380.0)
27.5% NM
Asset Quality H1’2014
2013 £ mn; YE December 31 Retail Banking (Core) Retail Banking (Non-Core) Total Group Retail Wholesale Banking (Core) Wholesale Banking (Non-Core) Total Group Wholesale Total Group
Credit Risk Loans 5,449.0 2,118.0 7,567.0 2,583.0 3,148.0 5,731.0 13,298.0
Provision 3,516.0 856.0 4,372.0 1,053.0 1,833.0 2,886.0 7,258.0
Coverage Credit Risk Loans 64.5% 5,429.0 40.4% 2,233.0 57.8% 7,662.0 40.8% 2,528.0 58.2% 2,705.0 50.4% 5,233.0 54.6% 12,895.0
Provision 3,609.0 823.0 4,432.0 905.0 1,629.0 2,534.0 6,966.0
Coverage 66.5% 36.9% 57.8% 35.8% 60.2% 48.4% 54.0%
Income Statement Metrics
£ mn; YE December 31 Net Revenues Net Interest income Fee income Trading income PBT Pre-tax Margin Pre-tax Margin before credit losses Expense Ratio NIM margins ROAA ROAE
XYZ Group Plc.
2010 31,708.0 12,523.0 8,871.0 8,078.0 6,065.0 19.1% 37.0% 58.3% 1.3% 0.3% 7.5%
2011 32,292.0 12,201.0 8,622.0 7,660.0 5,770.0 17.9% 35.2% 56.4% 1.2% 0.3% 6.2%
2012 25,009.0 11,654.0 8,536.0 3,347.0 797.0 3.2% 16.5% 69.8% 1.2% 0.0% 0.3%
2013 27,935.0 11,600.0 8,731.0 6,553.0 2,868.0 10.3% 21.3% 67.2% 1.3% 0.1% 2.1%
H1’2013 15,157.0 5,577.0 4,396.0 4,574.0 1,677.0 11.1% 21.8% 64.5% 1.1% 0.1% 3.6%
H1’2014 13,384.0 6,082.0 4,256.0 2,575.0 2,501.0 18.7% 26.8% 66.3% 1.3% 0.2% 5.1%
LTM’2014 27,392.0 11,102.0 8,702.0 6,312.0 1,603.0 5.9% 17.8% 64.7% 1.1% 0.0% 1.2%
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Balance Sheet Metrics
£ mn; YE December 31 Average loans Average interest earning assets Average deposits Average interest earning deposits Earning Assets/Interest bearing liab Average Loans/ Average Deposits Tangible Assets/Total Assets Trading Assets/Total Earning Assets Cash & cash equivalents / Total Assets
2010 2011 424,083.0 429,938.0 990,637.0 1,021,085.0 334,109.0 355,910.0 796,897.0 826,733.0 1.2x 1.2x 1.3x 1.2x 99.2% 99.3% 20.4% 19.6% 6.6% 6.9%
2012 426,733.0 996,556.0 375,469.0 786,352.0 1.3x 1.1x 99.2% 40.2% 5.8%
2013 H1’2013 427,159.0 461,403.0 898,435.0 1,021,685.0 393,157.0 434,267.0 806,981.0 904,890.0 1.1x 1.1x 1.1x 1.1x 99.0% 99.2% 20.3% 20.2% 3.5% 4.7%
H1’2014 456,306.0 943,549.0 451,951.0 854,914.0 1.1x 1.0x 99.1% 19.4% 3.3%
H1’2013 58.3% 15.4x 3.9x 2.2x 11.1% 13.5% 17.4%
H1’2014 64.6% 12.0x 4.7x 9.9% 9.8% 12.7% 16.0% 3.4x -
Capital Structure Ratios
YE December 31 Deposits / (Deposits+Debt) (Deposits+Debt) / Shareholders' equity Tangible Assets/Total Debt Equity tier 1 ratio (Fully Loaded) Transitional Equity Tier 1 Ratio Transitional Tier 1 Ratio Transitional Total Capital Ratio Adjusted Leverage Ratio Equity tier 1 ratio Tier 1 Ratio Total Capital Ratio
XYZ Group Plc.
2010 50.8% 13.4x 3.6x 10.8% 13.5% 16.9%
2011 55.8% 13.0x 4.3x 11.0% 12.9% 16.4%
2012 54.7% 13.3x 4.1x 10.8% 13.3% 17.0%
2013 61.3% 12.3x 4.3x 9.1% 9.1% 11.3% 15.0% 3.0x 13.2% 15.7% 19.9%
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