- Takeovers expand balance sheets without straining them
- NatWest poised to free itself and grow
There has been a distinct danger over the past decade that memories of deal-hungry banks pulling off mega-takeovers and challenging for global dominance might have faded into a folk tale of the sector’s former glories.
However, with Barclays (BARC) and building society Nationwide buying Tesco Bank and Virgin Money (VMUK), respectively, the UK’s financial institutions are again finding ways of deploying their excess capital that do not involve sticking strictly to dividends or buybacks.
At the same time, the past 18 months have seen distributions rise notably as the extent of excess capital on banks’ balance sheets became clear. Since the start of 2023, the big four banks have launched £13bn in total share buybacks. NatWest (NWG) alone is generating implied yields of 14 per cent.
Since 2008, banks have not been able to expand their existing balance sheets until they accumulated enough core tier one capital to offset some of the risks those balance sheets were generating. Yet there were ample signs in this results season that the capital-building process has finished and that banks are settling on core tier 1 capital ratios that are slightly lower than they were two years ago.
Banks are cheap
One clue as to why acquisitions have suddenly picked up is that valuations are clearly on the floor. At a sector price/earnings ratio of just five, it has never been cheaper to buy a bank.
To illustrate the point, after running the numbers on Nationwide’s proposed acquisition of Virgin Money, analysts at Jefferies concluded that the offer of £3bn, although a 38 per cent premium to the closing share price, was only 0.6 per cent of its tangible book value based on management projections of a return on tangible equity (RoTE) of 10 per cent.
Under the circumstances, Nationwide could hardly pass up such a deal as it allows the mutual to expand into areas where Virgin had built a solid business, such as unsecured credit lending and corporate banking, which Nationwide intends to rebrand over time. For £3bn in cash, the mutual becomes a full-line lender with the second-biggest mortgage book in the country.
By contrast, Barclays’ £600mn takeover of Tesco Bank was a more modest affair, but fulfils a strategic imperative for the bank to build on the success of its UK-focused retail banking business.
Barclays’ UK retail and wealth management business regularly achieves a RoTE of 19 per cent, whereas the group as a whole struggles to pass 10 per cent, mainly because of the lower returns that the investment banking division is currently generating.
The rise of NatWest?
Whether mergers and acquisitions pick up in banking will greatly depend on how NatWest reacts to its freedom from direct government ownership. Chancellor Jeremy Hunt confirmed in his recent Budget speech that the part of government’s remaining 33 per cent stake in NatWest, which at current market prices is worth £7.3bn, will begin to be sold off in the summer in a retail-investor-focused auction. So far, the government has raised about £14.5bn from selling NatWest shares, plus revenue from dividends that were first paid again in 2020.
However, it would be a stretch of the imagination to suggest that it will make back all of the £46bn that the original bailout of RBS cost. More likely, the taxpayer is looking at a 50 per cent loss. A full stake sale is planned by 2025 at the latest.
Clearly, lifting such a share overhang from the list will be a net benefit for NatWest, and frees it up to potentially change its strategy. Since 2008, the bank has been a net seller of assets, including Direct Line (DLG) insurance, and has shed 90,000 jobs in the process.
On its current trajectory, NatWest is on course to become one of the most profitable banks in the sector this year, with Berenberg forecasting that its return on tangible equity will rise to 13 per cent. What sort of takeovers it might attempt in the near future will depend on whether this dilutes the company’s risk-weighted assets ratio of 13.4 per cent, which is key for determining the security of the balance sheet. Luckily, most institutions have held capital back at that level to comply with regulatory requirements, and a takeover is unlikely to be dilutive.
A bigger deal might prove troublesome given the concentrated nature of the market – the four biggest banks held 64 per cent of personal customer accounts in 2021, according to the Financial Conduct Authority. However, NatWest would most likely focus on bolt-on acquisitions, as these are “unlikely to derail dividends or buybacks”, said Chris Howlett, a financials analyst at Quilter.
Moreover, since 80 per cent of its income is already exposed to interest rates, “anything they buy now should help them diversify, rather than consolidate”, Howlett added.
In short, the banking market is both cheap – at least cheap enough for even noted sceptic Terry Smith to consider investing again – and offers considerable tangible returns. If interest rates hold higher for longer, another tough period in banking’s chequered history might be drawing to a close.
