Metro Bank: Peak Uncertainty
Metro Bank (LON:MTRO) was the first new bank to open in the UK in over 100 years. It is one of the few neobanks that (almost) made it to scale, with $20bn in assets funded predominantly by customer deposits. As I wrote in Xinja’s Pivot, starting a new bank is like “pushing a very large ball of shit up an extremely long hill” which is why, fourteen years on, Metro still hasn’t become consistently profitable.
Metro has made it almost to the top of the hill, but it’s stalled out in the final stretch. Now, it urgently needs to generate additional forward momentum. Without progress the ball will start to roll backwards, with catastrophic consequences (for shareholders).
In 2018, Metro announced that risk weightings were incorrect for part of its lending portfolio. Correcting this caused the bank’s risk weighted assets to increase by £900m and it was forced to raise capital. Shortly afterwards, it failed to launch a bond offering and business customers pulled ~ £200m in deposits. The flamboyant founding chairman stepped down and shortly afterwards, the CEO also left the business. The PRA and the FCA both began investigating the risk weightings mistake. Metro itself began a costly audit of this part of the loan book that has cost circa ~£100m to date.
As to the impact of all this, well…
The stock is down 98% in the last three years. It has a market capitalisation of ~£160m and trades at 0.2x book value while the rest of the industry is on 0.6x. There is significant intangible value in the branch network and brand. Even so, the equity is clearly impaired.
A new CEO with experience in banking turnarounds, Daniel Frumkin, was appointed. He has been affiliated with private equity firm Carlyle portfolio companies before, and Carlyle made a takeover bid at an undisclosed price for Metro in early November. The talks fell through for undisclosed reasons (my guess is they couldn’t agree on price).
The problem is that Metro is essentially sub-scale. It has a high fixed cost base (cost to income ratio in 2020 was 143%) and doesn’t have enough funding to hugely expand the branch network. Raising money is hard because the equity is close to worthless, and the business is unprofitable. One solution is to grow the loan book, but that’s not easy because it is capital constrained and losses eat into its capital every year.
Metro could cut staff and close branches. But, there are leases, and the business is deposit funded at an extremely low cost (~30bps and falling) which would have to be replaced. Closing branches and firing staff also hurts the Metro culture and the community bank, people-to-people approach the company is famous for. Metro’s been ranked as the best consumer bank in the UK for >6 years running and has traded off first and second in SME lending over the same period.
It is an extremely tight spot to be in. The sole cure is operational excellence.
Perhaps the most fascinating part of this whole saga is that a new leadership team came in, looked at the bank and decided that actually, yep, the existing strategy and culture are great and they work and we’re going to adopt it pen and paper clips.
Given rapid historical growth in core lending from 2014-2019, Metro had neglected to add a lot of ancillary products like insurance and personal/auto loans to its stable. Consequently, it wasn’t getting a proper level of revenue per customer or employee, or a proper return on the balance sheet, and was thus unprofitable.
Management determined that the path forward (see FY19 AR, Transcript FY19) was to optimise the balance sheet, compete on loans rather than deposits and create new products. Essentially; to grow the way out of purgatory rather than cutting costs to survive. Notably there were no layoffs as part of this change.
The new CEO has done all of the right things, and a few that are downright genius.
- Closed the main company headquarters & downsized
- Bought several discounted branch properties during the Covid crash for close to the IRU asset on the balance sheet, removing years of rent expense with minimal capital impact
- Bought Ratesetter, closed the p2p lending and used the brand recognition to put high yield personal loans through the branch network (MTRO is already greatly exceeding Ratesetter’s monthly volumes pre acquisition)
- Added new high-yield lending products (personal loans, overdraft/credit cards, specialty mortgages)
- Adding new fee-generating products (insurance & pet insurance through partnership with a specialist insurer)
- Sold a lower yielding part of the mortgage book at a modest profit and now sitting on $3bn in liquidity which provides optionality
Metro is also progressing an AIRB application that will give it some latitude in measuring its risk. I assume the intention behind this & the drive into specialist mortgages is to take some pressure off on the capital requirements front. I find it remarkable, the idea that the PRA will approve an AIRB approach when the subtext is presumably “we are capital constrained, let us measure our own capital requirements so we can hold less capital” but if that is the plan it is very, very clever.
Progress So Far
The proof is in the pudding. Yields on risk weighted assets have risen from 6% to ~7.9% in ~18 months. Cost of funding is down significantly and 6% of the portfolio is now in high-yield personal loans.
“Run the bank” cost growth has been contained to 2% on a like-for-like basis and management is transitioning the portfolio towards higher risk & higher yield lending. Lending yield has risen 90bps over the past 18 months and will probably rise a little further.
It’s a fine tightrope to walk because incremental lending growth requires capital, which Metro doesn’t have a lot of. The company has said repeatedly that it will dip into its capital buffer later this year and intends to operate there for a time. Consensus (judging by analyst commentary on calls) appears to be that the PRA will not let a bank operate within the buffer and Metro will need to raise capital. However, Metro has operated inside its buffer before for a short period last year, and management appears confident it will be able to do so again. CEO Frumkin’s view is that the excessive amounts of liquidity on the balance sheet may give the company the tiniest bit of extra leeway with the PRA.
Whatever the case may be, this is a critical coin toss with an unknowable outcome. It could go either way, and a need for capital could easily lead to an emergency sale of the company.
Looking beyond that, management is working to generate additional fee income. Branch activity is still 20% below pre-covid levels and several types of fee income (like forex) fell during Covid. These should recover over time and the introduction of insurance products to the customer base for the first time should have a significant positive impact.
These are the last year’s worth of numbers for Metro:
£367m in revenue, £421m in run the bank costs, £115m in “change the bank” costs, £15m in credit losses, ~£50m a year in remediation expenses, and a total loss of ~£200m.
The Path Forwards
There are a bunch of moving parts here. It’s difficult to model because the next two years are critical yet so much depends on the timing of expenses and new initiatives. Here is a quick overview:
- Change the bank spend is frontloaded and mostly complete; this will decrease over the next ~12 months (management will stop reporting it separately from next year) and should drop essentially to zero.
- Future investment should typically be via opex as there will be minimal branch opening in foreseeable future
- Remediation expenses should start to decline this half although there is some uncertainty. My expectation is that these will drop to zero after 18 months.
Once those expenses drop off the radar (and we know Metro can fund them because of its excess liquidity), the revenue hole is somewhere around £100m. If Metro can get to £460m in revenue, it should be essentially break-even and capital neutral. If it can generate £500m in revenue it should be decently profitable (although ROE will remain low). The first event could cause the stock to re-rate, and will likely make it much more attractive to bidders who don’t need to take on the fixer-upper work and costs. There are a few levers that can be pulled to get there:
- Recovery of fee income to pre-covid levels, (adjusting for new customers added in FY20-21 (~£15-20m))
- Fee income from insurance products introduced to 2.4m customer base (unknown, perhaps £5-10m although conceivably much larger)
- Revenue improvement from new loans written as older, higher weighted loans roll off (hard to say, maybe £5m this year and potential for £20-40m by 2023 depending on balance sheet reshuffling)
- NIMs improvement from repricing deposit base and shifting lending mix to higher yield credit (hard to say, maybe 5bps this year [£10m] and 10-20bps over the next couple [another ~£10-20m]
- Deploy say £2.5bn of excess liquidity (management prefers to keep this un-deployed given macro uncertainty, but for illustration the £3bn disposed mortgage portfolio generated ~£60m p.a.. Deployment of this partly depends on how much of TFS was repaid vs deposit growth & growth in TFSME, so I’d say potential for ~20-50m per annum uplift. )
- Post-remediation, sell remediated portfolio of assets (which has a 100% risk weighting despite good credit quality) to free up capital. There are other assets on the B/S that are “hugely capitally-inefficient” that could also be sold and that capital redeployed.
- Add new customers (via marketing, being added to aggregator channels for the first time, instant-quote API rollout, and two more stores [~3% increase in footprint] – unknown, but footprint would suggest ~£5m ish). Metro is closing in on same-day credit decisions which is still very unusual in the banking world.
- Full-year impact from already implemented initiatives (hard to say; definitely >0, but I’ve assigned no value to this)
- Reduction in rent expense from purchased buildings (probably fairly trivial in the scheme of things – maybe £0.5m but I have assigned no value to this)
Note: I’ve deliberately not shared the root assumptions here because they are almost certainly specifically wrong. For example NIMs improvement – does cost of deposits fall to 28bps? 27? Does the personal credit part of the book grow to 10%? 12%? 80% of new loans are specialty mortgages, how many of those are 90% LTV, how many are professional BTL, how many are to the self-employed, how long does that continue and how large a part of the book does that come to? What’s the weighted average yield uplift – 50 bps? 55? What’s the incremental cost of risk on those? etc. The correct question to ask here (in my view) is: “Is it plausible that Metro can get X uplift in Y domain through a combination of actions A,B,C.” Is it reasonable to assume that MTRO can get a £20m uplift to interest income through NIMs repricing and mix shift?
So, through a combination of new products and initiatives within the existing book, Metro is attempting to chart a path towards profitability. Launching new products will require incremental costs, certainly. But they should be very profitable income streams because all that’s required is a few staff to run them, and those products will be distributed across a very large existing base. There should be minimal additional costs to the mix shifting & new loans.
My guess at the maths says that Metro has a £100m gap that needs to be filled – call it £110m after growth opex – to breakeven, and another £33m after that to be what I call “comfortably profitable”, or Healthy Profit on the charts below.
That doesn’t get it to a 15% ROE or anything flash – more like a 3% ROE – but it could be around £40-60m in annual profit before tax. For context, management is targeting a 8.5% return on tangible equity by 2024. I don’t think the precise RoTE calculation has ever been disclosed but making some guesses based on the balance sheet gets us roughly to the same ballpark, if not a little higher.
“New investment spend is key to the delivery of the strategy and you’ll see that we are forecasting
between now and 2024, between £250 million and £300 million of change opex in the plan. This will
be front end loaded. The first two years will probably account for just over 50% of that spend and
every year will be lower than the last. It’s just the way you need to think about how that change opex
is going to come through the plan.”Transcript 2019 (page 8)
In the above model, Metro is still unprofitable by the end of its transformation. However, no credit is given to unknowns like customer growth at existing branches, and further new product initiatives (e.g. auto loans) whereas we know in reality that Metro is still growing customers at a good clip and is proactive in creating new products.
In many of these examples the upside could potentially be a lot larger. You should be able to make more than £5m in insurance fee income from 2.4m customers. When deploying liquidity, management may be able to get higher yields, as the disposed mortgages were among the lowest yielding in the book. So here is an optimistic scenario:
Again I’ve avoided specific time frames because all of this will straddle financial years, but these changes should happen in the next eighteen months or so and have a full year impact in the year after that. I see the company breaking even on an underlying run rate in 2023, which roughly lines up with management’s forecast of actual breakeven in FY 2024.
The bottom line:
What you can clearly see from the models is that Metro Bank is at peak uncertainty. There is a lack of clarity around the timing, size, and profitability of all of the new initiatives, as well as the deployment of capital, capital adequacy, and finalisation of remediation and balance sheet restructuring. None of these things lend themselves well to being modelled which is why the above charts are basically conceptual in nature.
All of this explains why the bank trades at such a depressed valuation. ~£160m is completely the wrong price for an established bank with an outstanding brand & reputation, 77 branches, £20bn in assets and £1.2bn in book value, but there are very good reasons for the discount. I haven’t even bothered talking about the risks of moving into higher yielding credit & generating rapid growth in new credit products.
It must be said; I don’t think Metro Bank is can be owned by the average investor here. The upside is fairly limited (say 3x in the next few years), the risk of loss is severe, and you will have an opportunity to wait and buy once more information presents itself. New information will greatly reduce uncertainty and reveal much about the path forwards. If Metro reaches breakeven without raising capital it will be the most remarkable turnaround I’ve ever seen – proper hall of fame stuff. I think it will get there; but it is a hard company to own.
The second half result this year will be critical for showing the results of its initiatives to date. Visible progress on these will make it significantly easier for the path forwards to be modelled. Management has indicated it will return to providing guidance either at this result or at the first half next year. These two things combined should greatly reduce uncertainty, and make it easier to see the path forwards.
Food for thought.
I hold a small number of shares in Metro Bank. I am watching for an opportunity to add significantly to these but much depends on the uncertainty in business progress I have highlighted. Readers should not expect any disclosure of when or if I make additional trades in the stock. This is a disclosure and not a recommendation.