Interactive Investor

Stockwatch: does this stock have most to benefit from higher interest rates?

4th November 2022 10:44

Edmond Jackson from interactive investor

If the era of ultra-low interest rates is over, this company represents an enterprising play, argues analyst Edmond Jackson.

Do rising interest rates finally mark a turnaround for Metro Bank (LSE:MTRO), or might the benefits be offset by a long UK recession? 

A recovery case exists for this £143 million small-cap, given that its valuation represents an 81% discount to £742 million of net tangible assets on last June’s balance sheet – versus 10% or so for longer-established banks.  

Founded in 2010, Metro initially did well as a “challenger bank” but ran into over-expansion and accounting issues, such that its stock has plunged from over 4,000p in 2018 and bumped along sub-100p for a couple of years. 

But if the era of ultra-low interest rates is being left behind, Metro represents an enterprising play – despite little prospect of a dividend for some time – relative to the major banks. If the market senses a sustainable return to profitability, the net asset value (NAV) discount should reduce. 

Last Wednesday, the stock initially jumped 15% from 73p after a third-quarter trading update cited profitability – on both a statutory and underlying basis – returning in September, versus previous guidance for the first quarter of 2023. 

We can assume profit was marginal given it was not disclosed, and likely helped by the net interest margin (money earned from loans versus that paid out as interest) rising to over 2%. Otherwise, assets/loans/deposits numbers barely changed.   

Aided also by tight control of costs and risk, the CEO expects Metro’s retail margin to improve further during 2023, assuming the Bank of England continues to raise interest rates to combat inflation.  

The positive change is in context of a £62 million statutory net loss in the first half of 2022 and consensus for nearly £73 million for the full year. 

Metro Bank - financial summary
Year ended 31 Dec

 2015201620172018201920202021
Turnover (£ million)120195294404422434420
Operating profit (£m)-56.8-17.218.740.6-131-311-245
Operating margin (%)-47.3-8.86.410.0-31.0-71.8-58.3
Net profit (£m)-49.2-16.810.827.1-183-302-248
Reported earnings/share (p)-61.3-21.812.628.3-124-175-144
Normalised earnings/share (p)-53.0-17.213.931.6-89.6-122-116
Operating cashflow/share (p)6801,5222,670160-1,1096041,655
Capital expenditure/share (p)99.118619823513563.847.0
Free cashflow/share (p)5811,336 2,471-75.1-1,2445521,608
Cash (£m)282500 2,2122,4722,9892,9933,568
Net debt (£m)280153-2,091-1,879-1,807-1,870-2,542
Net assets (£m)4078051,0971,4031,5831,2891,035
Net assets per share (p)5071,0011,2401,440918748600

Source: historic company REFS and company accounts

Bank sector shares face a relatively novel prospect 

The classic assumption is for interest rates to fall during a downturn, yet monetary policy is tightening versus inflation, and globally too.  

Since the wider economic effects will be felt at least six and more like 12 months away, it is a dilemma for authorities to navigate monetary and fiscal policy, and for investors to decide what exposure they should have to banks. 

Financial stocks tend to lead the market, hence you would sell them early as conditions toughen, and buy in the teeth of a recession.  

This is being altered by rising interest rates, but if they end up overdone then balance sheet write-downs will follow from bad debts, while demand for loans and mortgages falls. 

Metro’s interim results cited retail mortgages are still the largest element of its lending book at 54%, so a slump in the housing market would be significant. Also, given some 90% of mortgages are fixed for two years, it will take some time for the bank to feel the full operating benefit of rising rates, by which time recessionary issues could be of greater concern. 

On the face of it then, Metro remains a high-risk cyclical, but the size of discount to net assets already prices a lot in, and weak sterling could revive foreign takeover interest (like a year ago, by the Carlyle US private equity group). 

Hedge fund positions reflect binary prospects 

Odey Asset Management remains short 3.38% of Metro’s issued equity, having very successfully exploited the 2019 accounting blunders when loans were not risked appropriately (by a previous management). 

Yet the only other short seller disclosed over 0.5% is UBS Asset Management, which trimmed its position 0.09% to 0.53% last September.  

They may stay rewarded by a tough long UK recession, but if we muddle through then the risk/reward profile on bank equities can tilt positively if interest rates stay moderately higher.  

If the market senses a big short position is cornered, causing a short squeeze, then the price will re-rate sharply. As a long-experienced short-seller, Odey should know such a position will need closing before perception shifts, unless his team reckons on a dire recession. 

Interestingly, and in line with my sense for mean-reversion potential here, last Wednesday Kernow Asset Management declared itself over the 3% disclosure threshold with 3.2%. 

This relatively new UK hedge fund manager proclaims on its website: “We capture contrarian alpha from UK equities...by using fundamental analysis coupled with catalyst-driven mean reversion investments...the result is a concentrated and directional portfolio of hidden quality longs and forensic accounting shorts.” 

Kernow now looks as tested: will it continue to buy despite the Bank of England now predicting UK recession to last until late-2024? 

Shifting expectations towards the UK economy 

Showing how futile macro-guessing can be, last January I made a speculative “buy” case for Metro at 96p because Goldman Sachs was projecting 5% UK GDP growth for 2022, and the EY Item Club was even more bullish, expecting 7%. 

Strong household financial reserves accumulated during lockdowns, plus a revival in business investments, would more than offset constraints, these macro analysts said. 

I noted a circa 80% discount to net tangible assets and thought Metro’s downside risk was limited unless a steep recession resulted in bad debts. 

The invasion of Ukraine was a force majeure, exacerbating inflation after Covid supply chain issues and impacting confidence. Thus, UK GDP grew by 2.0% from August 2021 to August 2022, down from 3.1% in July. 

It’s unclear whether the Bank of England will get anywhere near its 2% inflation target without materially higher interest rates, amid high energy prices and a tight labour market. 

But if its governor matches current resolve at the US Federal Reserve, for monetary policy to restore 2% inflation, the Bank is liable to engineer widespread bad debts. 

Metro already cites a £10 million “ECL charge” – a probability-weighted estimate of credit losses – during the third quarter of 2022, despite saying it sees “no deterioration in early warning indicators and no signs of stress or increased delinquency across the customer base”. 

A more positive view is this recession not – so far – being characterised by rising unemployment. People in jobs appear to be getting wage rises and even if not by 10% then possibly inflation will fall below this next year. 

Metro’s third-quarter net loans rose 4% to £12.8 billion, helped by residential mortgages and consumer unsecured lending. This seems likely to ease, however, as the housing market cools and people becoming generally more cautious. 

Three directors bought over £208K worth of equity post-interims 

This amounts to a material “cluster-buy” affirming their belief that Metro’s turnaround is happening despite economic uncertainties. 

At end-July, a non-executive director with a strong background in Irish banking and finance bought £16.1K worth at 80.6p. This was not a post-appointment formality as he had been on Metro’s board for three years. 

Most significantly, he was followed in August by the incoming chief financial officer buying £151.1K worth at 89.9p. His background was some 20 years at Standard Chartered then CFO at ClearBank – a digital bank providing clearing and settlement services to corporate customers – from 2019. 

Another non-executive director then bought £41.1K worth at 82.1p 

Like any broadly cyclical stock, Metro faces risks of economic downturn. Yet its extent of discount to net tangible assets already prices in significant impairment risks, and banks will have the operating benefit of higher interest rates – perhaps for years to come. A case exists at least for a starter position; hence around 80p I retain my stance: Buy. 

Edmond Jackson is a freelance contributor and not a direct employee of interactive investor.

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