LONDON  - Smaller UK banks look priced for the worst of Brexit. Shares in the upstart lender Virgin Money have fallen below tangible book value despite delivering a 14 percent return on tangible equity last year. Margin pressure and a subdued economy may admittedly lie ahead. But lowly valuations are already implying a steep downturn.

Despite delivering double-digit loan growth and returns, investors appear to have concluded that 2017 was as good as it gets for Virgin Money. Shares have fallen by 6 percent since the annual results on Feb. 27, underperforming the Thomson Reuters UK Banks index. Shareholders were spooked by lower projected mortgage lending and credit card growth, two products which account for 92 percent of revenue.

Higher funding costs could partly explain the jitters. Virgin feasted on cheap money last year under the Bank of England’s shock-absorbing Term Funding Scheme, which ended in February. New lending will now be funded with pricier deposits, meaning lending margins will remain squeezed in spite of higher rates. That’s why management guided lending margins falling to the “lower end” of a 165 to 170 basis point range, compared to the 172 basis points analysts had previously expected.

Yet Virgin’s lowly valuation – the stock trades at only 6 times its 2019 earnings – may also anticipate a steep rise in bad debts, which could be the natural corollary of a disorderly UK departure from the European Union. Imagine the lender hits 2019 revenue forecasts of 736 million pounds – which assumes growth of around 5 percent a year, less than half the rate in 2017 – and operating expenses of 379 million pounds. With a tax rate of 26 percent, bad debt charges would have to more than quadruple from 44 million pounds last year for the bank to trade, like Lloyds Banking Group and Royal Bank of Scotland, on 10 times 2019 earnings.

That’s quite a jump. An economic slump would also hit bigger peers, and both Lloyds and Virgin Money are exposed to slowing mortgage and credit card markets. An investor bet that storm conditions warrant being in a bigger boat is logical. That doesn’t help Virgin Money much.

CONTEXT NEWS

- UK bank Virgin Money reported a 28 percent rise in underlying full-year pre-tax profit on Feb. 27 as it sought to lure customers away from Britain’s Big Five lenders - Lloyds, Royal Bank of Scotland, Barclays, HSBC and Santander UK.

- The British challenger bank said that underlying pre-tax profit rose to 273 million pounds for the year ended Dec. 31, beating analysts’ expectations of 259 million pounds.

- Virgin’s share of the British mortgage market is 3.3 percent. Its gross mortgage lending rose to 8.4 billion pounds in the year and the bank expects to grow mortgage balances at a single digit percentage rate during 2018, helped in part by Britain’s new "open banking" reforms.

- On March 20 Virgin and Aberdeen Standard Investments announced a joint venture to provide asset management services to the lender’s customers. Insurers and asset managers are seeking distribution deals with banks to extend their customer bases.

(Editing by George Hay and Bob Cervi)

© Reuters News 2018