Why Challenger Bank Virgin Money Holdings (UK) Plc Could Continue To Trounce Lloyds Banking Group Plc

After acquiring the remnants of struggling Northern Rock, Virgin Money (LSE: VM) has undertaken a turnaround of the failed lender at an impressive pace. Revenues have increased over 200% and pre-tax profits are up a staggering 480% after the 2011 purchase.

Buying these assets offered Virgin the possibility of a dual-pronged path to growing profits by simultaneously increasing the top line and cutting out-of-control costs at a rapid pace. The company has successfully brought its cost-to-income ratio down from 148% in 2011 to 63.6% in 2015, at the same time increasing total assets 54% to £30.2bn.

Going forward, there’s obviously only so much profit growth to be found by cutting costs, but Virgin has some way to go. The company’s return on equity (RoE) improved from 7.4% to 10.9% but a target of mid-teens RoE by 2017 remains in place. However, even current RoE outpaces those of larger rivals such as Barclays and HSBC.

Prospects for top line growth at the challenger bank are also quite impressive. Despite growing both divisions by leaps and bounds, the lender only controls 3.4% of domestic mortgages and 2.5% of the credit card market. While confronting the big four will require more branches, bringing with them higher costs, Virgin’s more streamlined operations and narrow focus are a major competitive advantage.

Looking ahead, Virgin’s price/book ratio of 1.3 suggests that a good deal of future growth is already priced into shares. But, given the low market share in key markets and proven ability to keep expenses low even while growing assets lead me to believe Virgin Money’s best days may lie ahead.

Slow and steady

Lloyds (LSE: LLOY) shares may have underperformed Virgin’s by 40% since the latter went public in 2014, but the City is enthusiastic that the vastly larger bank is on the cusp of turning things around. Much of the positive news surrounding Lloyd’s lately comes from the company’s return to dividend payments last year.

Although these dividends currently only yield 3.1%, analysts are forecasting a large increase this year to 6.1%. These dividends will be the major driver of shareholder returns over the next few years as Lloyd’s prospects for growth aren’t fantastic. The lender already controls roughly 20% of the UK mortgage market, and 25% of domestic current accounts.

So, while Virgin Money could potentially double or triple its market share, that isn’t realistically an option for the massive Lloyds. Given that top-line growth is limited, the company will have to focus on trimming fat to grow profits. However, the company’s RoE is already a fantastic 15% and its cost-to-income ratio is a low 49.3%.

While this high operational efficiency is certainly to be applauded, it means earnings won’t be skyrocketing due to rapid growth or cost-cutting. The good news for investors then is that dividends are already high and have room to continue growing. At the end of the day, the bank may not offer explosive growth but remains a fairly stable bet for risk-averse income investors.

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Ian Pierce has no position in any shares mentioned. The Motley Fool UK has no position in any of the shares mentioned. We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors.