A view on Lloyds Banking Group

Thursday, 22nd October 2015 10:50 - by David Harbage

This article is one in a series, written in response to a request from readers, taking a look at big companies in the news – with the first being Lloyds Banking Group, which has captured more than its fair share of media headlines over the past few years.

In addition to the black horse banking brand, the group includes the Halifax (ex-Building Society), Bank of Scotland and the Scottish Widows insurance business – but now excludes the TSB, post its recent EU-forced disposal. Following the government’s bailout of Lloyds (and the Royal Bank of Scotland) in the financial crisis of 2009, the company has re-engineered its balance sheet (notably by reference to debt structure), shrunk its assets and liabilities, and HM Government’s equity stake has reduced to less than 13%.

After growing ‘like Topsy’ in the first decade of the new millennium (and typically by acquisition), Lloyds management have progressed a strong focus on cutting costs and achieving a reasonable return on capital against a backdrop of difficult economic (including a domestic recession) and market conditions. The latter featured local and European regulators – who had been caught out by the financial collapse of a number of leading financial institutions – demanding higher levels of capital adequacy of its banks. Such higher reserves inhibited banks’ ability to lend (jeopardising normal economic ‘bounce back’ behaviour, post a recession) which prolonged the downturn. Claims of bad behaviour and miss-selling, featuring payment protection insurance (PPI), over the past five years has taken a hefty toll – both financially, to the tune of £13.4 billion in provisions, and in terms of reputation – and remains a significant headwind.     

The half year to 30 June 2015 trading results, announced on 31 July, evidenced the best and worst aspects of Lloyds. An improving UK economy encouraged healthy demand from both personal consumers and business customers for the bank’s offering, evidenced by achieving 1 in 4 of all mortgages granted to first-time house buyers and finance for 1 in 5 of new business start-ups. Net interest margin (the difference between interest charged on loans, as compared to that allowed on deposits) continued its steady expansion to 2.62% - ahead of management’s own guidance. Driven by a 75% fall in the impairment charge to £179m, asset quality improved further (to 0.09%) and return on equity progressed from 14% in the first half of June 2014 to 16.2%. Underlying profit was 15% higher at £4.383 billion, but a £660 million exceptional charge in respect of the TSB sale and a further exceptional £1.4 billion provision for PPI (new and reassessment of previous claims) took the shine off the fundamental trading performance. Post the departure of TSB and other asset shrinkage, tangible net asset worth per share slipped from 54.9 pence to 53.5 pence per share. Following restoration of the dividend for 2014, an interim dividend of 0.75 pence has been declared and the board reiterated its intention of hiking the pay-out (from normal or sustainable earnings) to 50%.  

In terms of the immediate prospects for its core divisions, a ‘curate’s egg’ of tough conditions in the corporate sector and a more benign outlook for the personal consumer emerges. Lloyds is a significant player in the domestic Small & Medium Enterprise (SME) segment, and the middle company size segment – both of which are struggling to register any absolute growth – but, in the absence of a notable investment or merchant bank, possesses only a small share of the large multinationals’ business. More encouragingly, Lloyds have enjoyed 17% loan growth in consumer finance – with 34% growth in motor finance (in part, ironically, propelled by the proceeds of PPI claims) – and its insurance arm is a leader in corporate pensions. Helped by the introduction of compulsory workplace pensions, Scottish Widows’ assets under management rose from £27 billion to £28.4 billion over the past year.

The balance sheet, and associated financial ratios, continues to improve and should satisfy ever tougher UK and European regulators. The most frequently cited, common equity Tier 1 ratio is currently a healthy 13.3% and, unlike some of its banking peers, Lloyds has an uncontroversial business profile (no further call for separation or break-up of its subsidiaries). Having said that, there is undoubtedly a harsher wind of sentiment and set of rules governing the industry – driven by the media, politicians and the regulators themselves – which has seen the level of protection offered to consumers (and small businesses) rise, at the expense of the product providers. Beyond miss-selling of products, incidence of unethical behaviour – for example in the setting of interest rates - is being punished more aggressively by regulators; increasingly, the resultant fines have reflected the deep pockets of the employer rather than the misdemeanour itself. Leading fund managers, such as Neil Woodford, have cited this ‘fine inflation’ (often US-led) as being a prime reason to avoid investment in the banking sector. Relative to some of its more global competitors, such as Barclays or HSBC, Lloyds can feel more comfortable – but not complacent – in this regard.             

Essentially, in the year that Lloyds celebrates its 250^th anniversary and Scottish Widows its 200^th, this company represents a core play on the domestic economy – unlike some of the other banks and insurers in the FTSE100 universe. Turning to the potential for Lloyds shares, investors will need to have a view on the outlook for the UK consumer and the domestic housing market in particular (by reference to its leading position in mortgages and personal lending backed by home values). The writer believes that the UK economy is set to deliver steady, if unspectacular (and below the longer term trend level of GDP), growth in 2015 and 2016 – and can outperform the wider average of continental European countries. Secondly, and perhaps a more difficult call, surrounds the prospect of further unpleasant surprises: by reference to the ongoing PPI claims bill (which should be diminishing, but seem to have moved into a further potentially costly re-review of earlier settlements) or other evidence of inappropriate behaviour emerging from the past.

The clear majority of Sell-side opinion is positive: of 25 brokers expressing a view, 17 say ‘Buy’, 6 consider Lloyds stock to be a ‘Hold’ while only 2 recommend ‘Sell’ – in part, perhaps, reflecting their hope to be included in any remaining disposal of HM Government’s stake. Recent estimates of ‘fair value’ from these opinion makers ranges between 55p (Berenberg) and 105p (JP Morgan Cazenove), are based on consensual expectations of earnings per share of 8.5 pence for the full current year – which would represent a 4.8% advance from 2014’s disclosure. However, in calendar 2016, the same brokers anticipate a 6% retracement in EPS to 8 pence – offset by a belief that the board will have recommended the promised 50% pay-out of 4 pence, which equates to an attractive dividend yield of 5.1% based on the current 75.5 pence share price.     

On the ‘Buy side’, fund managers and institutional investors retain polarised views – with few ‘sitting on the fence’ via a neutral (to index or benchmark) position in one of Britain’s biggest listed companies. Lloyds appears to be a relatively safe exposure to the banking sector and a play on the financial health of the UK consumer, with bulls of the stock pointing to its retracement (in excess of the wider market’s own fall) from the 89 pence it reached three months ago and its increasing dividend appeal. The writer, by contrast, would prefer to see evidence that we have reached the ‘top of the hill’, and seen the worst of the big exceptional charges (of PPI et al) and the ever tougher regulation (cum taxation) regime, before considering investment. 

Written by David Harbage for lse.co.uk on the 5th September 2015

You can see the latest share price for Lloyds here

The Writer's views are their own, not a representation of London South East's. No advice is inferred or given. If you require financial advice, please seek an Independent Financial Adviser.