Questor Bearish on Lloyds8 Nov 2019 03:33
PESSIMISM suddenly seems the order of the day at Lloyds Banking Group, which published a third-quarter trading update last week.
The after-tax loss it announced for the quarter, while striking, was not our main concern because it was due to a £1.8bn bill for PPI compensation and, mercifully, no more PPI claims can be made.
But other things do worry this column: the continued, if slow, fall in the “net interest margin” – a key measure of a bank’s ability to make profits – and a rise in “impairment” charges, or the cost of bad loans, not to mention the economic backdrop of “lower for longer” interest rate expectations and minimal growth.
We already expected that Lloyds would not grow its top line: after all, it’s a mature, stable business (and while the famous inertia of bank customers prevents it from losing them in large numbers, it’s hardly a recipe for growth). What is new and unwelcome, for this column at least, is a sense that the bank may not be able to grow its bottom line either.
Such growth, when revenues are not expected to rise, could only have come from falling costs. Costs will indeed almost certainly fall next year thanks to the end of PPI but there seems less scope beyond that, partly because the worsening economic outlook suggests that bad debts may be about to rise.
Ian Gordon, an analyst at Investec, the broker, whose views on Lloyds this column has often quoted and who has also become more cautious about its prospects, said he now expected next year’s profits at Lloyds to mark the peak in the current cycle. He forecast pre-tax earnings of £6.8bn in 2020, then £6.6bn the following year and £6.1bn in 2022.
What does this mean for the dividend, our Income Portfolio’s raison d’être?
The possibility that profits will decline is no immediate threat to the divi because there is currently expected to be a wide margin of safety between what the bank makes and what it hands to shareholders. Mr Gordon said he expected the bank to pay a 3.5p dividend next year out of earnings per share of 6.6p, then 3.7p out of 6.7p and 3.9p out of 6.2p in 2022 – still a decent gap, but a falling one.
This column aims for long-term increases in dividends but they cannot keep rising forever if profits are shrinking. We have therefore decided to take pre-emptive action and, although we still regard it as a very well run bank, will sell Lloyds now.
By doing so we will sustain a 7.7pc loss on our purchase price of 62p in December 2016. However, we fear that the share price may also have peaked and that if we delay we risk a bigger capital loss.
We will advise readers of our choice as Lloyds’ replacement in next week’s column. Our aim will be to find a share that offers a yield similar to the bank’s but better prospects of dividend growth.
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