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Lloyds Banking Group Full Year Update – 04 March 2015

Company Overview:

Lloyds Banking Group Plc is a UK-based banking and financial services group. The group provides a wide array of financial services including retail and commercial banking, corporate banking, wealth management and insurance.

The group’s majority shareholder remains the UK government following a state bailout during the financial crisis of 2008, however, its total share of ownership has since reduced from 41% down to 24%.

Index FTSE 100 Ticker LLOY.L Latest Close 79.44
52 Week High 85.53 52 Week Low 70.01 P/E (H) 47.0X
Dividend Yield % 1% Dividend Cover 2.5 CEO: Antonio-Horta Osorio
CFO: TBC Previous Price Target 71.00 Current Price Target 71.00

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Lloyds shares recover from Autumn sell off, remain resilient throughout Q1

When we last updated our outlook for Lloyds we wrote extensively about how cost cuts, declining loan impairments and higher growth in deposits were counterbalancing the potential effects of increasing competition in retail industry, increasing regulatory costs and the potential for a less than satisfactory result in BOE stress tests during December.

The result of our previous announcement was a moderately improved outlook for the group and an upward revision to our price target for the shares (66.0 pence > 71.00 pence).

Since this time Lloyds Banking Group has passed the 2014 BOE stress tests with flying colours, as one of the industry’s strongest players.

Now after falling to within an inch of our price target (71.0 pence) in late December, and again in January, Lloyds shares have embarked upon a sharp recovery.  Despite this and the recent flurry of good news, the shares are yet to sustain a break above the 80.00 pence level.

Today we update our outlook for the group once again and, with the above and the group’s financial results for the full year taken into account, we outline our expectations for the bank going forward into the remainder of 2015.

Lloyds Banking Group Share Price / Daily Intervals

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Lloyds full year results show recovery continues, announces token dividend providing a yield of 1%

In February Lloyds Banking Group announced some its full year results for 2014, some of its strongest since before the financial crisis, thus prompting a sharp rise in the share price.

In detail, the bank saw total income for the year fell by 2% although this was outstripped by a larger reduction in costs and impairments (2% @ £223 million / 60% @ £1.8 billion respectively), which translated into a net gain for the bank during the period.

The bank’s net interest income and net interest margin also improved during the period (^ by 8% & to 2.45%), while its cost income ratio declined to an industry leading 51%. Returns on equity also improved considerably for the period although much of this is a “paper improvement” as a range of factors weighed on real terms earnings.

On this note, underlying earnings per share reached 8.1 pence during the period, up from 6.6 pence in the previous year, although again; this was largely a “paper improvement”. We say this because real cash earnings per share were actually 1.7 pence, which brings us to the downside, or negatives, in Lloyds full year results.

 

The downside

While Lloyds Banking Group Plc continues to position itself for growth in future years, the bank’s financial performance is still being hampered by past conduct issues and the need to further reduce run off assets, which often results in the bank having to recognise losses on disposal of assets (£1.4 billion in 2014).

In detail, the group charged a total of £3.125 billion to the income statement in 2014 for PPI redress and further regulatory provisions. It also booked a further £1.4 billion in losses on disposals, while TSB and simplification costs swallowed another £1.5 billion.

These charges drastically reduced post tax earnings per share for the period, from 8.1 pence on an underlying paper basis, to just 1.7 pence in real terms.

Furthermore the largest portion of financial gains for the group during the period, relative to last year, was attributable to a steep decline in impaired loans. In line with what we have written before, we see scope for this to change for the worse if interest rates were to rise before households are able to shore up their balance sheets.

 

The road ahead for Lloyds Banking Group Plc

Going forward the group is well positioned to capitalise on its slimmer cost structure and what will eventually be a clear road ahead in terms of redress for past misconduct. This could lead to an improved earnings performance in the coming quarters.

In addition to this, with the bank having secured approval to reinstate its dividend payment this year, there is now scope for dividend growth prospects to add meaningfully toward the investment case for the shares.

However, we continue to see an uncertain outlook for wage growth and monetary policy as having the potential to harm Lloyds financial performance. This is not just due to the potential impact of rising rates upon credit demand and private consumption, but also the potential impact that could be felt upon impairments as a percentage of loans at the bank.

As referenced above, a substantial part of the improvement in LBG’s bottom line during 2014 was the result of a reduction in soured loans, which could reverse if interest rates were to rise before wages have had chance to recover.

Furthermore, the government has now sold down its stake in the lender to below 24% on the quiet, while the group also reported in its full year results that there is a plan in place with UKFI (UK Financial Investments) that is intended to see the government reduce its stake to zero before June 2015. This could also lead to some level of downside pressure upon the shares during the weeks and months ahead.

Last but most certainly not least, with the general election approaching in May the financial sector will represent an ever easier target for those politicians who are looking to demonstrate some form of relevance or attractive policy, while grabbing quick political kudos points .

This may see some potentially quite hostile pledges made in the run up to polling, which could include increased regulatory levies, higher taxes and a greater degree of oversight from Whitehall. Each of these represent a potentially negative event for share prices in the UK banking sector.

 

Balance sheet, dividend and valuation update

In terms of the balance sheet, investor confidence in Lloyds financial position has materially improved during 2014 despite that the UK government has continued its exit from the bank, which is reflected by a further fall in the group’s CDS spread which is now among the lowest in the industry (45bp).

Much of the improvement in financial position came as a result of cash raised from further reductions to the “run off portfolio” and additional declines across large parts of the group’s liability structure.

However, we note that liabilities arising from insurance and investment contracts increased moderately during the period. This area of the business (insurance) has previously been described as a source of “hidden leverage” by other analysts, which could become a problem in the event of a rise in claims or a period of market instability.

One of our key issues for Lloyds is that in managing for regulation and not risk, it has levered up the insurance business to enhance its bank capital ratios. While all markets have risen this has not had a detrimental effect, but we believe Lloyds is more exposed were the situation to reverse.   – Berenberg Bank, September 2014

In relation to the dividend, it has been a long road for Lloyds to repair its balance sheet to a level where it can support a policy of regular cash returns to shareholders.

As many will already know, Lloyds received permission to reinstate its dividend early in 2015, which has resulted in a token payment of 0.75 pence per share. The token payment amounts to a yield of 1% and is covered 2.5X over by full year earnings for 2015.

We expect that this yield will rise steadily over time, in line with the group’s stated policy to pay out 50% of sustainable earnings. Furthermore, with the current low base of payments considered, we also believe it is fair to say that Lloyds will probably offer the greatest potential for dividend growth over the medium term; relative to the sector.

From a valuation perspective, we see Lloyds as neither fully valued nor undervalued. In short, we see both upside and downside for the shares during the months ahead. The group currently trades on a forward earnings multiple of 10X 2015 consensus projections for EPS, which is broadly in line with the average for the UK’s four major listed banks.

Looking ahead we see the imminent exit of the UK government from its 23.9% stake in the bank, in addition to the sector’s vulnerability to political attack in the run up to the election, being credible catalysts for a rerating to the downside over the near term.

Lloyds Banking Group CDS Spread / Lloyds Full Year Results

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Summary

On balance, we feel that with all bank stress tests now out of the way and the dividend reinstated, the investment case for Lloyds has materially improved during the last 12 months. However, headwinds still exist for the shares and for this reason, we still expect to see some level of weakness in the shares during the months ahead.

In this regard we note, the bank has recently announced that the UK government intends to make a full exit from its 23.9% stake in the lender before June, which we take as an indication that the incumbent establishment is seeking to exit ahead of the general election in May. This means that a certain level of downside pressure will be unavoidable for the shares, in any case, over the near term.

Furthermore, the banking sector still represents an easy target for politicians that are desperate to gain popularity points ahead of the election, which could see any number of hostile manifesto pledges put forward in order to shore up public support for the relevant parties. This may also have an adverse effect, but at the sector level as opposed to Lloyds specifically.

 

The takeaway

In short, we expect that over the near term, the sector could be facing a rerating lower, while we also believe that Lloyds in particular, is deserving of a discount to the sector given additional downside factors such as the likelihood of further government share sales.

As a result we prefer to see Lloyds rated on a par with HSBC, which is currently discounted as a result of an ongoing tax scandal, as opposed to Barclays where there are less barriers to positive returns over the coming quarters.

For this reason we maintain our price target for the shares today at 71.0 pence, which implies a reduction of 13% on a valuation basis (8.7X) and downside of 11.2% in the shares. This is commensurate with our projection for a discount to the sector, after a broad-based rerating lower to what is most likely to be an average of 9X earnings.

Our price target further corresponds with the 23.6% retracement off from the January 2014 peak which formed as part of the long term trend running between November 2011 and Jan 2014.

Despite our bearish guidance for the immediate future, we also add that an upward revision could quite possibly follow this report after either the general election in May, or the the first half update in September.

This would be because we expect that, over the longer term, investors are likely to overlook risks posed to the bank’s financial performance by changes in monetary policy in favour of a focus upon the prospects for lower levels of regulatory redress to boost cash earnings and support dividend growth.

The next scheduled event of note for Lloyds Banking Group Plc will be the release of the Q1 interim management statement on 01 May 2015. As always, we shall endeavour to keep all of our members up to date with developments as they occur, as well as at the time of release in May (Q1 Update).



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