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Lloyds Banking Group, H1 Update – 31 July 2014

 

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, although the total share of voting rights has since reduced from 38.7% down to 24.9%.

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Index FTSE 100 Ticker LLOY.L Latest Close 76.46
Price Target 66.00 52 Week High 86.87 52 Week Low 66.51
P/E N/A Dividend Yield % N/A Dividend Cover N/A
CEO: Antonio Horta Osorio  CFO: George Culmer

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Lloyds Banking Group End July 2014

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Lloyds Continues to Make Progress toward Objectives; Key Points

Following the announcement of yet another regulatory settlement late in July, Lloyds Banking Group’s first half results met with a mixed reaction from investors when they were released this morning.  

The eagerly awaited update saw Lloyds declare a substantial increase in underlying profits for the period (^32%), driven by lower impairments and growth in deposits and loans.

The group’s balance sheet position also improved, with its deposit to loan ratio down from 113% to 109%. This was while fully loaded core tier 1 regulatory capital was reported at 11.1%, up from 10.3% and driven by enhanced profits and an AT1 (Additional Tier 1) capital issuance earlier in the year.

In addition to the above, Lloyds’s Tier 1 leverage ratio also improved, rising from 3.8 % at the close of H1 2013 to 4.5% at 31 June 2014.  

Despite the profit and balance sheet improvements, overall income was lower for the period reflecting the reduced scale of the business following its disposal of St James’s Place and other “non-core” units.

In addition to lower income, provisions for future regulatory redress, stemming from past conduct issues, continued during H1 with a further £600 million set aside.

Management guidance sees the bank on track to make a full year profit for 2014. While this may be the case, the group’s declared earnings per share of 0.2 pence for H1 leaves a revised consensus estimate of 7.2 pence for the full year appearing ambitious.

Going forward, it remains the intention of the management team to apply for FCA approval in the final half of the year to reinstate the dividend. Current guidance suggests a payout of 30% of post-tax earnings.  

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Shares Succumb to Weakness throughout Q2, Further Downside Potential Exists

In line with expectations, Lloyds shares have sold off since our last review, reaching lows of 70.0 pence and 71.0 pence in April and July respectively.

While these levels remain a short distance away from our near term price target of 66.0 pence, and the 71.00 pence price level continues to attract strong support, our initial view of the shares remains very much valid.

Lloyds Banking Group Plc Share Price Hourly Intervals

Lloyds Banking Group Plc Share Price Short Term

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Risk Update

Although we continue to believe that LBG will remain a key player in UK mortgage, personal and business lending for many years to come, momentum behind earnings improvements has been less than many had previously anticipated. In addition to this, the risks facing the group have increased when compared with those identifiable at the time of our last review.

Most notably, if management are unable to deliver upon earnings expectations for the full year then LBG’s valuation will be in danger of being deemed as overextended, while some investors could also lose patience with the shares full stop.

Further from here, the bank faces risks to earnings performance as a result of recent regulatory changes in the mortgage market, with increasing scrutiny from the FPC in the face of an overheating housing market also a factor. Given that Lloyds is the UK’s largest mortgage lender (¼ of new loans), any downturn in housing market transaction volumes will be felt on the bank’s bottom line.

In addition to this, any increase in defaults that could occur when interest rates begin to rise in 2015 would also have a disproportionate impact upon the bank’s bottom line. This is particularly the case if our earlier concerns about potential government interference in lending practices at Lloyds prove to be valid (see our previous report).

Looking further out, the Competition and Markets Authority has recently announced a formal intention to carry out a full-scale review of the UK retail banking sector, with particular regard to the market for personal current accounts.

While it is difficult to predict the outcome, and more importantly any recommendations made as a result of this review, it does elevate the risk that some institutions could one day be broken up. The most vulnerable to such action are both Lloyds Banking Group and Royal Bank of Scotland, given the UK government’s large shareholding in the two.   

Should investors perceive that this risk is growing, then some could also develop the view that LBG’s future earnings capability is at risk, which would be negative for sentiment toward the shares.

Last but by no means least, a sudden increase in geopolitical tensions across Eastern Europe, Africa, the Middle East and some parts of Asia during H1 of this year has been largely ignored by investors, barring the odd spike of volatility.

While many of these conflicts have so far remained contained to their relevant areas, the severity of events on the ground has recently begun to escalate, and Western governments are now beginning to take a more active involvement, with economic sanctions already in place in Eastern Europe (Russia).

Should these conflicts or disputes escalate further over the months ahead then investors may no longer be able to ignore them in the same way that they have done and consequently, financial markets could be adversely impacted. Under such a scenario pro-cyclical (growth sensitive) stocks such as Lloyds Banking Group could be disproportionately affected.

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Summary and Takeaway

In summary, Lloyds Banking Group continues to make progress in its transition toward becoming a more streamlined and retail-focused bank. This has led the group to reduce its non-core assets run off  portfolio from £33 billion at the close of 2013, down to £25 billion at the end of June 2014.

This is while deposit and loan growth, combined with lower impairment charges, has enhanced profits substantially. However, overall income for LBG is in decline following progressive reductions to the scale of the business over recent years.

In addition, short run growth in deposits and loans is far from guaranteed as sustainable over a longer period of time, particularly in light of growing pressure upon the industry to reduce barriers to entry and increase competition (CMA Review).  

This has led to slower than anticipated earnings growth and is likely to continue to present downside risks to momentum in this regard.  Further from here, the group faces high-level risks emanating from the current geopolitical environment as well as the threat of a sustained slowdown in core markets at home (mortgages).

Although management’s plan to reinstate the dividend later this year offers scope for renewed interest in the shares moving into 2015, at the present time we see a lack of positive news flow as likely to lead the shares into another downward leg during the months ahead (H2). Consequently, we maintain our preexisting downside price target for the shares at 66.00 pence.

Looking further out, we are confident that Lloyds Banking Group will remain a key player in UK mortgages, personal finance and business lending. As a result, we also maintain our longer-term price target for the shares, which implies a break above 100.00 pence over the medium to longer term, although admittedly this is unlikely to take place within our initially envisaged time frame.

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