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Lloyds Banking Group Plc – 26th March 2014


Company Overview:

Lloyds Banking Group Plc (Lloy) 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 UK government has been the majority shareholder in the group since the financial crisis, with an initial stake equivalent to 38.7% of all shares in issue. This has now been reduced through two share offers to institutional investors. The most recent share sale saw the government’s stake reduced to an amount equivalent to 24.9% of outstanding share capital.

Index FTSE 100 Ticker LLOY.L Latest Close 79.02
52 Week High 86.89 52 Week Low 46.06 P/E N/A
Dividend Yield % N/A Dividend Cover N/A CEO: Antonio Horta Osorio
CFO: George Culmer 

 

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Lloyds pushing higher, supported by a wave of optimism

While Lloyds drive towards profitability was thwarted in 2013 due to tax changes, impairments and write-downs, management did make solid progress in their endeavours to return the bank to private sector hands.

The past year saw the UK government reduce its position in Lloyds by 6%, a reduction that was followed by a further sale of an additional 7.5% at the close of Q1 2014. Although the government beginning a gradual exit from Lloyds has largely been perceived as a political move, it does also validate, to a degree, the market’s growing confidence in the bank and its future prospects.

An improving global economy, positive investor sentiment generated from the share sales and the potential for a reinstated dividend later in the year have all helped Lloyds shares to find strong support above a three year resistance barrier at 75.44 pence.

Despite the fact that new investors in Lloyds have made a gain of 78% over the past year, there are many who bought into the bank long before its fall from grace during the financial crisis. These investors may be wondering whether or not the bank will ever return to its previous peaks and enable them to make a return on their investment. It is this question that we have set out to address in today’s report.

Lloyds Banking Group Weekly Chart

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Housing recovery helps Lloyds leverage significant footprint in residential mortgages

With a flurry of government initiatives in place (Help to Buy and Funding for Lending) to support the recovery and the support of a healing global economy, the UK has experienced a sharp rebound in growth since the summer of 2013. This has led a number of economists to tip Britain as a leading contender for the title of fastest growing developed nation in 2014.

This is highly positive for Lloyds. Given that the bank wears the crown of being the UK’s largest mortgage lender, it is ideally positioned to leverage the strong positive trends which are currently exerting themselves upon the UK housing market.

Infographic Provided by JP Morgan Asset Management

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As well as being a dominant player in residential mortgages, Lloyds also benefits from having a 20% share of the UK SME sector as business banking customers. With services, manufacturing and construction industries expanding throughout 2013 at paces not seen since before the financial crisis, and given that small businesses normally grow at a faster pace than larger rivals during an uptrend, it comes as no surprise that Lloyd’s management expect the banks strong performance to continue over the coming quarters.

In addition to the above, the bank also provides current accounts, savings facilities and other financial services to 25% of all UK retail customers. This completes a diverse and profitable service offering which avoids the complexity that often comes with many financial services groups, while still enabling Lloyds to remain highly geared to UK economic growth momentum. Each of these dynamics has positive implications for Lloyds earnings capacity over the near to medium term.

The above and below graphics illustrate some of the trends developing within various segments of the economy.

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A stronger and simpler bank, by divestments and management strategy

In addition to the support gained from a recovering economy, Lloyds has also undertaken a program of divestments which has seen many of the bank’s assets that are not cohesive with its new simplification strategy labelled as non-core operations and consequently targeted for disposal.

This has been with the intention of both simplifying and de-risking the business in order to aid the bank’s now exclusive focus on UK retail and commercial operations. So far the bank has reduced its balance sheet by £180 billion since the financial crisis of 2007/2008/2009 when total assets recorded as belonging to the business exceeded the £1 trillion barrier. The value of the bank’s assets now sits at just under £850 billion pounds.

The simplified focus, improving profitability and the large stake which the government still holds in the bank have each had the effect of improving both public and market confidence in Lloyds. This has been reflected in the cost of insuring Lloyd’s debt against default (CDS), which has fallen below that of all major UK banks.

A look at CDS prices for RBS, Barclays, HSBC, and Standard Chartered indicates a market perception that Lloyds is the least risky of them all. The below graphic, available on Lloyds website, shows the cost of insurance for Lloyds falling to just 76 basis points.

This represents a reduction of 77% from the January 2012 levels of 335 basis points and underlines the perception among investors of reduced risk in the banking sector which is amplified by an improving economic outlook.

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Lloyds Banking Group Balance Sheet Overview

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Prospect of dividend reinstatement for Q1 2015 underpins investor optimism

Lloyds has previously announced its intention to pay as much as 50 % of “sustainable” earnings out in dividends to shareholders after it gains approval from regulators. This could mean as much as 30% of post-tax EPS which would equate to roughly a 2-3 pence per share payment, providing a yield of between 2 % – 3.5 %.

Current expectations see a regulatory go ahead on dividend payments coming later in the year. This will most likely result in the first payment to shareholders being made sometime in Q1/Q2 2015.

A reinstated dividend will make Lloyds shares eligible for inclusion into the portfolios of both income as well as growth investors, the prospects of which should help to underpin sentiment toward the stock over the remainder of the year.

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Political meddling increases risk profile and has the potential to detract from shareholder value

Recent allegations made by former Co-operative Bank Chairman Paul Flowers against the Chancellor have exposed the true level of political interference that the management at Lloyds have been subjected to during the bank’s repair and recovery process. The former Chairman alleges that he was placed under unbearable pressure by the Chancellor to buy over 600 of the bank’s branches which were up for sale until a short while ago.

The Chancellor’s intentions are widely accepted as having been focused toward speeding up the repair of Lloyds while simultaneously increasing the size and market penetration of Co-op Bank in order to create a new challenger to the mainstream lenders. Regardless, this does potentially have further reaching implications for Lloyds outside of Project Verde.

In addition to the fallout from the Co-op affair, there has been much speculation over recent months relating to the true reasons behind Stephen Hester’s departure from RBS, another bank in which the government has a large stake.

Although Hester, now CEO of RSA Insurance, has remained relatively tight lipped about his sudden parting of ways with the organisation, many have repeatedly cried political interference.

It has been mooted that Hester disagreed with the Chancellor over his desire to see an amputation of yet more limbs from RBS’s investment bank, previously the most profitable part of the business. It is for this reason that many believe Hester was ousted by the board, at the Chancellor’s bidding.

Despite the fact that Osborne’s actions can be understood from a political perspective, seen through the eyes of a shareholder they are a cause for concern, in both the cases of Lloyds and RBS. This is because allowing the scoring of political popularity points to dictate strategic direction for a large financial institution is more akin to a recipe for disaster than an enhancement of shareholder value.

The key question which arises from these revelations is, if the Chancellor has been taking this form of involvement in decision making and strategy at Lloyds and RBS, then in how many other ways, and in just what areas, has he been influencing the actions of the two banks?

The obvious point behind the question is that given the tone of governmental rhetoric toward the financial sector over recent years, along with its penchant for playing to public hysteria, one should think that a prudent shareholder would be curious to see just how much political opinion and pressure has been allowed to impact upon lending standards and loan quality.

This is particularly the case when considering the government’s efforts, and very public drive, to improve access to finance for both mortgage borrowers as well as small and medium-sized enterprises.

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Premium valuation indicates an oversight by the market

On a valuation basis, Lloyds forward P/E sees the stock trading on a multiple of 11.4 x earnings for 2014. This places the shares at a premium relative to many of the banks UK competitors, including HSBC and Barclays.

RBS is also priced at a significant premium relative to other industry peers, with a forward P/E multiple for 2014 of more than 16 times earnings.

For both RBS and Lloyds to trade at a premium to their competitors, despite the potential that both banks have been engaging in riskier lending practices, the risk profiles and potential downside attached to the stocks are now increased.

Should any further adverse information come to light relating to Lloyds, then this could form the catalyst required for the market to take another look at the stock’s valuation.

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Summary

In summary, the multi-year restructuring programme the bank is undergoing has seen its asset base, which topped £1 trillion in 2008, scaled back significantly. This has served to reduce the longer term risk profile of the bank from what it once was, while still enabling it to retain a healthy exposure to UK economic growth.

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Given the strong momentum behind UK economic growth, a considerable appreciation in Lloyds shares and now that a reinstatement of dividend payments is in the pipeline, the Lloyds story is likely to remain an attractive recovery play for investors as the year progresses. However, there are downsides to consider as well.

Given the recent revelations relating to the Chancellor, the stock is at risk of undergoing a period of revaluation. This is as the longer term risk profile is seen as increased, given the possibility that lending standards and loan quality may have been compromised due to government pressure and political meddling.

This appears to have been overlooked by the market so far, given the current valuation that is attached to the stock. Although it is not possible to say for certain that the market will revalue the shares, either immediately or in the near future, it is worth bearing in mind for investors that as the UK economic cycle matures, so too does the risk attached to Lloyds Banking Group.

The increased risk status comes because poorer lending standards could lead to the bank, once again, suffering above average losses in the event of a downturn.

On the subject of whether or not Lloyds’ shares are likely to ever see a return to previous highs, the chances are slim.

Despite that, the bank is returning toward a stage where it can operate profitably, with healthy margins; the reduced scale of the business does not provide the same calibre of earnings power which the bank had in the past. This is while the UK government continues to push for greater competition in the banking industry which, if successfully encouraged, will almost certainly lead to reduced profitability in the sector.

In addition to this, the question also remains as to whether or not, and if so for how long, will investors be willing to pay the earnings multiples of the past for banking stocks.

To conclude, the longer term prospects for the bank remain positive; however, a return to past highs at 400.00 pence and above is unlikely. This is while over the short to medium term, hopes for a reinstated dividend will likely provide a degree of support to the shares at current levels. However, should the economic outlook deteriorate, or were further revelations to emerge relating to the Chancellor’s involvement with Lloyds, then the stock will become vulnerable to revaluation toward the downside.

Our own price targets for Lloyds sees shares trading at 79.02 pence succumbing to weakness in the short term. This, we feel, could lead the stock to track lower toward the 66.00 pence level over the coming weeks and months.

However, our overall price target sees a break above 100.00 pence per share taking place over the medium term, as the mid to later stages of the year draw closer.

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IMPORTANT:
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