LYG - Lloyds Banking: Capital Returns Potential Remains Compelling

2023-10-02 23:45:00 ET

Summary

• Lloyds shares have been disappointingly flat since I first covered the bank last year, with general UK apathy, FX and recession worries weighing on the shares.
• Net interest margins will contract heading into H2, but between growing structural hedge income, work on asset mix and growing fee income I am optimistic about the medium-term profitability outlook.
• A major recession in the UK is the big risk right now, but it would likely only be a temporary setback to the bank's attractive capital returns potential.

Covering British bank Lloyds ( LYG ) in Q1 2022, I had a positive view of its then valuation and capital returns potential ( "Buy The 5% Dividend Yield" ). Investment performance since then has been muted, with the USD-denominated ADRs near-enough flat off a headwind from FX and general apathy to UK-listed equities. Local currency returns have landed around 10ppt higher inclusive of dividends.

UK stocks are generally out of favor, but there are reasons to remain bullish on Lloyds. These include the end of previous costly regulatory headwinds like the PPI mis-selling scandal; previously resilient performance even in an unfavorable macro environment; the supportive impact of higher interest rates on medium-term net interest income and ROTE evolution; a modest valuation multiple to tangible book value; and finally, attractive capital returns potential.

A major UK recession remains the big risk to Lloyds. However, this would likely be a temporary rather than permanent setback, with the bank adequately provisioned and unlikely to suffer a meaningful hit to capital.

Resilient Across-The-Cycle NIM

Inflation in the UK remains uncomfortably high. Calling time on this hiking cycle may seem dangerously premature, yet consensus is that the current 525bps base rate is somewhere near the peak.

Part of my bullishness on Lloyds rests on its past underlying performance in various interest rate environments. For instance, between FY2015 and FY2021 Lloyds' net interest margin ("NIM") averaged 273bps (Fig 1) even though the BOE base rate was as low as 10bps (Fig 2). This has also driven reasonable underlying returns on tangible equity, which averaged around 15% pre-COVID (Fig 3), again despite the lower rate environment. As a reminder, net interest income accounts for the majority of Lloyds' total income (~74% as of Q2 2023).

Lloyds' NIM was 314bps in Q2, having fallen from 322bp in Q1. Like most European banks, Lloyds is now experiencing some pressure from deposits (higher rates on savings accounts and migration from current to instant access savings and time accounts). Mortgage margins have also contracted significantly in recent years due to strong competition. As a reminder, UK mortgages accounted for approximately 67% of Lloyds' gross lending as of H1 2023 (Fig 4).

As a result, management has guided for a full-year FY2023 NIM of 310bps, implying H2 NIM of just above 300bps. This will be a slight drag on net interest income (H1 2023: £7 billion), but NIM would still be above the 2015-2021 average.

I expect medium-term profitability to be supported by a number of factors:

1. Managing the loan book . This includes prioritizing value at the expense of volume in UK mortgages, while selectively looking for growth in higher margin areas like car financing (e.g. Tusker acquisition ), consumer lending and targeted areas in SME and corporate lending. This is expected to result in flat-to-down total loan balances.

2. Growth in 'Other Income'. Management is targeting £0.75 billion in incremental revenue by FY2026 (versus FY2021). Avenues for higher non-interest income include further growth in its mass affluent wealth offering and certain CIB lines like debt capital markets and FX.

3. Higher structural hedge income . In prior coverage I highlighted the attractiveness of Lloyds' low-cost deposit base, which the bank uses to fund the so-called structural hedge. The value of the structural hedge totaled around £255 billion at the end of Q2. This was only earning around 125bps (approximately £1.6 billion in H1 2023), but with interest rates having risen it can now be reinvested at much higher yields. This will provide medium-term support to NII, NIM and ROTE even if interest rates decline.

Recession A Manageable Risk

A major UK recession represents the biggest risk to Lloyds, but it should be relatively well-placed to manage one. The NPL ratio (Fig 5) remains relatively stable since last coverage, while there hasn't yet been a meaningful downtick in up-to-date Stage 2 loans either (92% at period-end H1 versus 93% at period-end Q4 2022). Lloyd's expected credit loss allowance was £5.4 billion at the end of H1, equivalent to around 1.2% of gross loans and higher than its pre-COVID marks. Lloyd's ECL further remains around £1 billion above that indicated by its 'base case' scenario (no technical recession, but further increases in unemployment and declining real estate values).

In a worse than expected recession, Lloyds would likely need to raise significant provisions, but with approximately £9 billion in annual pre-impairment income it could remain profitable. I would also note that its CET1 capital ratio remains around 160bps above its regulatory minimum. For those reasons, I expect even a bad recession to only prove a temporary setback to its capital returns potential.

Compelling Capital Returns Potential

Lloyds' capital returns potential remains compelling. In the past, meaningful cash returns to shareholders were hampered by numerous issues. These include the post-GFC restructuring, large fines related to the PPI scandal, COVID, and a material DB pension scheme deficit.

Most of these issues are now behind it. As recently as last month, management was still targeting 175bps for shareholder distributions in FY2023 and FY2024, rising to "greater than" 200bps from FY2026 onwards:

And we're not going to see a material drag on our capital from having to put money into the pension going forward. So that means that 175 basis points this year and next year and then greater than 200 basis points from 2026 is available to the Board for distribution to shareholders. So it's a cleaner and more stable form of capital generation than you've seen in the past as well.

Charlie Nunn, Lloyds Banking Group CEO, BofA Annual Financials CEO Conference

In cash terms, that works out to around £3.75 billion in each of FY2023 and FY2024, rising to around £4.30 billion from FY2026 onwards. At the current market-cap (~£29 billion), that indicates an annual shareholder yield of 13-15% in the medium term. This would result in attractive double-digit annualized returns for investors, even on a flat valuation.

Relative to H1 2023 tangible book value, Lloyds trades for a multiple of 1x. General apathy for UK-listed equities and a modest reduction in profitability from recent highs (Q2 2023 ROTE was 16.6%) may constrain any significant upside from multiple expansion. Even so, with these shares sustainably offering low-to-mid teens per annum from buybacks and dividends, valuation is not an important consideration. A nasty UK recession remains the biggest threat, but as per above is only likely to result in a temporary setback of 1-2 years. Buy.

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