LYG - Lloyds Banking Group: Pick Up This Dividend Opportunity At A Discount

2023-07-28 09:38:41 ET

Summary

• Lloyds Banking Group's share price seems slightly undervalued, with a P/E of 6 and a dividend yield nearing 7%.
• The company has shown resilience in the UK banking sector and has a strong liquidity base.
• The high-interest rate environment in the UK could lead to steady earnings growth and increased dividends for Lloyds.

Introduction

The share price for Lloyds Banking Group plc ( LYG ) is up slightly in 2023 so far, just over 4%. But when we look at the broader financials sector, many companies haven't recovered yet from the volatility and fear that was caused by the meltdown of two of the largest banks in the United States. The actual valuation of LYG is not outrageous, and I would even go to say that it's slightly undervalued right now. The p/e sits at 6 and the p/b at 0.83. With a dividend yield nearing 7%, I think that LYG offers dividend income investors a very appealing case right now.

Despite operating in the United Kingdom, the share price showed a similar decrease as banks in the United States. Founded back in 1695 the company is one of the oldest in the whole sector. The interest rates in the UK seem to be staying, and that will create an environment where LYG can generate significant returns from their deposits on the balance sheet. I think the worst has passed for the sector, and now is the time to pick up solid additions to a portfolio. LYG is one of those, and I am rating them a buy as a result.

Company Structure

As I mentioned in the beginning part of the article, the founding year for LYG dates back to 1695, making it one of the oldest in the financial sector. Since then, the market cap and portfolios have grown exponentially. It's currently valued at $37 billion.

Operating in the United Kingdom, it focuses mostly on providing a range of banking and financial services. Included in the diversified bank's industry, it has also diversified its business structure and has three different segments. First, we have the Retail segment, followed by Commercial Banking, and lastly Insurance, Pensions, and Investments. The first segment focuses on offering various offerings of different financial service products like current accounts, savings, and mortgages. The second segment focuses instead on providing lending and working capital management. Lastly, the Insurance segment focuses instead on just that, insurance and pension management, but also services that are related to that.

There have been a lot of worries in the UK banking sector as turmoil arose earlier, and now there seems to be a mortgage crisis on the horizon too. The pension crisis in the UK highlighted some of the cracks in their foundation, but during these times, LYG seems to have remained resilient.

LYG has proclaimed resilience across its portfolios , which has been supported by stable SME overdraft utilization trends and mortgage rate increase, which are driven by the legacy book. The liquid base for the company remains also very strong and the liquidity coverage ratio is 143%. In the face of rising interest rates, seeing a high coverage ratio like this invests the company to face less risk, I think. Seeing solid fundamentals should result in the valuation being higher, but as we have concluded, that isn't the case for LYG.

The rising interest rates in the UK are creating a very different environment for banks to operate in. They have over 10 years of significant high-interest rates but recently returned to some of the highest levels in the last 25 years as seen above here. The loan to deposit for LYG sits at 96% which is quite high, and something that will need to keep up to date and see a clear move downs to further enhance the quality of the investment case.

Earnings Transcript

The latest earnings call from LYG had some insightful information about the company's view on the market and what its outlook might be like. CEO Charlie Nunn had the following to say.

• " Secondly, in line with our guidance, our Q2 profits and net interest margin have stepped down versus our first quarter. This is due to the continued low margins on mortgages, as well as passing on more to our savings customers. However, the Group is performing well and our financial performance remains robust. As you'll hear later in the presentation, we've either reconfirmed or slightly enhanced our guidance for 2023 ".

This shows to me that in the face of rising interest rates, LYG remains in a strong position. Lower margins on mortgages won't break them, and they even announced an interim ordinary dividend that is 15% up on the first half of last year. I don't think investors should be expecting explosive EPS growth going forward, but rather a steady climb of around 7 - 8% YoY. This should be further possible if we see persistent interest rates in the UK. Inflation in the UK is still quite high at almost 8% and this incentivizes the Bank of England to maintain a high rate, a benefit for LYG in the medium term.

Valuation & Comparison

Above is a GGM model that is looking at LYG and the possibility of where a price might be for a return of 10%. I have a 6% continued dividend increase, which isn't what the company has done annually over the last few years, but I view the current interest rate environment as one that offers this possibility for LYG. Strong NII should continue and that will translate to raised dividends I think. The prices aren't necessarily price targets, but they do highlight the solid potential of returns and investment could have. Given that the company is also trading well below my targets I have set out here, the company has limited downside risk for investors right now, I think. The sector has been disproportionally hammered lately compared to other sectors. This presents the possibility of a sharp rebound in the short-medium term as well. I am optimistic about future earnings and will be rating LYG a buy right now.

Risk Associated

In contrast to other Western markets that are experiencing a decline in core inflation, the UK is facing higher and sustained inflation rates, potentially leading to stickier interest rates. While this scenario may offer short and medium-term support to Lloyds' net interest income, there are concerns about its long-term growth potential.

The prolonged period of inflation and high-interest rates could impact consumer spending and borrowing behavior. Reduced demand for credit products may limit Lloyds' scale growth, as consumers and businesses become more cautious about taking on additional debt. This could affect the bank's lending activities and overall profitability.

Investor Takeaway

For investors that want a solid dividend income company that is trading at a discount, then I think LYG ticks a lot of those boxes right now. The share price has been in a steady decline and the p/e is just above 6. The portfolio of the company is solid and lends them able to maintain this current yield, but with a high-interest environment, the likelihood of raises increases as NII grows. Inflation seems to remain in the UK longer than the other Western countries, and that forces the BOE to maintain the rates for longer. I think the risk/reward is very favorable now and will be concluding this article by saying I am rating LYG a buy now.

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