Retail banking is a scale game. Volume is king in a world where interest rates are very low by historical standards.
LLOY, which I am a shareholder in, is the gorilla in the UK banking space. It has over 25 million customers (18m of which are digitally active) and an average market share of 19% across its product suite, including 19% of the mortgage stock, 26% of credit card balances, 19% of SME lending balances, 15% of the stock of car finance and 13% in new home insurance policies. Almost 1 in 4 personal current accounts in the UK sit with LLOY, a useful platform for cross-selling revenue generating products.
A notable area that LLOY punches below its weight in is Wealth, but it is taking steps to address this, which I’ll return to later.
In this piece I will examine the recent performance of LLOY and conclude with some valuation thoughts.
Income
H1 Net Interest Income (NII) was £5.4bn, with Average Interest Earning Assets (AIEA) at £441bn and the Net Interest Margin (NIM) was 250bps. NII was down just 1% y/y despite the rate environment. Margins have exceeded LLOY’s expectations and it has raised its guidance here. Management sees low single-digit AIEA growth this year, supported by a modest recovery in unsecured (consumer) balances, presumably tied to the economic reopening. This seems fair given that consumer balances were stable in Q2, although the growth in customer deposits since the onset of the pandemic is a headwind for banks generally in this area. Another headwind (arising from the rate environment) is falling structural hedge income, which will shave c.£250m from revenue this year.
H1 business (non-interest) income was £2.4bn, of which £1.3bn was delivered in Q2, the best quarterly performance since the onset of the pandemic. The Group has taken steps to bolster its Wealth proposition, which has a three-pronged strategy (Mass Market through Lloyds, Halifax and the just-acquired Embark brands; Mass Affluent through Schroders; and High Net Worth / Ultra High Net Worth through Cazenove). LLOY’s Insurance and Wealth unit saw £4bn of net new money during H1, and, helped by the addition of Embark, management has raised its 2023 net new money target from £25bn to c.£40bn.
Lending
The open mortgage book increased by £12bn during H1, while there was modest attrition in consumer (likely reflecting COVID-related factors) and commercial.
Costs
Operating costs were up slightly in H1, reflecting bonuses. Nonetheless, the Cost/Income ratio of 54.9% is well ahead of many of LLOY’s peers, reflecting its scale advantage.
Given the COVID-19 backdrop, it is unsurprising to see that c.80% of LLOY employees will be working in a hybrid model going forward. The Group pared its office space by c.3% in H1 and targets an 8% reduction in the FY (presumably they have a good line of sight on this due to leases etc.).
Asset Quality
Loan books across the banking sector have proven resilient throughout the COVID shock, reflecting constructive fiscal and banking sector policies. LLOY was no exception to this, with a £656m net impairment credit (i.e. release) in H1. The Group is guiding a charge of less than 10bps for the full year, but given the improving macro backdrop I wouldn’t be surprised if they beat that guidance (put simply, I struggle to see c.£1bn of a net charge in H2 after a £656m release in H1).
Capital and Distributions
LLOY has a strong CET1 position of 16.7% as of end-June. This is post dividend accrual and was supported by strong organic capital generation of 93bps in the half. The Group’s capital target is 12.5% + a management buffer of 1%, so the surplus capital is (16.7%-13.5%)*RWA or 3.2%*£200bn = £6.4bn. LLOY’s market cap is £31.3bn, so the end-June surplus capital equates to 20% of the current market cap.
LLOY accrued a 0.67p dividend for H1. It will be interesting to see what the new CEO Charlie Nunn has to say about distributions at the FY results.
Guidance
Overall H1 net income was £3.9bn, which compares to breakeven in H1 2020. In July, the Group raised its full-year guidance as follows:
1. NIM is now expected to be “around 250bps” (was >240bps)
2. Operating costs to be c.£7.6bn (was c.£7.5bn)
3. Net asset quality ratio to be below 10bps (was <40bps)
4. RoTE expected to be c.10%, excluding the c.2.5pp benefit from tax changes (was 5-7%)
5. RWAs expected to be <£200bn (was “broadly stable on 2020”, which was £203bn)
On valuation, the Gordon Growth Model, a commonly used valuation method for banking stocks, says that the price/book multiple that an investor should pay is derived from this formula: (ROE-g)/(COE-g), where ROE = Return on Equity, COE = Cost of Equity and g = a nominal long-term growth rate. Assuming that the UK GDP should see trend growth of 2%; taking the (call it) 10% ROTE guidance for this year as the ROE and assuming a a COE of 10%, this implies that LLOY should trade on 1x book value (i.e. (10%-2%)/(10%-2%) = 1).
Is 10% cost of equity reasonable? I think so – the wider European banking sector is on ~0.73x P/B (for a lower average ROE of c.8.3%). So let us stick with 10% COE (and a 1x P/B multiple) for the purposes of this exercise. As an aside, I used an 11.4% COE in my recent write up on another national champion, Cyprus’ BOCH.
LLOY’s Tangible Net Asset Value (TNAV) was 55.6p at end-June, so based on yesterday’s close of 44.1p the Group trades on just under 0.8x P/B. Getting to 1x P/B would deliver 26% upside.
Is that the investment thesis? Wait for 1x book and enjoy the 26% uplift? No. The Group’s large surplus capital (equivalent to 20% of the current market cap) suggests the potential for material distributions, including share buybacks. To be clear, I’m not suggesting that they’ll deliver a 20% distribution in one go, but you could easily imagine (emphasis) several years of distributions (dividends + buybacks) totalling 6-7% a year from 2022 onwards, particularly given that capital should continue to build (pre-distributions) over that period. Buybacks would be very accretive to TNAV here as shares can be bought back at the equivalent of 80p in the pound at today’s P/B multiple. Furthermore, the Group’s organic capital generation prospects will likely see incremental distributions – compounding returns for investors.
Another possible use of surplus capital is, of course, M&A. Here LLOY can leverage its existing infrastructure by acquiring complementary businesses (apart from the £390m Embark deal, previous acquisitions include the £3.8bn purchase of Tesco UK residential mortgage book in 2019) and harvesting synergies.
I see LLOY as delivering elevated returns from here, based on its strong surplus capital position and a business model capable of delivering an ROE of at least equal to COE, supported by clear growth opportunities (both organic and inorganic). For shareholders with a long-term perspective (I would include myself here), buybacks (which I expect to be a key part of distributions given the P/B multiple) will allow holders to steadily increase their ownership of the Group without having to do anything beyond collecting their dividends (which should steadily grow on a per-share basis, given both underlying franchise growth and the compounding effect of buybacks on earnings). LLOY has 71bn shares in issue, so (all else being equal) a (I’m guessing – please note that there’s no guidance on this) 50-50 split of a distribution of today’s £6.4bn in surplus capital over the coming years (remember, this £6.4bn will, absent economic shocks, continue to increase as LLOY accretes capital, so I’m not assuming they’ll cut surplus capital to zero) between buybacks and dividends would reduce this current share count by a little over 10%.
Theodosian Capital 