Lloyds Bank: Worth the Pain

If there is a developed market that has been loathed to the point of total indifference, it is the UK. Between the initial Brexit horror, the slumping Pound and ongoing political shambles, investors have gone through all the stages of grief and with good reason. 

Within the UK market, the financial sector has been particularly pilloried, with Payment Protection Insurance (PPI) reparations ensuring the sins of the past have been hard to shake. UK banks have been uninvestable to many for most of the last decade, but the market moving on has left Lloyds Bank incredibly cheap relative to its normalised earnings power.

I am very bullish on UK value stocks as they are not only enticingly priced, but many of the headwinds that have plagued them are now abating. Lloyds is particularly enticing as the leader in the banking industry and leading the push to digitalise its customer base.

The lost decade

In the aftermath of the GFC, the UK government emerged with a 43% stake in Lloyds, following a £20.3 injection to save the bank from non-performing loans in 2008. The last of this money was recouped in 2017- a nod to the delayed recovery and ongoing financial stoushes in Europe.

This period played out partially concurrently with the PPI scandal, when it was revealed that from the mid-90s till 2012, British banks had made a tidy profit by hard-selling PPI policies to clients who didn’t need them. Even worse, many of them refused to pay out when legitimate claims came in. This predatory practice was rightly slammed when it came to light and set the banks on course for enormous costs to make things right. To date, UK banks have paid out around £55b by court order and Lloyds has led the way with around £24b- compared to a current market cap of £31b!

Brexit was the next catastrophe, plunging the UK into confusion following the “Leave” vote in 2016. Possibly even more damaging than the vote itself, was the pall of uncertainty that settled as the negotiations dragged on interminably over the following five years, stalling the economy as investors were reluctant to commit to projects, given the lack of an outlook.

Looking forward though, for better or worse, the Brexit issue is now finally being put to bed. Politicians can work on cleaning up the deal, but one is now in place and it is the not-knowing the market hates. Ultimately, I believe Brexit was priced into the UK markets several times over and am confident the European financial powerhouse will bounce back. Additionally, the Pound has remained weak since the vote and while this was painful for those holding UK equities in 2016, it has both provided a cheaper entry point for foreign investors and improved the competitiveness of UK exports. Priced in USD, Lloyds today remains at around half the price/share it entered the Brexit vote with.

Prevailing interest rates have also been brutal for Lloyds, with the Bank of England’s base rate entering the GFC at 5.5% only to emerge at .5% and spend the decade making its way to the .1% on offer today. Net Interest Margins (NIMs) become squeezed during low interest periods like this and the whole banking sector (worldwide also) has suffered. While I don’t claim any ability to predict interest rates, given several decades of their decline, emerging inflationary risks and an apparent reluctance to cross the zero-bound, I would argue there is a chance that future surprises are more likely to the upside and would provide a huge boost to Lloyds profitability.

Covid-19 provided the most recent blow to the company, with profitability plunging 54% YoY in 2020, due to a combination of lower interest income and significant impairments related to the economic outlook. This comparison would have been much worse, but there were no significant PPI provisions in 2020, compared with £1.3b in 2019. Despite this nightmare year, the group remained profitable and well capitalised under a devastating stress test.

After all, Lloyds traces its roots back to Taylors and Lloyds, formed in 1765- it is a survivor. Today it is the largest bank in the UK, with 25 million customers spanning retail, commercial, insurance and wealth management with its stable including Lloyds, Bank of Scotland and Halifax.

Antonio Horta-Osorio stepped down earlier this year, after a tumultuous decade at the helm. He was not always popular, but did an admirable job steering the company through such a difficult period. Horta-Osorio was the first bank CEO to halt the court battle against the PPI claims and accept responsibility for making amends, as well as being open about his mental health struggles and time seeking treatment. His successor, Charlie Nunn, joined the bank from HSBC last month and is likely facing a much more pleasant environment (could hardly be much worse).

Lloyds is one of the UK’s most efficient banks, managing to contain its cost to income ratio to 55.3% for 2020 (2019 48.5%), while leading competitor Barclay’s rose as high as 63%. This is also evidenced by its conservative loan to deposit ratio of 98% and further spending discipline, with costs projected to reduce further to £7.5b for 2021. Incumbency and scale remains a huge advantage in banking, known for its sticky customers. The group is also attempting to stay ahead of fintech, with its 17m online users making it the UK’s largest digital bank and 75% of new products now originating online.  

Why Lloyds is a steal  

A heavy influence on my investing style was Marty Whitman’s “The Aggressive Conservative Investor” where he details his preference for investments under the “financial integrity approach”. Whitman was a straight-talker and later simplified his philosophy to simply “safe and cheap”. I believe Lloyds is a perfect example of this ethos and represents one of the best opportunities available today, even after doubling off its lows.

On the safety front, Lloyds is generously over-capitalised with a 16.5% Core Equity Tier One (CET1) ratio, compared to the regulatory minimum of 11% and an internally imposed 13.5%. This received a boost last year, as UK authorities ordered banks to cease dividends, resulting in a build-up on the balance sheet.

After miserly dividends for the last decade, the company is committed to returning excess capital and paid out the maximum allowed (.67p/share) in H1 this year, when the regulatory constraints were lightened. This was due to an improvement in the outlook for the UK economy, with pre-emptive loan impairments booked last year also beginning to be reversed. Needless to say, a strong economy has been lacking for Lloyds for some time and would be a huge boost to both sentiment and earnings.

While London housing has been strong for some time, UK commercial real estate has been under pressure since Brexit, with the major REITs shrinking their NAVs over this period and suffering genuine distress as rent collections fell away last year. Landsec and British Land scraped through, but Hammerson was forced to undergo a painful equity raise at the worst possible time. 

As banks will look abnormally profitable near the tops of housing bubbles, it is important to know that you aren’t buying into peak earnings in one of these periods. I believe the UK is clearly not there, given these weaknesses and the headwinds described above.

On the cheapness front, I remain convinced that the group is among the best valuations you are likely to see on a market-leading, non-distressed bank. My framework for valuing Lloyds is based on normalising 2019 profitability, which was hardly a top-of-the-cycle year in the UK, by looking past PPI and impairment costs to a possible UK recovery.

This is a conservative view, given that 2019 was several years into the Brexit quagmire and UK GDP only advanced 1.3% that year (it’s fourth consecutive year with a one-handle post Brexit vote), while excluding the all-out carnage of Covid (GDP was down 9.8% for 2020). This is a similar normalised model I have used to value several energy businesses in recent posts. A year that was middle-of-the-road, but also non-catastrophic.

2019 (m£)Normalised (m£)Net Income17,14217,142Costs8,3208,320Trading Surplus8,8228,822Impairments1,2910Underlying Profit7,5318,822Restructuring and Volatility688688PPI Provision24500Pre-tax Profit4,3938,134Tax Expense1,3872,481Net Profit3,0065,653P/E at current market cap10.3x                5.4x

Source: Superfluous Value Blog

The above highlights the earnings power Lloyds is capable of once Covid and PPI reparations are finalised and the UK economy picks up again. By removing these passing headwinds, I can easily see a scenario where Lloyds generates £5.7b in net profit, which would have been an 11.3% Return on 2018 year-end Equity (£50.2b).

Lloyds balance sheet has emerged through Covid intact, with £51.9b in equity today. The company has suggested it may seek to catch-up the 2020 dividend, but this remains to be seen. In my opinion, a buyback would be by far the preferable allocation at current pricing.

The group also has an extremely modest valuation in relation to global peers, priced at a P/B of .59x today. Consider that Wells Fargo, Bank of America, UBS and ING all achieved ROEs of 9-11% in 2019, yet trade for 1.1x, 1.29x, .91x and .8x respectively. These are all also unpopular companies, long out of favour themselves, yet they are priced at meaningful premiums to Lloyds currently.

I place fair value for Lloyds Group at 14x normalised profit and 1.5x book, which today would give a market cap of £79b, implying 160% upside. However, I also expect this number to rise over time, given that costs have been reduced well below 2019 levels and equity value will expand as the economic pressures of Covid and Brexit abate. 

While these multiples may not seem realistic today, in a market where financials are no longer pariahs and the UK not left-for-dead, I believe they would be fairly standard and given that Lloyds could now support a 6% dividend on a one third payout ratio of normalised profit, I hope to be around to see it.

I have a 7% position in Lloyds Bank, bought last September.

*NZ will be moving out of Level 4 lockdown tomorrow, so I will be winding up my effort to publish several times a week while stuck at home. This is the 13th piece I have punched out since August 24 and I have deepened my knowledge about my holdings, got to know a few more and had some great feedback along the way. Thanks for reading!

Guy

Please don’t take this as financial advice. Do your own due diligence and consult a professional advisor, if unsure about your finances.