Description

Background

The big 4 banks (HSBC, Lloyds, Barclays and NatWest) dominate domestic banking. Competition outside of the big 4 can be grouped broadly into two categories: smaller-scale banks (Virgin Money, Santander UK, etc.) and digital upstarts (Monzo, Starling, etc.).  The latter focus on mobile app experience and have no or limited branch networks.

Overview

Lloyds Banking Group (LLOY) is a UK-based financial institution. The group offers retail banking, commercial banking, insurance, and investment management.  It operates various brands including Lloyds Bank, Bank of Scotland, and Scottish Widow. The majority of the group's profit is generated domestically.

As of 1Q23, the Bank has £452.3 billion in loans, £473.1 billion in deposits, and £210.9 billion in risk-weighted assets. Net interest income is more than 70% of underlying revenue in 2022.

Investment Thesis

The banking franchise is underpinned by scale, brand equity, large branch network, lower cost of capital, customer inertia, and switching cost. The fact that other banks and digital upstarts have failed to dislodge the incumbents despite years of trying is a great testament to the barriers to entry of the UK banking industry. 

The stock currently trades at 5.6x NTM consensus EPS which represents a great entry point.  I expect the stock will re-rate as the market recognizes the bank’s earnings power and resiliency.

Barriers to entry are high for the following reasons

Customer Inertia

Personal current account (PCA) is a sticky product. As long as the product works, there is nothing to prompt the customer to search for alternatives.  Direct fees charged are very low - the majority of fees are hidden in the form of forgone interest.  Many customers see limited benefit to switch banks for higher rates as the absolute reward is usually small. For instance, £1,000 at 1% higher interest rate is only £10 a year.

Similar to personal banking, there is a lack of events to trigger a business to switch its business current account (BCA).  

High Search Cost for Business Banking

Comparison between banks is difficult because BCA fees are complex. Fees are negotiable and come in different forms. Some are fixed fees with usage caps; some are on a per-transaction basis.  It is hard to make a clear comparison.

Moreover, comparing the quality of service beforehand is nearly impossible since there is no uniform definition of quality.  Some owners appreciate quick response time.  Others prefer quick approval of loans.  Also, service and skill levels vary among staff within the same bank. These factors make comparing service quality challenging.

Also, studies have found over half of startups open BCAs at the same bank where their founders hold PCAs, suggesting customer inertia and causation which benefits incumbents.

High Switching Cost for Business Banking

Unlike PCA applications which can be completed in an app, the account opening process and information requirements for BCAs are burdensome.  The time and effort involved to administer the switch - ongoing payment processing, bill payments, transaction history, data links to accounting software, etc - is high. The cost of disruption is also high.

For small businesses with bank financing, switching costs are even higher.  Other banks are unlikely to offer financing at a competitive rate as the existing bank due to a lack of financial history and familiarity.  The existing bank is better positioned to price credit risk.  In addition, the time and effort to apply for bank financing is onerous, and approval is uncertain.  Switching is often not feasible for businesses that require ongoing financing.

Cost of Capital Advantage

The primary way to gain deposits is to offer a higher yield.  It is almost the only way for digital banks since they have no branch network. Therefore the incremental costs of funds of the challengers are structurally higher.  In contrast, LLOY benefits from a stable deposit base, protected by inertia and switching cost.

Furthermore, LLOY is a “too big to fail” bank and benefits further from lower risk premiums charged by investors.

Digital Upstarts Disruption Risks

According to the FCA, measured by the number of accounts, digital banks have taken share from traditional banks and have around 8% market share.  However, the actual market share gain is less than the headline number.

Note that in the UK, the average adult has 1.9 PCAs.  For those who have PCAs with different banks, they rarely will have more than one main PCA - the account where they do most of their transactions, i.e. pay bills, payroll deposits.  Naturally, secondary accounts have lower balance, lower activities and thus generate less revenue.  

Studies conducted by Ipsos show that only 25% of PCAs at digital banks are customers’ main account. As such, digital banks only have 2 - 3% market share measured by main PCAs.

As mentioned before, digital banks have to offer higher deposit rates than incumbents to attract customers. Growing market share this way is expensive and slow. I don’t see digital challengers disrupting the incumbents in the foreseeable future.

Mortgage Loan Book

LLOY is the leader in mortgage lending, its market share by mortgage value, at 19.5% (the latest figure available is 2021), is 7 points higher than the number 2 lender.  Domestic mortgage is 70% of the loan book.  

The mortgage book is low risk.  Average LTV was 42.3% as of 1Q23. New lending during the quarter had LTV of 59%.  Only 1.9% of the mortgage book had LTV over 90%.  

Although this seems counter-intuitive, high rates actually benefit LLOY in retaining market share.  High interest rate represents a challenge for borrowers to refinance externally due to affordability tests; internal refinancing generally does not require affordability tests.  This helps LLOY to retain mortgage customers at a favorable yield.

Given the low LTV and the bank’s underwriting discipline, the mortgage book should continue to generate earnings despite a slowing economy.

Other Key Positives

• Strong capital and liquidity: 14.1% CET1 ratio; 143% liquidity coverage ratio; 96% loan to deposit ratio.

• Returning excess capital through buybacks and dividends.

Risks

The UK economy is slowing, though not in a recession.  High inflation has squeezed household finance.  Rate hikes have stressed the mortgage market.  An inverted yield curve suggests a recession is imminent. Any of these forces could trigger higher credit loss at the bank.

I do not have a differentiated view on the economic outlook.  I suggest hedging the UK recession risk by shorting the smaller banks (OSB, VMUK and PAG) which have less stable funding, riskier loan profiles and are sub-scale.

Valuation

Key Assumptions

I assume a higher cost to income ratio than consensus and normalized impairment at 0.35% of gross lending.

Earnings growth, assuming no more buybacks, should tie to GDP growth which I expect to be 1- 2%.  The stock is trading at 5.7x of my estimate of normalized earnings.  Given the banking franchise and earnings profile, I think the stock is worth at least 8x (61p).  Once the economic outlook improves, the stock should re-rate to 10x (76p).

Catalyst

Improvement in macro outlook; Bank of England base rate stabilizes