Description

Overview

Lloyds Banking Group is a simple, boring, and leading bank in the UK with 19% market share. We think Lloyds is remarkably cheap on both a relative and absolute basis and should provide a double over 3.4 years (19.5% IRR). First, Lloyd’s trades at 0.84x P/TBV and is a business we believe can doe 13% ROTE and therefore trades at 6.5x normalized earnings. Second, having followed both large cap UK and US banks throughout the pandemic, the stories has been remarkably similar: NIM pressure from falling interest rates, massive growth in deposits outpacing lending, significant government support for individuals and businesses, large credit provisions that have yet to come to fruition and are starting to reverse, strengthened capital ratios from capital return restrictions from central banks, etc. Meanwhile, large cap US banks now trade at the same P/B multiples as pre-pandemic, while Lloyds still trades at a 24% discount to its pre-pandemic P/B.

Quality Bank

Despite a messy history including a near bankruptcy in the GFC, a government bailout and government ownership, and massive PPI and other legal charges, we think Lloyds is a high-quality bank. Most of these issues can be traced back to the government brokered rescue of HBOS by Lloyds in September 2008 for £12B. This was an absolute disaster and included a nearly immediate £11B loss from HBOS and many more charges to come. This required a £13.5B rights issue and government injections leading to a government stake of 43% in Lloyds. Even today, the new remediation charges tie back to HBOS. With all that said, we believe that much of these issues are behind the bank today and the core lending and deposit franchises at Lloyds are high quality and had solid lending standards throughout these years. Lloyds has solid assets with their mortgage book at a 43% LTV and new mortgages having an average LTV of 63%, a 5-year CDS at 41bps (slightly below JPM, BAC, USB, etc.), an app with a 4.8-star rating in the Apple Store, and solid Glassdoor reviews from employees.

Regulatory and Legal Charges

A discussion of Lloyds requires mentioning the £22B in PPI charges and £7B of other remediation and conduct provisions since 2011. First, the larger of the two buckets, the PPI (Personal Protection Insurance) charges are now behind Lloyds. After taking close to a billion-pound provision or more for nine consecutive years, the Financial Conduct Authority set a deadline for final claims in August 2019. There have been zero charges for PPI in 2020 or 2021 and there should not be any more going forward. With respect to the £7B in other remediation and conduct provisions, this remains an ongoing issue. These charges peaked in 2016 and all stem from issues from prior to 2012. Charges were £1.1B in 2016 and £379m in 2020. In 2012, Lloyd’s implemented a new risk management process and removed sales targets at the branch level. These charges increased again in 2021 with £425m through the 1H due to an issue related to HBOS from the late 1990s/early 2000s. Naturally, if the bank can avoid novel issues after 2012, eventually lawyers, regulators, etc. should exhaust ways to come after them. Management believes that after the HBOS issues wind down in 2023, they would still have some charges and for them to normalize at ~£200-300m per year. Simply, there is a big industry now that has developed after the financial crisis and Lloyds will have to continue to spend money defending legal battles.

Normalized ROTE

We use Lloyd’s historical earnings to calculate our view of their normalized earnings power. Using 2015-2019 earnings, we add back PPI and other remediation and conduct provisions and adjust for the new higher 25% corporate tax rate. Based on these years, Lloyd’s core earnings power is a 13.7% ROTE. After factoring in a level of £300m in ongoing remediation and conduct provisions, we calculate their true ROTE would be 13.0%.

Valuation

We model Lloyds through 2024 with 2021-2023 reflecting consensus estimates and then Lloyds reaching our estimate of normalized ROTE in 2024. We assume an exit multiple of 1.21x P/TBV based on Lloyd’s average multiple from 2015-2019. With these assumptions, Lloyds Bank’s stock should provide a double over the next 3.4 years for an IRR of 19.5%. We believe this exit multiple is conservative and think a 1.4x multiple is also a reasonable expectation based on fundamentals. We note the 2015-2019 period included the previously mentioned PPI and large remediation charges and government ownership through 2017. Both of which make for a very reasonable case that they would have depressed Lloyds’ P/TBV during the 2015-2019 period. If we assume a 1.4x P/TBV exit, that increases the IRR to 24%.

Catalyst

Time
Higher rates (not necessary but would help)