|Shares Out. (in M):||72||P/E||12.5||9|
|Market Cap (in $M):||44,844||P/FCF||0||0|
|Net Debt (in $M):||0||EBIT||0||0|
Virtualodin wrote the name in November 2017, and I obviously agree with him. His write-up was excellent.
Banks that control a large share of a local deposit base are usually great businesses. These companies have a cost advantage, as they can finance a large pool of assets with low cost deposits and dilute administrative costs over a larger base. In the end, these market leaders are able to earn higher returns assuming the same level of balance sheet risk as competitors. Here are some banks with significant market share, and as shown, shareholders have done very well.
These banks would wish to have the dominance Lloyds enjoys. Lloyds is the largest bank, by a wide margin, in the UK with ~30% market share in deposits and mortgages.
It is very difficult to find banks with such dominance, much less in a developed market such as the UK. For this reason, we expect Lloyds to achieve top-class profitability.
We expect Lloyd´s will earn £0.08 per share in less than 2 years. Given the market dominance, the simple and profitable business model (mortgage and consumer lending) and conservative culture, we believe this franchise deserves at least a market multiple. For these reasons, the stock might double over the next 2 years.
A brief overview on how come Lloyds got to be so dominant? How regulators let this happen?
During the boom years in the mid-2000s, when competitors such as RBS and HBOS were “printing” money and expanding, Lloyds stuck to its boring business. The bank kept lending money the traditional way and intentionally didn´t enter the business of lending in sub-prime and structuring mortgage backed securities. At the time, the aggressiveness of that business model looked attractive, but the prudence of Lloyds paid off.
When the crisis brought RBS, HBOS, Northern Rock, etc. to its knees, Lloyds was in a position of strength. Years before the crisis, regulators had kept Lloyds from acquiring other banks because of its large market share. But in 2008, it was the only option the BOE really had. They didn´t want another Northern Rock-like run on the bank and HBOS was clearly going in that direction. HBOS depended on whole-sale funding and that dried up quickly, also the bank had a large amount of exposure to troubled sub-prime mortgages and commercial loans.
Late in 2008, after significant pressure from the BOE and politicians, Lloyds acquired HBOS. Lloyds got what it wanted and once again increased its share of the local UK market.
Unfortunately, HBOS proved to be a terrible acquisition which ended costing Lloyds shareholders dearly. HBOS had much more troubled loans than originally expected. This forced Lloyds to raise capital, diluting shareholders in the process. The Government ended up owning 43% of Lloyds after capitalizing the bank, in a series of controversial events. While this resulted in losses for shareholders, it also has left the Bank in an enviable position of total dominance in its local market.
What is Lloyds now?
Lloyds is a traditional bank with 95% of its assets based in the UK. It is primarily focused on lending money to households (mortgages, auto and credit cards). The bank also serves businesses with commercial loans and other corporate services. The bank has very little exposure to investment banking, international finance or other “complicated” business lines. Lloyds is a traditional and simple bank that makes most of its money lending the “old-fashioned” way.
The business is divided into three segments: 1) Retail, 2) Commercial and 3) Insurance and Wealth Management.
Retail: This segment offers mortgages, credit cards, auto loans, and certain unsecured loans through its +2,100 branches and digital channels. The Retail operation has £250bn in deposits and £340bn in earning assets. Of these assets, 86% are mortgages, 5% credit cards (last year the company acquired MBNA to gain share in this segment) and 4% auto loans. The mortgage portfolio is very healthy with LTVs of 43% compared to +55% less than 10 years ago. Also, only ~10% of the mortgages have LTV >80%. This is a low risk operation with low expected loss rates and high-quality assets with significant collateral value. In 2017, the Retail segment generated underlying profit of £6bn or 56% of Lloyd´s total profits.
Commercial: This segment offers services to SMEs, Global Corporates and Financial institutions. Most of these clients are UK based or have links to the UK. Services include lending, transactional banking and working capital management. The Commercial operation has £150bn in deposits and £100bn in earning assets. In 2017, the Commercial segment generated underlying profit of £2.5bn or 32% of Lloyd´s total profits.
Insurance and Wealth Management: This segment offers annuity payments, home insurance, pension services and wealth management. In 2017, the Insurance and Wealth Management segment generated underlying profit or 0.9bn or 12% of Lloyd´s total profits.
Why is Lloyd´s special?
A question that immediately pops up is, why invest in Lloyds over the large US banks, which have been doing well for some time now. Besides being cheaper and easier to understand (a simpler business and balance sheet), Lloyds is a much more dominant bank in its market. JP Morgan, Wells Fargo and Bank of America, each have roughly a 10% share of the local US deposit market. In the UK, Lloyd´s share represents these three combined.
Lloyds is a dominant franchise that customers trust. Anecdotally, after the turbulent moments of Brexit the bank experienced a large inflow of deposits. As a market leader, it is able to finance the largest UK loan book with a large base of low cost deposits. This is very important in a developed and competitive market such as the UK where yields are pressured. This large low-cost deposit base has helped the bank reach a NIM of 2.9%, which is very decent in this environment, taking into account the low level of risk and quality of the company´s assets. The bank also has the lowest cost/income ratio in the UK, largely due to its scale, as it is able to share costs over a larger base, and management’s push to reduce costs. Currently, Lloyds ratio is 47% compared to ~60% for its local peers and 56% for the efficiency leader of the large US banks, JP Morgan. Lloyds also expects to reach low 40s by 2020 as the bank keeps cutting costs and reducing the branch footprint. These advantages will be accentuated as banks transition into a digital world. Large banks have been investing and will be able to invest more in the digital platforms, while smaller competitors have fewer resources to make these large, fixed investments. For this reason, we expect the cost advantage to widen over time. 5 years ago, Lloyds was able meet only 30% of customer needs via digital, and now it has reached 70%. The bank has more than 13 million digital active users. Over time, the large branch fottprint will decline, as customer needs are met digitally, and the cost base will decline.
These 2 advantages, large and low-cost deposit funding and scale that permits the lowest cost/income ratio, will be the major reason why Lloyds will reach top class profitability. Also, these advantages let Lloyds focus on low risk and boring areas such as mortgage lending, instead of going after higher yielding but riskier lending activities.
Why invest now?
A series of events have pressured the results and share price. This has opened an opportunity for investors.
PPI: This is a type of credit insurance that protects in case of a fatality, illness or other events. For years, many banks in the UK sold these products to its clients. In many cases the PPI was sold without customer knowledge, at high rates and the product was inefficient in protecting the client’s interests. In 2011, Lloyds started taking provisions for future claims. In the past 7 years, the bank has paid almost £20bn in claims. This has hit profitability and capital. In 2017, the bank took a provision of £1.7bn and the unused balance sheet allowance stands at £2.4bn. This chapter should reach an end in August 2019, as the FCA has set a deadline for claims.
Brexit: This is an obvious risk that had an immediate impact on the share price. Investors hate volatility and well this was a major event. Brexit had a minor impact on results as lower rates compressed the yields on its loans. This has been solved with repricing of the deposit base and NIMs are now even higher than in 2016. Also, the BOE raised rates for the first time in a decade 6 months ago. There is also a risk that this will have a large impact on the UK economy and that NPLs will rise. While this is a possibility, the loan book of Lloyds is of extremely high quality and there has been no impact on loss rates so far. The final outcome of Brexit is to be determined, but Lloyds has a high-quality loan book that would be able to stand difficult economic times.
Government Ownership: During the crisis, the BOE became the largest Lloyd´s shareholder at 43%. The Government sold off its last shares in 2017. This episode of ownership and then prolonged divestment has put pressure on the stock price.
European banks: It is a fact that US banks took their medicine via charge offs and capital injections, while most European banks just delayed the inevitable. Having said that, UK was a special place where the Government took a radical stance and took large stakes in major banks. These banks got capitalized and there was a process of getting rid of the bad assets. Lloyds currently has a CET1 ratio of 14% compared to 7% in 2010. Also, the bank impaired loans have been reduced to 1.6%, from 10% in 2010. Risk weighted assets have also been reduced by more than £150bn, increasing the strength on the balance sheet. The bank has very little exposure outside the UK and there are no major exposures to peripheral countries. Some investors put Lloyds in the same pile as many of its European peers but the reality is that Lloyds took its medicine, 95% of the balance sheet is in UK based assets and there are not many similarities to the global European banks.
Household debt: The Lloyds loan book is composed mostly of UK mortgages. Investing in Lloyds is partly a bet that households will keep paying their debts. UK household debt is very high when compared to other regions of the world, and this is an area of concern. Since the crisis, UK households have been in a deleveraging process which has improved the leverage ratios. As home prices have risen LTV ratios have also been improving significantly, bringing more protection to lenders. It´s also important to note that default rates in the UK have been quite low compared to other countries. This might be mostly due to the fact that mortgages are full recourse in the UK, meaning that lenders have access to other assets in case of default. In the US, for example, the only asset banks can reach once a default occurs is the house.
The bank is currently trading as if non-recurring costs will remain at current levels for eternity and Brexit will impact NPLs and NIMs significantly.
In 2017, the bank generated adjusted earnings of £6bn, or .08 pence per share. Lloyds is trading at 7.5x adjusted earnings and 1.2x TBV.
Unfortunately, the bank had to pay £1.7bn in PPI provisions and £0.9bn in other conduct provisions. Eventually, most of these charges should go away. The Government has imposed a cutoff for PPI in August 2019, so that will leave a cleaner picture.
After all these exceptional charges, the bank earned £3.5bn, or 0.05 pence per share. So even if we assume these charges will be here forever, one way or another, the bank is trading at 12.5x.
We believe the bank will close the gap between adjusted and statutory profits over time. This will lead to higher earnings which combined with cost initiatives and possible higher rates, will cause earnings to increase significantly.
In the past, the market has agreed that this is a great business (Lloyds even traded at 7x BV and in the decade before the crisis, never traded under 2x BV) . Let´s hope the market changes its view of Lloyds once again.
We believe that as non-recurring costs decline and underlying performance improves, Lloyds will become a simple yet highly profitable bank. Eventually, the market should reward good results.
-PPI deadline in August 2019
-Higher rates in the UK
-Dividend increases continue