Seeking Alpha
Long/short equity, medium-term horizon, value, growth
Profile| Send Message| ()  

Lloyds Banking Group (LYG) is one of the largest banks operating in the United Kingdom. Its stock price has rallied by 104% over the past year, and currently trades at 1.04 times book value. This is while many large banks in Europe (including the UK), as well as those in the US, trade at a significant discount to their net assets. It may well lead you to think that Lloyds must be a very profitable and stable bank. But this does not seem to be the case. The bank has made a loss over the past three years. Had it not been for the £11 billion accounting gain in goodwill from the acquisition of HBOS, Lloyds would have made a loss in every year since 2009. Furthermore, Lloyds suffers from an £8.6 billion ($13.1 billion) capital shortfall, which needs to be filled in by the end of 2013, as Basel III capital rules are being phased in. It appears that Lloyds stock has got ahead of itself, and there are plenty of downside risks that could derail its full recovery.

LYG Chart

LYG data by YCharts

Weakness in the UK economy

One of the main things holding back profitability from Lloyds Banking Group has to do with the weakness in the UK economy and its housing bubble.

The UK is still well below its peak production output achieved in early 2008. In stark contrast, the US is almost 4% above its peak output prior to the recession of 2008/9. The economic recovery has been very slow in the UK compared to the US and Germany. The UK has seen many quarters of very low and sometimes negative GDP growth; and it had narrowly missed a 'double dip' recession in early 2012, as estimates of GDP were revised upwards in June 2013. The recovery for the UK is far from reaching 'take-off' and the economy is particularly vulnerable to faltering again.

GDP growth for 2013 is expected to be only 0.8%, and unemployment is stubbornly high at 7.8%. For 2013, Britain is expected to have one of the largest fiscal deficits amongst developed economies: at 7.6% of GDP, the UK's fiscal deficit is higher than the US, Italy, Greece and even Spain. Only Japan has a larger budget deficit at 8.7% of GDP.

(click to enlarge)

Source: OECD

The UK had not adopted the European single currency, but its economy is highly vulnerable to shocks from the Eurozone. The EU accounts for almost half of all of the UK's exports, and many of its largest trading partners are within the Eurozone. The recent European sovereign debt crisis has been detrimental to the UK's recovery, as many of its trading partners have reduced demand of British exports. Furthermore, the UK banking sector has significant exposures to the Euro area, especially Ireland, where many UK banks, have significant retail and wholesale operations.

Households in the UK are relatively highly indebted despite deleveraging since 2008, with a gross debt to disposable income ratio of 146%. This is higher than the OECD average of 121%, and the Euro area average which is at just 108%. According to the Economist, house prices in the UK are still overvalued by 19% by the long-term ratio to rents, despite having fallen 11.4% since the end of 2007. Continued consumer deleveraging may put further downward pressure on house prices which would have a detrimental effect to UK banks' credit quality and retail loan demand.

(click to enlarge)

Source: OECD

If you are concerned by Canada's high household debt and its property bubble, you may wish to read my article on Canadian banks here.

Lloyds Banking Group

Lloyds Banking Group was formed in 2008 by the merger of two British banks, Lloyds TSB and HBOS, the fifth and fourth biggest in the UK, respectively, as measured by regulatory capital. Soon after announcing the deal, both HBOS and Lloyds required government assistance in recapitalization, and this was achieved through the issuance of ordinary and preference shares. As a result, the British government became the single largest shareholder in the combined bank, Lloyds Banking Group; and currently, it still holds a 39.2% stake in the bank. Today, Lloyds Banking Group is the largest retail bank in the UK, measured both by the number of current account customers and by the total value of mortgage lending. Lloyds also has one of the largest market shares in the UK commercial banking sector. The bank has very limited international operations, with the exception of its retail and wholesale business in Ireland.

Lloyds Banking Group's main competitors in the UK are the other three Big 4 banks: HSBC (HBC), Barclays (BCS) and the Royal Bank of Scotland (RBS). The three competitors are on the list of globally systemically important banks (G-SIBs), and have significant operations internationally, as well as large investment banking divisions. Lloyds was originally on the list of globally systemically important banks (G-SIBs); but in 2012 Lloyds was removed as a result of its decline in global systemic importance.

Lloyds Banking Group shares are listed on the London Stock Exchange, and they are also traded on the New York Stock Exchange (NYSE) through a sponsored American Depositary Receipts (ADR) facility. One ADR represents four ordinary shares.

A comparison against its peers

Lloyds Banking Group trades at a 4% premium over book value while Barclays and RBS trade at a discount to book value of 32% and 54%, respectively. HSBC is the only UK competitor trading at a premium to book value, but HSBC is very geographically diversified, and generates the majority of its income outside of Europe, with a particular emphasis on Asia. But because many European and US banks have balance sheets significantly 'bloated' with intangible assets and goodwill, tangible book value is more relevant for comparing against the banks' market capitalizations.

Standard Chartered, another large bank headquartered in the UK was excluded for this comparison because it primarily operates in emerging markets. Given the lack of a retail banking operations in UK and Europe, it is not directly comparable. However, you may feel free to read my existing article on Standard Chartered here.

Selected Financial Data for the UK's Big 4 Banks

LYG

HBC

BCS

RBS

Market Capitalization ($ bn)

69.42

195.01

55.50

48.04

Net Interest Margin (%)

1.93

2.32

1.85

1.93

Impairment as a % of average loans and advances

1.02

0.90

0.75

1.06

Return on equity (%) [for 2012]

-3.1

8.4

-1.9

-8.8

Cost-to-income ratio (%)

78

63

85

99

Loan-to-deposit ratio (%)

121

74

110

100

Core Tier 1 capital ratio (%) [Basel II]

12.0

12.3

10.9

10.3

Capital Shortfall * (£ bn)

8.6

Nil

3.0

13.6

P/B

1.04

1.11

0.68

0.46

P/TB **

1.31

1.41

0.85

0.62

Forward P/E (2013 EPS)

14.3

10.8

7.8

n/a

Dividend Yield (%)

n/a

3.85

2.32

n/a

Source: Company Financials (2012) * as announced by the UK regulator in June 2013 ** adjusted price-to-tangible book excludes goodwill, intangible assets and deferred tax assets

On an adjusted tangible price-to-book ratio, Lloyds is trading at a 31% premium. This is while Barclays and RBS, and many other banks in Europe and the US are trading at a substantial discount. It is surprising that Lloyds can enjoy this premium over tangible book value given that the bank has yet to return to 'normal' profitability. Lloyds still suffers from a high cost structure and a relatively weak balance sheet.

On a price-to-earnings basis, it is difficult to compare Lloyds to its competitors, as Lloyds and two other UK banks have made a loss in 2012. But, in 2012, Lloyds' return on equity (ROE) was -3.1%, which, although better than RBS's ROE of -8.8%, was significantly worse than for HSBC and Barclays. Although Lloyds is expected to produce an EPS of 4.48p {equivalent to about $0.27 per ADR} in 2013, Lloyds is only expected to generate an ROE of 7.3% by the end of 2013. It is still a long way away from meeting its target for ROE to be between 12.5 - 14.5 %. For 2013, Lloyds' expected forward P/E ratio would be 14.3, which is significantly higher than for HSBC or Barclays, which are 10.8 and 7.8, respectively. Even on consensus estimates of EPS for 2014 of 5.88p, Lloyds would still sport a 2014 FPE ratio of 10.9, compared to 10.0 and 6.7 for HSBC and Barclays, respectively. On most of the valuations mentioned, Lloyds' stock trades at a significant premium to HSBC and Barclays. This is in spite of Lloyds having higher loan impairments and a larger capital shortfall compared to its stronger rivals.

Last month, the Prudential Regulation Authority (PRA), the UK's banking regulator had announced that large UK banks had a combined capital shortfall of about £27 billion. This is to achieve a core equity capital ratio of 7% to risk-weighted assets by December 2013, as Basel III rules are being phased in. Lloyds has a capital shortfall of £8.6 billion, which is £2.8 billion more than previously expected. This was mainly caused by higher risk-weighted assets being reported as a result of the implementation of stricter rules. Although Lloyds does not anticipate the need to issue equity or hybrid securities to fill this capital shortfall, it will need to accelerate its sale of non-core assets and shrink its balance sheet. This may reduce Lloyds' profitability as well as postpone plans to return capital to shareholders. Now it seems that Lloyds may only be able to pay a dividend in 2014, at the earliest. This is unattractive, as even 'weak' banks across Europe are expected to continue to pay significant dividends, including Barclays, Societe Generale and Banco Santander (SAN). Many of these banks are also trading substantially below tangible book value.

On a brighter note, Lloyds has made great steps in cutting costs; and in 2012, total operating costs had fallen by 5% to £10.1 billion, and management expects to reduce costs further to around £9.8 billion in 2013. Although Lloyds' cost-to-income ratio is 78%, the bank's core cost-to-income ratio stands at 55%. This compares favorably against many of its peers, but on its own, it cannot justify Lloyds' valuation premium over tangible equity.

The downside risks to Lloyds Banking Group

There are many potential catalysts which are negative to Lloyds Banking Group that carry the severity to return Lloyds to a comparable valuation on tangible book value against its peers. Lloyds' relatively expensive valuation for a UK (and European) bank can only be justified if the bank can avoid many of the risks present in the industry.

The current economic conditions in the UK remain weak, with persistently high unemployment and expected low GDP growth for the next few years. Together with relatively indebted consumers, the outlook for the UK retail banking sector remains poor. House prices in the UK remain overvalued, and they could fall further; which may lead to further increases in loan impairments and lowers the collateral the banks hold. Consumers are still deleveraging, as well as putting off home purchases, and this may lead to further declines in loan demand. Together with record low interest rates, banks earn very low net interest margins, which are unlikely to increase in the near term. Unlike in the US, the UK is likely to keep monetary policy loose for much longer, as the economy is recovering much more slowly.

Lloyds' lack of diversification, both geographically and in terms of the scope of businesses it provides, means that it is most susceptible to developments affecting economic fundamentals relating to consumers and business in the UK. It would be particularly vulnerable to changes in GDP growth for the UK, unemployment and falling house prices. The retail banking industry in the UK and Europe is particularly unattractive, given the indebtedness of households in the UK and overvalued property prices across many European countries. Retail mortgage lending accounted for over 65% of total lending for Lloyds. This compares to only 42% and 32% for Barclays and RBS, respectively. Barclays, RBS and HSBC have significant international retail operations which could offset some of the slack in the demand for consumer loans in the UK.

Although impairments have fallen substantially since 2009, it is not for certain that this trend could continue. The UK economy may be in better shape than in 2009, but it remains significantly weaker than many non-European economies, including the US. Large uncertainties remain, including fears of a 'double-dip' recession, falling house prices and weak consumer confidence. These risks may easily lead to rising loan losses in the near term.

Despite recent reforms, the bank is still heavily reliant on wholesale funding. It has the highest loan-to-deposit ratio of the big four UK banks, at 120%. Total wholesale funding amounts to £170 billion, with short-term wholesale funding accounting for £51 billion. This source of funding has historically been volatile and potentially very costly during a period of great uncertainty.

The UK government is the single largest shareholder in Lloyds, with a 39.2% equity stake in the bank. The government has persistently encouraged banks, especially part-nationalized ones, to expand lending to small businesses and to mortgages. This increase in 'new' lending may not be in the minority shareholders' interests, as it may affect credit quality and constrains the bank's ability to return capital to shareholders.

Furthermore, the government's plan to 're-privatize' the bank, through the sale of its 39.2% stake, may present near-term pressure to Lloyds' stock price, as it appears the government is intending to sell its entire stake within the next two years. The "break even" stock price is 61.2p per ordinary share {this is equivalent to $3.73 per ADR}: this is the threshold set by the government to begin selling its stake in the bank. At the time of writing, the stock is trading 4% higher than the "break even" price; and that may signal the beginning of the sale. The other part-nationalized bank, RBS, is still trading at far below the government's "break even" price, and therefore the onus is on the government to sell its stake in Lloyds. The current coalition government would like to claim it has returned one of the bailed-out banks to the private sector without making a loss, and claim a political victory over the opposition before the next UK general election, expected to take place in May 2015. Because the Conservative Party, the major political party in the current coalition, is trailing significantly behind in opinion polls compared to the opposition, the Labour Party, it may be especially tempting for the Conservatives to score this political victory before the election debates. Such a sale of a large stake in a short period of time could put downward pressure on Lloyds' stock in the foreseeable future.

The risks to shorting Lloyds

Before you consider shorting Lloyds because of the many downside risks, you must understand the risks of shorting the stock, including the potential for Lloyds' stock price to continue to rise.

Lloyds Banking Group's primary listing is in London, so there are significantly lower volumes traded on its ADRs listed in New York. The price of the ADR may deviate from the price of the equivalent ordinary shares traded in London; and so trading in ADRs may present its own risks. Nevertheless, the price differential has typically been very small, and Lloyds ADRs typically have modestly high volumes of trading, with an average volume exceeding 2 million shares.

Lloyds may continue to make strong improvements in cutting costs. If it continues to make considerable reductions through further cuts in the number of employees and restructuring to achieve simplification, Lloyds may be able to utilize its scale of operations in the UK to achieve a very low cost efficiency ratio. Given Lloyds' is the largest retail bank in the UK and has one of the largest market shares in commercial banking, this is quite possible. However, much of the improvement from restructuring is already shown through lower operating costs since 2009. Management expects total operating costs to fall by just 3% for 2013, down from 5% in 2012. Further improvements are likely to be less substantial; and let's not forget that lower costs are partly achieved by shrinking the size of the bank's balance sheet.

The UK economy could finally gain sufficient momentum to make a rapid recovery, and fears over the Eurozone may not turn out to be true. This would lead to further improvement in Lloyds' credit quality, and improve profitability from stronger loan demand. Although a stronger recovery is quite possible, the UK is likely to maintain sluggish growth. Furthermore, because of stricter capital requirements, Lloyds is unable to expand its lending by very much as it is already suffering from a large capital shortfall, despite rapid divestment of assets and a fast shrinking balance sheet. The greatest risk to shorting Lloyds would therefore be a rapid decline in impairment charges as a result of an improving economic outlook. For the first quarter of 2013, Lloyds reported a 34% fall in the impairment charge-to-average loan ratio over the corresponding quarter in the previous year. If Lloyds could continue to rapidly reduce loan impairments, it would return to strong profitability. However, further improvements in the impairments ratio is likely to slow in pace, as the economic outlook for UK economy remains weak.

Strong downside potential but limited upside risk

The main downside risk is, of course, Lloyds' expensive valuation compared to its peers. Although Lloyds is closer to returning to normality since the financial crisis than RBS; Lloyds still faces many challenges, including high loan impairment charges, weak loan demand and a large capital shortfall. Further weakness in the UK and European economies, as well as housing market troubles, could well serve as a catalyst to accelerate the return of Lloyds' valuation to be below its adjusted tangible book value. Given the overvaluation in many European housing markets, slowing growth in China, fiscal austerity, and the slow pace of structural reforms, this is not altogether unlikely.

Both Barclays and HSBC have a stronger balance sheet, higher underlying profitability and a more diversified business model to Lloyds. Yet, these two banks trade on a discount to Lloyds on current and future earnings. Also, Barclays trades at a 15% discount to adjusted tangible book value. HSBC, a globally diversified bank, with strong operations in Asia, trades with only a 41% premium, while Lloyds trades with a 31% premium. Given Lloyds' marked vulnerability to UK consumer and business loan demand and its weaker capital position, Lloyds should not trade higher than Barclays' valuation to adjusted tangible book value. Should Lloyds' valuation to adjusted tangible net assets fall to Barclays' level, Lloyds' stock has a potential downside risk of over 35%. But, it could, of course, fall further because Lloyds is not in a much better position than RBS, or many large banks across Europe.

Lloyds' upside potential is somewhat constrained by Lloyds' valuation above book value, and its low profitability. HSBC trades at an 11% premium over total book value. This is notwithstanding HSBC's strong return on equity of above 8% over the past three consecutive years, and expectations of higher profitability in at least the near term. So it would be rather surprising for Lloyds to trade above HSBC's premium over its tangible net assets, given the significance of the downside risks faced by Lloyds, as well as its weak profitability.

Conclusion

Lloyds Banking Group's limited upside potential, while having many downside risks, as well as its apparent overvaluation against its peers, suggests that there may exist an asymmetric risk-reward opportunity in favor of shorting Lloyds. Many of the downside risks are quite highly probable, and they carry the severity which could impede Lloyds' recovery to profitability and capital strength. Should any of these downside events occur, Lloyds would not be able to justify its premium on tangible book value. With Lloyds Banking Group trading at 31% premium above adjusted tangible book value, and continued weakness in the UK economy, the risks of substantial upside is significantly mitigated.

Appendix

If you are not keen on shorting Lloyds Banking Group because you expect that the UK (and/or the European) economy is going to recover more strongly, leading to greater profitability for European banks, you may consider hedging that risk by simultaneously opening a long position on a different European bank. Barclays is a possibility for that long position, as the bank has a much smaller capital shortfall and it is expected to be more profitable in the near term. Despite this, Barclays is trading at a 15% discount to adjusted tangible book value. In this way, you will have no net short position in the European banking sector, but you may still benefit from the convergence of Lloyds' valuation to the valuation of other European banks. However, should the value of these banks diverge further, then you could make even greater losses than simply shorting Lloyds' stock.

Source: Lloyds Banking Group Still Faces Many Challenges

Additional disclosure: The potential loss on short selling is theoretically unlimited. You may consider using derivatives to reduce your risk of trading. But, please seek all necessary professional advice in the light of your own circumstances before making an investment decision. I am long BARC.L