Update: Lloyds Bank to Test the Waters for Rights Issue

Looks like Lloyds Banking Group’s (LYG) will get a shot at buying its way out of the UK Government’s bank bailout scheme, with a significant assist from the government itself. As reported previously on Research Recap, the chances of the bank being able to pull this off got a boost from Citadel analyst Joseph Dickerson’s bullish call on Lloyds more than a month ago.

But the idea was given a scare by the European Commission’s move to break up Dutch bank ING (ING) after it received substantial government support , leading some to believe Lloyds might be required to follow suit.

Now, however, the UK Treasury has given a tentative blessing to Lloyds to test the waters for the rights issue of £13 billion or so it would need to pull this off. Even better from Lloyd’s perspective is Treasury’s indication it would take up its full allocation of new shares to maintain its 43.5% stake, adding about £6bn to the £17bn it has injected into Lloyds since January (FT Alphaville).

According to CreditSights ,

Lloyds also confirmed that the APS alternative would be a combination of a rights issue (the latest speculation centres on a £13 bln deal) and the exchange of 'certain capital securities' into 'contingent core tier 1 and/or core tier 1 capital' (likely to be £7.5 bln according to the Financial Times). That would leave probably £4 to 5 bln of capital to be raised from other sources, such as asset disposals. Contingent capital has recently become a favourite concept of regulators, being a debt instrument that would convert to common equity under certain stress conditions, such as capital ratios falling below a defined level – not unlike a mandatory convertible note. Presumably Lloyds thinks this might be more attractive to bondholders than an exchange straight into common equity, as well as being less dilutive for shareholders.

It will be interesting to see how such an instrument is structured to ensure it can pay a coupon if the European Commission tells Lloyds to stop paying non-mandatory coupons on its hybrids.

“I think the comments today provide comfort that the group will not be broken up and that any restructuring initiatives will not be particularly material to group earnings or capital,” Execution’s Dickerson said Thursday. (FinancialMirror) In reference to its talks with Brussels, the bank said: “(Lloyds) is confident that the final terms of its restructuring plan, including any required divestments of assets, will not have a material impact on the group.”

Other analysts also are upgrading the banking group. Exane BNP Paribas analyst Ian Gordon upgraded the stock to ‘neutral’ despite fears it will remain loss-making for the next year and a half. “Following the shares’ sharp underperformance since the interim results we now see the risks and rewards as evenly balanced.”

Credit Suisse also changed its view on the bank from ‘underperform’ to ‘neutral’ following its latest announcement, as well as near doubling its target price from 55p to 95p, on the assumption it will avoid entering the APS (CityWire)/ It said shares were ‘far from cheap, but no longer expensive’, after its comments on Europe in particular provided some relief. However, although it has upped its price, Credit Suisse said it remained worried about the structure of the group. ‘Structurally we remain concerned by Lloyds’ liability structure and think the market is underestimating this,’ it said.

Oriel Securities analyst Mike Trippitt upgraded Lloyds to Buy from Reduce on Oct 14, with a valuation of 90p, noting “additional potential growth in net asset
value per share could drive up the valuation to over 115p per share.” Deutsche Bank’s Jason Napier raised Lloyds to Buy from Neutral Oct 15, with a target of 115p.

Morgan Stanley’s Steven Hayne upgraded Lloyds to Equal-weight from Underweight on Oct 16 with a target of 105p:

Based on recent credit healing and improving underlying property markets, we have reduced our impairment assumptions over the next few years. On this basis we believe the APS no longer provides value for money, and would view positively any effort to exit partially or totally.

Evolution Securities initiated coverage of Lloyds on Oct 20 with a Buy rating and a 96p target price, noting that “Once the turnaround is over, LLOY should emerge as the largest distributor of banking services in the UK, and the largest mortgage bank in Europe.”