Lloyds: A Sustainable Dividend Yield Of 4.3%

| About: Lloyds Banking (LYG)
This article is now exclusive for PRO subscribers.

Summary

Following several years of restructuring, Lloyds is now a retail-oriented bank focused on its domestic market.

It has a low risk profile due to its large exposure to mortgages, good asset quality and strong capitalization.

This business profile allows Lloyds to offer a sustainable dividend yield of 4.3%, making it quite attractive within the European banking sector.

Lloyds Banking Group (NYSE:LYG) has changed considerably its business profile following the global financial crisis. It is now focused on retail operations in its domestic markets, has a low risk profile and very good capitalization. Its dividend yield is one of its main positive factors making Lloyds quite attractive to income investors.

Company Description

Lloyds Banking Group is one of U.K's largest financial services groups offering banking, insurance and consumer finance. It is also one of the largest banks in Europe with a market capitalization of about $80 billion. It trades in the U.S. on the New York Stock Exchange through its ADR program. Its closest competitors are other large U.K banks, such as HSBC (NYSE:HSBC), RBS (NYSE:RBS), Barclays (NYSE:BCS) or Standard Chartered (OTCPK:SCBFF).

Lloyds Banking Group was formed in January 2009 following the acquisition of HBOS by Lloyds TSB. Currently, Lloyds operates through three main banking brands, namely Lloyds Bank, Bank of Scotland and Halifax. Following its State bailout, Lloyds started a significant restructuring process of its business focusing its operations in the retail domestic market.

The bank now generates about 95% of its revenues in the domestic market, having a low risk profile compared to its closest peers. The U.K. government has divested its stake in the bank during the past few years and Lloyds has returned very recently to full private ownership.

Business Overview

Lloyds is nowadays U.K.'s largest retail bank, with market shares ranging between 20-30% across key products. Lloyds also has a major presence in the U.K. commercial and corporate banking sectors. Additionally, its insurance division is also a core activity, with operations in corporate pensions, protection, retirement and home insurance.

By division, retail banking is Lloyds' largest division accounting for about 40% of Lloyd's underlying profit, followed by commercial banking (32% of profit), while consumer finance has a weight of 17% and insurance is the smallest unit (11% of profit).

Given its retail and commercial specialization, Lloyds doesn't have meaningful exposure to investment banking, contrary to some of its peers like Barclays or HSBC. Investment banking has been following the global financial crisis, one of the worst areas for large banks, and theoretically Lloyds should have less volatile and more predictable earnings over the business cycle.

Lloyds has more than 2,200 U.K. branches and a strong brand, which still represents a distinctive factor, even though its importance should reduce in the future with digitalization. Lloyds is the market leader on mortgages, leading to a high weight of housing loans in its loan book (about 70% of total loans). The U.K. mortgage market is among the most profitable in Europe, with average customer spreads consistently above other markets despite strong competition.

Additionally, Lloyds holds a market share of nearly 30% of current accounts, a low-cost funding source that is key to its ability to competitively price loans and services. This combination of high-margin assets and low cost funding is one of the main reasons why Lloyds reports above-average net interest margin [NIM], which should be sustainable in the long-term taking into account its business model.

Following several years of business restructuring and de-risking of its balance sheet, Lloyds is now in a new growth phase and recently announced the acquisition of MBNA for £1.9 billion ($2.4 billion), a credit card operation owned by Bank of America. This is Lloyds' first acquisition since the financial crisis and will boost its market share in credit cards to about 26%. The acquisition should be financially accretive in the second full year and will be funded through Lloyds' organic capital generation.

Financial Overview

Regarding its financial performance, after several years of business restructuring and balance sheet cleanup, Lloyds' financial results have improved markedly since 2014. Its business profile has changed considerably and the bank is now simpler and more focused on its core strengths, leading to very good results over the past couple of years.

In 2016, its total revenues decreased by 1.2% to $21.4 billion due to the low interest rate environment, but its NIM increased to 2.71% (from 2.63% in 2015) due to lower assets. This is the bank's highest NIM in its history, reflecting its lower funding costs and stable product margins.

One area where the bank has made a significant improvement and has boosted its earnings has been efficiency. The bank has reduced its cost base by about 20% compared to 2010, leading to one of the best efficiency ratios among European banks. In the past year, Lloyds' cost-to-income ratio was below 49%, much lower than its closest peers which a C/I ratio of about 60% on average.

Despite this good efficiency level, the bank has a cost reduction program ongoing targeting £1.5 billion ($1.9 billion) of annual cost reductions by end-2017, of which about £900 million ($1.16 billion) have already been achieved. Therefore, improved efficiency should continue to support its earnings growth in the next few quarters, even though further cost savings may be harder to achieve in the medium-term.

Reflecting its defensive and low risk profile, Lloyds' asset quality is very good and its cost of risk [CoR] ratio has been very low over the past couple of years. In 2016, its asset quality remained strong with no deterioration in the underlying portfolio, leading to a CoR of only 15 bps a very low level within the European banking sector.

Given its good operating environment and lower provisions for payment protection insurance, which has been a major drag on Lloyds' earnings over the past few years, its net income increased markedly in 2016 to about $3.2 billion, from $1.2 billion in the previous year. Its return on equity [ROE] ratio, a key measure of profitability in the banking sector, rose to 5.3%. This is still a relatively low level and Lloyds targets an ROE of between 12-13.5% in 2019.

In the first quarter of 2017, Lloyds has maintained a strong operating momentum, reporting an increase of 1% in revenues. Its NIM increased further to 2.80% and now the bank sees this level has sustainable for the rest of the year. Lloyd's cost base has remained stable, while impairments and provisions continue to decrease. This justifies its increase of more than 60% in its net profit to £890 million ($1.15 billion) in the quarter. Going forward, Lloyds should report relatively stable operating metrics, with efficiency and lower charges for impairments and provisions being the main earnings growth drivers.

Capital and Dividends

Regarding its capitalization, Lloyds has improved substantially its balance sheet over the past few years and is now among the best capitalized banks in Europe. This improvement has been achieved through a combination of balance sheet de-risking, asset sales and organic capital generation through higher earnings, boding well for its future organic capacity to maintain a strong capitalization.

At the end of the first quarter of 2017, its fully loaded core equity tier 1 (FL CET1) ratio was close to 14%, a very comfortable level and higher than most U.K. peers. Moreover, this ratio is above its own target of 13%, thus Lloyds is already in an excess capital position. According to the bank, it expects capital generation of about 170-200 basis points (bps) per year, before dividend payments, which is a very strong capital generation capacity.

The acquisition of MBNA should cut its capital by about 80 bps, but its strong position and organic capital generation should enable Lloyds to provide an attractive and sustainable shareholder remuneration policy in the next few years.

Regarding its dividend history, Lloyds returned to dividend payments in 2015 (related to 2014 earnings) after a hiatus of several years. Its dividend policy is to pay a progressive dividend over time, distributing at least 50% of its earnings.

Its first dividend payment was very small, but it increased rapidly and its last dividend (related to 2016 earnings) was set at £0.0255 ($0.033) per share. This represented an increase of 13.3% from the previous year, reflecting its confidence in future prospects. Additionally, it also decided to make a capital distribution in the form of a special dividend of £0.005 ($0.006) per share. At its current share price, Lloyds offers a dividend yield of 4.3% considering its total dividend for the year.

Additionally, its dividend has good growth prospects in the next few years, reflecting Lloyds' improved earnings, making it also attractive to dividend growth investors. According to analysts' estimates, Lloyds's dividend should continue to grow significantly in the coming years, to about £0.05 ($0.064) per share by 2019, or about 18% per year.

Conclusion

After several years of business restructuring, Lloyds is now one of the best European banks. It has a quality profile, based on its retail-oriented business model with strong asset quality and low risk profile. Additionally, its capitalization is very good, leading to an attractive and sustainable dividend policy.

Its attractive dividend yield and good dividend growth prospects are the main positive factors of its investment case, which seem to be sustainable given the bank's strong fundamentals. Its excess capital position and good organic capital generation allow the bank to pay more than 50% of its earnings, possibly leading to higher dividends than expected in the next few years.

Disclosure: I am/we are long LYG.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.