Lloyds Banking Group: Fully Valued

Summary

• Following the FY20 result, I provide an updated normalized earnings framework for Lloyds.
• UK banks have performed very well so far in 2021 and investors should be realistic about further upside potential given current valuations.
• With a solid balance sheet, Lloyds has capacity to increase dividends over time.
• I downgrade my rating to Neutral on valuation grounds.

Photo by agrobacter/iStock via Getty Images

Introduction

Since my previous note on Lloyds Banking Group PLC (NYSE:LYG) and UK banking peers Barclays (BCS) and NatWest (OTCPK:RBSPF) have performed very well. Table 1 shows the total return for each stock for the period from 08 January 2021 to 01 April 2021. Note that LYG is still cum-dividend, whereas BCS and RBS have gone ex-dividend.

Table1:

Source: Author's calculations

With LYG having delivered such strong returns over a short period, this is a sensible time to revisit my assessment of the company and consider whether LYG still warrants a Bullish rating. Whilst I prefer to adopt an "absolute return" framework to assess valuation appeal, peer relative measures are also useful benchmarks. It remains the case that LYG has not bounced as vigorously off its COVID-19 era low point as BCS and RBS (Table 2) have done.

Table 2:

Source: Author's calculations

In this note, I drill down into a few points of interest to help readers build a deeper understanding of LYG. I also provide an updated assessment of normalized earnings for LYG, taking into account the new information provided at its most recent reporting date of 31 December 2020, "FY20". Using this normalized earnings framework, I refresh my view of the value upside potential for the stock. For a more general overview of LYG, I point readers to my previous Seeking Alpha note on LYG.

Plenty of Excess Capital - But Some Could Quickly Vanish

LYG reported a very healthy CET1 ratio of 16.2%. Note that this is after an allowance for the final dividend payable of 0.57p per share. LYG's internal CET1 ratio target is 13.5%, which includes a management buffer of 1%. On the face of things then, LYG has plenty of excess capital that may become available for distribution. The gap between the reported CET1 ratio of 16.2% and the management target of 13.5% equates to ~£5,474m or 7.7p per share.

Source: LYG FY20 Results Presentation, slide 30.

However, there are two material adjustments that should be made in order to get a more realistic view of excess capital. The UK banking regulator, the Prudential Regulation Authority, is consulting on a proposal to reverse the revised capital treatment of software assets. In my view, the Prudential Regulation Authority is likely to go ahead with the reversal, which will have the effect of reducing LYG's CET1 ratio by ~0.5%. Secondly, UK banks are currently benefitting from temporary capital relief relating to recently updated requirements for setting BDD provisions. This temporary capital relief equates to roughly 1.2% in CET1 ratio terms.

Adjusting for the two matters above, the stated CET1 ratio of 16.2% reduces to 14.5%. This is still a strong capital position, being 1% above the internal management target and ~3.5% above the minimum regulatory requirement quoted on slide 30 of LYG's FY20 Presentation. Excess capital of 1% equates to ~£2,000m or 2.8p per share.

It is hard to imagine a banking regulator agreeing to material distributions of excess capital in the near term. There is still far too much uncertainty regarding how the UK economy will perform once COVID-19 government support mechanisms drop away for a regulator to approve large-scale capital distributions.

Dividends - Recommenced and Upside Likely (Eventually)

In December 2020, the Prudential Regulation Authority announced that bank dividend payments could restart in 2021, albeit in a restricted manner with a cap applied to dividends relating to 2020. LYG's recently declared dividend of 0.57p is in line with the maximum distribution allowed by the regulator. This compares with the FY19 total dividend of 3.37p.

It appears likely that regulatory restrictions will also be applied to 1H21 dividends, and so we may not see a return to full dividend payment capacity until early 2022. That said, there is plenty of scope for the dividend to be increased from FY20 levels, and LYG has a stated commitment to a progressive and sustainable ordinary dividend policy. Further. Given LYG's strong capital position, I think that there is potential for a modest special dividend to be declared with the release of the FY21 result in February 2022.

Restructuring Expenses or BAU Costs?

The profit reporting framework used by LYG focuses on "Underlying Profit", with certain items that are deemed to be one-off or volatile (in both positive and negative directions) reported "below the line". It is very common for companies to use "underlying" or "adjusted" profit results as a basis for communicating business performance to the market. There is nothing fundamentally wrong with such adjustments, and in many cases, the underlying/adjusted results provide investors and analysts with a much clearer view of business performance than the corresponding statutory results.

LYG includes restructuring costs as a "below the line" item - in other words, the bank excludes restructure costs in the calculation of underlying profit. This is not a treatment that I fully agree with. Having observed banks for many years, my view is that restructuring is a regular part of a bank's business activity. As banks modify their strategies over time, it is inevitable that there will be regular impacts upon property footprints (resulting in lease-break costs) and headcount (resulting in severance-related costs). A bank might choose to lump other costs related to restructuring into the "below the line" bucket, such as write-downs to intangible carrying values, decommissioning of IT systems, regulatory updates. Definitions and approaches for such adjustments vary across banks, as does the consistency of application over time by a particular bank.

For valuation purposes, I rely upon an assessment of normalized earnings. Essentially, my goal is to arrive at a point-in-time estimate of how I expect the company to perform on a "through-the-cycle" or "sustainable earnings" basis. In my previous work on LYG, I have made an allowance of -£100m pa for ongoing restructure costs and included this adjustment within the operating costs line item. In effect, I was moving a bunch of costs that LYG reported "below the line" back into the underlying profit number. The logic for my adjustment was that these costs are effectively business as usual, "BAU", expenses.

LYG's FY20 release has motivated me to adjust how I model restructure expenses. Rather than including an allowance for ongoing restructure expenses within operating costs, I will now make an explicit adjustment, for reasons that will become apparent below.

The definition adopted by LYG for "below the line" restructure expenses is rather broad:

• "Restructuring, including severance-related costs, property transformation, technology research and development, regulatory programs and merger, acquisition and integration costs"

Source: LYG FY20 Profit Result, "basis of presentation".

At FY20, a new item has appeared within the restructuring bucket - "technology research and development". LYG incurred a cost of -£61m in FY20 in regard to this item and has advised that the FY21E cost will be higher again (source: LYG FY20 Profit Result, page 24).

In the FY20 results presentation, CFO William Chalmers provided the following explanation as to why these technology expenses were reported as restructure costs:

• "Technology R&D charges relate to costs associated with our initial investigation of new technology capabilities. I will provide more detail on the initiatives here later on in the presentation, but these activities are at an exploratory stage and represent a series of opportunities that we are looking at, to deliver and to accelerate transformation.
• Looking forward, we expect to continue to increase investment in technology R&D and therefore expect restructuring charges to be somewhat higher in 2021."

Source: LYG FY20 results presentation transcript, page 7.

In the sell-side Q&A roundtable transcript, the CFO provided further detail (bold is my emphasis):

• "Technology R&D, just a couple of words on that. This is a relatively new area of focus and as the name suggests is on new technology and its potential applications.
• It has the potential to fundamentally change the customer proposition and our legacy setup with revenue and cost consequences in due course and it cuts across a variety of areas. Customer offering, the enterprise core, the technology platform and architecture, the resilience capability and so forth.
• It is usually in the Cloud and often with partners, but the key point is and the reason why it is labelled R&D is because it is not yet proven.
• In 2021, we have a range of measures including a pilot migration. We have a test on various aspects of Cloud to see what the operating offering is and how promising that might be or otherwise. That requires investment in 2021.
• We will then look towards the end of 2021 about what next steps make sense off the back of that and we will talk to the market about that. Essentially what we are trying to do is to use some of our cost leadership and efficiency to invest in what we think might be the next stage of restructuring for the enterprise."

Source: LYG FY20 sell-side roundtable transcript.

From my perspective, this type of technology expense is BAU in today's banking environment. Technology is advancing rapidly and banks must react to progress made by peers and also to the threat of fintech challengers that are free of the technological complexity associated with more rigid, legacy IT systems that established banks typically depend upon. I, therefore, see the FY20 cost of -£61m as part of normalized earnings for LYG. And based upon the CFO's comments, we can expect this item to increase in FY21E.

Let's now take a look at the bigger picture on restructuring costs. As set out in the Table 3 below, severance and property transformation costs have been in the range of roughly -£200m to -£300m pa over the last two years. UK banks have been actively reducing their property footprint for several years, and it may be reasonable to conclude that LYG's property transformation costs have been higher than "normal" in FY19 and FY20. But it also seems likely that we will see further industry-wide property transformation costs in FY21 and FY22, as UK banks react to changes triggered by COVID-19 in regard to working from home and reduced bank branch utilization by customers.

Table 3:

Source: LYG FY20 Results Presentation, slide 28.

Turning next to "regulatory programs". Similar to technological change, regulatory change is a constant in the banking industry. LYG can safely argue that certain changes required in FY20 were "one-off", with a cost of -£42m, but history and common sense suggest that we will see a fresh batch of "one-off" regulatory changes in FY21 and coming years. Having reflected further on this item, I no longer consider it sensible as an exclusion from a normalized earnings valuation framework.

Bringing the above together, I have updated my assumption for "below the line" charges for LYG. I now include a total allowance of -£275m pa in my assessment of normalized earnings. The composition of the adjustment is -£125m pa for severance and property transformation (combined), -$100m pa for technology R&D, and -£50m pa for regulatory change costs.

Bad Debts - Forecasting Complexity vs. Robust Simplicity

As mentioned above, my preference is to use normalized earnings when making investment decisions. In regard to impairment charges, or bad and doubtful debts "BDD", this approach directs analytical efforts towards an average expected BDD charge, rather than worrying too much about the actual BDD expected in the next reporting period. So, as a general rule, I don't try to forecast near-term BDD outcomes. (One exception to this general rule is when a bank is at risk of needing to issue equity in order to meet regulatory capital requirements - in such a case, near term BDD charges can be an important factor as to whether or not the bank needs to come to the market with cap in hand.)

The framework that I use for normalized BDD is simple but robust. It is based upon a weighted average calculation of loss rate expectations across the different segments of the loan book (e.g. mortgages, credit cards, etc.). I use historical loss rate assumptions, which tend to be slightly on the conservative side (i.e. higher loss rates). My previous valuation update assumed a normalized loan loss rate of 45bp pa. During FY20, there was a modest drift within the LYG loan book away from the higher credit risk products towards lower credit risk products. This contributed to a slight reduction to my normalized loan loss rate, which now stands at 42bp pa. To place that assumption in context, LGY's CFO referred to a "through-the-cycle" impairment charge range of 30bp to 35bp (source: LYG FY20 results presentation transcript, page 15). Investors who are willing to back the CFO's judgment and think I'm being too cautious on BDD can adjust my numbers accordingly.

Recognizing that some readers do in fact have a keen focus on near-term BDD outcomes, let's have a closer look at the current position. Table 4 shows the BDD contribution to underlying profit (reported as impairment) over the four quarters of FY20. The table highlights that LYG put in place very large BDD provisions in the first half of 2020. After the large top-up to provisions at 2Q20, further BDD charges have been very low.

Table 4:

Source: LYG FY20 Results Presentation, slide 46.

BDD provisions are based upon forward-looking models. The economic outlook assumed by LYG improved at 4Q20 relative to 3Q20, contributing to a reduction in BDD provisions of £459m in 4Q20 (source, LYG FY20 Presentation, slide 20). In simple terms, we might say that the 3Q20 BDD provision booked was overly conservative in retrospect (if LYG's new economic outlook assumptions prove to be correct). LYG added back £200m to the 4Q20 provisions in the form of a "management overlay", which can be thought of as a safety buffer to allow for uncertainty in the BDD projection models. Without the management overlay, BDD would have actually been a positive contribution to profit in 4Q20 - not exactly an intuitive outcome given that the UK entered another COVID-19 lockdown in 4Q20 (welcome to the mysterious world of BDD accounting). LYG's improved economic outlook assumptions reflect progress with the vaccine rollout and further extension to government support mechanisms.

To put these numbers in context, the FY20 BDD charge of £4,247m is ~2.3x my estimated normalized BDD charge of £1,848m, and ~3x higher than the midpoint of the "through-the-cycle" BDD range quoted by the CFO. The BDD charge for FY19 was £1,291m. Clearly then, the FY20 BDD charge was abnormally high. This does not, however, imply that the BDD charge was "too high". Looking forward to FY21E, LYG stated the following:

• "Based on our current macro economic assumptions we expect the 2021 impairment charge to return closer to pre-pandemic levels and the net asset quality ratio to be below 40 basis points."

Source: LYG FY20 results presentation transcript, page 6.

If we accept LYG's guidance on BDD as being reasonable, this points to the FY21E BDD charge being slightly lower than the assumption that I use when setting normalized earnings (42 bp). This is despite that fact that in FY21E the UK will still be working through the economic crisis caused by COVID-19.

In my view, forecasting near-term BDD outcomes for banks is a very subjective game, and so it is not something that I direct much analytical effort towards. I feel a similar way about making near-term foreign exchange rate predictions. If readers wish to form a view on FY21E BDD, a good place to start is to assess the sufficiency of the BDD provisions that LYG has in place at the end of FY20. If economic outcomes are worse than LYG has assumed, then the FY20 BDD provisions will need to be topped up. If economic outcomes are better than LYG has assumed, then the FY20 BDD provisions could potentially be released. Table 5 provides an overview of the probability-weighted scenarios that LYG used to arrive at the FY20 total BDD provision of £6,860m. Interestingly, the final provision is only slightly above the base case scenario of £6,354m.

Table 5:

Source: LYG FY20 Results Presentation, slide 47.

An investor with a very bearish outlook regarding the UK economy might be inclined to lean towards the Severe Downside scenario of £9,838m. This represents downside risk of ~£3,000m relative to actual current BDD provisioning levels. To put that number in context, £3,000m represents ~10% of LYG's current market capitalization.

An investor with a moderately bearish outlook regarding the UK economy might be inclined to lean towards the Downside scenario of £7,468m. This represents downside risk of ~£600m relative to actual current BDD provisioning levels. To put that number in context, £600m represents ~2% of LYG's current market capitalization.

An investor with a bullish outlook regarding the UK economy might be inclined to lean towards the Upside scenario of £5,766m. This represents upside risk of ~£1,100m relative to actual current BDD provisioning levels. To put that number in context, £1,100m represents ~3.65% of LYG's current market capitalization.

Normalized Earnings

LYG has provided earnings guidance for FY21E as set out below, which can be used to assist with an estimate of normalized earnings.

• Net interest margin to be in excess of 240bp.
• Operating costs to reduce further to c.£7.5 billion.
• Impairment/BDD to be below 40bp.

Source: LYG FY20 Profit Result, page 10.

In Table 6 below, I show underlying profit for FY18, FY19, and FY20, as reported by the LYG. In the column to the right, I show my estimate of normalized earnings, which now includes restructure expenses that LYG reports "below the line" and therefore outside underlying profit.

Table 6:

Source: Author's calculations based on LYG financial reports.

I will briefly step through the most important components of my normalized earnings calculations.

Net interest income - I have assumed a net interest margin "NIM" of 240bp. This is in line with management guidance for FY21E. I have assumed that the average loan book for FY21E will be in line with the 4Q20 loan book size.

Other income - annualizing the 4Q20 result gives an outcome in line with my previous assessment at 3Q20. Other income is sensitive to reduced activity levels associated with lockdowns, and I believe that there could be good medium-term upside relative to the 4Q20 run-rate once COVID-19 disruption recedes. I have therefore allowed for a further £200m pa of earnings on top of the annualized 4Q20 contribution. The normalized earnings assumption of £4,429m pa is 23% lower than reported FY19 other income.

Operating costs - I have assumed -£7,500m pa, in line with management FY21E guidance.

Remediation - I include an allowance for ongoing charges relating to customer conduct and compensation expenses. This estimate for remediation costs can be thought of as an allowance for a "normal" level of annual remediation costs expected to be incurred over the medium term. I have increased the allowance slightly relative to my prior assessment due to a continuation of elevated costs in FY20.

Impairment, or bad and doubtful debts "BDD" - I allow for a normalized loan loss rate of 42bp pa. This is based on a weighted average calculation of loss rate expectations across the different segments of the loan book (e.g. mortgages, credit cards, etc.).

Restructure expenses - I now include a total allowance of -£275m pa in my assessment of normalized earnings. The composition of the adjustment is -£125m pa for severance and property transformation (combined), -$100m pa for technology R&D, and -£50m pa for regulatory change costs.

As shown in Table 6, I arrive at an estimate of normalized underlying profit before tax of £4,164m pa. To arrive at a normalized NPAT, I then apply an assumed sustainable effective tax rate of -25% and deduct my estimates for other equity instruments and non-controlling interests. These calculations are set out in Table 7, along with my estimates for the implied PE based upon my normalized earnings framework.

Table 7:

Source: Author's calculations

What Does This Imply for Valuation & Upside?

My general "rule of thumb" is that I see banks as fair value or a "hold" on a normalized PE multiple in the range of 11x to 12x. On my estimates outlined above, at 42.77p (LSE close 01 April 2021), LYG is trading on a normalized PE multiple of 11.65x. I, therefore, conclude that LYG is currently fairly priced, with future expected returns being an appropriate reward for the risks inherent in the investment. Given LYG's strong share price performance so far in 2021, it appears that the potential for outperformance identified in my previous Seeking Alpha note has already been delivered.

Risks - Bad Debt Provisions, Management Change, Further Lockdowns

As discussed above, there is much uncertainty regarding the near-term outlook for BDD provisions. This uncertainty provides both upside and downside risk. I tend to err on the side of conservatism, and feel that, on balance, the downside risk is somewhat greater than the upside risk.

In late November 2020, LYG announced the appointment of Charlie Nunn as the group's new CEO. Nunn will replace LYG's well-regarded current CEO, António Horta-Osório, who has headed the business since March 2011. Whilst I have no specific concerns regarding Charlie Nunn's appointment, I am mindful that a change in CEO introduces some short-term risk, given that the new leader is likely to want to put his own stamp on the business.

The UK is making good progress with the COVID-19 vaccination roll-out, and a path back to normality and a fully re-opened economy is now visible. However, variants that are resistant to current vaccines remain a material threat. I do not think that we can categorically dismiss the possibility that the UK will experience further lockdown restrictions at some point in the second half of 2021.

Conclusion

Based on my analysis of normalized earnings described above, I have moved from a Bullish rating on LYG to a Hold/Neutral rating.

Adopting an "absolute value" perspective, it is hard to see significant upside in LYG at the current price. However, given the current downside sensitivity of equity markets to upward bond yield movements, exposure to LYG may still be very a sensible play as part of a diversified portfolio of equities.

Analyst’s 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.

This writing is for informational purposes only. All opinions expressed herein are not investment recommendations, and are not meant to be relied upon in investment decisions. The author is not acting in an investment advisor capacity and is not a registered investment advisor. The author recommends investors consult a qualified investment advisor before making any trade. This article is not an investment research report, but an opinion written at a point in time. The author's opinions expressed herein address only a small cross-section of data related to an investment in securities mentioned. Any analysis presented is based on incomplete information, and is limited in scope and accuracy. The information and data in this article are obtained from sources believed to be reliable, but their accuracy and completeness are not guaranteed. Any and all opinions, estimates, and conclusions are based on the author's best judgment at the time of publication, and are subject to change without notice. Past performance is no guarantee of future returns.

Comments

[sampwil]

Great analysis. Looks fairly valued which is hard to find in this market.

[catsaunders financial]

I liked your article but disagree with your theory. I see LYG is selling ~60% book value. I like fundamental analysis vs/ technical

[Lilliana]

When did this outfit last pay a dividend to the long suffering investors...3 years....5 years....10 years...???
Yet Lloyds have payed out back bonus sums to employees for the years of long gone disasters....right?
Once a great and valued bank....and then there was HBoS
What a dog.

[ButscherDoug]

@Lilliana They last paid a dividend in 2019. They had already declared their first divy for 2020 on Feb. 20, and then canceled all on Apr. 01, 2020.
To bad, they had a nice 6% dividend.

[Sentinel Brit]

Thanks for a thorough analysis. I have normally valued banks on the basis of their price to book value. Lloyds has sold above 1x book in the past. At present, it is selling at about 60% of book value, which is historically very cheap. By your analysis, the bank will never get close to selling at book value. If this is the case, it makes for a very bad investment, as the return on equity is terrible. In a capitalist society, the bank has to compete for capital so it must increase its return on equity. It could do this by returning the excess capital via share buybacks or dividends. I suspect, capital will be reduced by either or both of these means; both would serve to increase the share price. However, I also think that this would be unlikely to get the share price to the bank's book value. At the end of the day, management is going to have to improve returns. I think the earnings power is above your estimates - it has to be to make the bank attractive to investors. Perhaps its R&D spending will result in higher revenues/profitability.

I first bought shares above $3.00 and have bought on the way down, my last purchase was at $1.50. Before this cycle is over, I suspect the shares will get back above $3.00, and I would not be surprised if they got to $4.00. I expect management to continue to improve productivity, and revenues to increase as the economy recovers. Lloyds has excellent businesses in the UK and should prosper under better conditions. I expect the regulators to back off over time, which should be favorably received by the market and management.

[Intrinsic Analysis]

@Sentinel Brit Lots of good points made there. I agree that P:B and P:NTA can be useful metrics for bank valuations. In my next LYG review, I'll aim to provide some analysis on such metrics, and also look into the other interesting issues you raise. The rate of return being generated by UK banks can certainly improve from here, and as you point out, capitalist dynamics imply that the returns 'should' improve. I suspect that this same argument could validly have been made for much of the last decade. But that's not to say that things cannot improve in the future. Thanks for the comment.

[Nab.Investments]

@Sentinel Brit I fully agree!

[Sentinel Brit]

@Nab.Investments I notice you also own Barclays. So do I!

[rackc1ty]

Fair points on costs. But I imagine the co might hope that 2021 isn't quite a year of normalised earnings, given the country will have been in lockdown for 4-5 months. E.g. hard to think Other Income being down on a subdued 2020 as normalised (historically £1.5bn higher)

[Intrinsic Analysis]

@rackc1ty Thanks for the comment. I'd agree that there is potential upside to my numbers for Other Income. If we used 1Q20 as a guide (mostly pre lockdown), then perhaps £5bn pa could be justified, rather than the £4.4bn pa that I adopted. I've allowed for an uplift of £200m pa from the annualised run-rate for 3Q20 and 4Q20, and it is reasonable to say that there could be more to come on top of that. At this stage I'm feeling rather cautious about how well the UK bounces back from covid, so I've been unwilling to fully bake in the potential benefit to earnings.

[LPeter]

I have set a sell limit order at $2.75

[Chancer]

Glad I bought BCS at US$8.94.

I did want to buy LYG. But so far I am glad that I waited.

[catsaunders financial]

@Chancer all the major UK banks are/were on sale. I picked up a bunch of BCS <$5, NWG at <$3, LYG ~$3 (have DCA down to $3). Why not own all the major banks in one basket?

[Chancer]

@catsaunders financial:

Because I do not want to put all my eggs in a UK basket. One thing I do like about BCS is they are diversified into the US. But I am less certain about the UK economic recovery.

I also bought BCS because I plan to sell the only big US bank I own when it hits my sell price. Then I plan to remain out of US banks.