Like most banks, Lloyds (LLOY) has had a pretty tough 12 months. Its business was obviously hit by the pandemic, while its stock remains subdued despite rallying on the back of positive vaccine developments. Still, 2020 results released on Wednesday were much better than many would have dared predict ten months ago. We can perhaps thank unprecedented intervention from the powers that be for that, but the point stands nonetheless. At circa 0.75x tangible book, the stock also remains quite cheap, albeit with some uncertainty still attached to it.
The company probably does not require much by way of introduction. Brands like namesake Lloyds, Halifax and Bank of Scotland are obviously well-known names. Together they form a banking giant with circa £870b in assets on its balance sheet. Size notwithstanding, Lloyds is actually a fairly simple retail bank engaged in everyday lending. That means mortgages, credit cards, lending to SMEs and so on. Net interest income (“NII”), the spread between what it takes on interest-bearing assets and what it pays out on interest-bearing liabilities, makes up over 70% of revenue, while domestic mortgages represent around 65% of the loan book. Lloyds also has significant non-banking operations in insurance and wealth management – with that making up a big chunk of non-interest income. Overall, the group remains heavily tied to the health of the UK economy and UK households.
The macro environment in recent years has obviously been shaped by low interest rates. And given most of its revenue comes from NII, that point seems especially relevant at Lloyds. Fortunately, the bank’s size affords it a bit of an advantage in that respect. It holds in excess of £400b in deposits – a cheap funding source for the bank – with retail deposits representing well over half of that figure. That dynamic allowed Lloyds to post solid, albeit now shrunken, net interest margins (“NIM”). Throw in steadily falling operating costs, and you had the recipe for an efficient bank with an industry leading cost-income ratio.
Last year was clearly a very tough one for UK households and the UK economy. GDP tanked, unemployment rose and interest rates fell. For Lloyds, well, it’s enough to say that this represents a less than ideal combination. Question marks also remain on the impact of the UK’s departure from the EU, though that plays second fiddle to COVID for obvious reasons. On that basis, 2020 results released earlier in the week were never going to be pretty. NIM came in at 2.52%, down from 2.88% in 2019 on the back of lower interest rates. That contributed to NII of circa £10.8b, down some 13% on 2019. Total income came in at £14.4b, circa 16% lower than the £17.1b posted the year before. Total loans remained steady at around £440b.
So, lower interest rates explain much of the above income numbers. Falling NIM led to lower interest income, which as mentioned before makes up most of the bank’s total income. Of course, the economic impact of COVID then took a big bite out of profit. The bank set aside around £4.2b for bad debt last year, up from £1.3b in 2019, with charge-offs registering at £1.5b. That was better than many folks would have predicted in the early days of the pandemic. Anyway, that sent the total loan loss reserve balance to £6.9b, up from £4.2b in 2019. Annual operating costs registered £7.95b, down 4 percentage points from £8.32b in 2019. At £2.2b, underlying profit before tax fell circa 71% from its 2019 level.
What else can we say here? Well, the balance sheet looks in solid shape. The bank’s CET1 ratio clocked in at 16.2% post-dividend, up from 13.8% at the end of 2019 and well above management’s internal 13.5% target level. The lack of dividend distributions last year obviously helped in that regard. Speaking of dividends, the bank declared a final 2020 payment of 0.57p per share, the maximum allowed by the regulator under its late-2020 guidance. Lloyds holds plenty of excess capital on hand, a portion of which will hopefully find its way to shareholders after COVID.
Looking forward, Lloyds expects to post a NIM in excess of 2.4% in 2021. It sees operating costs declining to around £7.5b, with its asset quality ratio – that is, loan loss provision to interest earning assets – at 0.4%. That is pretty close to pre-pandemic levels. Anyway, the bank sees that combination leading to a 5-7% return on tangible equity (“ROTE”) this year. That is basically what it was earning in Q3 and Q4 of last year. Now, tangible book value stood at 52.3p per share at the end of 2020. Some back of the envelope maths implies profit per share in the 2.6-3.7p range. The stock closed the day at around the 39.2p level, which puts the implied price-earnings ratio somewhere in the 10.5-15.5 area.
All said and done, that looks fairly attractive to me. Granted, headwinds – both potential and realised – are not exactly in short supply. Interest rates obviously remain on the floor, while some question marks remain in terms of Brexit and the COVID recovery. The 14-15% ROTE that the bank targeted before the pandemic seems a long way away. Still, from its current level the stock does not need the business to put in heroic performance to do okay. Looking slightly further ahead, the bank targets a medium-term ROTE in excess of its cost of equity. That implies a figure in the 9-10% area at a minimum. Based on the current stock price, it wouldn’t take much to generate double-digit annual shareholder returns off that. Implied multiple expansion coupled with capital returns to stockholders would do the trick.
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