Interactive Investor

Lloyds Banking Group privatisation: Investment pros and cons

31st July 2013 00:00

David Prosser from interactive investor

Background to privatisation

The British taxpayer has owned a minority stake in Lloyds Banking Group since 2009, when the Financial Services Authority conducted stress tests on the bank that showed it had substantially less capital than would be needed should the ongoing financial crisis cause severe economic problems.

With the funding markets closed to the banks during the crisis, Lloyds was forced to turn to the government for assistance - it took a 43% stake in the bank, though this has subsequently been diluted to 39%.

Since 2009, Lloyds' management has focused on restructuring the bank in order to overcome the problems caused by the crisis - including the bad debts of its subsidiary, HBOS, which it bought at the height of the credit crunch with the encouragement of the government.

With much of that restructuring work now behind it - the bank even expects to be able to resume making dividend payments by mid 2014 - George Osborne felt able in June's Mansion House speech to say publicly for the first time that the Treasury is now working on plans to sell the Lloyds stake.

Likely timetable

The Chancellor has so far avoided setting a timetable for the sale, but he is determined to have sold some or all of the taxpayer's stake by the general election in May 2015, in order to maximise the political capital of the privatisation.

Planning is proceeding quickly. The Treasury asked investment banks to submit proposals for how the privatisation process might work by 8 July and is now considering their responses. In theory, it could announce a formal timetable in the autumn, paving the way for a sale during the winter months.

The government will look to recoup at least 61p a share on the privatisation of Lloyds

However, it will be difficult to finalise this timetable until the fate is resolved of the 632 branches it has been ordered to sell by the European Commission, which deemed the bail-out of the bank as "state aid". Lloyds had agreed to sell these branches to Co-operative Bank, but this deal collapsed earlier this year.

The branches, which are being brought together under a single business operating under Lloyds' TSB brand, must in theory by sold by November of this year, though the bank is thought to be negotiating an extension with Brussels.

Lloyds could choose to run a stand-alone flotation of TSB, or look for a replacement buyer, but the question must be resolved before the government can offload its 39% stake. That makes this unlikely to happen until well into 2014.

Likely method of privatisation

Osborne professes himself open-minded, though he has promised to offer some shares to the public. The most likely scenario is that the Chancellor begins the privatisation process with the offer of a tranche of shares to institutional investors. This would then pave the way for a retail offer, possibly combined with a further institutional placing.

All sorts of variations on the theme are possible, however. The Chancellor might choose to follow the Royal Mail example and prioritise Lloyds Bank staff for allocations of stock. He may even still embrace the proposals from the Policy Exchange think tank, which are supported by the Liberal Democrats, which would see free shares offered to every adult in the country.

Should you invest?

The answer to that question will depend on the fine print of the privatisation process and, crucially, the price. The government will look to recoup at least 61p a share on the privatisation of Lloyds - the average cost at which the taxpayer's stake was acquired - but until it decides on pricing, any judgement about the value of the offer is impossible.

Factors in favour of investing:

  • The good news for taxpayers and potential investors alike is there are reasons to be bullish about Lloyds' prospects. Not least, the bank's problems did not turn out to be as serious as was once feared: its impairments since the crisis have never come close to worst-case scenario levels and most of the worst-performing divisions have now been sold or wound down. The bank has now been restored to profitability at both the headline and the operating level.
  • Moreover, the outlook is promising. Even after the TSB sale, Lloyds will be the dominant force in personal banking in the UK, including mortgage sales. As the housing market recovers - not least thanks to the remarkably generous support on offer from the government's Funding for Lending and Help to Buy schemes - Lloyds is well placed to benefit.
  • Happily, with most of the restructuring work out of the way, Lloyds should be able to concentrate on maximising that benefit. The Prudential Regulation Authority said in June that the bank needed to raise £8.6 billion in order to plug a capital shortfall, but the bank says its balance sheet is sufficiently strong for it not to need to issue more debt or equity in order to comply.
  • Assuming regulators accept Lloyds' view of its capital position, the bank should be able to restart dividend payments to shareholders - probably during 2014. Dividends have traditionally been a key attraction for investors in banks, which are usually highly cash-generative, so this would substantially boost the case for buying.
  • Investors will also be reassured by the fact that Antonio Horta-Osório, Lloyds's chief executive, appears to have overcome his health problems. Appointed chief executive in March 2011, the highly-rated Horta-Osório was forced to take a month off in November 2011 due to exhaustion.

The bank should be able to restart dividend payments to shareholders - probably during 2014

Factors against investing:

  • There are plenty of reasons to be nervous about Lloyds' future, for this is a bank that remains in transition and has yet to put all of its problems behind it. The restructuring work may have been substantial, but it is not yet complete - some operations are still being overhauled, there's the branch sell-off to worry about and the additional capital to raise.
  • Then there are the additional legacy issues with which Lloyds is saddled. Not least, the bank is still slogging its way through the payment protection insurance scandal, which has so far forced it to make provisions of £6.8 billion for redress to customers wrongly sold policies. There is no guarantee that bill will not rise further. Nor is there any clarity on the eventual cost of interest rate swap mis-selling, for which Lloyds and other banks are now being forced to compensate small and medium-sized enterprises.
  • Those scandals only offer further ammunition to critics of the banking sector, which continues to make it difficult for Lloyds and others to operate as freely as they might wish. Political pressure on issues such as lending to small and medium enterprises (SMEs) and executive remuneration often forces the bank to make decisions it might otherwise not.
  • Nor is it entirely clear that the bank's management is as stable as investors would like. While Horta-Osório continues to enjoy an excellent reputation in the banking sector, some analysts fear he does not run a happy ship. The current chief executive has recruited heavily from his previous employer, Santander, and there are have been signs of tensions that could destabilise the bank. For example, the recent leak to the press of the detail of Lloyds head of public relations Matt Young's pay packet suggests internal politics are difficult.
  • Finally, there's the fear of economic uncertainty. Setbacks to the recovery, particularly in the housing market, would damage Lloyds. Equally, the bank will also be nervous about the prospect of the Bank of England feeling confident enough to begin raising interest rates, which could see bad debt problems re-emerge among both retail and business customers.

In a nutshell

If Lloyds can begin delivering dependable dividends and convince the market its bad debt problem is under control, it may once again become a key blue-chip holding for many investors, particularly given its dominance in the mortgage market. But a worrying degree of potential for surprises on the downside remains.