Interactive Investor

Lloyds Banking defended by City analyst

30th September 2016 12:50

Lee Wild from interactive investor

Owners of shares in Lloyds Banking Group have had an uncomfortable few weeks. In truth, it's been a terrible decade, but there has always been hope, principally that the UK economy will be able to support higher interest rates. That improves bank profits and underpins more generous dividends. It hasn't quite gone to plan, but one long-time supporter has jumped to its defence.

Fund managers at Liontrust told us last week that Lloyds "will not return to the days of being a dividend cash cow," claiming it remains compromised by the financial crisis settlement and is under-capitalised.

And today, technical analyst Alistair Strang's software reveals a potentially scary outcome for the shares, although there is at least a glimmer of hope in the charts.

Now, at broker UBS, analyst Jason Napier repeats his 'buy' rating, but nips 3p off his target price to 65p and admits that capital generation in the second half, among the main drivers of sentiment, could disappoint.

Capital generation during the first six month of the year fell 20 basis points short of expectations. Its common equity tier 1 (CET1) ratio was steady at 13%, and 13.5% pre dividend, and in July it predicted 160 basis points of pre-dividend capital generation in the full-year.

That would be enough to finance a 5p dividend, but Napier has spotted three potential sources of capital generation pressure: damage to Lloyds' pension deficit done by the impact of Bank of England bond buying on gilt yields; £800 million of provisions for payment protection insurance (PPI) refunds; and a potential bid for Bank of America's MBNA UK credit card book.

"We now assume a 3p dividend in 2016 (2.5p ordinary, 0.5p special), a decent 5.5% yield, and affordable we think unless a capital dilutive deal is done or pensions and PPI are worse," writes Napier Friday.

"Though risks around near-term capital returns have risen materially, we think the longer-term prospects are undervalued at 9.2x trough [earnings per share]. Our [sum of the parts]-derived target price falls to 65p from 68p on lower peer multiples and lower forward excess capital; with 18% capital upside, retain 'buy'.

"We expect the stock to re-rate as the depth of the UK economic adjustment attending the referendum outcome becomes clearer."

Crucially, Napier also answers the two big questions for Lloyds shareholders right now.

Firstly, does the slowdown we expect in the UK economy rule out holding Lloyds as an investment?

"We don't think so," he says. "In four of the last five UK recessions it paid to buy the banks early. We also see LBG as well positioned for a down-turn: capital levels are good, the loan portfolio defensive, liquidity is high and there is significant room to cut deposit and branch-distribution costs."

Secondly, can Lloyds pay a decent dividend in a UK downturn?

"Yes, we think so. Lloyds faces near term capital headwinds from PPI and pension charges but with a forecast trough return on tangible equity in 2017 of more than 10% we expect the firm to remain soundly capital generative."

A weaker UK economy could cause lower interest rates and loan growth, and higher bad debts"Despite lower margins, depressed loan growth and higher bad debts, we see LBG as a strong capital return story in 2017 and beyond, capable of delivering a >7% dividend yield in a no-growth UK."

If Lloyds can achieve a loan/growth ratio of 1% in 2017 (base case is -0.2%), net interest margin (NIM) of 2.61% (base: 2.51%) and a cost/income ratio of 51.7% (52.7%), Napier believes the shares could be worth 79p.

"A strong package of fiscal support and less bank-unfriendly central bank intervention would make this more probable," he says.

On the flipside, a weaker UK economy could cause lower interest rates and loan growth, and higher bad debts, which would reduce capital generation and dividends. The corresponding numbers to look out for are -2% loan/growth, 2.41% NIM and 53.7% cost/income.

Interestingly, that would give a share price of 44p, roughly where Alistair's chart predicts the first stage of collapse might be if the share price breaks below the uptrend since 2011, currently at about 50.7p.

This article is for information and discussion purposes only and does not form a recommendation to invest or otherwise. The value of an investment may fall. The investments referred to in this article may not be suitable for all investors, and if in doubt, an investor should seek advice from a qualified investment adviser.