Bulls back Lloyds despite PPI hit

Robbed of the chance to buy the government's remaining stake in Lloyds Banking Group at a discount, shareholders now depend on under-pressure CEO António Horta-Osório to generate returns. Admittedly, initial reaction to third-quarter results was poor, but the numbers weren't really that bad and Lloyds has clawed back a near-4% slump.

Using latest forecasts from Deutsche Bank, the results were mixed, but hardly scary. A 3% drop in underlying pre-tax profit from £1.97 billion a year ago to £1.91 billion, was a little light. Deutsche had predicted £2.07 billion.

The broker got a £1 billion provision for payment protection insurance (PPI) spot on, yet statutory pre-tax profit was also down a smaller-than-feared 15% to £811 million. Net interest margin (NIM) - the difference between interest earned and interest paid - was a fraction better at 269 basis points (bp).

Despite being a UK-focused bank, Lloyds could struggle in the fallout of a "hard" BrexitHowever, earnings expectations have been revised upwards in recent weeks amid some high-profile calls among analysts to switch from "expensive defensives" into banks and other value plays.

"On valuation both banks and insurance companies are near the cheapest levels they have ever been in two decades," said Barclays on Tuesday, highlighting Lloyds as a value stock with earnings momentum better than the market.

And the lender does reaffirm expectations for the full-year. Look for NIM of around 270bp, a cost:income ratio below last year's 49.3%, and common equity tier 1 (CET1) capital generation - a key measure of financial strength - of 160bp pre-dividend. CET1 for the third quarter was 14.1% before the dividend and 13.4% after, up from 13% in June.

UBS analyst and Lloyds fan, Jason Napier, was quick off the mark Wednesday morning, and the numbers are there or thereabouts. Underlying profit was 2% ahead of his own estimate as better news on costs and lower-than-expected impairment charges offset a 1% drop in net interest income (NII) to £2.85 billion.

Margin was better, too, driven, says Napier, by a 1% drop in average interest-earning banking assets to £436 billion.

Interestingly, Lloyds generated an 80bp improvement in CET1 by deciding to reclassify the £20 billion of gilts held within its liquidity portfolio as "available-for-sale" rather than Wheld-to-maturity". That's because it will not now commit to holding gilts to maturity as interest rates are so low.

Without this, capital would have been a miss at 12.6%, points out Deutsche's Lock. However, "a beat is a beat", he says, adding, "13.4% CET1 should provide Lloyds the headroom to pay the 3p dividend that we and consensus expect for 2016 (requires 20-30bps capital generation in 4Q16), giving comfort for those focused on the dividend line."

On costs, Horta-Osório has made further progress. Shutting branches and penny-pinching elsewhere - the so-called simplification programme - has delivered £774 million of annual run-rate savings so far. It should be £1.4 billion by the end of 2017.

At around 55p, Lloyds shares trade pretty much in line with tangible net asset value (TNAV) of 54.9pOf course, low interest rates are bad for banks, and there's little sign that UK borrowing costs will increase up any time soon.

Despite being a UK-focused bank, Lloyds could struggle in the fallout of a "hard" Brexit, and a decision by the Financial Conduct Authority (FCA) to extend the deadline for PPI claims by a year to June 2019 has triggered extra provisions.

However, finance director George Culmer has said this will be "the last big PPI provision" before deadline day.

At around 55p, Lloyds shares trade pretty much in line with tangible net asset value (TNAV) of 54.9p. Using UBS estimates for full-year earnings per share (EPS) of 6p in 2017, down from an anticipated 7.2p this year, a forward price/earnings (PE) ratio of 9.2 times is hardly expensive.

Napier blames pressure on revenue and loan losses coming through for the drop in EPS next year. But he likes the opportunity for "proactive management of the P&L" offered by better costs and deposit re-pricing. "Crucially, capital generation - the raw material for our positive view on dividends - remains good," he says.

Add a 13% return on tangible equity (ROTE) into the mix, plus 5-7% running yield, and Napier still thinks Lloyds is "attractively valued". He repeats his 'buy' rating and 65p price target, and above-consensus forecast for a dividend yield above 7% for 2017.

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.