Interactive Investor

How Lloyds smashed profit and dividend targets

22nd February 2017 12:30

Lee Wild from interactive investor

Finally, business at Britain's famous banks is beginning to resemble something like normality. Less than four weeks after the government sold down its stake in Lloyds Banking Group to below 5%, the lender has more than doubled annual reported profit, announced a far more generous dividend than expected, and is bullish on prospects.

Now making the kind of money it did before the financial crisis 10 years ago, the shares have been chased up 4% to prices not seen since the Brexit vote on 23 June. Yes, they're nothing like they were in the late-90s, but lucky investors quick enough to snaffle some shares at or near the post-referendum low of 47p are still sitting on almost 50% profit in eight months.

And Ian Gordon at Investec Securities is in jubilant mood, harking back to 1999 when Sir Brian Pitman's Lloyds traded on seven times book value and boasted a triple-A rating.

"Today it feels like Lloyds is only just emerging from a 16-year nightmare, and the market hasn't quite been ready to embrace its recovery," he writes. "We think it will now! Profit before tax is up 158% to £4.2 billion, the dividend is 3.05p vs Bloomberg consensus 2.8p and an upbeat outlook statement must surely persuade even the most hardened bear to fold?"

And the bounce back under current boss António Horta-Osório - paid £5.5 million for his trouble in 2016 - does look justified. Net interest income for 2016 was flat at £11.4 billion, and some insignificant one-offs nipped just 3% off the underlying profit figure to give a little under £7.9 billion for the year.

However, provisions for payment protection insurance (PPI) fines plunged from £4 billion in 2015 to just £1 billion this time – the total paid now exceeds £17 billion. That's why the bottom line number swelled from £1.6 billion 12 months ago to £4.2 billion.

For the fourth quarter, underlying pre-tax profit of £1.8 billion was 9% ahead of consensus estimates and impairments smaller than forecast. A bigger charge for mis-selling of packaged bank accounts tipped the reported number below consensus to £973 million.

"Bank profits have been weighed down by past misconduct provisions, and the hope is that we are reaching the point where these payments are diminishing, allowing the banking sector to put the past behind them and concentrate on future profits and growth," said colleague and Interactive Investor head of investment Rebecca O'Keeffe this morning.

Bigger profits

And bigger profits meant Lloyds beefed up its common equity tier 1 (CET1) ratio – a key measure of financial strength - by 190 basis points, from 13% at the end of 2015 to 14.9% currently, excluding dividends. After shareholder payments, and prudently retaining 0.8% to cover the MBNA acquisition, Lloyds still targets 13%.

With its balance sheet repaired and PPI claims winding down, Lloyds can afford to reward its army of faithful retail investors. We asked last week whether Lloyds could "spring a surprise", and it has.

They'll receive a final ordinary dividend of 1.7p, taking the total for 2016 to 2.55p, as expected. But a confident Lloyds will also return 0.5p via a special dividend, much more than the 0.3p pencilled in by analysts.

Lloyds now expects net interest margin (NIM) – difference between interest earned and cost of funding - of over 2.7% in 2017, a cost/income ratio of around 45% by the end of 2019, and return on tangible equity at an aggressive 13.5-15% in 2019. It should also generate 170-200 basis points of CET1 capital every year before dividends.

"Given the scale of Lloyds' ongoing capital accretion, we continue to believe that consensus expectations for the dividend are too low," says Gordon, who predicts 4.5p of dividends in 2017, rising to 5p, then 5.5p in 2019. Consensus is for 3.5p, 3.9p and 4.9p.

These results certainly demonstrate Lloyds is in much better shape and, if its optimism is not misplaced, it can easily afford larger dividends. Even using consensus estimates, Lloyds offers a prospective yield of 5%. Use Gordon's and it's 6.5%.

And the shares, despite the remarkable recovery since June, trade on 10.4 times forward earnings, hardly expensive. Neither is 1.2 times tangible net asset value (TNAV) per share of 54.8p. Remember, too, that interest rates will rise in time, giving industry margins a further fillip, although Brexit negotiations will add some spice.

Gordon thinks Lloyds is a 'buy' and worth 74p a share. He could be right after these financials, and given the obvious attraction of that target price from a technical angle (see chart).

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.