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Lloyds - bad loans moderate, back in the black

Nicholas Hyett, Equity Analyst | 29 October 2020 | A A A
Lloyds - bad loans moderate, back in the black

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Lloyds Banking Group plc Ordinary 10p

Sell: 37.23 | Buy: 37.25 | Change 1.39 (3.87%)
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Lloyds' total third quarter income fell 19% to £3.4bn, as lower interest rates weighed on loan profitability, and reduced customer activity negatively impacted fee income. However, the non-recurrence of £1.8bn in PPI related costs meant profits before tax rose from £50m last year to £1bn this quarter. Excluding this effect, underlying profits fell 36% to £1.2bn.

Full year provisions for bad loans are now expected to be at the lower end of previous guidance.

The bank did not mention the resumption of dividend payments.

Lloyds shares rose 1.9% in early trading.

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Our view

Lloyds is a 'bread and butter' bank. It takes deposits and lends the money out to borrowers. It's overwhelmingly UK centric and most of its business is typical high street banking - mortgages, credit cards and smaller companies.

Unfortunately it's this core banking activity that's been hardest hit by the current crisis.

A relatively pessimistic outlook on the UK's economic recovery meant a massive increase in bad loan provisions. Meanwhile a shift in the loan book from higher value unsecured lending to government backed coronavirus funding schemes and mortgages has dented loan profitability - although reduced overall risk levels too.

However, the real challenge lies in the interest rate environment. Banks make money by lending money out at higher rates than they pay on deposits. With interest rates on bank accounts already on the floor (and zero in many cases) they simply can't push the cost of funding much lower - whereas competition and regulatory action means lower interest rates get passed on to borrowers relatively quickly.

Having said that, loan rates don't have much further to fall and Lloyds' deposits have actually grown despite the interest rate cuts. If a net interest margin of around 2.40% is sustainable that should be manageable for Lloyds - even if it's not highly profitable.

Given that low interest rates look like they're here to stay, and could even turn negative (which would be really bad news for banks) the small but growing wealth and insurance division could prove increasingly important. Asset management, general insurance and pensions aren't as closely linked to interest rates, and this division could deliver growth when others are struggling. It's early days, but we're watching the Schroders Personal Wealth partnership with particular attention.

The other thing to note is operating costs have fallen again despite one-off coronavirus-related costs, and a market leading cost:income ratio could be key in the months ahead. With lots of the savings driven by continuing digitalisation this not only supports profitability but should make it easier to keep the bank operating as usual during the current disruption.

The balance sheet is looking increasingly solid too, despite the significant writedowns in loan value. The cancellation of 2019's final dividend, following pressure from regulators, played a large part in that.

The dividend could resume at the end of the financial year in theory. But management didn't comment on that at third quarter results (when peers Barclays, HSBC and Standard Chartered all have). That probably reflects the bank's greater exposure to both Brexit and interest rate risk, and means investors shouldn't bet on a dividend at the full year. We also think any resumption in dividend payments will likely be from a lower base.

These are hardly ideal conditions for Lloyds, in fact they're pretty close to a perfect storm. Low interest rates mean the bank is likely to be less profitable for some time. However, a low cost base and healthy looking balance sheet should give Lloyds what it needs to ride out the economic weather. Ultimately we think Lloyds should emerge from this crisis with its attractive high street franchise broadly intact - but that doesn't mean the ride won't be rocky.

Lloyds key facts

  • Price/Book ratio: 0.41
  • 10 year average Price/Book ratio: 0.9
  • Prospective dividend yield (next 12 months): 4.7%

All ratios are sourced from Refinitiv. Please remember yields are variable and not a reliable indicator of future income. Keep in mind key figures shouldn't be looked at on their own - it's important to understand the big picture.

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Third Quarter Results

Quarterly net interest income fell 16% to £2.6bn. That reflects a decline in net interest margins (NIM - the difference between what the bank charges on loans and pays on deposits) from 2.88% to 2.42%, with loans and advances to customers broadly flat. The lower NIM followed the decline in the Bank of England base rate, financial relief given to customers during the peak of the crisis, and a shift in lending from higher interest rate credit cards to lower interest rate mortgages.

Other income in the half fell 25% to £988m. That was driven by reduced activity in commercial banking, insurance and the declining size of the Lex Autolease fleet. The lower number of cars on lease resulted in a lower operating lease charge (down from £258m to £208m) - as resale values held up.

Operating expenses fell 3% year-on-year to £1.9bn as the bank continued to benefit from digitalisation. However, the significant fall in total income meant the overall cost:income ratio still increased substantially from 47.6% a year ago to 56.9% this quarter. The bank took £301m of impairments related to bad loans during the quarter - significantly below the second quarter and in line with pre-crisis levels.

Lloyds reported a CET1 ratio (a key measure of banking capitalisation) of 15.2% at the end of the quarter, up from 13.8% at the start of the year.

Underlying return on tangible equity, which measures profitability before exceptional charges, fell from 14.3% a year ago to 9.3% in the quarter.

Net interest margins are expected to remain broadly stable in the fourth quarter, with total operating costs below £7.6bn (£5.6bn in first 9 months). Impairment charges are now expected to total £4.5bn-£5.5bn for the year -(£4.2bn in first 9 months).

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The author owns shares in Lloyds Banking Group.

This article is original Hargreaves Lansdown content, published by Hargreaves Lansdown. Unless otherwise stated estimates, including prospective yields, are a consensus of analyst forecasts provided by Refinitiv. These estimates are not a reliable indicator of future performance. Yields are variable and not guaranteed. Investments rise and fall in value so investors could make a loss.

This article is not advice or a recommendation to buy, sell or hold any investment. No view is given on the present or future value or price of any investment, and investors should form their own view on any proposed investment. This article has not been prepared in accordance with legal requirements designed to promote the independence of investment research and is considered a marketing communication. Non-independent research is not subject to FCA rules prohibiting dealing ahead of research, however HL has put controls in place (including dealing restrictions, physical and information barriers) to manage potential conflicts of interest presented by such dealing. Please see our full non-independent research disclosure for more information.