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Lloyds Banking Group - Bad loan writebacks boost profits

Nicholas Hyett, Equity Analyst | 28 April 2021 | A A A
Lloyds Banking Group - Bad loan writebacks boost profits

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Lloyds Banking Group plc Ordinary 10p

Sell: 45.25 | Buy: 45.27 | Change 0.00 (0.00%)
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Lloyds reported first quarter income of £3.7bn, down 7% year-on-year as lower interest rates continued to squeeze lending profitability and customer activity remained subdued.

However, a £323m net release of provisions for bad debts, compared to a £1.4bn impairment this time last year, meant underlying profits rose 271% to £2.1bn.

The board intends to update the market on dividend plans at the half year.

The shares rose 4.4% in early trading.

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Our view

Lloyds is an overwhelmingly UK centric business, and as such its fortunes are tied to the health of the UK economy.

Improvements in the bank's assumptions about future unemployment and GDP growth resulted in a huge reduction in expected defaults in Q1 2021. In fact, the improvement is so dramatic that some money set aside last year to cover expected bad loans has been released - boosting profits.

That's provided a very welcome short-term boost, and if conditions continue to improve there could be more releases to come. However, the headwinds are not over.

Lloyds is a classic high street bank. It takes deposits and lends the money out to borrowers, mostly in the form of mortgages, credit cards and loans to smaller companies. That's not a great place to be in the current low interest rate environment.

Banks make money by lending money out at higher rates than they pay on deposits - the difference is known as the net interest margin. With interest rates on savings 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 the bank expects net interest margins to exceed 2.45% this year, which would be manageable for Lloyds - even if it's not highly profitable. However, it could make revenue growth a challenge. As old mortgages and loans are paid off or renewed they will roll-off on to lower interest rates, offsetting growth elsewhere in the lending book.

The bank hasn't been helped by the move by consumers and businesses to repay higher interest credit card and overdraft debt during the crisis. Lower interest rate mortgage lending has made up much of the shortfall. That could reverse as the economy unlocks, but there's no evidence of that yet.

Given that low interest rates look like they're here to stay, it's perhaps no surprise Lloyds is looking elsewhere for growth.

The 2021 strategy review includes plans to build out the bank's small business offer as well as increasing the focus on larger corporate and institutional clients. Both groups have potential to generate fees, rather than interest income. That should prove more resilient if rates remain lower for longer. Meanwhile deeper customer relationships could support growth in asset management, general insurance and pensions, another area which isn't closely linked to interest rates. It's early days in both areas, but we're watching the Schroders Personal Wealth partnership with particular attention.

Operating costs are also in the spotlight, having fallen again despite one-off coronavirus-related spend. A market leading cost: income ratio could be key in the months ahead, with increased digitisation reducing the cost to serve customers and potentially boosting profitability of future revenue growth.

Like most of the UK banking sectors Lloyds' balance sheet looks in pretty good shape. The cancellation of 2019's final dividend, following pressure from regulators, played a large part in that. However, shareholder returns are now back on the menu.

The bank hit the new regulatory cap for the 2020 full year dividend, but we doubt it would have wanted to push the payout much higher in any case. We suspect management will use the crisis as an opportunity to permanently shrink the dividend, and grow it from a lower base. That would leave Lloyds with a sizeable capital surplus, giving the board some significant options. Share buybacks, a special dividend, aggressive organic growth or even an acquisition are all possibilities.

Overall, Lloyds has weathered the perfect storm in 2021, and done so in reasonably good shape. The bank's exposure to interest rates means it's likely to be less profitable for some time, but there are at least some efforts underway to diversify away from interest driven exposure. In the meantime a low cost base and healthy looking balance sheet should give Lloyds what it needs to ride out the economic weather.

Lloyds key facts

  • Price/Book ratio: 0.63
  • 10 year average Price/Book ratio: 0.88
  • Prospective dividend yield (next 12 months): 4.3%

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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First Quarter Results

Lloyds reported net interest income of £2.7bn, down 9% year-on-year. That's despite a modest improvement in loans and advances to customers, now at £444bn, and reflects a decline in net interest margin (the difference between what the bank earns on loans and pays for funding) from 2.79% to 2.49%.

Other income fell 7% to £1.1bn, as Retail, and Insurance & Wealth customers struggled with reduced customer activity.

The bank reported a modest reduction in operating costs and lower remediation expense, with total costs down 2% to £1.9bn. However, the major improvement was in impairment costs which relates to bad loans, where the bank reported a £323m gain rather than a £1.4bn loss this time last year. The release reflects the UK's improved economic outlook, with around £1bn still held back to offset coronavirus losses.

The bank reported a Common Equity Tier 1 Ratio (a key measure of banking capital) of 16.7%, up from 16.2% at the end of December.

Given the strong performance in the first quarter, management has updated its guidance for the full year. Net interest margin is now expected to come in above 2.45%, with operating costs to reduce to around £7.5bn. Return on equity is expected to be between 8 and 10%.

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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 for more information.

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