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Lloyds - higher rates offset bad debt provisions

Lloyds reported full year net income of £18.0bn, up 14%.

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Lloyds reported full year net income of £18.0bn, up 14%. That was driven by higher net interest income, which benefited from an increase in UK interest rates. Net interest margin (the difference between what a bank earns in interest and pays on deposits) rose from 2.54% to 2.94%.

£1.5bn was set aside over the year in preparation for debt defaults and operating costs were up 6%. That meant underlying profit fell 1% to £7.4bn and return on tangible equity (ROTE), a measure of profitability, moved from 13.8% to 13.5%.

For 2023, ROTE is expected to be around 13% and net interest margin's expected to exceed 3.05%.

The board has announced a final dividend of 1.6p per share and a buyback programme of up to £2.0bn. Taking those distributions into account the CET1 ratio (a key measure of capitalisation) was 14.1%, still ahead of target.

The shares fell 1.6% in early trading.

View the latest Lloyds share price and how to deal

Our view

Lloyds' full year results perfectly highlight the fine line banks are walking. Higher interest rates mean they can earn more from the difference between borrowing and lending rates, but preparations for higher debt defaults in the face of a cost-of-living crisis weigh on other side of the scales.

A focus on traditional banking means Lloyds is more exposed to the interest rate cycle than others, 73% of total income is interest related. So, markets were a touch disappointed by 2023 guidance on net interest margin, which suggested levels peaked in the fourth quarter of 2022. Nevertheless, if management's predictions of a year where margins never drop below 3% comes true, it'll be positive for income.

The flip side of the business model is higher exposure to potential loan defaults. £1.5bn was set aside over the year to provide a buffer. For now, at least, defaults remain low and it's possible that some of that provision can be unwound if unused. We'd expect default rates to increase as the year progresses but remain cautiously optimistic the £1.5bn will be more than enough.

The £311bn mortgage book is also of note. Broadly speaking we're supportive of the asset, but it is expected to be a drag on net interest margin into 2023. Banks were able to issue highly profitable mortgages in 2020/21 and as those 2-year fixes mature, and lenders re-mortgage, they're doing so at less profitable levels for banks like Lloyds.

Very aware of its reliance on traditional financing, a recently refreshed strategy plans to build out the bank's small business offer as well as increase the focus on larger corporate and institutional clients. Both groups have potential to generate fees, rather than interest income.

The group's also looking to grow its Wealth Management options, across asset management, general insurance and pensions businesses, another area which isn't closely linked to interest rates. These plans have merit, but we're a long way off knowing if that hefty investment will pay off.

Finally, there's the balance sheet to consider. The £2bn buyback goes some way to returning excess capital to shareholders and the 5.6% forward yield is attractive, but there's still room for more. Having a robust capital position as we enter a murky economic environment certainly isn't a bad place to be and management have pledged a return of further excess over the next 2 years. As usual, nothing's guaranteed.

Overall, we commend the efforts to diversify, but these are far from being the main event. In the meantime, Lloyds boasts one of the highest return on tangible equity percentages (a measure of profitability) among the major UK banks and an undemanding valuation. Investors should beware though, a worse than expected downturn would hit Lloyds harder than others.

Lloyds key facts

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.

This article is original Hargreaves Lansdown content, published by Hargreaves Lansdown. It was correct as at the date of publication, and our views may have changed since then. 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.

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Written by
Matt Britzman
Equity Analyst

Matt is an Equity Analyst on the share research team, providing up-to-date research and analysis on individual companies and wider sectors.

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Article history
Published: 22nd February 2023