Lloyds Banking Group plc (LLOY) Ordinary 10p
HL comment (30 April 2020)
First quarter net income shrunk 10.6% year-on-year to £4.0bn as lower interest rates and increased competition weighed on performance. Quarterly underlying profit fell 74% year-on-year to £558m, largely thanks to a £1.4bn provision for bad loans (credit impairment).
The bank will not pay any dividend until the end of 2020 at the earliest.
The shares fell 3.6% in early trading.
Without an investment bank to benefit from the increased trading caused by volatile financial markets this was always going to be a tough set of numbers for Lloyds. In the event it's been somewhat tougher than the market had expected, with lower interest rates and hefty bad loans provisions decimating revenues and profit respectively.
Fortunately the balance sheet has proven more than capable of handling the pressure so far. The cancellation of 2019's final dividend, following pressure from regulators, means the bank's key capital ratios have actually improved quarter-on-quarter.
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 digitisation this not only helps protect profitability but should make it easier to keep the bank operating as usual during the lockdown.
Like other banks, Lloyds has seen overall loans to customers increase, but there have been some underlying shifts in the loan book that we think are worth a closer look.
The fall in mature mortgages will be one reason revenues have been hit hard - since these mortgages were written at substantially higher interest rates - as will the fall in credit card borrowing. The increase in lending to corporate customers is probably a reflection of the trend we've already seen for companies to draw down on existing facilities to boost short term liquidity and help them weather the crisis.
We wonder whether we'll see consumers maxing out their credit facilities too if economic conditions deteriorate. If so, that could see further bad loan provisions in the months ahead. The government is underwriting a significant portion of new lending, but it's still something to keep an eye on.
That said, mortgages continue to make up the vast majority of the bank's assets, and these are generally considered safer loans. The shutdown of the UK property market will mean new loan growth grinds to a halt but, if we can avoid a severe recession, that should create some pent up demand for the second half of the year.
However, a bigger challenge in the long term is the very low interest rate environment. Lower interest rate will largely be passed onto borrowers (thanks to a combination of base rate tracking loans, competition and regulatory action), but the interest banks pay to savers is already on the floor. With little room to push funding costs lower the net interest margin (the difference between what the bank can make on loans and pays for funding) will be squeezed. That will significantly reduce the profitability of loans and interest rates seem set to stay lower for longer.
Lloyds also generates a significant portion of its profit from its wealth and insurance businesses -the Schroders Personal Wealth business and Scottish Widows. How recent market movements end up affecting the insurance business in particular is unclear at this point, but its role in diversifying income is important. We don't expect demand for the product to disappear.
There is some good news hidden among the doom and gloom. Banks generally, and Lloyds specifically, are significantly better capitalised today than they were before the financial crisis. While the next few months will be difficult that should allow the sector to weather the storm without the painful bailouts of last time around.
Of course, for many investors the all-important question at the moment revolves around the dividend. Unfortunately the longer the lockdown continues the greater the drag will be on capital, and ultimately it's the banks' capital position that will determine whether it can return to paying dividends at the end of this year. Generally we think a sizeable capital surplus and low cost base stand the bank in good stead, but given the uncertainty around second wave infections and the strength of the eventual recovery there are no guarantees.
First Quarter Results
Net interest income fell 4% year-on-year to $3.0bn as lower interest rates fed through to a lower net interest margin (the difference between what the bank charges on loans and pays for funding). The bank also saw a slight fall in total interest earnings assets despite total loans to customers rising. The bank saw particular growth in commercial and European retail loans with a decline in closed book mortgages and UK credit cards.
Other income fell 21% to £1.2bn impacted by weather related claims in general insurance, subdued activity among commercial clients, a smaller automotive finance fleet and valuations in the group's private equity business.
Operating costs fell 4% in the quarter to £1.9bn, slightly offset by higher remediation costs. Lower costs reflects continued savings from digitisation and other process improvements. However, lower income in the period meant the cost:income ratio rose to 49.7%.
Impairments were driven by coronavirus disruption, with significant provisions in both Retail and Commercial banking. The group believes additional provisions are likely.
The bank's CET1 ratio actually improved compared to the start of the year, rising from 13.8% to 14.2%. The reflects the decision not to pay the 2019 final dividend and organic capital build during the quarter - more than offsetting impairments and higher risk weighted assets.
Lloyds has withdrawn its previous guidance and given uncertainty does not feel able to issue a new outlook for the year.
The author owns shares in Lloyds Banking Group.
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