Lloyds Banking Group plc (LLOY) Ordinary 10p
HL comment (30 July 2020)
Lloyds reported a 16.0% decline in first half net income, coming in at £7.4bn. Operating costs showed a modest decline, however significant additional provisions for bad loans rose dramatically resulting in an overall loss before tax of £602m (2019: £2.9bn profit).
Lloyds has seen some signs of recovery, particularly among consumers, although low interest rates and a poor economic outlook are expected to weigh on performance for the rest of the year.
The shares fell 4.2% in early trading.
Lloyds is, by and large, what we think of as 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 coronavirus crisis.
Lloyds has taken a relatively pessimistic outlook on the UK's economic recovery - and that means a massive increase in bad loan provisions with more to come. There's also been a shift in the loan book from higher value consumer lending to government back coronavirus lending where profitability is capped.
However, the real problem lies in the interest rate environment. Banks make money by lending money out at higher rates than they pay on deposits. However, with 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 savings get passed on to borrowers relatively quickly.
Having said that we suspect the industry is now approaching something of a floor. Loan rates don't have much lower to fall and Lloyds' deposits have actually grown despite the interest rate cuts. If a net interest margin of 2.40% is a sustainable floor 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 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. Its early days, but we're watching the Schroder's Personal Wealth partnership with particular attention.
The other good news is that the balance sheet is in relatively good shape despite the significant writedowns in loan value. The cancellation of 2019's final dividend, following pressure from regulators, played a large part in that and while dividends could resume at the end of the financial year it's expected to be from a lower base.
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 supports profitability but should make it easier to keep the bank operating as usual during the current disruption.
If economic conditions continue to deteriorate as furlough schemes come to an end we could yet see borrowers maxing out their credit facilities. If so, that could see further bad loan provisions in the months ahead. That said, mortgages continue to make up the vast majority of the bank's assets, and these are generally considered safer loans.
These are hardly ideal conditions for Lloyds, in fact they're pretty close to a perfect storm. However, a low cost base and healthy looking balance sheet (even after recent impairments) should give the bank what it needs to ride out the economic weather. Low interest rates are probably here to stay, but we do think Lloyds has what it takes to emerge from the crisis with its attractive high street franchise broadly intact.
Lloyds key facts
- Price/Book ratio: 0.42
- 10 year average Price/Book ratio: 0.92
- Prospective yield: 3.8%
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Half Year Results
Loans to customers were broadly flat on the start of the year at £440bn, although down £3bn quarter-on-quarter. That reflects declines in most forms of consumer lending, including credit cards, mortgages and overdrafts, offset by a 20% increase in loans to smaller companies.
Net interest margin (the difference between what the bank charges on loans and pay depositors) fell to 2.40% in the quarter, from 2.89% in the same quarter last year. That follows the cut in the Bank of England base rate, steps taken to support customers and changes in the lending mix. As a result overall net interest income fell 10.9% to £5.5bn.
Other income declined 21.9% to £2.5bn, with reduced customer activity and a smaller automotive finance fleet both weighing on results. The banks also saw a decline in activity from larger corporate customers during the period and lower insurance sales.
Deprecation of the value of the bank's automotive finance fleet rose 11.2% to £526m, despite the fleet shrinking. This reflects a negative assessment of the residual value of vehicles given the economic environment.
Lloyds recorded impairments for bad loans of £3.8bn in the first half, including a £2.4bn charge in the second quarter. That compares with a £579m charge this time last year. The increase reflects the negative economic outlook, with actual defaults today continuing to perform well. Impairments were spread across both retail and commercial banking.
Operating costs fell 5% in the year, partly offset by higher conduct charges, with the result that overall costs fell 4% to £3.9bn. Lower revenue meant the bank's cost:income ratio rose 6.4 percentage points to 52.3%.
Lloyds CET1 ratio, a key measure of bank capitalisation, rose 0.6 percentage points year-on-year to 14.6%. That improvement was driven by the non-payment of last year's final dividend.
Lloyds now expects net interest margins to remain broadly stable at 2.40% for the rest of the year. Full year operating costs are expected to be below £7.6bn, with impairments of between £4.5bn and £5.5bn.
The author owns shares in Lloyds Banking Group.
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