With its third-quarter results, Lloyds Banking Group (LLOY) announced that it plans to close 200 branches as its customers increasingly embrace digital banking platforms. This brings to the forefront the question of whether the increasing importance of digital banking will reduce the competitive advantage of Lloyds' dominant branch network in the U.K. Digital-only banks have the potential for a large cost advantage over traditional banks by avoiding the expense associated with maintaining branches.
However, we find that pricing does not drive consumers' banking decisions, and the rise of digital banking platforms has not meant that retail customers are ready to forsake branches. Instead, consumer decisions continue to be driven by branch location, and it will be difficult for challenger banks to win market share by offering cheaper pricing or better customer service. As a result, we think Lloyds' branch network and the strength of its brands will continue to be key competitive advantages for the bank over the next decade.
The U.K. banking market naturally lends itself to moats in retail banking. It is highly concentrated—the big four control 75% of the market—and challenger banks have made little progress in gaining share.
We think the U.K. government's push to increase competition in retail banking faces material headwinds. Challenger banks are subscale, have less access to low-cost deposit funding, have smaller branch networks, and face consumer indifference to pricing and service.
The rise of digital banking obscures the enduring importance of branches: Within a year, nearly all consumers visit a bank branch, and branches are cited as the number-one reason consumers choose their bank. Strong branch networks will remain a key driver of market share in retail banking.
We see Lloyds as the most attractive play on the moaty U.K. banking market because of its positioning, improving financial results, and attractive valuation. Lloyds dominates the U.K. banking market. It controls about one fourth of current accounts, excluding TSB accounts that Lloyds is in the process of divesting, with 22 million current account customers and more than 2,000 branches. It is also the U.K.'s leading provider of other retail banking products like credit cards and mortgages. Moreover, Lloyds is much more narrowly focused on retail banking than competitors like Barclays (BARC), which operates a large investment bank, and HSBC (HSBA), with its far-flung international operations.
We expect shareholders' patience with Lloyds' turnaround to finally be rewarded in February 2015, when we expect the bank to announce that it will pay a dividend for 2014, its first since 2008. The dividend for 2014 may be fairly nominal—we project about 1p per share—but we expect it to ramp up quickly as management makes good on its promise to pay out "at least" 50% of earnings. Our projected dividend of 3p per share for 2015 and 4p for 2016 implies an attractive forward yield of 4%-5%.
