We’re glad that Lloyds (LLOY) has agreed to sell its remaining 50% stake in the challenger bank TSB to the Spanish bank Sabadell, as the transaction will bookend what has been a time-consuming distraction for management and put Lloyds even further down its path to producing business-as-usual results for shareholders.
Lloyds was required to sell the bank as part of its agreement with the European Commission in the wake of its bailout during the financial crisis. We don’t expect the sale to affect our fair value estimate for the narrow-moat bank, and we continue to see the shares as materially undervalued.
We see the agreed-to price for TSB as moderately attractive for Lloyds. Sabadell will pay £3.40 per share, a 30% premium to TSB’s June IPO price but a mere 4% premium to TSB’s year-end book value. Despite this premium, Lloyds will take a manageable £640 million charge on the sale, which reflects the costs of the transaction and the £450 million Lloyds has agreed to give TSB to fund its IT operations.
The initial tranche of 9.99% of shares will be completed by March 24, and Lloyds has irrevocably agreed to sell the remaining 40% stake after regulatory approvals are granted. When completed, the transaction will reduce Lloyds' CET1 capital ratio by 27 basis points, which we see as entirely manageable given Lloyds' strong 12.8% fully loaded CET1 ratio at year-end.
Why Invest in Lloyds?
Lloyds nearly destroyed itself in 2008 with its ill-considered acquisition of HBOS, and the U.K. government ended up with 43.5% of the combined group. Now, after years of bailouts and setbacks, the bank has come a long way in righting itself, and the government has begun selling down its stake. We're encouraged that the U.K. recovery is gaining speed, and we expect to see double-digit return on equity in 2015, along with a 2016 forward dividend yield of at least 4%, as a result.
Lloyds has closed HBOS’ worst businesses, wrote down much of its bad assets, and is close to re-emerging as the powerhouse U.K. bank that it once was. Net interest margin in the core bank finally began to tick up in the first half of 2013, and the loan/deposit ratio has fallen to 108% - and will be closer to 100% as noncore loans decline. Credit losses have fallen to about 0.3% of loans – below what we see as a medium-term level – and runoff assets have fallen by 91% since 2010, to £17 billion at the end of 2014.
Now that Lloyds has substantially completed its turnaround, we think its moaty retail and commercial bank will be the biggest driver of results going forward, rather than legacy issues. The retail bank is especially attractive, and has a 25% share of the U.K.'s concentrated banking market.
The unit is efficient – costs consume 50% of revenues – and pre-tax returns on equity are likely to be over 30% when interest rates increase. While its commercial bank has returns closer to the midteens, we see positive signs there too – loan losses fell to 0.08% of loans in 2014 – as loan growth picks up with economic expansion.
Still, we're wary of assuming it is smooth sailing from here. We're particularly concerned that misconduct charges, while well past the peak, may not be completely over. Lloyds has set aside GBP 11 billion against claims that it missold payment protection insurance including £2.2 billion in 2014, for example, and fresh scandals could emerge at any time. We're pencilling in an additional £2 billion of regulatory charges over the next several years.
