Lloyds’ Banking Group’s (LLOY) first-half results brought some bad short-term news but reinforced our positive long-term view on the bank. We were especially disappointed to see that Lloyds has had to put aside £1.4 billion of additional provisions for claims relating to the mis-selling of PPI insurance, bringing total provisions to a whopping £13.4 billion.
Political risks are more material than PPI payouts
The bank’s paltry £717 million half-yearly net income available to common shareholders also included a £745 million loss on the sale of TSB and £435 million of other misconduct charges. Still, the bank’s underlying performance was impressive: underlying return on equity was around 15% as we calculate it, annualised loan losses were a mere 0.07% of loans, and the underlying cost/income ratio was a market-leading 48%.
This reinforces our view that Lloyds can earn a 13% return on tangible equity in the medium term, supporting its narrow moat rating. We plan to maintain our 98p fair value estimate.
Despite the weighty misconduct charges, Lloyds reported a 50-basis-point improvement in its fully loaded CET1 ratio to 13.3%, paving the way for the more material dividends we’ve been predicting for 2015. Still, we were not overwhelmed by the bank’s 0.75p interim dividend and think that our full-year dividend estimate of about 2p seems about right. We think the payout will be more substantial in 2016 – we’re pencilling in 3.4p in our base case and 4p in our upside scenario – implying a forward yield of 4%-5%.
While we’re pleased with the underlying results, we think that events in the second quarter highlight the near-term risks that Lloyds faces. The £1.4 billion of additional PPI charges were more than we had expected, and management provided no assurances that more charges don’t lie ahead.
Our fair value estimate includes £2 billion of additional litigation and regulatory charges over the next several years. While we consider this estimate to be preliminary, we don’t see this as a major risk to our fair value estimate – tripling it would erase only 3% from our valuation. Political risks are more material.
In July, the U.K. announced plans to reduce the U.K. bank levy and replace it with an 8% surcharge on bank’s U.K. profits; Lloyds guided that its medium-term tax rate is likely to be near 30%.
We think this will hit Lloyds harder than other large U.K. banks, as its operations are very U.K.-focused, and the increase in taxes fully offsets savings from the lower bank levy, as well as income accrued and improved performance since our last update.
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