Lloyds: Evident Stability in Q1 Results, 8.4x Normalized P/E & 5%+ Dividend Yield

Company Update (LLOY LN) (Buy)

Highlights

• Lloyds shares are attractive on undemanding assumptions

• Shares are below TNAV and offer a 5.2% Dividend Yield

• Deposits fell just 0.5% in Q1 and Net Interest Margin rose

• 2023 guidance was reaffirmed, including a 13% ROTE

• We see a 44% upside (15.9% p.a.). Buy

Introduction

Lloyds Banking Group released Q1 2023 results on Wednesday (May 3); shares have fallen 6.7% in the past month.

We believe Lloyds is a fundamentally stable business and its stock is attractive on undemanding assumptions. Shares are at 0.92x Tangible Net Asset Value, offer a 5.2% Dividend Yield and we believe have an 8.4x normalized P/E.

Q1 results support our investment case. Deposits continue to be stable, falling just 0.5% from Q4. Net Interest Margin (“NIM”) was flat sequentially, and management expects a small decline in Q2 then stabilization in H2. Loans were down slightly, but largely due to one-offs, and the structural hedge has continued to provide a tailwind. Credit losses have remained low. Management has reaffirmed 2023 guidance, which includes a Return on Tangible Equity (“ROTE”) of around 13%. Capital generation is strong, and the dividend will likely be raised again in July. With shares at 45.76p, assuming a 11% ROTE and a 10x P/E, we expect a total return of 44% (15.9% annualized) by 2025 year-end. Buy.

As this is our first Lloyds article on Substack, we start with a longer recap of its investment case. Readers familiar with our research can jump one section ahead to “Lloyds Q1 2023 Results Headlines”.

Lloyds Investment Case Recap

Lloyds is the #1 retail bank in the U.K and largely focused on the domestic market, where it provides a broad range of products and services to consumers and businesses.

Lloyds has three segments. Retail Banking is by far the largest, providing more than 60% of income and underlying profit in 2022; the other segments are Commercial Banking and Insurance, Pensions & Investments:

Lloyds Key Financials by Segment (2022)

Source: Lloyds results release (Q4 2022).

Lloyds has historically been a lending-centric business, with Net Interest Income (“NII”) contributing 73% of Net Income in 2022. As of 2022 year-end, 66% of its gross lending consisted of personal mortgages.

As in other large banks, the core of Lloyds’ franchise is its large low-cost deposit base, the result of its strong brand, longstanding customer relationships and economies of scale. Cheap deposits help protect NIM in Lloyds’ loan book, and fund a “structural hedge” that functions like a portfolio of fixed-rate bonds in generating additional NII.

Following the Global Financial Crisis, lending margins at U.K. banks have faced increased competitive pressures, due to both Quantitative Easing and new ringfencing regulations restricting bank capital to domestic lending. During António Horta-Osório’s tenure as CEO in 2011-21, Lloyds protected its profitability by keeping a mostly-flat loan book,  selectively expanding into higher-margin areas and cutting costs. Since 2014 (when TSB was spun off), Underlying ROTE has been in the low-to-mid teens every year, except in COVID-impacted 2020, when it was still a positive 2.3%:

Lloyds Underlying Return on Tangible Equity (2014-22)

NB. Not adjusted for restatement of TNAV after IFRS17 at 2022 year-end. Source: Lloyds company filings.

Since 2022, new CEO Charlie Nunn has been implementing a new, more growth-oriented strategy, with key pillars including the deepening of existing consumer relationships (including with a mass affluent investment offering), diversifying the SME business and selectively expanding offerings to Corporate & Institutional customers. Nunn’s plan now includes a ROTE of around 13% in 2023-24 and more than 15% in 2026.

We are cautious about the new strategy. The top team has a relatively weak operational track record, and most of the strategy’s pillars seem to imply doing the same things as before but better. However, Lloyds shares are attractive even on relatively undemanding assumptions, having collapsed in the early months of the COVID-19 pandemic and not yet fully recovered. We have assumed a 11% Return on Tangible Equity and a 10x exit P/E multiple.

Lloyds Share Price (Last 5 Years)

Source: Google Finance (05-May-23).

A major U.K. recession and credit losses are the main risk for Lloyds. However, we believe any damage would be survivable and temporary, given Lloyds’ lending has historically focused on prime+ borrowers and its mortgage portfolio has conservative Loan-To-Value ratios (with an average of 41.6% at 2022 year-end). Lloyds’ record of staying profitable through the pandemic (with half-yearly ROTE troughing at 0.1% in H1 2020) also offers assurance.

Compared to NatWest (Buy-rated), Lloyds a similar ROTE target, but with less loan growth and cost reduction potential.

Lloyds Q1 2023 Results Headlines

Lloyds achieved a 19.1% ROTE in Q1 2023, higher than both the prior-year quarter and full-year guidance:

Lloyds Key Financials (Q1 2023 vs. Prior Year) (£m)

Source: Lloyds results presentation (Q1 2023).

The results were expected. NII grew 20% year-on-year, driven by higher interest rates. Other Income was helped by better insurance results after benign weather. Operating Lease Depreciation rose due to growth in the motor lease fleet and lower gains on vehicle resales (after used car prices fell). Operating costs rose due to planned investments. Impairment Charge rose year-on-year from pandemic lows but were significantly lower than in Q4 2022 (£465m).

More importantly, operational performance has remained stable during Q1.

Low-Cost Deposits Remain Stable

Lloyds’ deposits continue to be stable, with the total balance falling just 0.5% from Q4 (and 1.7% year-on-year):

Lloyds Customer Deposits (£ bn) (Since 2019)

Source: Lloyds results presentation (Q1 2023).

Within a stable total balance, there was also minimal internal movement between different account types, with only £8-9bn shifting from personal and commercial current accounts to fixed rate term or “with notice” accounts, etc. Interest rate pass-through on deposits have been at 40% and expected to remain there in H2 and 2024.

Management disclosed that 28% of its Commercial Banking deposits are non-interest-bearing. This means that, together with Retail current accounts, 33% (or £157bn) of Lloyds’ deposits continue to pay no interest despite recent rate hikes.

Lloyds Deposits by Account Type (Q1 2023 vs. Prior Periods)

Source: Lloyds results release (Q1 2023).

Management expects the total deposit balance to be “broadly flat from 2022” in 2023.

Net Interest Margin Flat Sequentially

The broadly stable deposits have also helped Lloyds’ NIM. NIM was flat sequentially in Q1, with tailwinds from the higher base rate, deposits and the structural hedge offset by a headwind in lending margins, especially in mortgages:

Lloyds Net Interest Margin Bridge (Q1 2023 vs. Prior Quarter)

Source: Lloyds results presentation (Q1 2023).

Q1 2023’s NIM of 322 bps is higher than full-year guidance of “at least 305 bps”. Management expects NIM to decline slightly in Q2 and then stabilize in H2.

The main headwind to NIM is the mortgage front book, where existing mortgages with an average margin of around 180 bps are being replaced with new or refinanced mortgages with a (blended) average margin of around 50 bps during Q1 (similar to Q4 2022). This headwind is elevated at present, because the mortgages being refinanced are coming disproportionately from the higher-yielding 2020-21 vintage. Fixed-rate mortgages accounted for 81% of Lloyds’ mortgage book at 2022 year-end, and is roughly 50/50 split between 2-year and 5-year terms.

This headwind should abate by H2 2024 as we lap the 2020-21 cohort. As CFO William Chalmers said on the earnings call:

“The bulk of the mortgage headwind is addressed and dealt with by the time we get to the back end of 2024.”

In addition, the current blended margin is lower because of a lower mix of new mortgages, which are higher-margin than refinanced ones. This is in turn the result of a weaker U.K. housing market, and should normalize eventually.

Lloyds Loan Book & Structural Hedge

Lloyds’ total loans were up 1.1% year-on-year but down 0.6% (£2.6bn) from Q4 2022. The sequential decline was largely due to one-off headwinds, including the exit of a £2.5bn legacy mortgage portfolio and repayments of SMB loans in COVID-related government support schemes:

Lloyds Loans & Advances to Customers (Q1 2023 vs. Prior Periods)

Source: Lloyds results release (Q1 2023).

The structural hedge has continued to provide a tailwind as maturities are reinvested at higher rates. It currently has an average yield of just 1.2%, much lower than spot rates, and has a 3.5-year average maturity. The nominal balance stands at the target maximum of £255bn. It is expected to “provide a healthy tailwind in the coming quarters”.

Management expects Average Interest-Earning Assets to be “broadly flat” year-on-year in 2023.

Credit Losses Remain Low

Credit losses have remained low, with Q1 2023 Impairment of £243m, compared to £465m in Q4 2022. This was helped by an upward revision in macroeconomic assumptions, following the fall in energy costs and better-than-expected U.K. government finances. The Asset Quality Ratio was 22 bps, compared to full-year outlook of around 30 bps.

2023 Outlook Reaffirmed

Management has reaffirmed full-year 2023 guidance, which includes a ROTE of around 13%:

Lloyds 2023 Outlook

Source: Lloyds results presentation (Q1 2023).

Lloyds generated 74 bps of capital in Q1 2023 and accrued 21 bps for its dividend. Including a £800m fixed pension contribution, an acquisition and an increase in Risk Weighted Assets, its CET was flat sequentially (on a pro forma basis) at 14.1%, higher than the targeted 13.5% (12.5% regulatory minimum + 1% buffer).

This indicates more capital can be returned to shareholders, and management hinted at the possibility of a dividend hike after interim results in July. (Further buybacks are unlikely to be authorized by the Board with full-year results.)

Lloyds Dividend Yield & Valuation

At 45.76p, Lloyds shares are trading at:

• 0.92x P/TNAV, relative to Q1 2023 TNAV of 49.60p per share

• 8.4x P/E, relative to our assumption of a medium-term ROTE of 11%

• 5.2% Dividend Yield, relative to 2022 dividend of 2.40p

Share buybacks have been a regular part of Lloyds’ capital allocation. Lloyds is currently executing a £2.0bn buyback program  (equivalent to 6.6% of the current market capitalization) announced in February and expected to be completed by the end of 2022. £750m of shares have been repurchased to date.

Lloyds Return Forecasts & Conclusion

We keep the assumptions in our forecasts unchanged:

• ROTE to be 11% in 2023-25

• Dividends, buybacks and pension contributions to be 94.5% of Net Income

• Dividend to grow 5.0% annually

• Pension contributions to be £800m annually

• Buybacks to be conducted at 1.0x P/TBV (was 1.2x)

• P/E to be 10x at 2025 year-end

Our new 2025 EPS forecast of 5.81p is 12% lower than before (6.59p), largely due to the reduction in 2022 year-end TNAV following the IFRS 17 accounting standard change:

Lloyds Illustrative Return Forecasts

Source: Librarian Capital estimates.

With stock at 45.76p, we expect an exit price of 58p and a total return of 44% (15.9% annualized) by 2025 year-end.

Lloyds still looks attractive on relatively low expectations. We reiterate our Buy rating on Lloyds Banking Group.

Ends

Stocks mentioned: LYG 0.00 NWG 0.00. We are long both.