Can Lloyds Banking Group PLC Double Again?

Published in Company Comment on 4 July 2013

It has been a good year so far for Lloyds Banking Group PLC (LON:LLOY) -- how much more is left?

Lloyds Banking Group's (LSE: LLOY) (NYSE: LYG.US) shares are up 34% on the year and have more than doubled over the past 12 months, but the shares still trade at just one times book value (the reported value of assets less liabilities) -- one-third their level in 2007.

So do they have further to go? That is the million pound question, isn't it?

Let's look at the basics of banking to try to find the million pound answer.

Easy peasy

Banking is a simple business at its core. A bank just needs some deposits from someone with too much money so it can lend on to someone with too little.

Of course, the interest it receives from this lending needs to be higher than the interest paid on the deposits if the bank (and we as shareholders in that bank) is to make any money. The spread between these numbers is called the net interest margin.

So at its most basic, there are two ways for a bank to grow earnings: improve its net interest margin or increase its lending.

Currently, Lloyd's net interest margin at its core banking operations (the stuff they plan to keep going in future years) is 2.32%, which is down from 2.42% a year ago (they call that 0.1% drop a 10 basis point decline in the biz), so that is going the wrong way.

The bank's core loan portfolio dropped from £453.8 billion at the end of the first quarter of 2012 to £430.4 billion on 30 March 2013. Again, going the wrong way for earnings growth.

Not so black and white

Of course, in the complicated world we live in, there are other items that impact a bank's earnings. The big one we're concerned about is actually getting paid back by borrowers. This might seem like a simple thing, but banks have proven to have a hard time with this in recent years.

But they've been getting better after the disastrous years of 2008 and 2009 and writing off bad loans has generally cost them less and less each year since, which has provided what I'd classify as an artificial boost to earnings -- earnings have been growing, but not for the two fundamental reasons we would expect them to.

Banks have also been cutting costs (mainly by cutting staff) to help earnings, but there is a limit to how far this can go (though I'm sure some would argue there will always be too many bankers) and should also come to an end shortly.

Pretty soon the reduction in write-downs will come to a stop and Lloyds (and all the other banks) will have to start writing more loans or improving their margins in order to grow earnings.

Not so easy peasy

But it is hard for a bank to grow its loan book if an economy is struggling -- assuming we want them to write profitable loans -- and there are some regulatory headwinds for Lloyds, too.

The government is pushing for more competition in the retail banking sector. More competition usually means lower prices -- and prices for banks are interest rates - which will likely mean increased or at least continued pressure on margins.

Secondly, the banks are being forced to hold more capital than they previously did. This means they can lend out fewer of their deposits than in the past which will make it harder to grow the loan portfolio.

With these constraints, I find it hard to believe Lloyds will be able to rapidly grow its earnings in the coming years and its ability to pay dividends will be more restrained than in the past.

There is another way

Of course, there is another way Lloyds shares could continue their climb and that is through multiple expansion - investors could lose their fear of banks and what might be lurking within book value and be willing to pay 1.5, 2, 2.5, or even 3 times book value again.

Given the market's history of short term memory I find it hard to believe this won't happen again at some point. When, though, is anyone's guess. Patient investors may be handsomely rewarded at some point.

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> Nate does not own any share mentioned in this article.

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Comments

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H2F5 04 Jul 2013 , 3:09pm

One of the best articles I've read on here to date. Excellent.

Giveusagooddeal 04 Jul 2013 , 6:05pm

Good article - but it doesn't mention external factors to the share price, Euro fail or recovery, HMG selling off it's stake etc. This will have an influence on the sp as well.

BigJC1 04 Jul 2013 , 8:13pm

Good article. As the main player in the mortgage market shouldn't Lloyds see some volume in a faster moving property market though ?

Also it normally takes some years to see the cumulative impact of cost savings because to make those savings often costs a lot (redundancies, etc).

I actually think that as long as the euro keeps on track and the recovery continues Lloyds will see a dramatic improvements in profits.

How can lower bad debts be seen as an artificial boost, they're no different to higher bad debts been an artificial drag !!!

citruspips 05 Jul 2013 , 8:48am

Thanks for a great article. It's so easy to forget what a business actually does to make it's money, which I think is especially true for both the banks and insurance companies.

TMFTheSnake 05 Jul 2013 , 9:11am

BigJC1

The point I was trying to make was that the bulk (nay, all) of the earnings improvement we've seen from Lloyds in the past few years has been a result of bad debts coming down from ridiculously high levels.

Bad debts will always be a part of banking so the fall in bad debts will end at some point, just as cost cutting can only go so far.

When that happens, the underlying drivers of the business - lending and margins - will need to improve in order for earnings to grow and justify a multiple over book value.

ANuvver 05 Jul 2013 , 12:40pm

Fair analysis.

There is also the issue of the SP "ceiling" that will naturally occur when HMG starts offloading its stake.

I find it hard to imagine a premium to book value (hard enough to calculate, but esp so with a bank) on Lloyds anytime soon. Meanwhile political and regulatory pressure will be suppressing the dividend side of shareholder return.

brightncheerful 05 Jul 2013 , 1:38pm

I think the sp is well up with events and has the potential to overshoot. A slight premium over tangible NAV is reasonable give the prospects for profit and probability of dividend resumption now that the most of the drag has passed but what then?

I expect a sell off of the government's stake to be accompanied by an announcement of a dividend payable within the first year. A carrot to lure the punters?

As for the business model of borrowing to relend, there has to be a demand for the roundabout to have a running momentum. At present, the momentum is artificially fuelled: partly well-run business have no need of extra borrowing and many are awash with surplus cash, and domestic customers don't really contribute much to the slack. The banks aren't allowed to take risks thanks to political objection, not to mention shortage of opportunity, so really it's just a slow-moving merry-go-round that provides a lucrative career path for the staff.

LLOYD is not alone in minimising the interest it pays Joe Public for their savings. It's not that LLOD doesn't need to borrow money so it can relend, simply that thanks to the government's Funding for Lending Scheme (FLS) it can borrow more cheaply from the BoE. In effect, the Government (or the tax-payer to be more accurate) is subsidising the cost of borrowing and in doing so is masking the slow-down in the rate of economic growth.

In a new paradigm, to which the Government hasn't adjusted, borrowing is going to be less important, which begs the question where are the banks going to earn more than enough to give the impression that everything is rosy?

wastedyouth 09 Jul 2013 , 10:22pm

Another way that Lloyds share price could rise is if they actually start paying a dividend, and investors buy for yield. Current dividend is zero.

capetownpeter 10 Jul 2013 , 5:49am

It's a good article for explaining the basics of banking - and you're left wondering why these guys earn so much more than, say, a hairdresser.

But the recent dramatic rise in the share price must be connected to the government's announcement of its intentions to offload the shares.

If you were a fund manager, you'd be buying now knowing that indexers will be necessarily buying as soon as the float goes through. Plus once back in the private, a dividend policy can resume. And a final factor this side of the election - Osborne has commissioned the Rotschilds to master mind the sell off so you can bet it'll go cheap to city friends and then subsequently pick up.

The economy will truly be in fine form for the elections. 2% GDP growth, why not? Output will pass its January 2008 pre-recession peak. Now the fundamentals will be able to take over and support the share price and dividend policy.

Incidentally, the government can say what it wants today, but the break-even point for taxpayers is 70p a share.

This share price rise has been on the up since September last year. At that time, Lloyds overtook the FTSE100 index, and stock's 20 and 50 day moving averages crossed the 200. And it's been plain sailing ever since except for the PPI scandal and EC-obliged sell-off of its branches in April this year.

The rumours of sell-off by the government started in May and the price rise restarted from a low of 46p.

My own opinion is that politics is driving this one. You can put fundamentals and technicals to one side and consider what effects Osborne achieving his objective will have on the share price over the next couple of years. After that, fundamentals re-assert. If this is true, this would make it a good buy-and-hold.

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