Now that narrow-moat Lloyds has substantially completed its turnaround, its moaty retail and commercial bank will be the biggest driver of results going forward.
By Stephen Ellis | 12-29-16 | 12:00 PM | Email Article

Lloyds Banking Group now one of the sturdiest banks in Europe. It nearly destroyed itself in 2008 with its notorious 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 essentially righted itself, and the government has largely sold down its stake. We're encouraged that the U.K. recovery is continuing, and we expect to see double-digit return on equity in 2016 along with a 2016 forward projected dividend yield of at 5.8% as a result.

Stephen Ellis is an energy and utilities strategist for Morningstar.

Lloyds has closed HBOS’ worst businesses, wrote down much of its bad assets, has re-emerged as the powerhouse U.K. bank that it once was. Net interest margin in the core bank finally began to tick up in early 2013 and continued to rise through 2015 as funding costs declined. The loan/deposit ratio has fallen to 108%--and will be closer to 100% as noncore loans decline. Credit losses have fallen to about 0.1% of loans--well below what we see as a medium-term level--and runoff assets have fallen by 94% since 2010, to GBP 11 billion at the end of 2015.

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 (about 30% of risk-weighted assets) is especially attractive and has a 25% share of the U.K.'s concentrated banking market. The unit is efficient--as costs consume 50% of revenues--and pre-tax returns on equity are already near 40% even with low interest rates. While its commercial bank (50% of RWAs) has returns closer to the mid-teens, we see positive signs there too--loan losses fell to 0.01% of loans in 2015--as loan growth picks up with economic expansion.

Having said that, we expect Brexit to introduce a period of slower economic growth in the U.K., lower loan growth, higher loan losses, and higher legal and compensation expenses. We're also concerned that misconduct charges, while well past the peak, may not be completely over. We're penciling in an additional GBP 3 billion of regulatory charges over the next five years.

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