Lloyds Banking Group PLC (LSE:LLOY) and NatWest Group PLC (LSE:NWG) could both pay out cash worth more than 40% of their market caps in the coming few years, analysts at Barclays said, as they assessed the sustainability of the recent step-up in the UK banking sector's profitability from higher interest rates.
Lloyds was upgraded and both NatWest Group PLC and Virgin Money UK PLC (LSE:VMUK) were downgraded as the analysts noted that UK banks have benefited from margins widening back towards historical norms and are also benefiting from substantial excess liquidity.
NatWest has benefited from over £100bn of deposit inflows since 2019, with an estimated £55bn of “excess” cash that could be worth up to 18% of 2023 forecast earnings at NatWest and £20bn worth 6% at Lloyds, equivalent to +3% and +1% of return on tangible equity (RoTE), respectively.
But Lloyds is seen as “relatively better placed” to cope with the combination of the Bank of England carrying out ‘quantitative tightening’ following its rate hiking cycle and the escalating competition for customer deposits raises the prospect of deposit outflows at big banks.
This is due, the Barclays analysts said, to Lloyds having “greater reliance on retail savings”, while NatWest “may be more exposed given its weighting towards flightier commercial current accounts”.
Deposit outflows have now been factored in at both banks, which if the rest of the City was to agree, could be worth up to 10% and 6% of 2025 consensus forecast EPS at NatWest and Lloyds, respectively (all else being equal).
Lloyds was upgraded to an ‘overweight’ rating from ‘equal weight’, with a new price target of 75p, up from 55p, versus a close price of 53.3p at the end of last week.
The analysts said: “We see a more enduring tailwind from rising rates than previously and RoTE less impacted by excess liquidity/deposit outflows, alongside falling provision risks given UK macro de-risking.”
The Barclays analysts envision sector-leading capital returns for Lloyds, including that the lender will return around 45% of its £36bn market cap by 2025.
Lloyds’ valuation “appeals” at circa seven times 2023 estimated EPS, which it is noted is a discount to European banks at nearer 8 times.
NatWest was downgraded to ‘equal weight’ from ‘overweight’ and its target price was kept at 400p, although the analysts remain positive, particularly in the near term and the valuation remains “very attractive” at 6.7 times 2023 EPS.
However, capital returns are a “key attraction”, including the potential for increased payout guidance with this month’s full-year results and with NatWest being seen as the highest-yielding capital return stock across the European bank sector, with scope to return at least 40% of its market cap by 2025.
But longer-term risks are seen around “liquidity unwind/deposit outflows which may raise questions around over-earning”, and a perception of looming “acquisition risk” as the lender may decide to use some of its capital in strategic M&A to boost its fee income, as four-fifths of revenue comes from net interest income.
Virgin Money was similarly downgraded to ‘equal weight’ from ‘overweight’, with “limited catalysts” seen.