Lloyds Banking Group PLC (LON:LLOY) has dished out bigger returns to shareholders after higher profits, stronger revenues and improved capital generation in 2017 – but it is not out of the woods yet.
Its focus on the UK market means it is one of the most exposed lenders to an economic downturn – something many economists have warned could happen in the event of a bad Brexit deal.
READ: Lloyds hikes dividend and unveils £1bn buyback as profits jump but miss forecasts
“Implications of the UK leave vote for the housing market and consumer confidence will take time to emerge and some regulatory uncertainty still remains meaning capital requirements will remain elevated,” Morgan Stanley said in a note to investors.
Morgan Stanley left its rating at ‘equal weight’ and raised its target price to 78p from 75p.
Uncertain economic outlook
Neil Wilson, senior market analyst at ETX Capital, agreed that downside risks remain in terms of the broader British economic outlook.
He added that the tail risk for Lloyds lies in rising interest rates and a frothy credit market.
The Bank of England raised interest rates for the first time in a decade in November from 0.25% to 0.5%, which is a boost to banks' profits but harder on those paying off loans.
“The growth in consumer credit is a risk of the UK economy deteriorates, particularly if it coincides with a Bank of England tightening cycle,” Wilson said.
While Lloyds acknowledged that the outlook remains uncertain during Brexit negotiations, it said the economy has been resilient with low unemployment, stable house prices, record employment and gross domestic product growth of 1.8%.
Laith Khalaf, senior analyst at Hargreaves Lansdown, pointed out that bad loans at Lloyds remain at low levels, thanks to the benign economic environment and record low unemployment.
“Here lies the risk with Lloyds, as a shock to the domestic economy would be keenly felt by the bank," Khalaf said.
PPI saga set to continue
Meanwhile, Lloyds is still grappling with misconduct costs.
It took a £1.65bn charge last year for compensation claims related to the payment protection insurance mis-selling scandal, bringing its overall bill to £18.7bn.
The Financial Conduct Authority has given victims of the scandal a deadline of August 2019 to make complaints, meaning Lloyds is likely to see further PPI claims on the horizon.
“We can expect further adjustment of the Lloyds PPI war chest to reflect consumer behaviour as we head towards the August 2019 deadline, though these are likely to be incremental tweaks to the existing budget,” Khalaf said.
Last year’s results also included impairment charges of £717mln, a 10% increase on the previous year, mainly due to the costs of integrating the MBNA credit card business. Lloyds completed its £1.9bn takeover of MBNA from the Bank of America in June.
“The slight uptick in impairments comes at a time when Lloyds finds itself in an economic sweet spot and therefore needs to be contained, whilst the additional PPI provision – a race surely in its final furlong – is an unwelcome development,” said Richard Hunter, head of markets at interactive investor.
“Elsewhere, any retrenchment of the UK economy could threaten progress, particularly in the recently acquired credit card business.”
Profits jump but miss forecasts
The extra provisions to cover PPI claims meant profits missed analysts’ expectations.
The lender reported a statutory profit of £5.3bn in 2017, up 24% on the prior year and the highest level since 2006 – but below market forecasts of £5.7bn.
But Lloyds trimmed its cost base last year and is targeting operating costs of less than £8bn by 2020 under its new strategic plan, which was presented alongside the full year results.
The net interest margin increased by 15bps to 2.86%, including a 7bps contribution from MBNA..
Lloyds sees the net interest margin for 2018 rising to 2.90%, in line with the level reached in the fourth quarter.
“The net interest margin is a closely watched profitability measure, as it highlights the difference between interest paid out on savings and the interest charged on loans, and for Lloyds it came in at 2.86% - a touch higher than its previous forecast,” said David Madden, market analyst at CMC Markets.
Dividend yield of 6% keeps investors happy
On the back of an increase in capital generation, the bank lifted its 2017 dividend by 20% to 3.05p and announced a share buyback of up to £1bn. The dividend hike and the buyback brings total shareholder returns for the year to £3.2bn, up 46% on the prior year and representing a dividend yield of around 6.4% at the time of writing.
“The combination of the dividend and the new share buyback scheme means shareholders are getting a pretty tasty 6% return on their investment, which offers some compensation for the chance that Brexit may unfold in a messy manner,” said Khalaf.
Lloyds said it plans to deliver “progressive and sustainable ordinary dividends whilst maintaining the flexibility to return surplus capital to shareholders”.
In its strategic plan for 2018-2020, Lloyds revealed that it aims to generate 170-200 basis points of distributable capital per year.
The bank generated 245 basis points capital last year, slightly more than the 240 bps estimated in October.
Capital position strengthened even after buyback and dividends
The pro-forma common equity tier 1 (CET1) ratio – a measure of capital strength – stood at 13.9% at the end of 2017, including dividends and the £1bn share buyback, compared to 13.0% a year earlier. Excluding the buyback and dividends, the CET1 ratio was 15.5%, up from 14.1% in 2016.
Analysts at UBS said the bank's plans to grow revenues at stable margins, cut costs and generate surplus capital "should reassure investor concerns", delivering pre-tax profit upgrades and earnings momentum.
"The new strategic plan looks good to us. Lloyds aims for a return on investment of 14-15% from 2019 on a higher CET1 requirement of 13.9%, generating 170-200bps of distributable capital per annum, 5.4p or an 8% yield."