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Buy Lloyds for income potential

The retail banking giant is the best capitalised of the UK-listed sector and should continue to pay out a healthy dividend
December 29, 2016

No one thought the path to recovery would be either speedy or easy for UK banks such as Lloyds Banking (LLOY). The Brexit vote threw another curveball at the domestically-focused retail bank in 2016. That was bad news for us as around 12 months ago we made Lloyds our Recovery Tip of the Year, pinning our hopes on the industry giant rediscovering its income-stock status. While the share price has not performed well, a lot of the progress we'd hoped to see has actually materialised. Gaining the mantle as the most well-capitalised UK-listed bank, Lloyds was able to triple its dividend earlier this year. And with a deadline looming for payment protection mis-selling redress and a significant earnings-enhancing acquisition just announced, we think prospects look strong for the shares in the year ahead.

IC TIP: Buy at 63.95p
Tip style
Income
Risk rating
High
Timescale
Medium Term
Bull points
  • Well-capitalised
  • PPI deadline expected
  • Progressive dividend policy
  • Earnings-accretive acquisition
Bear points
  • Brexit risk
  • Public share sale called off

Lloyds has been growing its capital base during recent years. At the end of September the bank's common equity tier one ratio increased to 14.1 per cent, which was up from 10.3 per cent at the end of December 2013 when management entered into discussions with the Prudential Regulation Authority to resume dividend payments. In February management announced a dividend of 2p a share, from just 0.75p the previous year, as well as a 0.5p special dividend. At the half-year stage during the current financial year, management once again increased the dividend, by 13 per cent to 0.85p a share. This was ahead of market consensus, which has assumed it would be maintained at 0.75p. We feel the bank's growing capital base bodes well for future dividend increases.

But Lloyds has also found other uses for its improved balance sheet. This week the bank agreed to buy MBNA, the UK credit card business of Bank of America, for £1.9bn. While this will hinder management's ability to repeat 2015's special dividend payment, given the capital spent on the deal, it looks as though this could well prove a better use of funds.

At the end of September management calculated Lloyds' tier one capital ratio by pricing a dividend of 2.55p. Announcing this latest purchase, management said it was "confident in delivering a progressive and sustainable ordinary dividend in 2016" and would continue to target a payout ratio of at least 50 per cent of earnings. Even without the payment of any special dividends this year, and ordinary dividends merely maintained at the previous year's level, at a share price of around 63p this would give a decent yield of 3.6 per cent, before a potential resumption of special dividend payments in 2017. Importantly for shareholders, the acquisition is expected to enhance EPS by 3 per cent and 5 per cent during the first and second full years of trading after its completion. The underlying return on investment also exceeds the cost of equity - which analysts assume is 10 per cent - during the first year, before rising to 17 per cent in year two. Meanwhile, the recent steepening of the 'yield curve' may also help profitability.

And the payout could easily be a lot better, equating to more than a 3.6 per cent yield. Management expects to generate capital equivalent to 160 basis points of risk-weighted assets during 2016. This represents 5p a share, leading analysts at Shore Capital to forecast a basic dividend yield of 4 per cent.

The most recent Bank of England stress test underlined Lloyds strength. It modelled the effects of a UK and global recession on banks' balance sheets, and Lloyds came out top. The bank had a core capital ratio of 12.8 per cent at the end of December 2015, which under a stress scenario reduced to 9.7 per cent. This was easily clear of its hurdle rate of 7 per cent. Meanwhile, Royal Bank of Scotland (RBS), Standard Chartered (STAN) and Barclays (BARC) failed to pass their hurdle rates under the same stress scenario without converting additional tier-one securities.

During the third quarter of the year Lloyds took a £1bn provision for mis-selling of payment protection insurance, which was down from £1.9bn at the same time in the previous year. Management reckons this is the last big provision it will need to take and provisions relating to the MBNA acquisition are capped at £240m. The new confidence around PPI is based on the Financial Conduct Authority setting a deadline of mid-2019 for compensation claims, although this is a year later than initially expected. The stemming of PPI provisions should vastly improve the bank's profitability as well as investor confidence.

LLOYDS BANKING GROUP (LLOY)

ORD PRICE:63.95pMARKET VALUE:£45.6bn
TOUCH:63.94-63.95p12M HIGH / LOW:74p47p
FORWARD DIVIDEND YIELD:4.5%FORWARD PE RATIO:9
NET ASSET VALUE:69pLEVERAGE:20.8

Year to 31 DecTotal income (£bn)Pre-tax profit (£bn)Earnings per share (p)Dividend per share (p)
201318.86.176.61nil
201417.47.307.480.8
201517.67.998.252.3
2016*17.57.807.192.6
2017*17.37.496.952.9
% change-1-4-3+12

Normal market size: 30,000

Matched bargain trading

Beta: 0.72

*Shore Capital forecasts, adjusted PTP and EPS figures, excludes special dividends of 0.5p in 2015, 1.45p in 2016 and 2.15p in 2017, prior to MBNA takeover