Tuesday, October 11, 2005
October 11 2005 - Financial Times
Lloyds? Lloyds TSB? Is that a property and casualty insurance company?" "No, a British bank." "Oh . . . " I'd imagine this is the start of a typical conversation between Lloyds TSB's management team and US investors, [at the time feeling like Yogi Berra when he said, “I wish I had an answer to that because I'm tired of answering that question.”]
Lloyds TSB is the largest UK-based, non-multinational bank but new investors outside of the country confuse the company with that icon of risk UK commercial property and casualty insurer Lloyd's of London.
Ironically, Lloyds TSB is the epitome of conservatism. Moody's, the rating agency, strongly agrees with this assessment by granting a triple A rating to Lloyds TSB's debt. Such ratings are very scarce, especially for banks, Wells Fargo is the only other non-government sponsored bank that commands it.
Lloyds TSB is comprised of three similar size businesses: retail banking, wholesale banking, and insurance. The majority of the insurance business is conducted by Scottish Widows - a life insurance subsidiary acquired in 2000, one of the most strongly capitalised life insurance companies in the UK - the rest is in home-grown property and casualty insurance, serving the retail segment (not the high risk, more volatile commercial segment), representing about 6 per cent of total company earnings.
The late Rodney Dangerfield would have said Lloyds TSB is getting no respect, and he would be right. The stock is hovering only a couple points away from its recent lows because of fears about UK consumers giving in to economic slowdown. The UK is a couple of years ahead of the US in its economic cycle, its strong housing market has softened, the economy's growth has slowed and central banking has started to lower rates.
Economic softening has led to a reversal of a long-term trend of declining debt impairments; the first half of 2005 was arguably an inflection point in that trend reversal. On the surface, bad debt impairments have jumped 51 per cent in the first half of 2005. However, that is far from the economic reality, as most of the jump was driven by implementation of IFRS (International Financial Reporting Standards).
But fears about consumer weakness are overblown. Lloyds TSB has stayed away from high-risk areas of near- and sub-prime lending and thus growth in impairment charges in personal loans and credit cards was about 15 per cent, slightly higher than growth in loans. Commercial loan impairments declined 28 per cent, reflecting the strength of UK corporations. Overall growth of bad debt impairments, excluding the IFRS impact, was just a bit above 7 per cent - resulting in a decline in impairments as a percent of assets, a vital sign of a healthy company, not a struggling one.
Lloyds TSB is getting even less respect considering its solid operating performance in all segments, which we expect to continue. Since it divested international operations in 2003, it has consistently increased earnings in mid single digits, achieving a remarkable 7 per cent operating earnings growth in the first half of 2005, excluding IFRS impact, loans grew 12 per cent and customer deposits rose 9 per cent. All this growth was organic and achieved at a time when the company maintained a 80 per cent dividend payout, rewarding shareholders with a 7.2 per cent dividend yield.
Although the bank's dividend payout is fairly high relative to other banks, its dividend appears to be safe. The company showed a remarkable ability to increase earnings with the current dividend structure, through deepening relationships with existing customers, and it has plenty of room for growth. Investments into the Six Sigma programme are paying off in improved efficiency - costs are growing at a slower pace than revenues, resulting in operating profits growth exceeding revenue growth - operating leverage, the beauty of a banking business.
Lloyds TSB uses derivatives for interest rate risk hedging only. It doesn't play the "proprietary trading" game that turned many banks into super leveraged hedge funds on steroids. Thus it deserves to trade at a premium to the "global" banks as its investors are not taking the risk of waking up one morning and seeing shareholder equity dissipating into thin air (Barings bank comes to mind here).
Lloyds TSB is trading at about 11 times 2006 projected earnings, in line with its peers, although due to its above industry average dividend, impeccable-Aaa -rated balance sheet, predictability and sustainability of earnings growth should command an above average industry PE.
The stock works as a great hedge against a declining dollar, as the dividend paid in pounds and converted into US dollars becomes even more valuable to US investors if the dollar declines. In addition, a high dividend yield creates a solid support under the stock as it is a big attraction for current income hungry investors. Also, as an unexpected bonus, Lloyds TSB would be an optimal acquisition target for a bank looking to set a solid footprint in UK.
The author is a portfolio manager with Denver-based Investment Management Associates and teaches equity research at the University of Colorado. His company owns shares in Lloyds TSB.
Vitaliy N. Katsenelson, CFA
Copyright Financial Times 2005 This article is written for educational purposes only. It is not intended as a recommendation to buy or sell securities. Author and/or his employer may have a position in the securities discussed in this article. Security positions may change at any time.