Usually when you’re after a reliable income generating stock one of the core desirable characteristics is a long history of stable operations and dividend payments. Apply that to a long-term orientated portfolio of UK dividend payers and it would lead you to the usual suspects such as Unilever, Reckitt Benckiser, Imperial Brands, British American Tobacco and Diageo.
On that note the rehabilitation of Lloyds Banking Group (LON:LLOY) into a stodgy dividend stock over the past couple of years has been quite interesting to see. I don’t think British readers will need reminding that Lloyds was one of the big UK banks to come out of the 2007/2008 financial crisis in particularly poor shape (though not as calamitous as Royal Bank of Scotland), and its current share price is still something like 85-90% lower than it was a decade ago. That probably puts it into the irredeemable zone in terms of permanent capital impairment for those who bought shares before the global financial crisis.
What’s particularly galling about that fact is that from a certain point of view Lloyds has actually recovered in terms of its underlying business performance. In fiscal year 2007 the bank earned something like £4 billion in pre-tax profit. We then had the onslaught of the financial crisis and other nasties like the payment protection insurance (PPI) mis-selling scandal which wrecked profits for several years. Fast forward to last year and statutory profit before tax came in at £4.2 billion. So basically Lloyds has been on one heck of rollercoaster ride over the past decade and has now roughly ended up back at the starting point. The difference, however, between 2007 and 2016 is that Lloyds now has about 12x more shares in issue than it did in 2007. That was essentially the price for recapitalising the bank during the dark days of 2008-2010.
This, in a nutshell, is why talking about Lloyds as a dependable dividend stock seems a bit odd. Granted banks are inherently cyclical by nature and you’ve got to expect ups and downs. Even those banks with one hundred or more years of consecutive dividend payments had to cut them from time to time. But the extent of the punishment meted out with Lloyds is on a different scale compared to what you might expect with other cyclical blue chip stocks.
Take BP as a good recent example. Between 2007 and 2016 it has had to deal with two particularly large blows to its underlying business. First of all the average price of a barrel of oil has fallen from well over $100 per barrel to around $50 a barrel. Needless to say a 50% drop in the price of your primary product isn’t going to do wonders for the bottom line. Secondly, BP has had to contend with a mammoth $65 billion bill stemming from the Gulf of Mexico oil spill back in 2010. Again it kind of goes without saying but this has added enormous strain to the underlying business.
Factoring in those two huge headwinds means that if you bought BP shares ten years ago you’d be down about 22% on your initial capital outlay (a decade ago BP shares were trading for £5.70 each and now they’re going for around £4.45). However during that time BP has paid out around £2.25 per share in dividends as well, meaning that in actual fact you’d have come away with a positive total return.
In the case of Lloyds you obviously can’t say the same thing. On the flip side the bank is now a vastly different entity to the one that existed pre-2007. Let’s take a closer look at where Lloyds is right now and whether its new found tag as a dividend cash cow makes it appropriate for long-term investors.
Lloyds Q1 2017 Results: The Turnaround Continues
On Thursday Lloyds released its financial results for the first quarter of 2017. Pre-tax profit came in at around £2.1 billion, beating analyst estimates by around 7% on the back of higher margins. The group’s net interest margin (NIM) – i.e. the difference between interest generated and paid out to lenders as a proportion of assets – was up by around 0.1% to 2.8% compared to the previous quarter.
The main positives to takeaway are that the bank expect NIM to remain closer to 2.8% than the previously forecast 2.7% over 2017, and that so far there are no signs of any Brexit related wobbles. Indeed impairments came in lower than at this point last year. The group also expect the acquisition of specialist credit card company MBNA to add a further 10 basis points to NIM.
On the dividend front shareholders will be pleased with the bank’s capital position. The current CET1 ratio is up to 14.3%, which is one of the strongest in the UK and Europe and well ahead of the bank’s 13% target, and organic capital generation is forecast to come in at around 200 basis points over 2017.
(Source: Lloyds Q1 2017 Results Presentation)
The key takeaway for investors is that Lloyds is throwing off plenty of surplus capital. Shareholders can expect to see that returned via increasing ordinary and special dividends now that PPI claims are finally winding down.
Lloyds: The New Boring Bank?
When it comes to banking, and probably all long-term buy-and-hold dividend stocks, boring is best. This is why many folks value small US regional banks like Farmers & Merchants Bank of Long Beach more than the globally systemically important ones. They generally focus on retail customers and small & medium sized enterprises, and have super high quality loan books and strong balance sheets. They can be extremely conservative, but that’s where I’d want a bank to be if I were a long-term shareholder. These are cyclical businesses after all and need to be strongly placed when inevitable downturns crop up.
Lloyds is now essentially positioning itself along more conservative lines with a bog standard business model focusing on UK retail and business customers. Before the financial crisis the bank sported a leverage ratio of just under 30:1 (as a reference someone with a 95% mortgage has a leverage ratio of 20). Needless to say when leverage is running that high it doesn’t take all that much boat rocking, relatively speaking, to wipe out your equity position.
These days Lloyds’ leverage ratio is down to around 20. In other words it has become a less risky bank, albeit still a fairly leveraged play on the UK economy. On the positive side of things being a more boring bank has allowed Lloyds to become inherently low cost. It’s cost to income ratio during the first quarter was 47.1% which compares favourably to its UK listed peers. By the end of 2019 Lloyds expect that to decrease further to around 45%. In addition the bank’s asset quality remains strong with a loan loss rate of around 0.15%.
(Source: Lloyds Banking Group Presentation)
As far as mortgages are concerned its worth talking about more given the importance of the UK housing market to Lloyds. Around two thirds of the bank’s loans are personal mortgages to UK customers and it currently has around a 25% share of the domestic UK mortgage market. The key issue over the long run is that house prices in the UK are too high, particularly in London and the South East. As far as Lloyds and its shareholders are concerned the danger is not just a house price decline, but that coupled with a recession a portion of those households won’t be able to meet their repayments. This would obviously have an impact on the bank’s balance sheet although it’s worth pointing out that the average loan-to-value ratio is around 45%.
My view is that as far as UK and European banks go Lloyds is now probably the best of the bunch. It has an extremely profitable underlying business which is currently generating buckets of surplus capital. As you’d expect the plan is to return a chunk of that to shareholders given Lloyds’ limited future growth and acquisitions outlook.
As it stands the dividend yield based is around 3.9% based on the 2.55p per share ordinary dividend and 4.5% once you factor in the 0.5p per share special dividend (2016 figures). All things being equal there’s scope for that to increase fairly substantially in the short-term now that PPI mis-selling claims seem to finally be winding down (having already cost the bank something like £17 billion). In the long run I doubt there’s many folks who will be relying solely on shares of any British bank to meet their income needs. After all there’s a very good reason why Neil Woodford doesn’t include them in his fund. Ultimately Lloyds remains a cyclical stock and a leveraged play on UK households, albeit it is in markedly better shape than it was a few years ago.