Important: This is not a recommendation to buy Lloyds shares. I’m just a private investor, storing and sharing notes for interest and entertainment. Read my disclaimer [1]. Your core portfolio should be in passive funds [2].
I see Morgan Stanley downgraded Lloyds shares (Google Finance: LLOY [3]), and set a price target of 50p.
In contrast, I’ve built up a position in the UK bank over the past two months, paying an average price of 59p.
Lloyds closed last night at 55p. The share price has been falling for weeks.
Sovereign debt crisis? Coalition bank bashing? Fund managers who’d rather admit to crabs than owning bank shares?
Who knows and who cares? I smell an opportunity to buy a cash cow of tomorrow on the cheap.
Why buy Lloyds shares? Why buy any shares?
Let’s backtrack for a moment. Passive index funds [4] beat most active share traders, but there are still at least four reasons to pick stocks:
- You believe you can beat the market.
- It’s fun, and you’re prepared to pay the price of under-performing.
- You want (extra) exposure to an asset class or sector not represented (sufficiently) by the market. Say forestry or gold.
- You’re hedging: for example, buying BP shares [5] to offset the unusually high fuel costs you rack up racing dumper trucks at weekends.
I pick stocks with some of money for the first two reasons. Even after a decade it’s too early to tell if I can consistently beat the market, but I’m having fun trying.
With Lloyds though, the fourth reason – hedging – also plays a role.
Regular readers may recall I’ve long thought London property expensive [6] and so have rented for several years. So far I’ve been wrong, with the dip in prices in 2009 quickly rebounding.
I therefore partly see my new holding of Lloyds shares as a consolation prize should I continue to be wrong:
- If UK house prices rise by 25%, I’d be gutted but I could easily see Lloyds more than doubling in such a climate.
- If UK house prices fell 25%, the money I’d potentially save on buying a home would dwarf any loss in Lloyds.
With that explained, let’s look more closely at the case for Lloyds.
The economic backdrop and Lloyds
I haven’t done my usual summary of the share price and fundamentals like P/E, price to book, earnings and so forth for this write-up.
That’s because such figures are pretty meaningless for Lloyds shares. The situation is changing fast from a capital, regulatory and political standpoint, and also in terms of the value of its assets and the outlook for its earnings.
Instead, I’ll outline what I think will happen to Lloyds over the next 1-3 years, and what it will do to the share price.
This means taking an economic view, which is always risky.
- I expect the UK to keep growing (as does the new Office of Budget Responsibility) [7] although my view back in February [8] looks a bit over-egged in retrospect. (I didn’t foresee snow, ash or the Euro crisis!)
This outlook is critical, because following the UK banking recapitalization and Lloyds’ withdrawal from the asset protection scheme [9] (which prompted me to dump Lloyds for the second time in barely 12 months), the Government and the regulator insisted that Lloyds retain sufficient capital to be pretty much bombproof. Lloyds then raised £21 billion via a rights issue, and it has taken every opportunity to reduce liabilities and build up capital since then.
My main reason for thinking Lloyds is cheap today is that I am more confident than the consensus in the economic recovery, even domestically.
I am therefore more confident that Lloyds won’t need any more capital, and that it will soon be a money-printing machine rather than a money pit. (Note: by ‘soon’ I mean 1-3 years, not 1-3 months!)
Lloyds is already making a profit
I first came back to Lloyds looking for a highly-geared way to invest in commercial property. Most of Lloyds’ bad debts (acquired from the HBOS merger) have been in commercial property, so any stablisation ahead of schedule would lead to the shares re-rating.
This seemingly happened in late April, when the company said it had returned to profit [10] in Q1 – sooner than anyone expected – largely because the flow of rising bad debts had been staunched.
So far so good. But on reading through the analysts’ reports and Lloyds’ own update, the company’s ability to throw off cash once the bad times were over really struck me.
Given that I expect a recovery quicker than almost anyone I read or talk to (i.e. I expect it this side of hell freezing over) that makes Lloyds very tempting.
One minor snag is the vast number of shares out there – 67 billion!
However, I think Lloyds will eventually have so much excess capital as a faster-than-expected recovery sees its marked down assets re-rated that it will be able to buy back lots of its own shares. (It may have to wait for EU permission to do so – I don’t expect anything until 2012).
Buying back billions of shares will go some way to driving up earnings per share and eventually the dividend.
A penny share with a massive footprint
The sheer scale of Lloyds’ business is staggering. Its dominance is even more extraordinary when you consider that we’re statistically more likely to divorce than change bank accounts.
- Lloyds has 30 million customers in the UK (more than half the population) and nearly 30% of the UK mortgage market.
True, it has been ordered to sell some 600 branches by the EU, and it will probably sell its Scottish Widows business when the market improves (which will reduce its core capital requirements further, in my view). But it will still be the nearest thing to a national banking utility the UK has ever seen.
And utility is a good word to use, because it explains why I think Lloyds will escape serious harm from Vince Cable’s banking fatwa.
The new Business Secretary is to spend a year looking for the tartan paint and a left-handed screwdriver at how to break up the banks, but the most he’s likely to establish is a case for hiving off investment banking from retail banking. That would affect the likes of Barclays and RBS, but it wouldn’t mean much for Lloyds.
A smaller fly in the ointment could be the £14 billion action [11] being taken by former shareholders. I don’t expect it to succeed.
The evolving Lloyds business
I have created a massive spreadsheet detailing every nuance of the Lloyds’ business activities. If a secretary orders extra flowers for a bank manager’s mistress, I capture it.
Only kidding! I’ve not worked out my own projections for Lloyds’ business. Banks are incredibly complicated, and there are various analysts who do this full time. I don’t claim to know better.
Rather, I’ve looked at the picture painted by analysts through the prism of my own economic optimism.
- Lloyds is borrowing money very cheaply, and writing new business at good margins to an absolutely enormous market. In April the CEO said net interest margin would be around 2% for the year.
- It increased deposits by £5 billion in the first quarter.
- The new Lloyds 5.375% corporate bond [12] aimed at private investors shows another way for Lloyds to raise money. Small potatoes so far, but more could follow.
- Lloyds is making big cost savings from its merger with HBOS – there’s a huge overlap in banking, compared to say digging up a road where you can’t really cut bodies. Ditto everything from marketing to databases. I think Lloyds will probably save more than its £2 billion a year target by the end of 2011.
As a result, I sense Lloyds is racking up capital. By the time any new legislation comes in (the mooted Basel-III requirements) I wouldn’t be surprised if it has much more than it needs. Bullish estimates of T1 capital of 10.5% or more by the end of this year look achievable to me.
What about impairments? Last year the bank wrote down £24 billion in impairments. It hasn’t yet given figures for 2010 – only verbal guidance [13] – but by the first quarter this had slowed sufficiently for the bank to report a profit. The bank says impairments have ‘passed the peak’.
When you consider Lloyds made a loss of £6.3 billion last year due to those £24 billion impairments, you get a flavor for what it could achieve when it stops kitchen-sinking the HBOS loan book.
Earnings and the Lloyds share price
When will that be? I think 2010 is still a bit of a crap shoot, given all the upheavals going on in the markets (most of which are hot air).
But for what it’s worth, the consensus among analysts is for the bank to earn about 0.9p per share for this full year, putting the shares on a P/E of around 60!
From next year though (the year to the end of 2011) things get interesting. The Office of Budget Responsibility reckons the UK will be growing at 2.6% [7]; I would expect few bad debts and big writebacks in such a climate.
The median forecast of £5.8 billion in pre-tax profits and earnings per share of 6p for 2011 looks pretty doable to me, given my economic outlook. The Lloyds portion of the business alone was earning £4 billion in pre-tax profits in 2007, and it was a very conservatively run business (so no frothy profits) that faced a lot more competition (so it’s making more from each deal now).
I’d think along the lines of Merrill Lynch’s banking analyst, who expects earnings of 12p per share by 2012 [14], and I wouldn’t be surprised by 8-10p in 2011.
The Lloyds share price will march up just as soon as investors buy that future. If we value Lloyds shares at 10x earnings, then that would imply a share price of 120p, or more than double today’s price, within a couple of years.
That’s almost twice the government’s entry price of 64p per share, incidentally. If Cameron has any sense, he’ll wait until the recovery is in full swing before unloading the shares. The UK taxpayer owns 41% of the company, or 27 billion shares. A £30 billion windfall from selling up at around 120p would make a nice dent in the UK’s public debt.
The big risk? That the economy turns bad, writedowns resume, and Lloyds is forced to raise yet more money while postponing future profits.
Otherwise I think it’s just a mater of when, not if, the Lloyds share price doubles.
Note: I take no responsibility for the accuracy of this post. Read my disclaimer [15].