Are Lloyds’ 1H Gains a One-off Event?
Lloyds’ future earnings potential improves, but remains short of certain, as write-ups fuel first half profits.
Lloyds's good results were driven by a £2,066 sequential decrease in provisions for loan losses. Loan losses fell to an annualized 2.1% of loans from 2.7% during the trailing half. However, results were also plumped up by two substantial one-time events: a £1,131 "fair value wind" recorded as Lloyds wrote back up some of the assets written down during the HBOS acquisition, and a £423 million gain on liability management transactions. Without these one-time gains, Lloyds would have found itself in the red again this half.
While Lloyds's return to profitability may not be as solid as we might have liked, we see reasons to be increasingly optimistic about the bank's future. The bank's capital base is strong, with Tier 1 and core Tier 1 ratios of 10.3% and 9.1% respectively. These are likely to strengthen further, given that Lloyds is barred from paying dividends until 2012. Once it does pay dividends, we think payouts are likely to be hefty, as the bank likely won't need to build capital any further.
Net interest margins are improving on reduced competition and more rational risk pricing. They reached 2.08% this half, up from their year-ago low of 1.72%, and Lloyds expects them to reach historical levels of 2.5% in the medium term. Lloyds is also projecting that loan losses will fall to around 0.6% of loans in the medium term, and that the bank's cost-to-income ratio will fall to 40% by 2014, from 43.1% this period.
If Lloyds is able to meet all of these targets, a prospect that we're not banking on, we think its return on equity will far outpace its target of greater than 15%.
Erin Davis is a Morningstar equity analyst.
