Description

"Because leverage of 20:1 magnifies the effects of managerial strengths and weaknesses, we have no interest in purchasing shares of a poorly managed bank at a “cheap” price. Instead, our only interest is in buying into well-managed banks at fair prices." (WB's 1990 Letter)

I believe the confluence of low rates, global investor apathy towards banks and fears over Brexit have come together to allow investors today to buy into a well-managed bank at better than a fair price. The thesis here is quite simple. Lloyds is the leading banking franchise in a consolidated market within a country with strong creditor rights and trades at an extremely cheap valuation. Lloyd's is a pure retail bank (no investment banking/trading etc.). The loan book breaks down as 70% mortgages, 20% corporate lending and 10% consumer lending. 

The UK is consolidated banking market, with the top 5 banks controlling 85% of current accounts and the top 8 banks controlling 97% of current accounts between them. If you remember Einhorn's ill-fated Greek Bank presentation from 2014, he pointed out that the more concentrated a country's banking sector, typically the higher the sector RoEs and the UK was among his examples (alongside Belgium, Australia, Sweden and the Czech Republic). Lloyds typically has a 25 to 30% market share depending on the product so has likely reached a point where its balance sheet is grows or shrinks with the market.

The following numbers are 9M Annualized. Lloyds generated ~ 280 bps of NIM and another ~ 80 bps (on total assets) of fees/trading/etc. The bank operates at a cost/income ratio of ~ 49%. This makes for revenue / assets of ~ 230 bps and pre-provision-income / assets of ~ 120 bps. Today provisions/interest-bearing assets are running at ~ 20 bps. This makes for an RoA (before tax) of ~ 110 bps which comes down to ~ 85 bps (using the UK's current corporate tax rate of 19%). Given shareholders' equity / assets of 5.3%, 85 bps of RoA equates to a ~ 16% RoE.

Valuation

As of September 30th, Lloyds reported tangible equity of £40b, or £0.551 per share (vs current price of £0.665). That's a P/TBV of 1.2x. If you look at where US retail banks generating mid-to-high teens RoTEs trade, its in the 2.5-3.0x TBV range. More importantly, Lloyd's also looks exceptionally cheap on a normalized earnings power basis. Through Septmber 30th 2017, Lloyds generated Annaulized ~ £8,750m of underlying PBT. Taxed at 19%, that equates to £7,100m of underlying PAT. On today's market cap, the stock is trading at 6.7x PE. Lloyd's also sports a 14.1% CET1 ratio. The average US bank sits at ~ 12% today and the average European bank sits at ~ 12.5% today. Realistically the trend for European bank capital ratios is still upward, and within that the average of other large UK banks is ~ 12.8%. I think its fair to assume a 13% normalized capital ratio for LLoyds, impling 110 bps of excess. That equates to £2.4b and stripping that out of the PE numerator (the denominator barely moves given where UK ST rates are today) takes the number down to 6.4x (I'll refer to this metric as the adjusted PE below). That's an eye-popping 15% earnings yield but instead of the type of stuff you normally find yourself looking at when confronted with a number like that (i.e. a fraud, a business with excessive debt or a business on the verge of a spectacular earnings implosion) here you are looking at a market leading bank where the franchise is finally showing signs of growth (LTM Underlying PBT is growing 7% YoY as of Q3 2017), a business with limited-to-no obsolescence risk, an excellent management team and a company returning significant cash flow to shareholders (LTM DY is 4.8% while consensus has Lloyds at a ~ 6.6% DY for next year).

If at this point you don't think the stock sounds interesting/cheap, you should probably stop reading here and reinvest your time elsewhere. The rest of the write-up tries to go through the 4 main bear arguments that are used to justify Lloyd's valuation and how I get comfortable with them.

Bear Arguments

1) NIMs are "too high" due to rate hedges management put on when UK rates were higher than today, when they roll off, earnings will get crushed

2) Provisions are "too low" because we're in the latter stages of an economic cycle and they're now running below historical averages, when they go up, earnings will get crushed

3) Capital ratios are "at risk" because the next round of banking regulation is going to focus on increasing risk weights on mortgages (which make up 70% of Lloyds loan book), when that happens dividends will get crushed

4) The PPI saga continues forever and "underlying" profit is thus effectively a fiction

Bears argue that Lloyds NIMs are inflated by what management refers to as the "structural hedge" (the bank doesn't give precise details around exactly what they are doing here but they are, in one way or another, shorting rates to "hedge" their P&L to the fact that with deposit rates floored at close to zero, their NIM & NII is correlated with rates). Bernstein thinks that Lloyds is getting 20 bps of NIM uplift / 7% of total NII via the "structural hedge". Taking this out of NII completely would represent a 10% hit to earnings, putting Lloyds on 7.5x PE / 7.1x adjusted PE.

Bears argue that Lloyds' provisions (17 bps on interest bearing assets YTD) are too low and have to come up at some point, which will thus hit earnings. I don't disagree with the medium-term direction of travel of Lloyds' cost of risk but (a) think the UK has seen nothing like the kind of expansionary/lending boom that tends to lead to bad lending decisions and eventually a proper cycle of restructurings/write-offs/heightened provisions and (b) think that the mix of Lloyds' loan book means that normalized cost of risk at this bank is lower than people are giving it credit for. On the first point, outside of misselling scandals, the biggest public criticism of the UK banks over the post-GFC period has been that they are not lending enough, in particular to small businesses and financially stretched homebuyers. I just don't see excessive risk taking by UK banks/Lloyds in the numbers. The average LTV for UK mortgages is ~ 50% today (for Lloyds its more like mid-to-low 40%s) and mortgages represent 70% of Lloyds book. Lloyds has also been pulling back from the London market ever since the GFC, where house prices have become stretched on most valuation/affordability measure (as of a few years ago, Lloyds had halved its share of London mortgage lending from 31% in 2008 to 16% in 2014). Data points like these gives me comfort that Lloyds has not lent too aggressively and that absent a major economic hiccup, which doesn't seem likely based on today's data, we are not anywhere near a major NPL and provisioning cycle. Its also important to note that the combination of low LTVs and UK mortgages being fully recourse to the consumer has meant for extremely low historical loss rates over very long time periods. I don't have hard data on the subject but I've spoken to MBS investors in the UK who've combed through 50+ years of UK mortgage data and they've all said that historical loss rates on UK prime mortgages have averaged single digit basis points (including the GFC). Assuming a 5 bps normalized CoR for mortgages, 50 bps for coroprate lending and 250 bps for consumer lendign suggests a blended normalized CoR of 40 bps. Running that through the P&L puts Lloyds on 7.6x PE / 7.2x adjusted PE.

Bears argue that Lloyds is at risk of potential RWA inflation under Basel IV which puts a "risk weighting floor" on certain assets that previously had very low realised/expected losses and therefefore low risk weights. In theory this means that $1 of mortgage has incremental $s of RWAs associated with it, pushing up total RWAs, pushing down capital ratios, weakening arguments that Lloyds is over-capitalized. That's the narrative. I think there are two things to consider here which get relatively little airtime. First, this regulation is being fought tooth-and-nail by the European banking community which has trotted off to their respective governemnts/regulators to explain that ultimately this will just cause (1) a period of disruption just as the European economy is showing green shoots and (2) ultimately just increase the cost of mortgages to consumers. So maybe it doesn't happen / gets significantly watered down. Second, if this does happen every bank in the UK will be affected in just the same way, so I see it ultimately being reflected in pricing and therefore a non-event for Lloyds' earning power over a medium-term timeframe. If I try to be intellectually honest about this component of the bear case, in times of transition like this industry input costs and pricing don't always move synchronously and so there could absolutely be a period of earnings headwinds. There could also be pockets of the market where shadow banks, unburdened by Basel IV pop up and take share away from the traditional banks. But you'd have likely thought the same in 2006/7 if someone had told you that aggregate European banks' tangible equity / assets would almost double over the coming 10 year period and aside from small niches, the banking model and its share of lending remains pretty much unchanged. The fundamental goal of bank regulators is also not just to push riskier lending outside of their visibility or purview so if that is clearly what is happening as a result of "mortgage floors" beind introduced, my guess is they find a way to tweak the regs to course-correct.

Bears argue that costs associated with the PPI saga and other "conduct" issues will continue to eat up underlying profits for an extended period of time, meaning that its disingenous to value the bank on underlying numbers. At this point, I think that's a lazy argument. The trajectory on "below the line" items is pretty clear (it's improving). The PPI saga has a regulator-imposed "longstop date" (August 2019) and the other items that have historically made up the bulk of these costs are now almost behind Lloyds (e.g. divestiture of TSB, ECN redemptions). Reflecting the direction of travel, Q3 2017 was the lowest reported "non-underlying cost" number in 4 years at just £124m for the quarter, continuing a trend that's been in place for the last couple of years.

Conclusion

The market looks at Lloyds today and sees a narrative focused on the UK (weak-ish macro data / Brexit risks / maybe even Corbyn risks), banks being uninvestable (black boxes, ZIRP headwinds, regulators who seem to want to pound on them for the next 50 years), Lloyds as a black sheep because there is no "earnings story", in fact the opposite (NIMs propped up by hedges, cost of risk flattered by where we are in the cycle). I see the leading bank in a consolidated market with the worst of its problems behind it and on the verge of its earnings power coming through + significant capital returns. For me, when I find a stock trading at 6.4x adjusted trailing earnings in this market environment, I am looking for reasons not to own it and I just can't find enough good ones here. If the NIM & CoR normalization scenario comes to pass (i.e. underlying earnings go from £7.1b to £5.6b) and the stock were to trade in line with EU banks last 5 year median PE (12x) in 3 years time, assuming you get credit for excess capital at 1x BV at that point, the stock has 85% upside from here / a 23% 3 year IRR (with the IRR # sensitivity to exit date significantly derisked by the earnings yield on which you can buy the stock today).

If you are looking for some legs to an upside case, there is likely some near-term earnings upside from the recent BoE rate hike (the first since the crisis) and over the more medium-term around branch closures (which have taken place at a slower place in the UK vs other EU countries over since the crisis but are now starting to ramp up in earnest) and the fact that the UK corporate tax rate is being phased down from today's 19% to 17% starting in 2020 (that's a 2.5% mechanical uplift to earnings if it doesn't get competed away / the taxman doesn't change his mind). Over time, I think there's an interesting story around banks pivoting from a largely variable cost business model (branches, advisors, etc) to a more fixed cost one (technology, cyber security, etc) and potentially as a result seeing much greater returns accrue to scale players than has been the case historically. But that's really long-term stuff and I don't think you need to believe in any of these sources of upside to want to own Lloyds today.

Catalyst

- Convergence of underlying & reported profits over time meaning bank screens better on reported #s

- DPS hikes attracting more income investors

- Management potentially starting a buybacks programme alongside the dividend and investors doing the math on how accretive it is to buy back stock at a single digit PE

- UK economy continuing to muddle along despite Brexit + Corbyn noise