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UK Value: Lloyds Banking - Picking Up the Baton

Why David Herro's largest holding is poised for recovery

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The City Letter
Sep 16, 2021

Summary

  • Lloyds Banking Group is a pure UK banking play, with 95% of its assets domestic.
  • The new CEO has said he's not starting afresh, but just picking up the baton, which I see as a good thing.
  • The group's low price-earnings ratio and attractive loan to deposit ratio make the stock like a bargain.
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One of the gurus I most like to follow is

David Herro (Trades, Portfolio). Whenever he talks to the media, I find his words insightful. Thanks to GuruFocus, I can easily see what’s in his portfolio. Using his portfolio as a tool for idea generation, I have even ended up buying a few stocks that he owns.

The largest position in his portfolio is Lloyds Banking Group PLC (

LSE:LLOY, Financial). I happen to know Lloyds quite well, as I use their services and am a happy customer. More importantly, Lloyds is seen by the market as the best proxy of the UK economy because it’s the bank with the purest focus on the UK.

The group has four segments: Retail (which is by far the largest), Commercial Banking, Insurance and Wealth and “Central items” (which is essentially the "other" segment). The group’s 2021 strategic review says, "We focus on helping Britain recover, and enhancing our capabilities as Britain's preferred financial partner."

For me, in banking, the most important metric is the loan to deposit ratio. Above 100% and the group relies on external funding in the money markets (up to one year duration) and capital markets (over one year duration) to fund part of its loan book. As we saw with Lehman Brothers and others in the financial crisis, this can disappear fast. A loan to deposit ratio less than 100% means that a bank’s loan book is fully funded through deposits (which are typically more reliable and cheaper than money and capital markets). It also means the bank can grow the loan book easily if good opportunities come along. In short, the loan to deposit ratio reflects management’s approach to discipline and risk management. Lloyds’s loan to deposit ratio has been below 100% for the last four quarters and stands at 94%.

Talking of management, Lloyds Banking Group has recently changed its CEO after Sir António Horta-Osório moved to become the chairman of Credit Suisse (

CS, Financial). Charlie Nunn took over as the new Lloyds CEO in August. I take some comfort in Nunn’s first comments, in which he made a point of saying, "I’m not starting afresh, I’m picking up the baton."

A UK recovery play

Lloyds Banking Group has lagged the other domestic UK banks since the start of the pandemic, with a lower diversification in revenue, exposure to more cyclical areas within banking and lower relative capital surplus weighing on performance. Compare this to Barclays (

LSE:BARC, Financial), which has benefitted from its strategy of focusing on growth while retaining diversification with investments into wholesale banking and corporate and investment banking delivering strong revenue growth as capital markets and investment banking activity surged, offsetting the net interest income decline in rate-sensitive retail businesses.

However, I personally agree with activist investor Edward Bramson’s position on Barclays, which is that European banks cannot compete with American bulge bracket investment banks over a full cycle, and therefore this isn’t the business to be in. It’s a reason why I prefer Lloyds over Barclays at this stage.

Under Sir António Horta-Osório, Lloyds streamlined its balance sheet and refined its strategy to focus purely on the United Kingdom, where it retains a scale advantage due to its leading share in key retail banking products. However, from a product perspective, the group’s reliance on net interest income increased significantly to 72% of total revenues versus a 50/50 split envisaged after the global financial crisis. Lloyd remains more dependent on net interest income, which in 2020, due to the pandemic, declined significantly, hitting Lloyd harder than any other major UK bank.

A key factor that explains the higher cyclicality within Lloyds Banking Group’s net interest income is the significant decline in UK credit card balances and the increased reliance on credit cards through the acquisition of MBNA, which allowed Lloyds to increase its share in the UK credit card market to equal that of Barclays with its strong Barclaycard franchise. On the one hand, while the MBNA deal was highly accretive for earnings per share, it probably increased cyclicality within Lloyds’ earnings, and this higher risk caused Lloyds’ valuation multiples to decline somewhat at the time.

While Lloyds is focused on remaining a UK pure play, they seem to understand the need to grow fees and non-net interest income revenue. This isn’t easy, but they have started with the large Wealth Joint Venture with Schroders and the acquisition of Embark Group, which grows Lloyds’ Wealth segment.

With Lloyds’ low price-earnings ratio, it wouldn’t be wise to make material acquisitions of fee businesses in stock deals, so management will have to concentrate on better execution of its organic growth and recovery plans across the entire franchise.

Delivering this growth would be key to further upside for Lloyds' stock. It has successfully reduced its overall balance sheet size over the past decade, to simplify the group, reduce balance sheet risk and improve returns, which is why I own the company today.

Longer term structural growth is difficult to see thanks to Lloyds’ already high market shares in core banking areas. The new management team can focus on growing in areas the group has a lower market share: Wealth, Pensions, Merchant services and Non-card consumer lending. If they can do that then perhaps the price-earnings ratio could show some multiple expansion.

Until then, Lloyds will be a cyclical stock given the businesses it operates in. Lloyds has become more capital efficient with current pro-forma Risk Weighted Assets of about 210 billion British Pounds ($289 billion) compared to £415 in 2010. All things considered, I believe Lloyds is well positioned for a cyclical recovery in revenues over the next few years, partly driven by interest rates as the UK economy rebounds from the pandemic.

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Disclosures

I am/we are Long LSE:LLOY
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