City view on Lloyds Banking Group

A day after Lloyds Banking Group'sdecent third-quarter results, analysts at Societe Generale have done the maths and decided the shares, at 74p, are hugely undervalued.

In a nutshell, Lloyds reported a 41% increase in quarterly profit to £2.2 billion, driven largely by beats on net interest margin, costs and impairments. The high street bank is also axing 10% of its workforce.

SocGen's banks analyst James Invine writes:

Management set out some new targets, which appear in line with consensus, but we note that Lloyds consistently outperforms previously-given targets/guidance, whether for the margin, costs, impairments, capital or funding. The timing of a base rate rise has moved further back, but it was pleasing to hear management suggest that sensitivity to a rate rise could be more positive than it has previously noted.

The broker trimmed forecasts by 1% for 2014, giving adjusted pre-tax profit of £7.94 billion and adjusted earnings per share (EPS) of 8.3p, and by 2% for 2015, giving £8.45 billion and 8.8p, respectively. But even now, SocGen is 16% ahead of the pre-results consensus for 2016 underlying profit. It says:

The main issue for Lloyds, in our view, is the surplus capital that should build. Management yesterday said that an 11.5% core tier 1 ratio is its likely requirement, but it is already at 12.0% and we expect this to rise to 14.7% by end-2017, even with the likely reinstatement of the dividend. We think that the value of this surplus (and the ability to return it to shareholders) will move up the agenda as three events in the next two months should clarify UK bank capital requirements: on Friday the Bank of England should set out leverage requirements more clearly; the Brisbane G20 meeting should give us TLAC requirements; and the Bank of England stress test results will be released in December. We think that Lloyds is well placed on all three issues.

SocGen uses a sum-of-parts model, valuing each division separately according to estimates for sustainable returns, growth and cost of equity. The core retail business is priced at 36p a share, core commercial operation at 37p, and insurance at 19p. After all the numbers are put through the wash, the broker comes up with a target price of 96p.

Of course, there are risks, including a sharp correction in UK house prices. Of all the UK banks, Lloyds is most exposed given that it's the country's number one UK mortgage bank and, says SocGen, has a lower quality book than peers.

What we said yesterday: Well, Lloyds shares have been largely range-bound since March and they're unlikely to hit 100p any time soon. That said, a current-year price/TNAV ratio of 1.4 is still well below pre-credit crunch levels and Lloyds will likely return to the dividend list soon. Any pick-up in market sentiment should rub off on the shares.

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