Interactive Investor

Lloyds numbers prompt target upgrade

5th May 2015 10:44

Lee Wild from interactive investor

A promising set of first-quarter results put a fuse under Lloyds Banking's share price Friday - up 7% by the close. Improving margins grew net interest income, impairment charges more-than halved, and profits beat expectations. Now, after spending the weekend reworking its numbers, Nomura has decided the £59 billion bank is worth more than it thought.

With a dividend yield expected to improve from 3% this year to 6.6% in 2016, Nomura thinks upside potential is driven by estimates of a 2016 Common Equity Tier 1 (CET1) capital ratio of 14.6%, despite £6.5 billion of one-off charges. "We expect the stock to rerate from a 16E P/E of 9.6x closer to north of 12x (where the Swedish banks trade)," says analyst Chintan Joshi.

"For this to occur, we believe that the difference between underlying and reported earnings needs to reduce, so that regulators have confidence to allow payout ratios to rise and investors are able to reward Lloyds for greater stability. PPI, TSB sale and restructuring costs remain a drag through 2015, but as we get into 2016-17, we think this rerating potential will likely come through."

There will be visibility on political risk for Lloyds by the end of this week when the election results will be known. And solid fundamentals mean the stock overhang - the government still owns 21% of the shares - should not prevent a rerating.

Joshi accepts that PPI remains an issue and conservatively pencils in £3.8 billion by next year. Underlying loan growth must come through against known headwinds, and other operating income (OOI) needs to arrest its falling trend. "We assume at 14% CET1 requirement given risk from mortgage floors, but this could still prove inadequate by up to 100bp."

"Prior to 1Q14 results, we had ventured a 260bp NIM [net interest margin] expectation for 2016/17," says the broker. "Since then, margins have surprised positively even when adjusted for the lower asset base. We now believe NIMs can rise to 270bp, but we are likely to be below consensus on loan growth. The main risk to NIMs is not underlying trends but political risk, if they expand much more than 270bp

"Our estimates are broadly unchanged, as better NII is offset by OOI weakness where we are below consensus. However, we can see COE [cost of equity] for Lloyds falling, given improving visibility on dividends and growth prospects improving, given run-off book headwinds are fading."

Nomura upgrades its target price to 95p and reiterates its 'buy' rating, given the bank trades on 1.5 times 2016 price/book ratio (P/TB) for a 15% return on tangible equity (RoTE), a 2016 prospective dividend yield of over 6% and 14.6% CET1 ratio.

This article is for information and discussion purposes only and does not form a recommendation to invest or otherwise. The value of an investment may fall. The investments referred to in this article may not be suitable for all investors, and if in doubt, an investor should seek advice from a qualified investment adviser.