Lloyds on track to top 100p

On the day that Lloyds Banking Group agreed to pay another £117 million of PPI fines, the analysts at HSBC have upgraded shares in their high street rival and think they could be worth substantially more.

HSBC's earnings forecasts are unchanged, although remain 9-10% higher than consensus estimates, reflecting a more positive stance on margin. It expects 8.5p of underlying earnings in 2015 - the figure excludes asset sales, volatile items, conduct redress, and restructuring - up from 7.9p last year, then 9p in 2016 and 9.8p the year after.

And HSBC is more optimistic than the market both on Lloyds' margin development and costs. A second phase of the bank's simplification programme targets £1 billion of annual savings during 2015-2017. That earnings per share figure for 2017 represents a return on tangible equity of 15% on an estimated 66p of net tangible assets. Only a handful of European banks can claim better.

Technical factors, which have inhibited performance, will ultimately come to end with a retail placing expected within the next 12 months, too, points out HSBC. The government has been selling down its 39% stake in Lloyds since September 2013, which has acted as a "glass ceiling on share price performance". Indeed, until last month's first quarter results, the shares had traded exactly in line with the currency adjusted Euro Stoxx bank index. A chunk of the remaining 19% will be drip fed in to the market in the coming months.

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True, there's evidence of intensifying competition in the UK mortgage market, but management has raised margin guidance twice this year already. That reflects "their capacity to lower the cost of liabilities whilst the possibility of rising domestic rates raise the prospect of further gains in 2016".

Proposed changes to the regulatory regime which would impose a floor on mortgage risk weights might also threaten profits, says HSBC. But even here, only at the individual exposure level would there be an adverse impact.

Assuming a 9% cost of equity, the level of profitability pencilled in my HSBC would validate price/net tangible assets of 1.6 times, giving a theoretical value of 110p. Add in projected 2015-17 dividends of 12p and discount back two years to give a target price of 103p. Lloyds shares haven’t been that high since the end of 2008. HSBC based its previous target of 87p on 2016 data and a 9.5% cost of equity to reflect government share sales.

With that in mind, and with high returns expected to feed into a 50% payout and a 5-6% dividend yield by 2017, HSBC upgrades Lloyds from 'hold' to 'buy'.

"The main downside risks to our target price stem from competitive pressures on mortgage spreads and the risk that domestic interest rates do not rise in 2016. These factors could prevent Lloyds achieving the 15% ROTE [return on tangible equity] that is critical to our valuation."

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