Why Lloyds may be worth 50% more

Thump! A weighty tome on European banks has just landed on our desks, written by the team at JP Morgan. Over 192 pages, the analysts pick apart the numbers to decide their top six players. Only one UK lender makes the final cut - Lloyds Banking Group.

There's greater clarity now on most regulatory issues for investment banks, except on the drive to harmonise capital ratios by Basel and the European Central Bank (ECB). Banks both here and on the continent are currently able to calculate their capital differently, but the Basel Committee on Banking Supervision wants to level the playing field and improve competition.

Now JP Morgan tries to harmonise capital ratios for 35 European banks by focusing on both the capital and risk-weighted assets (RWAs) to arrive at the "true" capital ratios. The broker concludes that potential rule changes would reduce the Common Equity Tier 1 (CET1) ratio by 1.5 percentage points by 2018, while ECB-driven changes impact ratios by a further 0.4 percentage points.

That could destroy as much as €137 billion of capital and leave the banks with a CET1 capital shortfall of €26 billion, which they would have to find from somewhere. Thankfully for the British lenders, the gap is mainly concentrated in just six of the 13 banks with a shortfall - none of the six are UK-based and only HSBC features in the baker's dozen.

With this in mind, JPM goes about picking its favourites. It avoids banks with material capital deficits following its harmonisation analysis, those with exposure to impacts from the recent China economic uncertainty, and lenders with material commodity exposure, especially to low oil prices.

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Interestingly, the broker estimates that Barclays has £22 billion of exposure at default (EAD) to energy & water, while Standard Chartered has $49 billion of exposure to commodities of which $26 billion is oil & gas. RBS has £33 billion EAD to natural resources of which £13 billion oil & gas and £3 billion metals & mining, and HSBC has $34 billion exposure to oil & gas.

In a lower-for-longer interest rate environment, JPM likes banks with dividend payout potential and favours domestically focused retail market players with attractive valuation and solid capital position. On that basis, UBS, Danske, Nordea, CaixaBank and Deutsche Bank all make the cut. Making up the six, and top pick within the UK banks, is Lloyds.

"With current CET1 ratio at 13.3% and clean organic capital generation of c2.5% per annum (pre dividends and redress), we believe that Lloyds can positively surprise market expectations on dividend per share (DPS), delivering a yield of 7% plus potential for excess capital return," writes JPM's Kian Abouhossein.

Lloyds has already said it will consider special dividends and buybacks above 12% CT1 plus the amount for another year's ordinary dividend (JPM estimates 0.9% for 2015). "We forecast c20p cumulative DPS and c13p excess capital above 13% by 2018 (which is when we expect full impact from capital rule changes around RWA harmonization)," says Abouhossein.

Reducing its share of the mortgage market, while at the same time focusing on higher margin small-medium-sized companies and consumer finance businesses, has resulted in an ongoing improvement in net interest margin (NIM) at Lloyds. JPM reckons NIM will remain stable for the rest of the year before rising next year as interest rates rise.

Payment Protection Insurance (PPI) complaint volumes should continue to fall, too, although at a slower rate than the bank expects. JPM estimates a further £2.9 billion hit out to 2018.

The European banking sector trades on a forward price/earnings (PE) ratio of 9.5 times, 1 times price/net asset value, giving return on net asset value (RoNAV) of 11% based on 2017 estimates. But Lloyds trades on multiples of 8.2 times, 1.2 times and 15%, which JPM thinks fails to factor in material capital return potential.

It also believes Lloyds shares will be worth 105p, but it could be much more if things go their way. "In our view Blue Sky scenario which assumes strong pickup in loan growth in the UK, ongoing rise in the property prices and higher interest rates, we calculate 14% upside to our already above consensus EPS estimates and a fair value of 120p."

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.