Interactive Investor

Lloyds Banking primed for significant rally

13th October 2015 13:43

Lee Wild from interactive investor

Lloyds will launch a £2 billion share offer for retail investors next spring, and the merits of investing in the high street lender are the topic of much discussion. A 5% discount for the offer may not be overly generous, but a 1-for-10 bonus issue is you hang onto your new stake for 12 months seems like a no-brainer. It certainly does to Jefferies who's the latest in a line of brokers backing Lloyds to rally.

Despite the research note's dubious title 'Straight Outta Gresham Street' - it's a reference to Lloyds's London HQ, and is a play on the debut album of American gangster rap pioneers NWA (look 'em up) 'Straight Outta Compton' of which chancellor George Osborne is a fan - analyst Joseph Dickerson makes some sensible points.

"With equity now a more meaningful part of the capital structure and a robust funding profile, sub-debt can be called and fixed deposit costs can fall," writes Dickerson. "This, combined with a mix bias to consumer finance, offsets mortgage pricing pressure and leads to 14bps NIM [net interest margin] improvement."

That supports near term earnings upgrades. Dickerson has just introduced earnings per share (EPS) estimates of 2.2p for this year and increases forecasts for 2016 to 7p and by 7% in 2017 to 8p. That puts Lloyds shares on a forward price/earnings (PE) ratio of 10.8 times for 2016, dropping to 9.5 times. A predicted dividend of 4.2p next year also gives a prospective yield of 5.5%, rising to 6.3% the following year.

"Now that LLOY's post-crisis balance sheet transformation is complete, we believe that the pendulum will shift such that the group is increasingly run for the benefit of equity investors as opposed to bond holders," says Dickerson. That means bosses will have greater capital structure flexibility, especially around sub-debt. If, as expected, Lloyds calls £6 billion of sub-debt between now and end-2017, it could save £400 million of interest expense.

An estimated drop in deposit costs over the next three years could save a further £500 million. In all, Jefferies thinks NIM will increase to 2.75% in 2017 from 2.61% currently and an estimated 2.66% in 2016. Says Dickerson:

"We estimate that LLOY can now achieve a 16% return on required equity by 2017 (up 100bps). This, combined with £4.7bn of excess capital generates a price target of 104p, suggesting 37% upside. The quantum of excess capital may be dictated by the future size of PPI provisions. Key risks to the buy case are macro, regulatory and idiosyncratic."

He reckons that £4.7 billion of excess capital - defined as Common Equity Tier 1 (CET1) ratio in excess of 13% of risk weighted assets (RWA) - could easily finance special dividends or share repurchases.

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.