Lloyds Bank shares upgraded by another City heavyweight

Lloyds Banking Group is getting some serious press right now across the investment community. Fund managers are queuing up to buy the shares, even banks sceptic Neil Woodford just added the stock to his Woodford Equity Income fund. Now, a respected City analyst has had a change of heart and gone all positive on the revitalised lender.

Just a month after trimming his price target on Lloyds to 66p - mostly to factor in recent dividend payments – Deutsche Bank's David Lock has revisited the numbers and now believes the bank could be worth substantially more.

"Lloyds now screens too cheap within Europe in our view," says Lock, upgrading his rating from 'hold' to 'buy' and price target by 20% from 66p to 79p.

There are four reasons, explains Lock: net interest income (NII) is growing again, industry fines are winding down, capital strength underpins the generous dividend, and valuation.

On NII, Lock likes first meaningful growth here in two years reported for the first quarter of 2017 to over £2.9 billion. It now exceeds levels recorded at the end of 2014 when Lloyds still owned TSB.

"With greater stability in mortgage balances in 2017, lower drag from non-banking NII, and further reductions in deposit pricing in train we think NII can grow in 2017/18," writes Lock.

This is important as net interest margin had been improving, but NII had not because of falls in average interest earnings assets. "1Q17 has marked a step change," says the analyst. "This higher base on NII drives earnings upgrades."

Deutsche raises earnings per share (EPS) estimates by 8% for 2017 from 6.92p to 7.48p, for 2018 from 6.6p to 7.12p and the year after from 6.31p to 6.8p.

On industry fines – Lloyds has paid £28.6 billion so far since 2010 - Lock still expects £1 billion of PPI charges this year, and £1 billion of other customer compensation over two years. However, "these are far lower than historical periods which should see underlying and statutory returns converge".

There's also "greater capacity for dividends than we had previously forecast" following a common equity tier 1 (CET1) ratio of 14.3% reported in the first-quarter results, and maintenance of management guidance of 13%.

"This gives a dividend yield of 6.8% in cash in 2017, rising to 7.6% in 2018 and 8.6% in 2019. Management could also consider buybacks, which has been well received by the market for HSBC in the last 12 months."

Lock pencils in 4.65p of dividends for this year, 5.25p in 2018 and 5.9p in 2019, although the payout could be higher in 2017 if one-off costs from PPI or elsewhere are lower than the £1.4 billion Deutsche forecasts.

In terms of valuation, Lock now has Lloyds trading at 9.6 times 2018 adjusted EPS forecasts, 1.27 times 2017 tangible net asset value (TNAV), for an adjusted return on tangible equity (RoTE) of 13.1%.

The European average is 1.13 times TNAV, and 11.4 times earnings for adjusted RoTE of 10%. "Even taking our forecast stated EPS and RoTE (given the risk of below the line items to linger into the future), we have the bank at 11.4 times 2018 EPS, for a 11.1% ROTE. Lloyds now screens too cheap within Europe banks in our view."

Stripped back, Deutsche values Lloyds using both sum-of-the-parts (SOTP) and dividend-discount-model (DDM) methodologies. Its price target is an average of the two. SOTP gives 70p and DDM 87p.

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.