February 20, 2019 / 11:01 AM / 3 months ago

Breakingviews - Brexit and costs cloud Lloyds’ sunlit uplands

Customers use ATMs at a branch of Lloyds Bank in London, Britain, February 21, 2017.

LONDON (Reuters Breakingviews) - Brexiteers like to describe the ‘sunlit uplands’ awaiting the nation’s departure from the European Union. Investors in the country’s largest retail bank aren’t so sure. Lloyds Banking Group shares look cheap when weighed against CEO Antonio Horta-Osorio’s plan to hit a 15 percent return on equity. That relies on a steep fall in one-off costs and an easy Brexit.

So far the latter has left Lloyds’ profit blissfully undisturbed. Sure, loan losses increased by nearly one-fifth year-on-year, but from an extremely low base to a manageable 937 million pounds. Rather, it was the fall in so-called ‘one-off’ items which helped drive up profit: pre-tax profit increased by 13 percent year-on-year to 5.9 billion pounds due largely to a decrease in provisions for missold payment protection insurance (PPI). The return on tangible equity rose 2.8 percentage points to 11.7 percent.

Horta-Osorio thinks he can repeat the trick this year, and is promising a 14 percent to 15 percent return. Maybe. PPI provisions should fall further, given an August deadline for compensation. So should nearly 900 million pounds in restructuring charges given the integration of credit card lender MBNA is largely complete. The snag is that supposedly exceptional charges have bedevilled Lloyds for years.

If Lloyds can roughly halve the one-off nasties to 1.4 billion pounds, plus lower operating expenses by another 200 million pounds to around 8 billion pounds, Horta-Osorio can just about hit his 14 percent minimum return target, according to a Breakingviews calculation which assumes flat revenue, a 20 percent rise in bad debts similar to last year, and a 27 percent tax rate. A share buyback would nudge it further towards the 15 percent upper-end target.

The trickier bit is Brexit. A chaotic exit, or even extended period of political uncertainty, would push up loan losses. Analysts are already pencilling in a roughly 37 percent year-on-year jump to 1.3 billion pounds, according to Refinitv. Given that Lloyds has massively grown its share of unsecured lending, where losses heavily correlate with unemployment, that could prove optimistic.

Horta-Osorio can at least plausibly argue that Brexit is out of Lloyds’ control. His stock is trading at 1.1 times book tangible book value, suggesting the market is not panicking, but not giving him full credit for the 15 percent target. Increasing the premium remains contingent on goodwill between London and Brussels. Investors are right to remain nervous.

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