Lloyds Bank making progress despite profits miss

Lloyds Banking Group (LSE:LLOY) finds itself in the midst of attacks from several angles, but all things considered is standing up defiantly to the challenges.

A number of emerging thorns in the side have combined to deflate the numbers and in turn profitability. The remediation for the potential impact of the motor finance commission arrangements continues to overhang the stock and Lloyds took a further provision for the outcome of £700 million. This is in addition to the £450 million previously set aside, and the number had a material effect on fourth-quarter profit.

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At the same time, the group faced lower income over the year, due in part to asset margin compression on its key mortgage lines as customers refinanced at lower rates. This was partly offset by the structural hedge, designed exactly to mitigate the group’s susceptibility to changes in interest rates, and which should provide a significant revenue boost over the next two years. But a 7% decrease in Net Interest Income to £12.8 billion and a Net Interest Margin (NIM) of 2.95% compared to 3.11% the previous year, are meaningful misses.

Meanwhile, higher operating expenses resulted from a number of factors, including lease depreciation, inflationary pressures and ongoing growth costs both in terms of investment but also severance payments.

The net result of these headwinds was a 20% fall in pre-tax profit to £5.97 billion for the year, shy of the expected £6.39 billion and a reduction of 5% in total income to £17.1 billion, which was in line with estimates.

The partly toxic cocktail was also felt in other areas such as the cost/income ratio, previously a metric in which Lloyds was sector-beating, which rose to 60.4% from a previous 54.7%, and a Return on Capital Employed (ROTE) figure which fell from 15.8% to 12.3%. The capital cushion, or CET1 ratio of 14.2% had previously been at 14.6%, but the number is not only above the required level but is also an area which the group intends to drive down to free up capital elsewhere.

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Indeed, the dour figures overall tend to hide some strength and progress which is being made. An increase to the dividend propels the projected yield to 5%, while the announcement of a £1.7 billion share buyback programme should, all things being equal, be supportive to the share price. The level of shareholder returns remains an important area of focus and attraction for the UK banks, and Lloyds is no exception.

There was also some promising news in terms of more traditional business, with growth of 2% in both loans and deposits. These have stabilised the decline in NIM while also leaving the door ajar for further growth and the £6.1 billion growth in its key mortgage lending book is a perfectly respectable result amid what has been a challenging economic environment.

Moves into other income streams such as credit cards, insurance and the pursuit of high value including mass affluent clients could well bolster revenues, with specialised growth in sectors such as infrastructure within its Commercial Banking unit also boosting prospects.

The group’s acceleration towards becoming a digital bank is an area where investors have been taking a longer-term view. The push towards an increasingly digital business will undoubtedly reap rewards in the coming years, but the associated costs such as branch closures and severance packages are currently resulting in something of a slog until the ultimate aim can be achieved.

In the meantime, the group is targeting a cost/income ratio of below 50% in the next two years, with this strand of the business growing apace, with more than 20 million active users of its mobile apps for example. In terms of further outlook, Lloyds is guiding for a ROTE of around 13.5% this year and for more than 15% next year, which would restore some credence to its growth aspirations.

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Overall, a positive direction of travel towards a more streamlined and digital business, underpinned by a healthy financial position, are elements of proof that the bank remains on track. Despite the headwinds, the shares have been positively rerated of late and have added 47% over the last year, as compared to a hike of 13% for the wider FTSE100.

Without doubt, Lloyds remains a longer-term play bolstered in the meantime by the potential for generous shareholder returns. That being said, the motor finance overhang and the higher valuation attached to the recent share price gain leaves the shares up with events, with the market consensus coming in at a hold for now.