Lloyds Bank: The case for 34% upside

There had been much to like about Lloyds Banking Group (LLOY) before the start of summer. Impressive profits, a generous dividend, and all-round improvement in the banking business has rewarded patient shareholders and attracted new ones.

Indeed, buying at the post-referendum lows of 47p and selling at the May high would have generated a capital return of around 56%. Over 4p a share of dividends has also been announced since.

Yet, there is disagreement about the merits of backing Lloyds now. Certainly, from a technical angle, our analyst John Burford suggests the shares are at a critical juncture, with further downside quite possible.

Bears point to a 14% drop in the share price from 73.5p three-and-a-half months ago to levels last seen in April. That’s at a time when the wider market has moved sideways and the bank sector has risen 2%. And this downtrend (see red line on the chart below), currently at 63p, remains a significant level.

There’s been a hiccup on the fundamentals, too. Lloyds has done a great job rebuilding its financial strength following the Credit Crunch, and the shares had been moving nicely. However, second-quarter results late July disappointed. Reported profit was up 4%, but a fifth less than expected because of surprise PPI provisions and other conduct issues.

An increase in UK interest rates, which would be a significant boost to margins at Lloyds, appear no closer, either.

Despite this, Jason Napier at UBS remains a fan, and Lloyds stays on his list of top bank stocks to buy. A price target of 85p implies 34% upside.

Launched in May 2016, Napier’s list has returned 40%, outperforming the index by 5%. And that’s despite holding Lloyds – down 6% from its 67p portfolio entry price – through the Brexit vote.

However, the high street lender is “safer than you think” and “cheaper than the market believes,” writes the analyst.

“Despite our cautious view on the UK economy we expect Lloyds to deliver broadly flat adjusted EPS in 2017-2019 as pre-provision profit growth offsets substantially higher loan losses,” says Napier. “We do not expect earnings growth but we believe good capital generation will finance a dividend yield of over 8%.”

And UBS differs from others, arguing that net interest income generation is more sustainable than the market credits. In fact, there’s room for re-pricing of deposits and return to growth in the open resi[dential] mortgage portfolio.

“We see more capacity for cost reduction to offset revenue weakness should competitive conditions worsen beyond management expectations. We see optionality in investing in investments and insurance-driven businesses too.”

And UBS admits its assumptions could be conservative. “In four of the last five UK recessions, the banks made their share price lows before the recessions began,” points out Napier.

Expect a share price re-rating if Lloyds keeps outperforming peers like Barclays in unsecured loan losses, defends interest margins and grows the balance sheet.

Of the other London-listed banks under UBS’s microscope, the broker rates HSBC (HSBA) and Standard Chartered (STAN) both ‘neutral with targets of 725p and 800p respectively, suggesting modest downside for the former and a small tick up for Standard.

HSBC’s valuation – 1.3 times tangible net asset value for a 10% forecast return on tangible equity with 5.3% dividend yield – fully discounts UBS’s base case forecasts.

For Standard, its turnaround is on track this year, but things will be “far more of a stretch” in 2018, argues Napier.

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.