17th February 2014
Lloyds Bank’s dividend policy may prove more much more generous than would have been thought possible two years ago, says Jupiter fund manager Steve Davies.
Davies, co-manager of the Jupiter UK Growth Fund and manager of the Jupiter Undervalued Assets Fund, believes Lloyds Bank could end up returning much more money to shareholders in dividends and share buybacks than was thought possible just two years ago.
In a note issued this week, he says: “Lloyds seems to have taken inspiration from central bank policy speeches with its measured tone and talk of shareholder distributions at a ‘modest level.’ Yet, there is every reason to believe dividend pay-outs may prove much more generous than initially anticipated, with the bank’s share price also potentially seeing further upside over the next two years.”
Davies says there are three reasons behind his cautious optimism.
First he says Lloyds Bank is close to satisfying the Prudential Regulation Authority (PRA), the banking sector watchdog, that it has built up sufficient capital buffers to be allowed to start paying out dividends again.
“The bank’s core equity tier 1 ratio – a measure of a financial institution’s ability to withstand potential future losses – stands at 10.3% of its risk-weighted assets. The company now believes this needs to rise to around 11% and we believe Lloyds can achieve this by the end of the year or by early 2015 at the latest. Meeting this key regulatory requirement should allow the PRA to give Lloyds Bank the permission to issue dividends for the first time since 2008,” he writes.
Second he says the strengthening of the bank’s balance sheet is being accompanied by a “normalisation” of the bank’s earnings power.
“Shorn of its more esoteric banking activities, Lloyds has returned to being a bread-and-butter UK-focused retail and commercial bank. Retail banks with decent market shares have the potential to make good returns and there is no reason why Lloyds would be an exception. The bank may have been hamstrung by payment protection insurance (PPI) payments and impairments on bad loans but these impediments are now receding. The bank has also implemented an extensive cost-cutting programme that has resulted in a much leaner, more efficient institution. Against this background, Lloyds is finally starting to deliver what could best be described as normal levels of profit from a loan book that is now starting to grow again”.
Davies argues that this back-to-basics approach is reflected in the bank’s outlook. The note continues: “When we were setting out the case for investing in Lloyds three years ago, we estimated the bank might eventually be in a position to pay a dividend of 5-6 pence a share – a pay-out that would in our view support a share price in the region of £1 or more. Yet, Lloyds, at the presentation of its full-year results, told investors it now believes it could be quite capable, two years from now, of generating 2% of excess capital a year even after retaining the capital they need to fund any growth in the business. For a bank with a balance sheet of around £300bn, this would equate to around £6bn a year of capital generation.
“More importantly, for a Lloyds shareholder, it suggests the bank could be in position to distribute as much as 8 pence a share in dividends and share buybacks in years to come. Given this, a share price of 140-150 pence for Lloyds looks a plausible aspiration for the patient long term investor”.
Davies says that third reason is that under the current regulatory climate, UK banks are increasingly likely to have the sort of growth characteristics more typical of a utility company although arguably retaining a higher risk profile. “Slower, steadier growth means a bank like Lloyds will not need to hold back as much as of its profit to fund future growth, boosting instead the amount it can re-distribute via dividends to its long-suffering shareholders. It also means the bank may have more money at its disposal to buy back shares, including possibly part of the 33% stake still owned by the UK government”.
The are risks. The fund manager says that Labour’s talk of a 25% market cap for banks does cast a shadow were it to get elected. The UK economy could falter a particular concern for a domestically focused bank while there could be further provision for PPI.