Lloyds may struggle to earn its cost of capital

Lloyds Banking Group and Royal Bank of Scotland recently announced plans to raise a total of £54.4 billion capital. The decision caused Morningstar analyst Erin Davis to reassess her view of the two stocks and her updated thesis for the Lloyds shares is detailed below, while her initial response to the banks' plans can be read here. Lloyds' shareholders will next week vote on the bank's plans to raise a record £13.5 billion via the UK's largest ever rights offering. The new shares will trade from December 14, 2009. Lloyds' 2.8 million shareholders have an average of 740 shares each and the offering will cost them £366.67 should they take up their rights, the company has said. Investors looking to explore their options can use this tool, provided by Hargreaves Lansdown, which can help explain what will happen should you opt to not act, take up the offer in full, partially take up the offer, or sell your 'Nil paid shares'.

Thesis
(Last updated 16-11-2009)

In September 2008, Lloyds TSB, now Lloyds Banking Group, announced plans to acquire HBOS at what amounted to a fire-sale price, thus tying its fate to that of its struggling competitor. As a stand-alone company, Lloyds was a top-quality, profitable traditional retail bank in the United Kingdom, albeit one with fortunes that were deeply tied to that of the UK economy. The combined banks are an even more dominant force in UK retail banking, controlling 30% of the mortgage market and 50% of the savings market. Although Lloyds paid only a fraction of book value for HBOS, it has turned out to be a rotten bargain. HBOS was a less conservative bank than Lloyds, both in terms of its lending and how it was funded, and absorbing HBOS' losses has forced Lloyds to seek multiple rounds of assistance from the government and shareholders. As a result of this, and the very real threat of government interference in Lloyds' business practices, we think it will be difficult for the bank to earn its cost of capital in the long run, and we have reduced our moat rating to none.

As a stand-alone company, Lloyds' credit quality has held up fairly well so far during the credit market turmoil, thanks to its strict underwriting standards, but the former HBOS' credit quality has deteriorated significantly. Furthermore, both banks were deeply wounded by their 2008 government-sponsored capital raising--the UK government ended up with 43.5% of the combined Lloyds-HBOS entity, and existing Lloyds shareholders with just 37%. In November 2009, Lloyds announced a plan that would allow it to leave the UK's expensive Asset Protection Scheme but would force it to seek another £13.5 billion from shareholders and agree to numerous restrictions. These include not paying dividends on common shares, preferred shares, and some bonds for at least two years. We don't think Lloyds is out of the woods yet--the UK economy is facing a deep slowdown and a sharp drop in property prices. We think loan losses will remain elevated for some time, especially in HBOS's less conservative commercial property portfolio.

Despite our pessimistic outlook regarding financial performance, we note that Lloyds is emerging from the financial crisis in far better shape than rival Royal Bank of Scotland. By exiting the Asset Protection Scheme early, Lloyds has dodged giving the government a much larger stake in the firm. Moreover, the divestitures demanded by the European Union in exchange for receiving state aid are likely to be less material to Lloyds than to RBS, although the details have not been finalised.

Valuation
We have withdrawn our fair value estimate for Lloyds because of the uncertain outlook. While Lloyds is not as deeply troubled as RBS, the losses it will take, especially in its commercial portfolio, are likely to be large and lumpy and may test the bank's capital base. While escaping the Asset Protection Scheme has protected shareholders from additional dilution, at least for now, it increases uncertainty about the size of Lloyds' future losses.

Risk
A combined Lloyds-HBOS is extremely exposed to the UK property market, and sharp falls in property prices are almost certain to mean painful losses for some time. Losses may be high enough to force some of Lloyds' debt to convert into equity, thus further diluting shareholders. Mortgages constitute about half of the firms' combined loan books and commercial property another 25%. Lloyds and HBOS raised a large amount of capital from the UK government and are likely to face pressure to increase lending to risky sectors, possibly increasing long-term losses.

Management & Stewardship
Lloyds management has come under fire in the wake of its disastrous acquisition of HBOS. CEO Eric Daniels has managed to retain his position for now, but chairman Victor Blank retired under pressure and was replaced by Winfried Bischoff in September. Daniels, an American who formerly worked at Citigroup, unleashed a massive restructuring and divestiture programme to focus Lloyds on its core markets after he was hired in 2003. We had largely been pleased with his leadership until the HBOS acquisition, which was undertaken with too little due diligence and under government pressure. Lloyds has since admitted that it would not have needed government assistance as a stand-alone bank. We're worried that further government interference in Lloyds' business could destroy what is left of shareholder value. We wouldn't be surprised to see further changes in Lloyds' leadership.

Overview
Growth: Lloyds more than doubled in size when it acquired HBOS. As a stand-alone company, Lloyds' growth had generally been modest, and we expect it will be even lower over the next few years, given the challenging economic environment.

Profitability: Lloyds has historically been extremely profitable, with returns on equity typically in the mid-20s. We expect profitability to be much lower in the next several years, with losses likely, as the UK economy shrinks and property prices tumble.

Financial Health: The rights issue announced in November will lift the bank's pro forma core Tier 1 capital ratio to an adequate 8.6% as of June 30. If this should fall below 5%, newly restructured debt will convert to equity. This would dilute shareholders but prop up Lloyds' equity base.

Profile: London-based Lloyds is a financial services firm that operates primarily in the UK through its retail bank, insurance group, and wholesale and international banking unit. Lloyds more than doubled in size when it acquired rival HBOS and now controls 30% of the UK mortgage market and 50% of its savings market.

Strategy: Lloyds' strategy is to focus on its core retail banking and life insurance businesses, where it can sustain its competitive advantages, and on carefully controlling costs. The bank emphasises improving customer service for its retail and commercial customers by streamlining product offerings and procedures, thereby winning a larger share of its customers' wallets.

Bulls Say
1. Lloyds' acquisition of HBOS will make it a powerhouse in UK banking, controlling some 50% of the savings market. Moreover, the knockdown price Lloyds paid for HBOS should translate into even higher profitability in the future.

2. Lloyds' Scottish Widows insurance unit is beginning to deliver solid economic profits after introducing new products and enforcing capital discipline.

3. An investment in a state-of-the-art customer-management system has enabled Lloyds to increase wallet share and switching costs, allowing the company to retain more retail customers than its competitors.

4. Management's focus on costs, economic profitability, and efficient growth has led to returns on equity in the mid-20s and a huge dividend yield.

Bears Say
1. HBOS was a much less conservative lender than Lloyds, and Lloyds will be left holding the bag if falling property prices cause HBOS' charge-offs to increase to unmanageable levels.

2. UK property prices, which appreciated rapidly over the past several years, are falling rapidly. Delinquencies are rising rapidly and cutting deeply into Lloyds' profitability.

3. Lloyds' relentless focus on costs could cause it to underinvest in personnel, marketing, and technology.

4. Lloyds' reliance on government assistance in the wake of the HBOS merger means that the UK government now has substantial influence over the bank's business practices and makes it more likely that the bank will make uneconomical business decisions.

Disclaimer: Morningstar is not responsible for the content on Hargreaves Lansdowns' web site, nor for the accuracy of the stock broker's Lloyds rights offer tool. The link to the tool is solely intended to assist Lloyds Banking Group shareholders to make an informed decision and in no way constitutes financial advice.