What should investors do with Lloyds shares?

Lloyds Banking Group logo

Things suddenly appear to be coming together for Lloyds Banking Group - the lender being talked up amid good underlying progress.

Chancellor George Osborne started this in his March budget, declaring the prospect of a £9 billion share sale - £4 billion of which would be sold to private investors in the style of 1980s privatisations.

More recently, better-than-expected first-quarter 2015 results have fuelled profit upgrades and the general election outcome has boosted UK bank shares. Lloyds is apposite because it has de-risked its balance sheet and shows positive earnings momentum, is returning capital, and is relatively easily understood.

Additionally, broker Jefferies estimates that not only will the ordinary dividend be restored - such that buyers can currently lock in a 5 per cent to 6 per cent prospective yield - but excess capital will enable a further £6 billion return by 2017.

SEVERAL BROKERS HAVE UPGRADED PRICE TARGETS

That's quite some leap forward from the bank's recent figures, but the table below shows the extent of status change expected from 2015 onwards. The return would probably involve reducing Lloyds' 71.4 billion shares in issue, which will otherwise dilute earnings growth as profits recovery evolves.

Largely in response to the first-quarter 2015 results, one survey of brokers' opinion shows upgrades to a 95p to 102p zone, with Credit Suisse the only sceptics - reckoning on 72p.

A cautious view effectively assumes the UK economic recovery has run full cycle and is exposed - as bank shares are effectively a play on consumer/business cycles, and anticipating change in the trend.

The election of a Conservative majority involves the possibility of tough new spending cuts; although the last coalition government showed the Conservatives paying more regard to Keynesian imperatives of spurring growth as a means to debt reduction - even allowing for compromises with the Liberal Democrats.

This may be the macro crux for the UK economy and the extent to which professional investors decide to weight portfolios in bank shares - if growth can broadly be sustained then bank shares will remain in demand and possibly ratings increase also.

A forward price/earnings (p/e) of 11, reducing to 10 for Lloyds is speculative because it is based on projections rather than anything achieved in recent years. However, the first-quarter results did show a £2.2 billion underlying profit, so the bank is well on its way.

Indeed, looking to 2017, JPMorgan Cazenove projects dividend growth to 5.3p a share, implying scope to lock in a prospective yield just over 6 per cent at the current buying price of 87p.

This is likely to be one among various attractions peddled when it comes to the government selling out its remaining 20 per cent stake, possibly later this year (although no timetable has yet been given).

Osborne has expressed eagerness to 'get rid' of the government stakes in Lloyds and RBS, probably to show he is successfully moving on from Labour's legacy.

The government's break-even price is 73.6p versus a current market price of 86.5p - its stake having reduced from 43 per cent to just over 20 per cent - and, with stock markets globally buoyant, the timing is already good.

SWEETENERS FOR STAKE SALE TO BOOST DEMAND

It is already mooted to involve a discount of at least 5 per cent to market price in a likely range of £250 minimum to £10,000 maximum applications; also a loyalty bonus of one additional free share for every 10 shares held for a year.

It remains to be seen how this would be financed, or merely by dilution. These would still be useful teasers for demand, able to help continue Lloyds' re-rating.

While this kind of state asset sale is unlikely to generate the froth seen around Royal Mail's privatisation, people can also see little downside risk in the market unless the UK economy turns down and/or another major crisis erupts from the eurozone.

But even in the event of a market slide undermining the suggested £4 billion allotment to private investors, institutions would likely add to their £5 billion allotment anyway.

So despite the risk/reward profile on the Lloyds' offer lacking spice like some privatisations, buyers are likely to see little short-term downside. The investment banks involved will also conduct 'market stabilisation' trades, as a bid to justify their fees.

It would be unsporting to describe all such support as 'market rigging', but altogether, and considering likely investor demand, the sale should be net positive for Lloyds' market price.

BREAK-OUT AFTER 16 MONTHS' CONSOLIDATION

The five-year chart shows the current market price of 87p as effectively a return to the high achieved in early 2014.

Previously the stock had rallied like many others - part-benefiting from quantitative easing - after a plunge from 70p to 22p in the second half of 2011, when the eurozone debt crisis intensified fears over bank balance sheets.

The last 16 months have seen a consolidation phase in a 71p/83p range, the jump since the general election potentially establishing a break-out.

Strictly speaking, the stock needs to consolidate this gain, but the context is looking good for it to happen.

Assuming forecasts, a p/e multiple reducing to 10 and prospective yield approaching 6 per cent will come across as relatively good value, whether considering European banking stocks or indeed most other UK equities.

In terms of 'behavioural finance', buyers are likely to see fundamental and technical indicators in favour.

AVERAGING-IN WOULD APPEAR PRUDENT

It's impossible to say if it is better to wait for consolidation again after last Friday's 5 per cent jump; but on a two-year view, and assuming no downturn in the UK economy, then Lloyds will find regular buyers among investors who seek meaningful income and capital growth.

The stock market tends to be exposed to jitters amid more thinly traded summer holiday time, so then could be a useful time to accumulate. The government offer would then provide an opportunity to average down slightly on price.

For more information see: lloydsbankinggroup.com.

*On 11 May, the government sold almost 732 million shares, taking its stake down to 14.2 billion, or 19.93 per cent.

Lloyds Banking Group - financial summary

Consensus estimate

Year ended 31 Dec

2010201120122013201420152016
IFRS3 pre-tax proft (£m)281-3452-6064151475
 
Normalised pre-tax profit (£m)1886-250020421055163177718380
IFRS3 earnings/share (p)-0.5-4.1-2.1-1.21.6  
Normalised earnings/share (p)2.1-1.992.150.541.857.898.65
Earnings growth rate (%)


-74.924331512.5
Price/earnings multiple   (x)  
 46.911.3101
Price/earnings-to-growth (x)    0.190.040.8
Dividend per share (p)




2.854.18
Dividend per share growth (%)      46.5
Yield (%) 





3.284.81
Covered by earnings (x)




2.72.07
Shareholders' funds (£m)4606145920418963898948690  
Net tangible assets per share (p)48.749.652.748.662.5

Source: Company REFS.

This article was written for our sister website Interactive Investor.


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