The discount embedded into Lloyds Banking Group’s shares has proved difficult to budge. At worst investors fear that the lender could be set for a wave of toxic debts as borrowers buckle under the cost of living pressures; at the least, the market suspects a slowdown in new lending will materialise.
A rise in returns guidance for the second time this year indicates that investors could be overly cautious. Higher interest rates and better-than-expected loan default rates mean returns on tangible equity, a key profit measure, are expected to come in at about 13 per cent this year, ahead of initial guidance of 10 per cent given in February.
Executing on that improved profitability guidance could help close the gap between the share price and the lender’s tangible net asset value, which stands at 17 per cent versus Lloyds’ tangible net asset value (TNAV) at the end of June and 24 per cent below the TNAV forecast at the end of December this year by analysts at brokerage Shore Capital.
Higher interest rates provided the biggest benefit to Lloyds’ pre-tax profits during the second quarter, which came in at just over £2 billion and vaulted analyst expectations of just under £1.6 billion. Higher rates and a delay in passing through the benefit to customer deposits, an already cheap funding base, means the net interest margin is expected to increase above 2.80 per cent this year, above a market consensus forecast of 2.73 per cent. The result? Lloyds reckons it can ratchet up capital generation even more than it previously expected this year.
Bullish guidance assumes gross domestic product growing by 3.3 per cent this year, house prices rising by 1.8 per cent and the base rate hitting 1.44 per cent. Based upon Britain’s experience so far this year and projections from economists and investors, those assumptions look unambitious. Traders expect a 50 basis point rise in the base rate when the Bank of England rate-setters meet next week, which would push the bank rate up to 1.75 per cent.
Meanwhile GDP rose by 3.5 per cent in the three months to May and is expected to turn out at 3.2 per cent for the year, according to forecasts by the International Monetary Fund. House price inflation is still running hot and a basket of forecasts for the year are higher than the base case scenario for growth pencilled in by Lloyds. A rise in borrowers defaulting on loans is the big caveat to Lloyds hitting its returns target. Thus far, a deterioration in the loan book has not materialised. Lloyds took another £200 million in impairments in the second quarter, but that was only about £30 million higher than the first three months of the year but lower than the same three-month period in 2019. Impairments equated to only 0.17 per cent of outstanding loans in the first half and is expected to remain below 0.2 per cent over the year. Thus far, only 1 per cent of Lloyds customers are showing signs of financial stress, according to management.
Regulatory capital levels were already comfortably above management’s target of 13.5 per cent, at 14.8 per cent at the end of June. Beefier capital generation means there is the prospect of additional cash returns for shareholders’ this year, via share buybacks or special dividends. Lloyds is in the middle of a £2 billion share buyback programme. Analysts have forecast a dividend of 2.39p a share for this year, which would leave the shares offering a dividend yield of 5.3 per cent at the current share price.
There is the chance that a more competitive mortgage market could weigh on margins, but Lloyds thinks it is a profitable part of the market to be in. Its shares look cheap and even more inexpensive against profit upgrades set to be put through by analysts based on first-half results.
ADVICE Buy
WHY The shares could re-rate if impairments remain benign and rates move higher
Unite Group
Rising interest rates pose a double risk to property companies that have been awarded generous premiums by investors. Higher financing costs not only weigh on earnings for the companies themselves, but should also mean property values ease to reflect increased funding costs for would-be acquirers of assets.
For student landlord Unite, both factors could impact earnings growth in years to come. About 15 per cent of the real estate investment trust’s debt is at a floating rate and higher interest rates will push up the cost of debt from 3.2 per cent at the end of June, to 3.4 per cent by the end of this year. The result? Earnings guidance has been cut to 40p-41p a share for this year, from the 41p-43p.
Analysts at Peel Hunt cut their forecast for net asset value at the end of December to 917p a share, from 950p. Against that forecast, shares trade at a 21 per cent premium and are priced above the NAV forecast by Peel Hunt at the end of 2024.
Given the potential impact of higher interest rates on property values and the risk of inflationary cost pressures overshooting management expectations between then and now, the shares look too optimistically priced.
The cut to earnings guidance this year is despite rental growth being upgraded to 3.5-4 per cent for the academic year commencing in September. The year after, management expects rental growth to rise to 4-5 per cent, but the question is whether that is enough to compensate for the rise in financing and operating costs.
The company is completely hedged against rising energy costs this year and next, and 50 per cent for 2024. But there are other areas of cost pressure to think about, such as staff costs and a rise in the cost of financing to 3.6 per cent next year. Analysts are currently forecasting earnings of 47p a share for next year.
Cost inflation is also set to eat into the returns generated by developments due for completion in 2024 and 2025, which represent almost 50 per cent of the 6,100 beds in the development pipeline.
Management believes it can still generate a profit on cost of 35 per cent on committed developments.
ADVICE Avoid
WHY Shares look expensive given greater challenges on NAV growth in years ahead
