After a strong run post-Brexit, you may be surprised to find out that City analysts are still bullish on shares in Lloyds Banking Group (LSE: LLOY). Out of the 26 investment banks covering the stock, a clear majority (16) rate it as either a “buy” or a “strong buy”. Of the remainder, five say Lloyds is a “hold” with another five saying it‘s either a “sell” or a “strong sell”.
Additionally, three investment banks raised their price targets for Lloyds’ shares following the bank’s better-than-expected first quarter earnings release on 27 April. HSBC hiked its target price to 76p from 75p, and maintained a “buy” rating on the bank.
Meanwhile, despite keeping their “sell” ratings on the stock, Citigroup and Goldman Sachs lifted their target prices to 63p and 58p, respectively. Their new target prices are still below Lloyds’ current share price, but they’re improvements on their previous targets of 55p and 57p, respectively.
So why are analysts generally bullish?
Firstly, it’s Lloyds’ steadily recovering profitability. Since the financial crisis, it has reacted decisively to changing market conditions by scaling down from costly business lines and reducing its dependence on volatile wholesale funding sources. The bank has made significant efforts to reshape its business model and in doing so, it has made substantial progress in improving its underlying profitability.
Already, Lloyds has the lowest cost base of the big four banks, with a cost-to-income ratio of just 47.1% in the first quarter of 2017. And the bank isn’t being complacent either — it’s still in the process of cutting costs, and is targeting a reduction in its cost-to-income ratio to 45% by 2019.
On top of this, PPI provisions are declining and this has a significant impact on its capital generation. Assuming that underlying earnings is broadly stable, the boost in capital generation should translate into higher dividends.
What’s more, the bank has a very strong capital position, with a common equity tier 1 (CET1) ratio of 14.3% — this puts Lloyds among the highest of the UK’s big four banks.
Reasons to be less bullish
Despite the generally positive outlook on Lloyds, it’s impossible to deny that it also faces some major political and economic headwinds which could hurt earnings over the next few years.
Firstly, there’s the Brexit uncertainty and the slowing growth outlook in the UK. Already, consumers are feeling the pressure of higher prices, which has squeezed real wages. Banks are highly cyclical and Lloyds is particularly exposed because of its outsized exposure to UK consumers.
Loan losses are expected to rise from historical lows, while “lower for longer” interest rates could squeeze net interest margins. So far though, Lloyds has confounded many analysts who had believed loan losses would rise in its first quarter. Instead, loan losses continued to fall, while net interest margins widened on the same period last year.
Bottom Line
Despite the recent run in its share price, I continue to believe that a long-term investment in Lloyds Banking Group makes sense at current levels. The bank has consistently exceeded analyst expectations on its credit quality and net interest margins — two important factors affecting profitability — and I expect further analysts forecast revisions to take place this year.
