2017 has been a landmark year for Lloyds (LSE: LLOY). With capital buffers building, the company has been able to pay out a special dividend of 0.5p per share and is currently trying to complete the acquisition of credit card group MBNA.
What’s more, after nearly a decade of state ownership, this week the bank was finally fully privatised.
Lloyds’ recovery has attracted investor attention across the UK, mainly because of the company’s dividend potential now that its legacy issues are behind the group. Even star fund manager and dividend guru Neil Woodford has expressed his support for the bank and recently acquired a position for his fund.
Profit potential
I’ve written about Lloyds’ dividend potential several times in the past, and on each occasion, my argument has revolved around the bank’s rapidly expanding capital cushion. However, during the past two weeks, some research from City analysts has been published, which questions whether Lloyds’ capital buffer is as healthy as many believe it to be. The report also points out that the bank’s bottom line has been inflated in recent years thanks to several factors that may not be around for much longer.
Specifically, around 50% of Lloyds’ £135bn mortgage book are still on a standard variable rate, which yields double the income of fixed rate mortgages. Around 10% of these mortgages per annum have been switching to fixed-rate deals, costing Lloyds millions in lost interest income.
This trend is not likely to come to an end anytime soon. On average only 10% of peers’ mortgage books are SRV meaning that Lloyds’ book still has a long way to correct before it comes into line with the rest of the sector. Secondly, analysts claim that Lloyds has benefited from £43bn of free funding from the Bank of England. This tailwind has helped boost earnings per share by an estimated 5% to 7%, but once again, it won’t be around forever. Add on the fact that Lloyds is currently experiencing a record low level of loan losses, and the uncertainty over the bank’s future earnings potential is evident.
Earnings set to suffer
Earnings are set to suffer over the next few years as the above tailwinds evaporate and Lloyds’ good capital cushion might also come under pressure before the end of the decade.
Analysts predict that a 10% fall in house prices, could wipe 118 basis points, or 1.18% from Lloyds’ tier one capital ratio. A 20% drop would cost the bank 242bps. To put these figures into perspective, after the MBNA deal, Lloyds’ management believes the bank will have a tier one capital ratio of 13.5%, 0.5% above what it believes is adequate. A 20% fall in home prices, assuming all other factors remain equal, would erode capital buffers to around 11%, a level at which management would likely be forced to reconsider the dividend altogether.
The bottom line
Overall, Lloyds may look to be a model dividend stock, but the company’s not without risk and the perfect operating environment that’s helped it thrive over the past few years, will not last forever.
