COMMENT
Go Buy Banks

By David Kuo (TMFDragon)
March 1, 2006

With results from four of the UK's Big Five banks already in the bag, combined profits of £32bn are looking likely. HSBC (LSE: HSBA), forecast to report annual profits of £11bn, will complete the full set of figures next week.

Lloyds TSB (LSE: LLOY), despite worries that it may miss estimates, announced a 10% profits rise to £3.8bn. The strong performance was thanks to Scottish Widows, which saw profits rise 12% to £683m. However, good news at the insurance division was offset slightly by disappointment at its Retail Banking unit, where profits slipped £100m to £1.5bn as bad debt charges took their toll.

Bad and doubtful debts were a thorn in the side of Barclays (LSE: BARC). It reported a 20% fall in profits at its Barclaycard unit. Additionally, mortgage lending did not live up to expectations as Woolwich lost market share. But profits at Barclays still jumped 15% to a record £5.3bn as higher investment banking income came to the rescue -- Barclays Capital saw profits surge 25% to £1.3bn.

Royal Bank of Scotland (LSE: RBS), the UK's second largest bank, said annual profits jumped 21% to £7.9bn. Its performance was driven by robust corporate lending and strong consumer banking at its US Citizens division. In common with other banks, RBS has set aside more cash to cover bad consumer loans. Charges for bad debts rose 29% in the bank's retail division, though it stressed that there are signs that credit quality is stabilising.

HBOS (LSE: HBOS), formed when Halifax merged with Bank of Scotland, reported a 17% rise in annual profits to £4.8bn. Like Barclays, growth was driven by its corporate banking division, which saw profits rise 27%. HBOS, which is Britain's biggest mortgage lender, has also been expanding internationally. It now has operations in countries that include the US, Ireland and Australia that in total account for 13% of group profits.

Two of Britain's smaller banks have also reported results recently. Northern Rock (LSE: NRK) said annual profits rose 14% to £494m, and Alliance & Leicester (LSE: AL.), which has little exposure to overseas markets, saw profits inch up 1% to £547m.

You would have thought that based on these results, banks deserve a significant re-rating after reporting yet another year of mammoth profits. But by and large, their valuations remain clustered around 12 times earnings, which is slightly lower than the market average. Royal Bank of Scotland is currently the cheapest at 10 times earnings, and Northern Rock the dearest at 13 times earnings.

The banks' low ratings can be explained by in part by continuing concerns over bad debts. However, there are signs that credit quality is stabilizing as banks adopt a more prudent stance towards lending. Another worry is the prospect of a windfall tax plus a possible clampdown on excessive overdraft and penalty charges. Indeed these may be legitimate areas for concern. However, as banks expand their overseas interests any impact from Government action may be considerably lessened. For instance, HSBC generates less than 20% if its profits in the UK and over 30% of RBS's earnings are now derived outside of Britain.

The threats mentioned above don't bother me greatly. These are likely to be short-term risks, and I prefer to focus on the long term. And with valuations below the market average, and dividend yields above the market average, I think banks still look quite attractive.

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David owns shares in Barclays.