QUALIPORT
Juicy Dividend Makes Lloyds Attractive

By Maynard Paton (TMFMayn)
August 5, 2002

With a near 6% dividend yield, Qualiport share Lloyds TSB (LSE: LLOY) is cheap. However, the bank recently published its interim figures and reported a rather humdrum performance. Bad loans and lower sales of stock market products left profits at a standstill. But the big picture story remains intact: Lloyds TSB remains a leading player in the banking sector and has significant exposure to the long-term growth market of savings and investment.

The financials

Here's a summary of Lloyds TSB's six-month figures:

Half-year to June                               2002           2001

Total income (£m)                              4,597          4,351
Trading surplus (£m)                           2,237          2,014
Provisions for bad and doubtful debts (£m)       479            323
Pre-tax profit (£m)                            1,604          1,603

Earnings per share (p)                          20.0           20.5
Dividend per share (p)                          10.7           10.2

In short, a 6% improvement in total income and just a 1% increase in costs allowed Lloyds TSB to report an 11% 'trading surplus' advance. However, a 48% hike in bad debt provisions kept pre-tax profits flat at £1.6b. A slightly higher tax rate saw earnings per share slip 2.5% to 20.0p. However, the interim dividend improved 5% to 10.7p per share.

On a divisional basis, there were mixed performances:

* Pre-tax profits from UK Retail Banking increased by £25m to £243m. The performance was underpinned by growth in personal loans (up 19%) and credit card lending (up 24%). Although asset quality "remains good", the operation's bad debt provision jumped 36% to £272m. While Lloyds TSB stated that this increase was "largely as a result of volume related asset growth", it's worth noting the relevant assets only grew around 10%.

* Pre-tax profits from Mortgages increased by £3m to £431m. Although net new lending increased 11% to £2.0b, Lloyds TSB's market share slumped from 7.5% to 5.9%. Commendably, the bank continued "to avoid exposure to the buy-to-let and sub-prime mortgage markets" and decided "not to chase market share growth at the expense of price and quality".

* Excluding "short-term fluctuations in investment returns", pre-tax profits from Insurance and Investments increased by £18m to £785m. An extra £55m generated largely by insurance broking was offset by a £37m profit shortfall from equity-based products. Stock market volatility discouraged Lloyds TSB customers from purchasing unit trust and ISAs, sales of these products falling some 36%.

* Pre-tax profits from Wholesale Markets fell 14% to £355m. The shortfall was caused by additional bad debts of £83m, mostly as a result of loans and advances to Enron (OTC: ENRNQ) and Worldcom (OTC: WCOEQ)

Capital issues

The results also remarked upon the company's capital position.

Lloyds TSB stated: "Notwithstanding its strong capital position, the Group intends to raise additional non-equity tier 1 capital during the next few months in order to strengthen its capital ratios. We see this as a prudent measure for the Group, given the uncertainties surrounding current economic and stock market conditions".

Essentially, the tier 1 capital ratio represents shareholders' equity as a proportion of the groups' risk-weighted assets. Although Lloyds TSB's tier 1 ratio was a satisfactory 7.8% at the end of the half-year, the need to bolster reserves suggests investors shouldn't expect dramatic dividend growth in the near-term.

In terms of 'solvency' ratios for the Scottish Widows life assurance operation, the FTSE 100 could fall to below 3,500 before Lloyds TSB would need to need to inject capital into this particular business.

Summary and valuation

The long-term picture remains quite bright for Lloyds TSB. For starters, Lloyds TSB still remains entrenched as one of the big four High Street stalwarts. Furthermore, the increasing importance of savings and investments to the UK public should benefit the group's Scottish Widows business. Profits here should increase in line with the stock market (which as we all know, does rise over the long term).

For the ordinary private investor, a leap of faith is required with Lloyds TSB's finances. The company's accounts are difficult to understand and issues such as bad loans and low solvency ratios are not the easiest to form an independent judgement on. Investors have to rely on the boardroom to a large extent, and as Abbey National (LSE: ANL) shareholders have recently found to their cost, management talent can sometimes be found wanting.

Of course, Lloyds TSB also carries the usual sector risks. Increasing competition, regulatory interference and a dreadful acquisition are the continuing worries of a banking sector investor. With the Abbey National bid blocked on competition grounds, there is scope for Lloyds TSB to sniff around elsewhere. Favourites perhaps would be a tie-up with a foreign bank or a purchase in the insurance sector. Just how much shareholder value will be generated by any such move remains to be seen.

That said, the company's current valuation does more than offset all the inherent business risks. At 575p, Lloyds TSB shares stand on a rolling 12-month price to earnings (P/E) ratio of 10.8 (using Lloyd TSB's 'adjusted' earnings figures) and offer a historic dividend yield of 5.9%.

Dividend cover has fallen in recent years and is now approaching 1.5 times, which is (reportedly) the minimum level acceptable to the board. Increasing tier 1 capital also supports the suggestion of short-term pedestrian dividend growth to come. But all things considered, compared to the 4.8% return on offer from gilts, the present dividend yield makes Lloyds TSB shares very attractive.