QUALIPORT
Qualiport Sells Lloyds TSB

By Maynard Paton (TMFMayn)
February 17, 2003

The time has come to sell Lloyds TSB (LSE: LLOY)(NYSE: LYG). Within the next five trading days, the Qualiport will dispose of its entire 510-share holding.

Results 2002

Lloyds TSB published its 2002 results on Friday. Although not the 'kitchen sink' affair many had expected, the figures did reveal another round of 'significant hits':

* A £952m 'adverse investment variance';
* An additional £50m relating to bad debts in Argentina and certain US corporate customers;
* £205m for pensions/endowment mis-selling, and;
* £57m due to 'revised mortality assumptions' in the group's life businesses.

With bad debts rising from £747m to £1,029m, full-year pre-tax profits fell (a reported) 18% to £2,607m. Earnings per share (EPS) fell (a reported) 21% to 32.0p.

Comparisons with the first half are revealing. Excluding 'short-term fluctuations in investment returns', Lloyds TSB made a £2,003m pre-tax interim profit earlier in the year. On the same accounting basis though, pre-tax profits in the second half were 25% lower at £1,501m. On a statutory basis (i.e. after all of the accounting nasties), first-half EPS was 20p while second-half EPS was just 12p.

Also of note was Lloyds TSB's employee pension fund. Under FRS17, Lloyds TSB had a net £2,077m (36p per share) pension deficit at the end of December.

And the good news: the final dividend was maintained at 23.5p per share, which increased the full-year payout by 1.5% to (an uncovered) 34.2p per share. Read more.

Why sell?

So why sell?

* Complexity: Admittedly, Lloyds TSB's impenetrable accounts are hardly a revelation. However, the time has finally come to admit defeat.

You see, there are plenty of issues at Lloyds TSB which leaves the private investor floundering: the capital adequacy of Scottish Widows, bad debts, provisions for product mis-selling, demographic and economic assumptions and the rest. In short, the accounts have far too much reliance on management guesswork.

Take the latest results. Few commentators mentioned Lloyds TSB's change in reporting for 2002, which distorted the comparisons against 2001.

Last year, Lloyds TSB trumpeted 'business as usual profits', whereby 'exceptional items' and other (supposedly) one-off factors were excluded. On this 'underlying' basis, 2001 EPS was reported as 57.6p. Indeed, on a statutory basis, 2001 EPS was previously reported as 45.2p.

One year on, and there's no sign of 'business as usual profits'. In fact, EPS for 2001 is now re-stated as 40.2p (i.e. 11% lower than that reported twelve months prior). Changes in how the 'embedded value' of the company's insurance business is calculated caused most of the number re-jig.

If historic profitability can be altered so significantly at the stroke of an accountant's new assumption, what chance the ordinary investor accurately interpreting past performance?

* Franchise: Lloyds TSB undoubtedly has a solid franchise in the current account market. When the Competition Commission investigated the proposed takeover of Abbey National (LSE: ANL) two years ago, it reported Lloyds TSB being market leader with a 22% market share. The DTI subsequently made some favourable comments on Lloyds TSB's entrenched market position.

However, only 10-15% of group profits come from the UK Retail Banking (current accounts, personal loans, credit cards etc.) stronghold. The balance of profits comes from areas where Lloyds TSB does not posses such dominance. For instance, Lloyds TSB's market share of net new mortgages touched 10% during 2002 (versus 25%-plus for HBOS (LSE: HBOS)). Market share of life, pension and unit trust sales increased to only 6% last year.

* Dividends: "The Board is mindful of the level of dividend cover and consequently, profit growth may not necessarily result in increases in dividend."

Translation: For the next few years, payouts will be static at best.

For some time now, the dividend has long been the major reason for holding Lloyds TSB shares. However, outgoing chief executive Peter Ellwood said the bank is to concentrate on growing its dividend cover to 1.5 times. So if profits stagnate, will the dividend be cut?

And what will happen when new broom Eric Daniels takes up the reins, especially when second-half profits have just taken a nosedive? Maybe the 'kitchen sink' will appear later in the year.

* Circle of competence: After the Qualiport bought Lloyds TSB in September 1999, the portfolio has embraced other sectors (such as tobacco and share trading exchanges) where the number of players is far more limited.

As outlined here, the trick to successful share picking is defining a circle of competence. Unfortunately, monitoring the banking sector involves scrutinising at least nine sizeable businesses and a few big competitors in the life assurance industry, too. It's a daunting prospect.

* You don't have to make it back the way you lost it: Other watch list shares are looking attractive. Imperial Tobacco (LSE: IMT), Associated British Ports (LSE: ABP), Halma (LSE: HLMA), Metal Bulletin (LSE: MTLB) and Renishaw (LSE: RSW) are possible replacement candidates.

Summary

Over the past few years, the Qualiport kept the faith with Lloyds TSB. Sure the accounts were complex, but relying on a big name share with a decent dividend yield would see the portfolio right, wouldn't it? Well, not really. Various issues continue to surface and those that have turned a blind eye have been rewarded by a significant threat to their income.

For those who take a business perspective when investing, banks make life very complicated. For ordinary investors believing the sector holds promise, the best approach would be to hold a spread of banking shares, rather than any particular favourite.

The author owns shares in Halma.