Should You Buy TSB?

Lloyds Banking Group PLC (LON:LLOY) plans to sell 25% of TSB this month and the rest of TSB sometime before the end of 2015.

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Whisper it, but I think there’s a flotation on the horizon that could actually be worth serious consideration.
Rest assured, this market newcomer is not some new-age tech business such as Boohoo, AO World or Just Eat and is valued at a ludicrous triple-digit P/E.
Instead, the business is a mighty 200 years old and the shares could well be priced at book value.
It is TSB.

More attractive than Lloyds Banking

I must admit, I normally do not pay much attention to bank shares.
You see, I sensed banks were full of impending financial trouble before the credit crunch, and post-crash they’ve generally been a mess.
Mix in political interference, regulatory burdens, sizeable legacy issues (such as PPI mis-selling) and their generally complex accounts, and I have plenty of reasons to look elsewhere for sizeable stock-market returns.
TSB could be different.
In fact, once it is spun out of Lloyds Banking (LSE: LLOY) (NYSE: LYG.US) later this month, TSB could offer some attractive features over and above its former parent and the rest of the sector.

Traditional banking and a lower-risk balance sheet

Here are five TSB highlights for me:
1) Traditional UK banking: TSB looks to be a relatively simple bank, as the balance sheet consists mainly of UK retail mortgages that are funded by ordinary customer deposits.

Indeed, there seems to be no high-rolling investment banking division, large insurance operations or any overseas activities to worry about here.
2) Lower-risk financial structure: The bank’s assets and liabilities translate into promising capital ratios.
TSB in fact boasts it enjoys “the strongest capital position of the major UK high street banks“, with a fully loaded core equity tier 1 ratio of 21.6%. (In comparison, the same ratio for Lloyds is 10.7%).
3) Lack of legacy risks: Incoming TSB investors should benefit from guarantees promised by Lloyds.

In particular, the blue chip is giving TSB “significant economic protection against legacy issues, including historical conduct-related claims and losses and historical employment and pension legacy issues“.
4) Greater opportunities for growth: With just 4% of all UK personal bank accounts, TSB ought to have more room to grow.
One opportunity should be improving the number of customers per branch, which at present is 30% below the industry average. Encouragingly, the Financial Times last week reported TSB branches were opening four times as many accounts as they had been under the Lloyds name.
Another opportunity for TSB is resuming the sale of mortgages through intermediaries.
5) Could become a bid target: The banking sector has seen numerous smaller players consolidated over the decades. And with TSB the country’s seventh-largest bank, there’s always the chance it could become a target for a foreign bank wishing to enter the UK market.

But forget about any forthcoming dividend

But TSB does come with some downside risks. Not least…
1) Progress could be scuppered by a house-price crash: TSB’s balance sheet has substantial exposure to residential property and the bank’s growth plan involves selling more mortgages. So trouble in the housing market could easily de-rail the share price.
2) Returns on equity are low: TSB plans to “move towards a double-digit return on equity“. That suggests the current level of profitability from the assets at hand is not great. Which is why perhaps…
3) There is no imminent dividend: TSB expects to pay its inaugural dividend in 2018.

And remember that Lloyds is a forced seller

Of course, whether TSB shares will be worth buying will depend on the price at which Lloyds decides to sell. We’ll discover that later this month.
I suspect the valuation could be about £1.5bn — equal to the net equity value that Lloyds has previously said TSB would carry as an independent business.
(For reference, shares in Lloyds currently trade above net equity value while both Barclays and Royal Bank of Scotland trade below.)
One point to remember here is that Lloyds is a forced seller. In return for government aid the other year, the bank was ordered by the European Commission to hive off TSB — and I don’t believe TSB will have been ‘pumped’ for flotation as so many ordinary IPOs seem to be.
On the contrary, I bet the Lloyds managers involved will have been so immersed in the complicated task of separating TSB to have given much thought to showcasing a grand financial record to achieve the best possible selling price.
Certainly buyers of Direct Line, which was spun out of RBS in 2012 for the same EU reasons, have done well. Floated at 175p, Direct Line now trades at 257p and has declared dividends of 25p. I make that a total return of 61% in less than two years.

Just so you know, Lloyds plans to sell 25% of TSB this month and the rest of TSB sometime before the end of 2015. There will also be a special bonus offer, whereby retail investors can acquire one free share for every 20 acquired (up to £2,000) if they’re held for at least a year after the float.
Anyway, we’ll know more about TSB when the full prospectus is published in around a fortnight.

Should you invest, the value of your investment may rise or fall and your capital is at risk. Before investing, your individual circumstances should be assessed. Consider taking independent financial advice.

Maynard does not own any share mentioned in this article.

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