Lloyds (LSE: LLOY) (NYSE: LYG.US) is a decent banking business whose shares are overvalued by at least 20%, in my view. Here’s why.
Capital Strength
Lloyds’ capital strength will be severely tested by the Bank of England in December, after Lloyds narrowly passed a stress test from European regulators in November. The state-owned bank was the worst performer among the British banks, according to results announced on Sunday.
“Twenty-five eurozone banks flunked financial-health exams designed to measure their ability to withstand another economic crisis, falling short of minimum levels of capital by a total of €24.62 billion ($31.17 billion),” the Wall Street Journal reported on Sunday.
Based on several trading metrics, the shares of Lloyds are the most expensive in the UK banking universe right now. Sovereign risk is alive and well, as testified by plunging bond prices in Europe’s periphery earlier this month. According to the European Central Bank and the European Banking Authority, 40% of the banks that failed the stress test are from Italy, the third largest economy in Europe… ouch!
Performance
The bank’s stock is in negative territory in 2014, although the shares recouped almost 4% of value last week, before coming under pressure on Monday following the ECB stress test. The stock is down 1.4% in early trade on Tuesday, and is underperforming the market by two percentage points.
Lloyds stock rose last week in the wake of press reports suggesting that the bank would cut about 9,000 jobs in the next three years. That’s 10% of its global workforce.
Job losses were confirmed on Tuesday, when the banks reported underwhelming results for the third quarter, which showed some improvements on risk metrics, but underlying profits are not growing as fast as they should to justify a high valuation, and almost £1bn of additional provisions have been reported.
“Statutory profit before tax (for the nine months ended 30 September) was £1,614 million, a decrease of 5 per cent on the same period in 2013. This includes charges relating to legacy provisions of £2,000 million, including an additional £900 million for PPI in the third quarter,” Lloyds said.
Moreover, investors were not given any real update about the payout. “We are in ongoing discussions with the PRA regarding the resumption of dividend payments,” the bank said.
Lloyds may become more efficient over time but is not a compelling buy at this level. In fact, its stock is more likely to plunge to 60p than to rise to 90p, in my opinion. It currently trades at around 75p.
A Few Other Problems
Are dividend projections safe? No, they are not.
Bullish forecasts for earnings and dividends seem to underestimate the possible impact of a low-growth environment on the bank’s bottom line. Lloyds is mainly a UK bank operating in the retail sector. Along with a strong pound, the economic recovery in the UK is jeopardised by a growth rate that is just acceptable and is not as high as it should be for a country whose fiscal deficit remains highly problematic.
“Addressing historic conduct issues continued to be a key theme in UK retail banks,” Lloyds said in its 2014 half-year results. This is one of the biggest issues weighing on the valuation of the entire banking industry in the UK – and it’s not reflected in the valuation of Lloyds stock. One could easily argue that the shares of Barclays and RBS are much cheaper based on this risk metric.
What else? First, the pressure will inevitably build up on the stock when the UK government decides to get rid of its stake. Second, the assets base of Lloyds is shrinking, but there are fewer assets to sell.
Lloyds may be perceived as a bond-like investment — one offering a stellar forward yield — that today could be bought at a significant discount to its fair value. But based on the bank’s assets base, at 75p a share, Lloyds stock doesn’t factor in the risks associated to the tough macroeconomic and regulatory environment in which the bank operates.
