Having fallen by 11% since the start of the year, 2018 is not looking great for shares in Lloyds Banking Group (LSE: LLOY). They’ve recently managed to hit a new year-and-a-half low earlier this month, with shares in the bank falling to a trough of 59.4p a piece.
If you haven’t been following the bank’s progress, you could be forgiven for thinking that it has been all doom and gloom over the past year. It certainly hasn’t been — pre-tax profits in the first half of 2018 jumped by 23% to £3.1bn on growth in net interest income and a lower PPI provision.
However, investors should nonetheless be wary. Analysts from HSBC, which recently cut its price for shares in Lloyds from 72p to 68p, warned that Lloyds could face earnings pressure due to the run-off of its higher-yielading legacy gilts and mortgage book and the need to invest more into digitisation and updating core banking systems.
With roughly one-quarter of the UK consumer credit card market and around a fifth of the residential mortgage market, Lloyds is also highly exposed to cyclical loan losses, particularly given the risks surrounding the UK economy and household debt levels.
Loan losses are hovering near cyclical lows, and seem more likely to rise from here, potentially significantly higher, which would weigh noticeable on profits. Household debt in the UK is at its highest level ever, as consumers took out another £80bn in loans in 2017. Meanwhile, Brexit uncertainty continues to overshadow property prices and the overall health of the economy.
Premium to net asset value
With the bank trading at a premium to its tangible net asset value of 17%, there’s certainly the potential for a big fall in its share price should earnings come under pressure from heavy cyclical loan losses. After all, rivals RBS and Barclays still trade at significant discounts to tangible book value.
But, in the absence of the economy entering a deep recession, which seems like the most probable scenario to me, Lloyds’ profitability should continue to improve. City forecasters are currently expecting the bank’s underlying earnings to grow by 63% this year, to 7.2p a share. For 2018, they’ve pencilled in a further 3% increase to earnings, to 7.3p a share.
This seems all the more likely as the payment protection insurance (PPI) claim deadline is only just more than one year away. Lloyds, which has so far paid out £18.8bn to PPI victims, is set to see a major drag on earnings disappear.
Capital generation is also set to improve, paving the way for further dividend growth and even bigger share buybacks in the near term. Lloyds, which has limited growth options due to its already sizeable market share in the UK and lack of interest in expanding abroad, is in a position to deploy more of the capital generated in future years to shareholder payouts.
Shares in the bank currently yield 5% and are valued at just 8.1 times its expected earnings this year.
Jack Tang owns shares of Lloyds Banking Group. The Motley Fool UK has recommended Lloyds Banking Group. Views expressed on the companies mentioned in this article are those of the writer and therefore may differ from the official recommendations we make in our subscription services such as Share Advisor, Hidden Winners and Pro. Here at The Motley Fool we believe that considering a diverse range of insights makes us better investors.