Slowly but surely Lloyds Banking Group (LSE: LLOY) is beginning to look like the dividend dynamo it was before the financial crisis hit over a decade ago.
In the half year to June, the company’s statutory return on equity (RoE), banks’ core measure of profitability, reached 12.1%. That was thanks to a strong focus on cost cutting, a benign economic environment and rising net interest margin – or the difference between what it pays out as interest and what it receives from making loans.
Rising profitability and stable capital levels mean Lloyds can more than afford to both pay out a dividend that currently yields a comfortable 5.1% and embark on a share buyback programme that should help further boost earnings per share.
However, in my eyes, the bank is still far from the ideal income stock among its large-cap peers. My first qualm is that the firm is simply too large to realistically grow much further. Indeed, in the first half of the year its net income was up a mere 2% and with sky-high market share in areas ranging from current accounts to mortgage lending, there are few opportunities to reliably grow ahead of GDP.
Of course, if the firm can continue to increase profits ahead of revenue, shareholders won’t complain and there is scope to do this. But much of the heavy lifting has already been done and I believe such a sprawling bank will have trouble cutting its cost-to-income ratio much below the 44.9% it reached in H1.
Management is targeting RoE of between 14% and 15% by 2019, but with capital requirements much higher than they were pre-crisis, competition increasing with challenger banks nipping at its heels and interest rates still very low, I can’t imagine much improvement from this level.
So I see a bank with limited opportunities for growth and a valuation of 0.88 times book value that doesn’t imply significant space for upward re-rating. Add in its vulnerability to any economic downturn and I’m left reckoning Lloyds is far from the best FTSE 100 income share.
Long-term growth, short-term rewards
I’d be much more interested in Legal & General (LSE: LGEN), which offers a higher 6.1% dividend yield and, to me, has better long-term growth prospects to boot. This growth is coming from taking on capital-intensive businesses that other insurers and asset managers are shying away from, like taking on pension liabilities from corporations, selling annuities to retail investors and making very long-term investments in Britain’s infrastructure and housing stock.
In the half year to June, profit grew in five of its six divisions, the only laggard being general insurance. This meant underlying operating profits rose 5% to £909m. RoE during the period clocked in at a substantial 20.3% and it should rise further for the full year as the company benefits from a £400m reserve release stemming from a greater-than-modelled increase in early deaths in the UK.
In short, the business has very good long-term growth prospects as it takes market share in profitable-but-unsexy areas where rivals are pulling back, which combined with good profits from its core insurance and asset management businesses, makes a compelling combination. And with its shares valued at just 9.3 times trailing earnings while offering a great dividend yield and history of consistent hikes, Legal & General is one dividend growth stock to watch closely.
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Ian Pierce has no position in any of the shares mentioned. 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.