Merrill Lynch has attempted to upstage Lloyds boss Eric Daniels, who is appearing at Morgan Stanley’s European Financials Conference later on Wednesday.
Merrill’s banks analyst Michael Helsby is telling clients that Lloyds’ share price could double — yes, double — on a two-year view.
Here’s the pitch:
In brief, we believe that a cocktail of rising margins and Net Interest Income (NII), coupled with falling costs, can lead to a step change in pre-provision profits. If we combine this with a sharp fall in bad debts, we think Lloyds can generate £3.5bn of proforma profit in 2010 and command earnings of 12p by 2012 (c.35 per cent above consensus). Despite higher capital requirements implied by the current Basel III draft proposals, our 2012E EPS translates into a RoNAV of >15 per cent suggesting the current 1x 2009 Tangile Net Asset Value rating is too cheap. We reiterate our Buy with an end-2010 PO of 85p per share. On a two-year view, our SOP drives a valuation of 122p suggesting that the share price could more than double if our projections prove correct.
So what are these projections?
Here’s a chart of Merrill’s view on bad debt charges (click to enlarge):
And its assumptions on funding (emphases ours, throughout):
We estimate that the stable funding ratio stood at c.89% at the end of 2009, broadly in line with management’s guidance of c.90%. Clearly this remains under the 100% target set out by the Basel committee. To reach 100% we estimate that Lloyds needs to reduce its balance sheet by its target of c.£100bn, grow deposits by c.3% per annum and replace its term funding as it comes due (detailed calculations are available on request).
Costs:
At the full-year results, Lloyds increased its targeted cost synergies to £2bn from £1.5bn, with the full benefit to be felt from the end of 2011. Alongside an assumed 3% underlying cost inflation, we envisage that costs can fall in 2010 and 2011, allowing the cost/income ratio to drop to 40% by 2012. Note that this is somewhat more ambitious than management guidance of a 2ppt reduction in the CIR pa for the next three years.
Income:
Despite a c.£100bn reduction in the balance sheet, we think the combination of rising NIM (2.32 per cent by 2012E) and other income (£12.2bn by 2012E) can lead to a 21 per cent increase in income generation versus 2009. We continue to believe Lloyds can manage its funding position and are further encouraged by the increased issuance in the market. If we combine revenues with an 8% reduction in costs over the period, then pre-provision profits expand to c.£16bn, on our estimates.
And finally capital:
While Basel III is increasingly likely to be pushed back and phased in over a number of years, it is still important to consider the implications for Lloyds given this impact on potential dividends, but more fundamentally on the ownership structure of the long-term savings business. Given the large deferred tax assets of Lloyds and the investments in the insurance subsidiary, it suffers from a large headline reduction in core capital. While the return to profitability should reduce the DTA, clearly the insurance deduction raises long-term questions about the ownership structure of this business.
We think that management will increasingly look to derive value from the business for existing shareholders. One option is listing the life businesses, while maintaining a minority stake so that it can continue to sell and influence the products sold through the branches.
A Scottish Widows IPO then.
All in all, pretty panglossian stuff.
Related links:
Back in (the) black at Lloyds – FT Alphaville
Bad debt surprise at Lloyds -FT Alphaville
BarCap’s funding findings – FT Alphaville
Lloyds needs to sell Scottish Widows - FT Alphaville