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Jupiter's Davies: three reasons why Lloyds' dividend may beat forecasts

Jupiter's Davies: three reasons why Lloyds' dividend may beat forecasts

Lloyds seems to have taken inspiration from central bank policy speeches with its measured tone and talk of shareholder distributions at a 'modest level.'

Yet, there is every reason to believe dividend pay-outs may prove much more generous than initially anticipated, with the bank’s share price also potentially seeing further upside over the next two years.

There are three reasons behind our cautious optimism.

Satisfying the regulators

First, Lloyds Bank is close to satisfying the Prudential Regulation Authority (PRA), the banking sector watchdog, that it has built up sufficient capital buffers to be allowed to start paying out dividends again.

The bank's core equity tier 1 ratio - a measure of a financial institution's ability to withstand potential future losses - stands at 10.3% of its risk-weighted assets. The company now believes this needs to rise to c11% and we believe Lloyds can achieve this by the end of the year or by early 2015 at the latest.

Meeting this key regulatory requirement should allow the PRA to give Lloyds Bank the permission to issue dividends for the first time since 2008.

Normalisation of earnings power

The strengthening of the bank's balance sheet is being accompanied by a 'normalisation' of the bank's earnings power - a second factor giving us grounds for optimism.

Shorn of its more esoteric banking activities, Lloyds has returned to being a bread-and-butter UK-focused retail and commercial bank.

Retail banks with decent market shares have the potential to make good returns and there is no reason why Lloyds would be an exception. The bank may have been hamstrung by payment protection insurance (PPI) payments and impairments on bad loans but these impediments are now receding.

The bank has also implemented an extensive cost-cutting programme that has resulted in a much leaner, more efficient institution. Against this background, Lloyds is finally starting to deliver what could best be described as normal levels of profit from a loan book that is now starting to grow again.

This back-to-basics approach is reflected in the bank's outlook.

When we were setting out the case for investing in Lloyds three years ago, we estimated the bank might eventually be in a position to pay a dividend of 5-6 pence a share - a pay-out that would in our view support a share price in the region of £1 or more.

Yet, Lloyds, at the presentation of its full-year results, told investors it now believes it could be quite capable, two years from now, of generating 2% of excess capital a year even after retaining the capital they need to fund any growth in the business.

For a bank with a balance sheet of around £300 billion, this would equate to around £6 billion a year of capital generation. More importantly, for a Lloyds shareholder, it suggests the bank could be in position to distribute as much as 8 pence a share in dividends and share buybacks in years to come.

Given this, a share price of 140-150 pence for Lloyds looks a plausible aspiration for the patient long term investor.

Steady growth

Finally, under the current regulatory climate, UK banks are increasingly likely to have the sort of growth characteristics more typical of a utility company although arguably retaining a higher risk profile.

Slower, steadier growth means a bank like Lloyds will not need to hold back as much as of its profit to fund future growth, boosting instead the amount it can re-distribute via dividends to its long-suffering shareholders.

It also means the bank may have more money at its disposal to buy back shares, including possibly part of the 33% stake still owned by the UK government.

Whilst the overall outlook for Lloyds remains rosy, there are potential headwinds.

Potential Headwinds

Uncertainty over the outcome of the UK general election in 2015 and Labour's talk of a 25% market share cap for UK banks do cast a shadow.

There is also the danger that the UK economic recovery may falter, which is of particular concern to a domestically-focused UK bank like Lloyds.

Meanwhile, any further provisions for PPI payments would lengthen the time it would take a bank like Lloyds to build up its capital buffers and delay or reduce any future dividend pay-outs.

Steve Davies co-manages the Jupiter UK Growth fund and has managed Jupiter Undervalued Assets since January 2012.

In the three years to the end of January 2014 the fund has returned 42% versus a 27.7% rise in the FTSE All Share.

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Steve Davies
Steve Davies
48/182 in Equity - UK (All Companies) (Performance over 1 year) Average Total Return: 8.44%
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