Lloyds' return to form will be worth the wait

Lloyds Banking Group’s long-suffering shareholders shouldn’t phone their broker yet. After three years of turbulence and a share price still 88 percent off its 2007 peak, they have been handed another ostensibly duff set of annual results. But the investment case for holding the shares is much clearer than for the other UK state-dominated bank, Royal Bank of Scotland.

That may not be readily apparent just now. Lloyds made a 2.8 billion pound net loss in 2011 and said income in 2012 would dip below last year. Chief executive Antonio Horta-Osorio says his 12.5 to 14.5 percent return on equity target will take longer to achieve. And there is still no clarity on dividends.

Yet Lloyds fundamentally has something going for it. A 3.2 billion pound provision as penance for mis-selling payment protection insurance won’t reoccur. The bank is closer to throwing off its European Commission-mandated shackles from 2008 than RBS: Lloyds is now permitted to pay dividends, and risky HBOS legacy assets and wholesale funding have been shrunk quicker than expected.

Strip the bad bank inside Lloyds away, and the core operations are already generating 6.3 billion pounds of pre-tax profit, on 243 billion pounds of risk-weighted assets. Assuming Lloyds has a 10 percent core Tier 1 ratio, its continuing business is therefore already generating roughly an 18 percent post-tax return on equity. In other words, Lloyds has a powerful money-making engine.

The snag is that the engine is currently running on very low-octane fuel. Lloyds is heavily geared to the domestic economy, and its assumption of flat real UK GDP and low base rates until 2013 will hit demand for loans. Worse, Lloyds thinks higher wholesale costs could erode the net interest margin at the same 14 basis point rate as in 2011. A 200 million pound increase in annual cost savings might compensate for anaemic top-line growth, but dividends still look some way off.

Still, battered investors have something to cling to. Their bank has a dominant market share which the UK’s Independent Commission on Banking has not seriously eroded. If the core bank can be unshackled, the shares would deserve to be trading at 1.5 times book. Continuing losses from the restructuring obscure that. But if investors can hang on, salvation should eventually come.