What do you make of a chief executive who says the mission of his business is “to build an inclusive society”? If he runs a margarine manufacturer, incredulity would be natural. However, Charlie Nunn is boss of Lloyds, the UK’s largest domestically-focused retail bank.
His statement, which prefaced full-year results this week, deserves applause for displaying his grasp of realpolitik.
In most countries, retail banks are quasi-public institutions ordinarily financed with private capital. They can expect government bailouts if they screw up. Complete collapses would threaten financial stability. Lloyds, for example, got handouts in 2008 and 2009. The corollary is that lenders have to hold buffer capital and provide public services even as they seek private gains.
This is just one of the complexities confronting would-be investors attempting to get their heads around UK banks. The sector has produced healthy profits lately, thanks to interest rate rises. These help widen the margin between the percentage banks pay savers for their deposits and the percentage at which they lend money out to borrowers.
At Lloyds, the gap grew from 2.54 per cent in 2021 to 2.94 per cent. Net interest income accordingly jumped 18 per cent to £13.2bn.
Impairments are the bluebottles in the calamine. Banks put money aside, in theory to cover potential loan losses. This messes with the bottom line. Lloyds reduced impairments in 2021, as the pandemic attenuated, and raised them last year as the economy faltered. Pre-tax profits were therefore £6.9bn both years, despite the interest rate bonanza in 2022.
Cynics suspect impairments also give bosses a handy way to tweak statutory profits up and down. That might be advisable if, for example, politicians and media were having a hissy fit about the level of returns.
If banking profits are unreliable guides to value, what metrics should investors look at? Since the financial crisis, they have scrutinised buffer capital carefully. If this is plentiful, the bank should be able to pay some of it out sooner or later.
The headline measure is common equity tier one capital. This is usually expressed as a percentage of risk-weighted assets. For Lloyds, the end-2022 figure was 14.1 per cent of £212bn.
Nunn has promised to reduce that to a target level of 13.5 per cent in a couple of years. Calculations on the back of an envelope suggest about £1.3bn might be handed out. That would be worth 2p per share, alone equivalent to a 4 per cent yield at the current stock price.
The real numbers should be much better than this if Nunn succeeds in raising profitability as he has promised. Even so, our simple sum points to plenty of capacity for payouts. A glance in the rear-view mirror shows that Lloyds shares have yielded an average of about 5 per cent a year over the last tumultuous decade.
Despite its size and the complexity of its numbers, Lloyds is a relatively safe, straightforward play on UK rates and the pedestrian UK economy. Lex is a perma bear on European banks, reflecting their exposure to politics and mature markets. We prefer banks elsewhere, notably the US.
But for yield-seeking sterling investors spooked by foreign currency exposure, Lloyds has homely virtues beyond its social mission.
BHP: riddle of the wriggle
It can take a century or more to become a one-year wonder. Shares in BHP, a business founded in the 1880s, have outrun peers with a 40 per cent return over the past 12 months. Thank bosses — and activists — who refocused a vast portfolio built over decades.
The new structure should continue performing well even as the commodity boom subsides. But fat returns are set to attenuate.
Investors should see big miners such as BHP as assemblages of multi-decade projects each of which costs billions. Bosses come and go, shifting emphasis between commodities and spending priorities as they do so. But the overriding goal sustained through successive tenures and asset cycles is to supply high quality metals and hydrocarbons at low cost.
Since 2015, BHP has spun out minerals grab bag South32, deconsolidated remaining oil and gas production, and swapped a dual listing for a primary quote in Sydney. Full-year results this week underscored that this is now an Australian miner of iron ore, copper and coal.
That description is admirably simple. There is more nuance to BHP’s 10 per cent dividend yield. The share price, by implication, is low. But everything is relative in the cyclical world of mining. BHP’s enterprise value — which totals net debt and market capitalisation is nearly 6 times forward earnings before interest, tax, depreciation and amortisation beats that of diversified peers.
The scale of the yield also signals that the dividend is seen as unsustainable. This, in turn, points to investor caution towards prices for iron ore, copper and metallurgical coal.
Over the next few years, expect BHP’s free cash flow to slide as it raises capital expenditure. Some of the money will go to a Canadian potash fertiliser project, Jansen. Chief executive Mike Henry is enthusiastic about the potash mine, scheduled to open in 2026. BHP — at some risk to its much-vaunted focus — believes it will produce earnings uncorrelated with those of other divisions.
Estimates service Visible Alpha forecasts group annual mean free cash flow of $12.9bn to June 2025. Dividend payouts should average about $12.8bn. That limits Henry’s financial wriggle room.
It also leaves him dependent on iron ore and copper operations accounting for 80 per cent of group ebitda. As economies normalise in the wake of lockdowns and rate rises, so will demand for these commodities. Expect Henry to let the dividend drift before he slashes investment. Investors, like BHP itself, should think in multiple years, not months.
This article has been amended to clarify that Lloyds’ target for common equity tier one capital is 13.5 per cent.
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