Lloyds Banking Group plc (NYSE:LYG) Q2 2023 Earnings Call Transcript

Lloyds Banking Group plc (NYSE:LYG) Q2 2023 Earnings Call Transcript July 26, 2023

Lloyds Banking Group plc beats earnings expectations. Reported EPS is $0.11, expectations were $0.09.

Operator: Thank you for standing by. And welcome to the Lloyds Banking Group 2023 Half Year Results Call. At this time, all participants are in a listen-only mode. There will be presentations from Charlie Nunn; and William Chalmers followed by a question-and-answer session. [Operator Instructions] Please note, this call is scheduled for 90 minutes and is being recorded. I will now hand over to Charlie Nunn. Please go ahead.

Charlie Nunn: Thank you, and good morning, everyone. And thank you for joining our 2023 half year results presentation. Another dynamic media morning for us to do our results. I’ll begin with a short overview of the Group’s financial and strategic performance. I’ll also highlight some of the actions that we’re taking to support customers given the ongoing changes in the macroeconomic environment. William will then provide the usual detail on our financials. And following a brief summary, we’ll take your questions. Let me begin on slide three. The external environment continues to change significantly with persistently high inflation and higher-than-anticipated interest rates. Against this backdrop, I’d like to take away four key points from the presentation today.

Firstly, uncertainty for our customers has increased given the changes in the external environment. To this end, we once again stepped up our support for customers, especially for those most in need. I’ll discuss specific actions we’ll be taken shortly. Secondly, in line with our guidance, our Q2 profits and net interest margin have stepped down versus our first quarter. This is due to the continued low margins on mortgages, as well as passing on more to our savings customers. However, the Group is performing well and our financial performance remains robust. As you’ll hear later in the presentation, we’ve either reconfirmed or slightly enhanced our guidance for 2023. Thirdly, we’re making good progress on delivering our strategy.

We remain on track to deliver the strategic benefits we laid out in February of last year for both 2024 and 2026. This is despite a more challenging environment, and as a result, slower growth in AIEAs. Our performance in other income in the first half shows positive business momentum and is an example of the progress we’re making. And finally, as we look ahead, our capital position and financial strength, together with our prudent approach to risk positions us well. Regardless of future uncertainties, we are well placed to support our customers, safeguard deposits, support the U.K. economy and continue to deliver for our shareholders. On slide four, I’d now like to highlight how we’ve delivered for our customers and other stakeholders in the first half.

We’re playing our part to provide proactive and targeted support for customers through a period of increased uncertainty, whilst ensuring we provide good and fair outcome for all. Increasing mortgage rates are a notable area where customers across the industry are experiencing challenges. To mitigate this, we proactively contacted over 200,000 customers, most affected to offer additional support. We’ve also committed to the Government’s Mortgage Charter and offer product transfers for all residential mortgage customers, even if they’re in arrears. We’re also keen to ensure that our deposit customers benefit from rising rates with a range of attractive savings options. We’ve used our significant reach to proactively encourage 10 million customers to review their savings free through prompt within our mobile app, contributing to 1.9 million new savings accounts being opened in the first half of 2023.

Our proactive support also extends the businesses, providing more than 550,000 customers with guidance on how to build their financial resilience. It should be noted that we continue to see significant resilience across our portfolio with customers adapting to the environment. However, we deem these actions appropriate, prudent and aligns to our purpose of helping Britain prosper. We also remain highly focused on our broader stakeholder objectives, such as building an inclusive society and supporting the transition to a low-carbon economy. For example, in the first half of the year, we announced a new goal to double the representation of colleagues in senior roles with the disability by 2025. And we continue to make great strides on our green financing initiatives.

Our continued support for customers and other stakeholders is made possible by our robust financial performance. On slide five, I’ll provide a brief overview of the trends that influenced our second quarter results. The Group is performing in line with expectations. We reported a net interest margin of 314 basis points in the second quarter, consistent with guidance provided earlier in the year given expected headwinds. Customer deposits of GBP470 billion reflect a resilient performance in a competitive market and amidst the continued shift in mix across the industry. Our second quarter return on tangible equity of 13.6% was lower than Q1 as expected, but demonstrates that the Group is performing well and provides us with confidence for the full year.

As a result of this confidence, we have today announced an interim ordinary dividend that is 15% up on the first half of last year and represents an attractive return for shareholders. William will provide more information on how we expect financial performance to develop over the second half of the year, including our enhanced 2023 guidance. I’ll now briefly discuss our strategic progress, starting with slide six. We’re now in the second year of our five-year strategic transformation and halfway towards our first strategic milestones at the end of 2024. You’ll recall that at the full year, I highlighted that in 2022, we prioritized reorganizing the Group and laying the foundations for our strategic success. Having achieved this, we’re now building momentum across our strategic initiatives.

This is supported by continued investment with a further GBP0.6 billion invested in the first half of the year, bringing the total to GBP1.4 billion of additional strategic investments to date. I’m pleased to say that we are on track to deliver against our 2024 strategic outcomes, and in some cases, have already surpassed these. This is translating into financial benefits, which will grow more meaningful in future periods. We’re on course to deliver the circa GBP0.7 billion of additional revenues from strategic initiatives by 2024, as well as the GBP1.2 billion of gross cost savings target that we increased at the full year. On slide seven, I’ll highlight some examples of the strategic priorities we’ve delivered in the first half. Our strategic pillars are focused on driving revenue growth and diversification, strengthening cost and capital efficiency, and maximizing the potential of our people, technology and data.

We’re making good progress across our priority growth areas. This includes further increasing our unrivaled level of digital engagement. We’re now operating with 20.6 million digitally active customers, surpassing our original target of greater than 20 million by the end of 2024. We’ve also made good progress in developing our mass affluent offering in the first half, including the rollout of ready-made investment and tiered savings propositions. We’re attracting new customers and increasing balances, and expect to build greater momentum as we develop the offering further. Our enablers are critical to both our execution efforts and ensuring that we deliver a more cost efficient and less capital-intensive business. We’ve now reduced our office footprint by around one-fifth since the start of the plan.

Actions such as these have supported the delivery of approximately 50% of our 2024 gross cost savings target to-date. Finally, we’re increasing the number of new hires in both technology and data as we continue to improve our ways of working to better unlock the potential of our people. Turning now to strategic delivery on slide eight. Our progress to-date increases our confidence in successfully executing our strategic transformation. In addition to our achievements in the first half, we have a clear pipeline of deliverables for the rest of 2023. This includes launching a new dedicated offering to support our mass affluent ambition, as well as investing further in our markets capabilities to improve our competitiveness, support more client needs and deliver other income growth.

Alongside customer focus developments, our disciplined approach to cost and capital efficiency will remain unchanged. We’ll continue to progressively modernize our technology and data capabilities. I’ll now end my opening remarks on slide nine with a look ahead to future updates. As a reminder, it is our intention to provide you with a series of deep dive seminars over the coming 12 months, focused on four priority growth areas. They’ll provide you with an opportunity to hear more from the respective management team and to spend more time focusing on our progress to-date and our vision for the future. We’re really excited about sharing our ambitions with you and hope that you’ll join these sessions starting in October with a look at our consumer franchise.

Thanks, listening. I’ll now hand over to William for the financials.

William Chalmers: Thank you, Charlie. Good morning, everyone, and thanks again for joining. Let me start with an overview of the financials on slide 11. As you heard from Charlie, the business delivered a robust financial performance in H1 and in Q2. Statutory profit after tax of GBP2.9 billion is up 17% on the prior year. Return on tangible equity was 16.6%. Net income is up 11% year-on-year, supported by a margin of 318 basis points and growth in other income. Total costs including remediation of GBP4.5 billion are up 5% year-on-year, in line with expectations. Asset quality is resilient. The impairment charge of GBP662 million equates to an asset quality ratio of 29 basis points. Tangible net assets per share were 45.7 pence, down slightly in H1 given the sharp movement in rates in Q2.

Capital generation of 111 basis points was strong and supported our increased interim dividend. With that, I’ll turn to slide 12 to look at the customer franchise. The customer franchise continues to be resilient. Total lending balances stand at GBP451 billion, down slightly in the second quarter. Retail balances were essentially flat in the quarter, as the small reduction in mortgages was largely offset by continued growth in Cards, Motor Finance and Loans. Commercial banking balances were down GBP1 billion in the quarter, continue to see net repayments significantly relating to government guaranteed loans. Total deposits stand at GBP470 million. Performance was resilient with retail essentially flat in the second quarter and commercial down GBP2.9 billion, the latter driven by expected short-term placements flagged to Q1.

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Alongside, we continue to see steady growth in insurance with around GBP1.4 billion of net new money in the quarter. Turning now to net interest income on slide 13. Net interest income performance was strong in H1. NII of GBP7 billion in the first half is up 14% year-on-year, although stable on H2 last year. Average interest earning assets were down slightly in the quarter, small reductions in the mortgage book and commercial banking were partly offset by growth in the other lending portfolios. Net interest margin of 318 basis points in the half includes 314 basis points in the second quarter. This fell 8 basis points from Q1, given the mortgage and deposit pricing headwinds that we called out at that time. Having said that, base rate changes were stronger than we expected then, implying a step down in margin was a little less.

Looking forward, we expect AIEAs for 2023 as a whole to be slightly lower than Q4 2022 as the unsecured growth is offset by lower mortgage balances and repayment of government guaranteed loans. We now expect the margin for 2023 to be greater than 310 basis points. We’re forecasting a peak base rate of 5.5%, significantly ahead of our previous expectations. This will support the margin through H2, in particular, driving stronger hedge income. Going the other way, mortgage margin pressures and deposit mix shift are both expected to continue in the second half. Non-banking NII was about GBP80 million in Q2. This is driven by volumes within our non-banking businesses, as well as rates. Given the increase in rates seen in Q2 and increasing levels of activity, we expect non-banking NII funding costs to increase slightly from here and the run rate to be slightly higher, therefore, in the second half.

Now moving on to the mortgage portfolio on slide 14. The mortgage book is resilient and now stands at GBP306 billion. The open book is down GBP1.7 billion in H1, partly due to the legacy portfolio sale in the first quarter. The back book continues to run down and is now around GBP39 billion. Customers continue to refinance their mortgages given higher rates. Indeed, we are actively supporting them in doing so. Mortgage pricing remains competitive. Front book maturities rolled off at about 180 basis points in Q2, while completion margins remain at around 50 basis points. We expect mortgage margins to remain around this level through the second half, but of course, that will depend upon swap rate volatility and indeed margins in other parts of the balance sheet.

That said, mortgage lending remains attractive from a return and an economic value perspective. Let me now look at the other lending books on slide 15. Consumer balances are performing well. Balances were up GBP1.8 billion in the half, including GBP1 billion in Q2. We continue to see credit card spend recovery, although repayments are still somewhat dampening interest-bearing balance growth. Motor Finance is up GBP0.6 billion in the half as industry supply issues continue to ease. Within Commercial, Corporate & Institutional is up GBP0.6 billion, including client growth alongside FX impacts. As said previously, government-backed borrowing repayments alongside limited customer demand are impacting the net SMB performance. We expect this to continue.

Now moving on to deposits on slide 16. Deposit performance in the half has been solid. Total customer deposits of GBP470 billion are down 1.2% in the half or GBP5.5 billion. Retail deposits were down GBP4.9 billion in H1 and essentially flat in Q2 with current accounts down and savings up. The retail current account reduction in Q2 was a smaller movement than we saw in Q1. This reflects inflationary spend pressures, offset by wage increases and transfers into savings as customer behaviors evolve. We estimate around GBP4 billion of current account outflows or around to-thirds have been retained within our savings proposition. Supported by this retention activity alongside new money, retail savings balances were up GBP3.1 billion in H1. Commercial deposits were flat across the half, albeit decreasing GBP2.9 billion in Q2.

Notably, while this reflected expected outflows of some short-term placements from Q1, Business Banking current accounts were much more stable in Q2. Recognizing that it’s a fast-changing environment, we continue to expect total deposits to be broadly stable from here through the second half of 2023. Having said that, the mix shift to term savings is likely to continue. As you know, the performance of our deposit franchise supports the structural hedge. I’ll now look at this further on slide 17. Our structural hedge remains a significant tailwind to earnings. Today, the structural hedge capacity remains around GBP255 billion. The notional balance is fully invested. As you know, we manage the hedge prudently and maintain a buffer of hedgeable balances outside of the approved capacity.

Given the deposit movements highlighted, this buffer is reduced. Accordingly, assuming deposit movements continue into H2, we expect a modest reduction in the hedge notional balance. This will be managed out of upcoming maturities. That said, the circa 1 percentage point movement in the curve over the last quarter means the expected income effects of this are negligible. The hedge will continue to provide a very material and a consistent income tailwind looking forward. In H1, we saw gross hedge income of GBP1.6 billion, an earnings rate of around 1.2%. Looking forward, we expect hedge income will be around GBP0.8 billion higher in 2023 than 2022, with a similar increase again in 2024. Now moving to other income on slide 18. We continue to build confidence in our growth potential in other income across the franchise.

Other income of GBP2.5 billion in the first half includes GBP1.3 billion in the second quarter. Retail is seeing improved current account and credit card performance alongside a growing contribution from Motor Finance. Commercial other income benefited in the first half from improved performance in markets and a successful bond franchise. Insurance, pensions and investments saw improved performance in life and pensions, general insurance and stockbroking, together driving higher income in H1. The operating lease depreciation charge of GBP356 million in the half included GBP216 million in the second quarter. After two years of low charges during the pandemic, it is now normalizing. It picked up in Q2 as a result of higher value new vehicles and lower gains on sale, growth from the Tusker acquisition and an adjustment to take account of recent price declines in electric vehicles.

As we look forward, we expect operating lease depreciation to be broadly stable at the Q2 level through the rest of 2023, with EV prices steady but offset by growth in business volumes and normalizing car prices. Overall, we expect other income to continue to develop, supported by our ongoing franchise investments. This is, of course, dependent on activity levels, but the underlying business trends are favorable. Moving on, let me focus on costs on slide 19. Cost management remained very close to our heart. Operating costs of GBP4.4 billion for the half are up 6%, given our planned strategic investments, the costs associated with our new businesses and inflation. This gives us a cost income ratio of 48.8%. In the context of persistent inflationary pressures, we remain focused.

We are on track to deliver operating costs of circa GBP9.1 billion in 2023. Alongside, remediation remains low, just GBP70 million in H1 and GBP51 million in Q2. Looking now at impairment on slide 20. Observed asset quality is resilient. This reflects our prime customer base and our prudent approach to risk. The GBP662 million charge in the first half is equivalent to an asset quality ratio of 29 basis points in line with our guidance. First half includes a small charge of GBP5 million in respect of updated macroeconomic scenarios alongside of GBP657 million underlying charge. GBP419 million in the second quarter includes GBP84 million for updated economics. Excluding this, the pre-MES quarterly charge of GBP335 million is stable on Q1 and on Q4.

Most of this includes both the Stage 1 provision roll forward into a more adverse economic environment and bank base rate effects on recoveries, which do not represent actual defaults. Together, this equates to an AQR of 29 basis points, again, in line with guidance. Our stock of ECLs increased marginally in the half to GBP5.4 billion. This provides coverage of 1.2% across the portfolio. Away from the assumptions, we are seeing sustained low levels of new to arrears. Importantly, 92% of our Stage 2 balances are up to-date. Alongside, Stage 3 balances were broadly stable during H1 and Q2. Based on our latest projections, we continue to expect the net asset quality ratio for 2023 to be around 30 basis points. Given the importance of our macroeconomic assumptions, the impairment outcome, let me now briefly look at our updated base case on slide 21.

Overall, we see 2023 as better than expected at Q1, but slower growth thereafter, partly down to higher rates. We now expect base rates to peak at 5.5% in Q3 this year and for inflation to reduce more slowly than previously anticipated. We expect unemployment to remain low, but forecast a gradual increase to around 5.3% by 2025. After strong house price growth in 2022, we now model HPI declining 5% in 2023 and see a peak to trough decline of around 12%. Moving on, let me now turn to slide 22 to look at the performance across our lending portfolios. Performance across our portfolios is consistently reassuring. We’ve seen a modest increase in new trades in mortgages and to a lesser extent credit cards. However, this is from a very low base.

The trends in most portfolios remain similar to or favorable to pre-pandemic levels. We continue to see stable trends in SME overdrafts. Alongside, RCF utilization remains more than 30% below pre-COVID levels. We have a very high quality commercial portfolio. Around 90% of SME lending is secured, whilst more than 75% of commercial exposure is to investment-grade clients. We also have a modest and well-diversified commercial real estate portfolio. Net exposure after significant risk transfers is around GBP11 billion and lending is focused on cash flows. 80% of the book has interest cover of 2 times or more. The average LTV of the portfolio is 44%, while around 91% have an LTV below 70%. Given the focus on mortgages in recent weeks, let me now turn to slide 23 to give some further insight on the strength of that business.

The mortgage book is very resilient. We’re seeing a modest increase in new to arrears, but again from a very low level and overall remaining below 2019 levels. The increase is also focused on the legacy predominantly variable rate business originated in 2006 to 2008. This legacy book now has an average LTV of 34%, an average loan size of around GBP100,000. Over two-thirds of this book are on variable rate products and so have been dealing with progressively higher rates for over a year now. Arrears remain at low levels and have stabilized over the last couple of months. The rest of the book remains very resilient with just 0.2% new to arrears. The average household income in our portfolio is over GBP75,000 per year. And in this context, average payments for customers refinancing on the fixed rate since October of last year have increased by GBP185 per month or GBP2,200 per year.

Looking forward, in H2 and 2024, an average capital repayment mortgage moving to a 6.5% pay rate from a fixed rate of 2%, we’ll see the customer paying an additional GBP390 per month. Our affordability testing in recent years means customers refinancing in 2023 have, in fact, been tested to over 6.5%. Most customers are funding these levels manageable. For any that have difficulties, we will, of course, support them. Alongside, our customers have significant equity in their homes. The average loan to value of the portfolio is 42% and 92% of the book is below 80% LTV. Putting this all together, based on our client profile, our lending criteria and security and testified to by our experience, mortgage portfolio is very well positioned for higher interest rates.

Let’s now move to slide 24 and the below-the-line items on TNAV. Underlying and statutory profit continue to be convergent. Restructuring costs of GBP25 million reflect only M&A and integration costs. The volatility line includes GBP182 million of negative insurance volatility, largely driven by higher interest rates in the second quarter. Taken together, statutory profit after tax of GBP2.9 billion and the return on tangible equity of 16.6% in the first half constitute as set a robust performance. Looking forward, driven by both income performance and TNAV, we now expect the RoTE for 2023 to be greater than 14%. Turning to TNAV, tangible net assets per share were 45.7 pence, down 0.8 pence in the half, including 3.9 pence in the second quarter.

The quarterly movement is significantly driven by higher rates impacting the cash flow hedge reserve. As we look forward, we continue to expect TNAV per share to grow as it benefits from the unwind of current headwinds over the medium-term. Now turn to slide 25 and looking at risk-weighted assets and capital. We have seen strong capital generation so far in 2023. Risk weighted assets ended the half at GBP215 billion, up GBP4.4 billion. This includes a GBP3 billion impact anticipated from CRD IV models and remains in line with our 2024 expectation of GBP220 million to GBP225 billion RWA. Capital generation of 111 basis points in the half was, as said, a strong result. This is after taking the full GBP800 million fixed pension contribution in Q1.

If we deduct the CRD IV mortgage model changes and the phased unwind of IFRS 9 relief in January, capital generation was 75 basis points in the half. The closing CET1 ratio of 14.2% is also after 21 basis points for the acquisition of Tusker and 44 basis points dividend accruals. We have a very strong capital position, well ahead of our ongoing target of around 13.5%. You will have also seen the Group passed the recent stress test comfortably. The strength of the Group’s capital position and prospects enables the Board to announce an increased interim dividend of 0.92 pence per share, up 15% on last year. As usual, we’ll consider further capital distributions at year-end. We continue to expect capital generation for 2023 even after CRD IV and the phased unwind of IFRS 9 relief to be around 175 basis points.

This represents a very healthy level of capital generation from a strong business. I’ll now move on to slide 26 to wrap up the financials. In summary, the Group has delivered a robust financial performance in the half. Strong income and resilient credit trends support capital generation of 111 basis points and an increased interim dividend. Looking forward, we are enhancing our guidance for 2023 and now expect the net interest margin to be greater than 310 basis points. Operating costs to be around GBP9.1 billion. The asset quality ratio to be circa 30 basis points. The return on tangible equity to be more than 14% and capital generation to be around 175 basis points. In a changing external environment, the Group consistently performs well.

That concludes my comments for this morning. Thank you for listening. I’ll now hand back to Charlie to wrap up.

Charlie Nunn: Okay. Thanks, William. So to recap, the Group continued to deliver in a changing external environment. These changes have increased uncertainty for our customers and in response, we’ve been proactive in providing support where necessary, in line with our purpose of helping Britain prosper. At the same time, the Group is performing well. This includes a robust financial performance in the first half of the year, which supports enhanced guidance for 2023 and continued delivery on our strategic ambitions. Our confidence in the future is increasing and we expect to achieve both the revenue and cost benefits that we laid out at the start of this plan. This will drive higher, more sustainable returns and capital generation.

Taken together, our purpose-driven business, financial strength, resilient franchise and continued strategic execution, enable the Group to better support customers both now and in the future. Thanks for listening. That concludes our presentation and we’re now happy to take any questions.

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Q&A Session

Operator: Thank you very much. [Operator Instructions] Our first question today is from Guy Stebbings from Exane BNP Paribas. Your line is unmuted. Please go ahead.

Guy Stebbings: Hi. Good morning, Charlie and William. Thanks for taking questions. And really around the deposits, the hedge and margins. So I come back to the guidance on the hedge contribution this year being unchanged versus prior guidance despite the higher swaps. Can you help us think a little bit more in terms of what all the notional banks the hedge you’re expecting and how this differs with the prior views? I think shortly after Q1 results you’re talking quite positively about deposit mix or has that mix has got deemed during the quarter, even more and more attractive term deposits on off, et cetera? And in that context, you see the quantum of outflows in current accounts and commercial deposits in Q2 is a substantial [ph] run rate as we look forward or would you expect that to moderate?

I don’t know to share the size of the hedging buffer now. And then just a sort of final big picture margin question. Thanks for the headline guidance revisions. Previously, you supplemented that with saying no quarter below [inaudible] that door has moved up at all alongside the full year guidance or still sits as it did before? Thank you.

Charlie Nunn: Guy, just before we get going, can I just ask you to repeat the last question? I didn’t quite catch it.

William Chalmers: The floor of 300 basis points…

Guy Stebbings: Last question…

William Chalmers: Yeah. Go ahead, Guy. I think I’ve got it, are we saying is that leading up as well, the floor of 300 basis points that we guided to in Q1.

Charlie Nunn: Yeah. Thanks.

William Chalmers: I think, Guy, most of that fall in…

Charlie Nunn: Sure. Happy to…

William Chalmers: I mean.

Charlie Nunn: Guy, thanks very much indeed for the question. In terms of modest reduction, we didn’t define the term precisely, of course, but modest reduction is single digits, we expect. So let’s see how we fare, but single digits, I think, is a decent guide. In terms of deposit performance, I think, overall, actually, the deposit performance has been pretty pleasing, as I said in my comments, solid in Q2. So if you look at Q2 overall, it’s down about 1%, about GBP3.3 billion. Within that, you’ve basically got flat retail performance and you’ve got a slight reduction in CBE. But actually, the reduction in CBE was very substantially composed of the short-term placements that we flagged at Q1 and expect it to come off in the course of Q2.

Looking within that retail flat performance, as I said, balance is overall flat. We saw PCAs down a nudge. We saw savings up. But actually, if you look at the flow of PCA, the PCA performance in Q2 was slightly stronger than it was in Q1. Both outflows to be clear, but about GBP2.7 billion in Q2 versus over GBP3 billion in Q1, so actually a flattening off in terms of PCAs. When we look at that overall, that gives us a view that as we look into H2 and just get the third of your questions, that we’ll expect to see customers continue to make choices as to where they put their savings in the course of Q2 and we expect movements from PCA into savings to continue in Q2. But overall, in the context of fewer bank base rate changes than perhaps we’ve seen in H1, we would expect to see fewer prods, if you like, to those customers to instigate deposit movements going forward into the second half.