Lloyds Bank’s primary objective is to create value for its shareholders – by increase in the dividend and appreciation in the share price. This is the driving force behind our decisions and actions. . . . We rank each business on the basis of the shareholder value they create; each activity is viewed as a creator or destroyer of value. Businesses which consume cash and destroy value are targeted for divestment. (CEO’s Report, 1989)
Lloyds Bank was one of the success stories of the 1980s with a compound growth rate of 27 per cent (on January 1981 investment with dividends reinvested), a performance not matched by any other UK bank. During 1991 its business mix enabled Lloyds to achieve a return on assets 50 per cent higher and
dividend growth 37 per cent higher than the peer group. Its distinct structural advantages with focus on high margin, low capital intensive domestic businesses, together with its philosophy of maximising shareholder value, have made it the core bank holding of an increasing number of investment portfolios.
The group’s three basic strategies, responsible for its remarkable results, reinforce its belief in what drives value for shareholders (Figure 12.4) and its sub- targets for creating shareholder value:
(i) To achieve a net ROE greater than 18 per cent (Lloyds’ cost of capital).
(ii) To increase the dividend payout ratio.
(iii) To maintain a strong balance sheet with equity grown from retained earnings.
The objectives and methodology of value strategy and management have been debated and agreed with the bank’s senior management. The methodology is used for major strategic issues, and to a lesser extent for business unit strategies.
Below this level the approach is simplified to the objective of achieving a sustainable after-tax return on equity, which will at least equal its cost of equity.
Nevertheless, Lloyds believes that there is still plenty of scope for extending the full approach to lower levels within the organisation.
With the 1990 economic fluctuations out of the way, the benefits of the approach are clearly shown in the growth in shareholder value of Lloyds Bank compared with its peer group (which included a 35 per cent+ growth in share price during 1991). The philosophy of shareholder value, which was formulated and propagated by the current CEO Brian Pitman (appointed December 1983) places primary emphasis on creating distributable returns (free cash flow) for shareholders via profitable non-capital-intensive business.
Figure 12.4 Value drivers in Lloyds’ business
Lloyds’ strategies for creating shareholder value
Lloyds implements three basic strategies to achieve the goals stated above.
Reallocation of assets
This strategy for creating shareholder value has transformed Lloyds from a diversified international bank into a focused domestic bank. Lloyds’ policy is to focus on the strengths of the market, not necessarily domestic investment versus international activities. Although it has recently disposed of some UK assets (selling its stake in Yorkshire Bank and closing its gilts and eurobond operations) and acquired others abroad (Abbey Life in Ireland and Germany), the larger proportion of its business is in the UK.
Its 62 per cent international assets in 1981 had been reduced to 28 per cent by the end of 1990. The significantly wider domestic net interest margins reflect a large component of consumer and small business lending funded from a base of cheap retail deposits. The international segment was wholesale in orientation, geared to low margin, euro-currency and large corporate lending. Now this is focused on international private banking in those countries where Lloyds is not a major player in the retail market.
Lloyds has moved away from low margin euro-currency lending and sold international offices in the USA, Canada and Portugal. It has also enhanced value to shareholders by recognising that growth, to compensate for declining (at the time) corporate loan margins, must come from other areas, such as increasing arrangement and lending fees, and enhancement of the personal customer base (thus Lloyds’ acquisition of Abbey Life).
Lloyds estimates that its interest margin is almost 25 per cent higher than the peer group average because of its low percentage of international assets.
Seeking selective market leadership
Lloyds’ second strategic principle concerns competitive advantage. Its stated policy, which underlies its switch from international to domestic assets, is to seek selective market leadership and to avoid those markets and products where it cannot obtain a strong position. It pulled out of gilts and eurobond operations in 1987, for example, because ‘markets were overcrowded and we were marginal players’.
High margin/low capital intensive businesses
In keeping with its policy of producing high affordable dividends (distributable returns) Lloyds has sought balance sheet growth by moving away from low margin commodity lending into risk management and fee-based services.
Development of its life assurance subsidiary, Black Horse Life, began with the acquisition of a 57 per cent stake in Abbey Life, projected to generate significant
cash flow from its existing client base. This is expected to prove extremely effective in terms of capital cost regulatory requirement (cash holdback) as requirements are minimal in relation to the costs of lending under the BIS rules.
Although embedded value life profits are not technically distributable, they can be included within the group’s capital and so effectively free up banking-derived earnings for distribution.
Lloyds’ focus on high margin areas like personal and small business lending has resulted in a higher yield on its domestic assets and stronger net interest margin than its peers.
The results of Lloyds’ adherence to its strategic principles has produced amazing results since 1986 (see Figure 12.5): its pre-tax return on assets was 185 per cent better than peers in 1990 against 33 per cent in 1986.
Figure 12.5 Comparison of Lloyds with peer groups
Difficulties in implementing a value approach
The problems experienced by Lloyds in implementing VSM were primarily technical and involved retraining its own financial experts and those within the investing community to think of cash flow in terms of ‘free cash’ or ‘affordable dividends’ to shareholders rather than cash flow in the traditional sense. Lloyds’
experience with the investing community was that, with a few notable exceptions, there was little awareness of, but a lot of interest in, the value techniques. Its regular meetings with analysts and fund managers has succeeded
‘only up to a point’ in educating and convincing the investing community of the benefits of managing for value. ‘They [the investors] are convinced by the results, but not by the theory.’
Lloyds feels its value strategy can be summarised as:
(i) Ensuring profitability of ongoing businesses without going to its share- holders for more capital.
(ii) Reducing investment in those parts of the business which cannot realistically expect long-term returns which exceed the cost of equity.
(iii) Increasing investment in high return businesses.
Overall, Lloyds’ objective is to maximise shareholder value, which means
‘maximising the present value of (estimated) future affordable dividends’. It does not attempt to maximise ROE but instead to take on all business which at the margin will generate 18 per cent ROE. Lloyds believes that maximising ROE does not maximise shareholder value. Rather, it feels that success is better measured by the actual change in shareholder value over time.
When asked if it felt it would be a takeover target in the future, Lloyds’ opinion was that it would not: ‘Management is already maximising returns for shareholders.’ Indeed, if the sentiments of many of the analysts surveyed are to be believed, it is a share to buy. To quote one: ‘Lloyds Bank represents the best combination of dividend productivity and cheapness and should be the core long-term holding in portfolios’ (UBS Phillips and Drew).