Blue Chip: Time for a horse trade

When the Bank of England warns of overheating in the mortgage market and voices concern about future trouble, investors are wise to sit up and take notice.

In its annual report last week, Governor Eddie George said that "in conceding weaker financial covenants, it is worth noting that banks may be reducing the scope for insisting on pre-emptive remedial action if borrowers encounter difficulties". In other words, banks that continue to all but give away mortgages will have only themselves to blame when the next credit squeeze occurs.

Unsurprisingly, shares in banks with the biggest exposure to the sector were off sharply. Lloyds TSB has the most to lose, and its shares fell the sharpest, by 11.5p to 316p. As well as integrating Cheltenham & Gloucester, its pounds 5bn merger with TSB faces several unresolved dilemmas. The two deals catapulted Lloyds to third in the overall league of mortgage lenders, behind the Halifax/Leeds with 21 per cent, and Abbey National/National & Provincial at 15 per cent.

Yet as Lloyds Bank, and now Lloyds-TSB, the shares have been among the best performing of any blue chip over the last 12 years. The attainment reflects the passionate commitment of chief executive Sir Brian Pitman to shareholder value. It is a simple, even brutal, maxim to live by: double capital appreciation and dividends to investors every three years. That is, for every hundred pounds invested, the investor should hold pounds 200 within three years, including dividends. Investors have seen the value of their investment grow at an average compound rate of 26 per cent a year over the last 12 years. In 1985, a market value of pounds 1.35bn had increased to pounds 8.12bn by June, 1995. Over the same period, the dividend has risen at an unrestrained compound rate of 15 per cent.

Yet Lloyds achieved this while resolutely sticking to its knitting. Unlike its high-street rivals, it has eschewed the capital intensive and risky world of share trading and global capital markets.

Few analysts have a bad word to say about the bank's well-oiled profits machine. In its latest preliminary figures, in February, the combined group reported profits of pounds 1.65bn, after a restructuring provision of pounds 425m.

But there are doubts about how long this can continue. Superficially, the deal with C&G is superb. But was it mistimed? The bank insists it is safe from calamity. It says the credit quality of C&G's loan book grants it strong protection against any downturn in the ability of lenders to repay loans.

Management has its hands full streamlining the three businesses. C&G will become a "centre of excellence" for all the group's mortgage products. But there are still obstacles to overcome. There is no news on the sale of TSB's corporate finance arm, Hill Samuel, which proved a disastrous buy under Sir Nicholas Goodison's stewardship of TSB.

Meanwhile, Lloyds has yet to finalise a strategy for its life and general insurance business. Its 63 per cent stake in Lloyds Abbey Life is a source of constant speculation. Sir Brian's team is in a quandary over how to rationalise the two groups' insurance business, with a review of LAL under way.

LAL was the central pillar of Lloyds Bank's assault on the personal insurance market. TSB, however, has its own life sales and underwriting capability. If Lloyds disposed of LAL, it would first have to disentangle Black Horse Financial Services, which it set up within LAL to sell its personal finance products.

There are factors that can help Lloyds-TSB defeat these problems. A strong management culture supports its effective presence on the high street. Unlike other banks, where talented managers dream of escaping the branches, the pinnacle of a Lloyds' manager's ambition is branch management.

A strong balance sheet will also serve it well in the current price war, although any downturn in the housing market will hit its lending book more severely than its more diversified competitors.

Some 52 per cent of its balance sheet is now tied up in mortgage lending, one analyst reckons. He adds: "Very few mortgage lenders make any money for the first year or two in the current climate."

Last year alone, the shares rose 62.5 per cent. It looks as if the bull market should be nearing its last gasp. Time, perhaps, to dismount the Black Horse while the going is still good.

Lloyds-TSB

Share price 316p

Prospective p/e* 11

Gross dividend yield 3.1%

Year to 31 Dec 1994 1995 1996* 1997* 1998*

Pre-tax profits pounds 1.30bn pounds 1.65bn pounds 2.28bn pounds 2.60bn pounds 2.90bn

Earnings p/share 22.8p 19.2p 28.0p 31.7p 35.1p

Dividend p/share 9.5p 11.0p 12.5p 14.0p 15.5p

* Forecast by Salomon Brothers