Bank on Britain

02/17/2006 12:00 am EST


Don Phillips

Managing Director, Morningstar, Inc.

Don Phillips’ Morningstar may be best known for its coverage of mutual funds, but the firm now covers 1,800 stocks in 130 industries. Here, analyst Ganesh Rathnam looks at a trio of banks in the UK market that he considers in "the bargain bin."

"Among foreign banks, our most-compelling ideas are Allied Irish Banks (AIB NYSE), Barclays (BCS NYSE), and Lloyds TSB (LYG NYSE). All three banks share some common characteristics. Their primary operations are in the decidedly under-appreciated UK banking market, they have strong corporate governance standards, and they have returns on equity greater than 20%. The management teams of all three banks are compensated for delivering economic profits and total shareholder returns (dividends plus capital appreciation) measured on a multi-year rolling basis. The chairman and CEO roles are split. Total compensation is very modest, especially when compared to US peers, and options dilution is minimal.

"Allied Irish Banks is one of our favorite international banks. Ireland's phoenix-like rise is not the only reason for Allied Irish's success. Competition in Ireland is limited to five big banks, dominated by Allied Irish and Bank of Ireland. Allied Irish focuses on the basics of running a good bank collecting deposits, controlling credit quality, diversifying among different sectors and keeping costs low. Non-performing loans and charge-offs are minuscule.

"Despite Barclays' current struggles in the UK retail banking market, we like its collection of diverse businesses and strong market positions. Barclays boasts a world-class investment bank that specializes only in debt, allowing for rapid innovation and introduction of new products to capture trends early. Barclays' card businessa business where scale bestows tremendous advantages is the biggest in Europe, propelled by affinity marketing programs.

"But perhaps most exciting is Barclays' asset management division, spearheaded by its stable of ETFs. Though it contributes just 7% of operating profits currently, asset management is a wide-moat business with above-average growth potential. All the while, management has taken stern measures to bolster the cash cow banking business by hiring new managers like Deanna Oppenheimer, credited for turning around Washington Mutual’s retail bank.

"Lloyds TSB is scaling down its overseas operations to concentrate solely on its home market in the UK. We applaud management's courageous decision to eschew acquisitions, but this is not to say that management has totally given up on growth. Lloyds has stepped up the cross-selling of products in an effort to grab ‘wallet-share’ after identifying such opportunities. For example, it discovered that its insurance customers didn't have Lloyds as their mortgage bank and vice versa. Growth from these initiatives requires no additional capital and will directly impact measures such as returns on invested capital, our litmus test for a company. The bank pays out 75% of its net income as dividends to enforce capital discipline."

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