The Anglo File: Lloyds Goes Shopping, but the Selection Looks Limited

The company will probably end up acquiring a European bank, but that could result in a legal nightmare.
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LONDON -- Most people with money to spare pop it in the bank. Sir Peter Ellwood, the CEO of Lloyds TSB Group, does indeed have an enormous amount of spare cash, but deciding where to put it is proving to be a difficult decision.

Lloyds is generating surplus capital in the order of about $160 million a month. The market believes this buildup in excess capital should be redeployed in value-enhancing acquisitions and, in anticipation of this, Lloyds' shares are trading at a premium to both the U.K. and European bank sectors.

Lloyds is trading at seven times net asset value, and over the past three months, the bank has outperformed the

FTSE 100 Share

index by 19%. On Monday, the shares closed up 1.4% at 981 pence.

Hopes for an acquisition were boosted over the weekend by encouraging noises from Ellwood. At a conference and in a newspaper interview last week, the CEO repeated what Lloyds stated in its interim results last year: It intends to make its next major strategic move within 18 months.

The problem for Ellwood and his gang is that the list of suitable candidates is a very short one indeed.

Home Sweet Home

Ideally, Lloyds would like to make an acquisition in the U.K. The problem with this is that with only four major clearing banks -- of which Lloyds is one -- operating at home, the competition authorities are unlikely to be impressed with a merger between, say,

Barclays

(BCS) - Get Report

and Lloyds. And rather than softening their attitude, the authorities are actively trying to encourage more competition.

Alternatively, Lloyds could look to a smaller target such as

Northern Rock

. However, Lloyds has a market capitalization of $83 billion compared with Northern Rock's measly $2.6 billion. According to James Hamilton, analyst at the British brokerage

Charterhouse Securities

, "In the great scheme of things, Lloyds has to buy something of a reasonable size to affect the bottom line." Charterhouse has a buy recommendation on Lloyds and has not had an investment banking relationship with Lloyds in the past three years.

Lloyds could look to the insurance sector, especially life insurance, which is the weakest link in the Lloyds chain. The performance of

Abbey Life

since it was acquired has been disappointing, and Lloyds may look to bolster this part of the business with someone like

Legal & General

.

Yet even with its massive war chest, Lloyds may find the valuations of a sector in which the cheapest buys are trading at about 30 times new business profits a little hard to swallow.

To avoid regulatory problems, Lloyds could look north to Scotland, where a new assembly will be elected in May. It remains to be seen whether the new political climate in the country will be amenable to a bank of the

auld enemy

swooping in on one of its prized assets such as

The Royal Bank of Scotland

or

The Bank of Scotland

.

National sensitivities aside, one of these two well-run and profitable banks would make an attractive partner. Yet the fact that they are both regional concerns would provide Lloyds with little in the way of cost-cutting opportunities, something that may not sit well with the bank's philosophy of creating shareholder value.

Ellwood said last week that Lloyds is still looking at possibilities in the U.S., and Ian Poulter, analyst at investment bank

Williams de Broe

, believes that, in the longer term, Lloyds may look to buy a large U.S. insurer. Williams de Broe has a buy recommendation on Lloyds and has not had an investment banking relationship with the bank in the past three years.

However, it is unlikely that Lloyds would follow the lead of

Deutsche Bank

(DTBKY)

and try to get into investment banking, with the sector's low return on capital and volatile earnings.

East Is East, and West Is West

There are some tentative signs that Asia is emerging from the mess it found itself in last year. Notwithstanding the difficulties of 1998,

Standard Chartered

, a U.K. banking and financial services company with a focus on Asia, managed a very respectable 18% return on equity during the year.

Nevertheless, Standard Chartered is still trading at around three times net asset value and is looking vulnerable.

"Standard Chartered has an excellent franchise in Asia and as a first step in the region, if Lloyds could work the same magic here that it worked in the U.K., in the long term this could be a very positive acquisition," says Charterhouse's Hamilton.

However, Lloyds was rebuffed previously by Standard Chartered, and there is no reason to believe the bank is any more amenable to a deal than it was before. There has never been a hostile bid for a bank in Europe, and the chances of one now, let alone a successful one, are slim.

En Vacances

Ultimately, the most likely destination for Lloyds will be Europe, where, following the advent of the single currency, consolidation in the banking sector is picking up steam. In general, it appears that banking systems where the return on equity is low -- in France, Italy and Germany, for example -- have plenty of incentive to merge and improve their profitability ratios through cost savings.

Certainly, this is an area where Lloyds excels. Since incorporating the U.K. bank TSB in 1995, Lloyds is well on track to achieve the $650 million of merger cost savings by the end of this year, and in 1998 Lloyds had a return on equity of 33%.

Unfortunately, Europe remains far from being the Shangri-La that the number of recent mergers might suggest.

"Bank acquisitions on the continent are a political and legal nightmare, and restructuring to bring U.K. level ROEs would be a real challenge," says Neil Worsely, manager of the

Lombard Odier/Bartlett Europe

fund and a holder of Lloyds shares.

Although the inflexibility of the labor markets in Europe remains a fact of life, Lloyds' Ellwood nevertheless said last week that he is optimistic that the spate of recent mergers in Europe would lead to a relaxation of the tight labor regulations.

So should Lloyds move sooner rather than later? Perhaps. The profitability of banking in the U.K. has spawned a number of new entrants such as the

Prudential's Egg

and

Virgin

, who are bound to put some pressure on the profitability of the likes of Lloyds.

However, Europe still has a nasty habit of reverting to its bad old ways. Being stuck with an elephant and the accompanying dilution on earnings would lead to charges of adventurism from the very same investors who are so keen for Lloyds to do something soon.

Pity poor, or rather rich, Mr. Ellwood. A few years ago, he could have sat there and counted his gold coins. Now the maxim of "if it ain't broke, don't fix it" just doesn't wash anymore.