Shares in focus: Should you avoid the TSB float?

It’s no exception to my IPO golden rule, says Phil Oakley.

The market for new share issues, or initial public offerings (IPOs), is booming. But this is not necessarily good news for investors. Too often, IPOs are designed to maximise value for the seller and leave little or nothing on the table for the buyer. Brokers and advisers love them, because they earn fat fees.

I have a simple rule when it comes to IPOs and that is to buy when the government is selling and avoid all others. The experience of Royal Mail and some very pricey recent IPOs bears this out.

That said, TSB looks like it is going to be priced more realistically than many others. Could it be one of the few exceptions that breaks my rule?

After the bungled attempt to sell some of its branches to the Co-operative Bank, Lloyds Banking Group is selling them on the stock exchange instead, branded as TSB.

Investors can now subscribe for shares. TSB used to be known as the bank that liked to say ‘yes’. But should you say the same and sign up for some shares?

How has the business fared?

The rescuing of Lloyds by the government back in 2008 counts as state aid under EU rules. To get round this, Lloyds is having to sell off some of its business in order to increase competition. So 25% of TSB (125 million new shares) is being sold to investors. The remaining 75% of the bank will have to be sold off by the end of 2015.

TSB has 4.5 million customers and 631 bank branches across the UK. In many ways it is a throwback to the old days of banking.

There’s no fancy investment banking going on here. Instead, the focus is on the relatively unexciting tasks of taking in money from current and savings accounts (depositors) and lending it out to borrowers who want mortgages, personal loans and credit cards.

This may seem rather boring to some, but as far as investors are concerned, banks should be boring because it makes them less risky. If all goes well, a bank such as TSB should make more interest from its borrowers than it pays to its depositors.

On top of that it should have plenty of equity to absorb any loan losses if the economy turns down. This should then allow it to make a modest return on shareholders’ money where most of it is returned to them by way of a dividend.

So far, TSB scores quite well – but when it comes to shareholder returns and dividends, it still has a lot to prove. TSB gets most of its interest income from mortgages. This effectively makes the bank a play on the health of the British housing market.

It has received a nice boost in the form of £3.4bn of mortgages lent to it by Lloyds, which is intended to boost profits by £220m over the next four years. Whether it will still have these mortgages after 2017 is by no means certain.

A slight problem for TSB is that a fair-sized chunk of its mortgages are paying interest capped at 2% above the Bank of England base rate (0.5%), which means it doesn’t make as much profit as it could do. It is hoping to sell more profitable fixed-rate mortgages in future.

But just how risky are TSB’s mortgages? High house prices and overstretched customers have burned investors in banks before. It is slightly worrying that 45% of TSB’s mortgages are interest-only, which means that if house prices crash, the people who took out these mortgages could find that they can’t repay them.

That said, the average loan-to-value (LTV) ratio of these mortgages is 45%. Eighty per cent of them have an LTV of less than 80%. Currently, these loans look reasonably safe.

However, mortgages are a key part of TSB’s growth strategy. It wants to grow its loans by 40%-50% over the next few years.

With house price affordability looking stretched even at today’s low interest rates, it’s difficult to see demand for mortgages soaring when interest rates start to rise. TSB will hope to take market share from other lenders.

It might be able to do this as it currently has plenty of reserves to aid expansion. It will also look to win more current-account customers, but may have to offer higher interest rates to woo them.

How are the finances?

TSB’s finances are a doubled-edged sword. It is very well funded. It has lots of equity to absorb any potential losses and, unlike Lloyds, can finance all its loans with customer deposits.

Unfortunately, TSB doesn’t make enough profit to make an acceptable return on its big equity buffer (a high return on equity, or ROE). It’s difficult to work out how much return it is making, but our guess is less than 10%, which is not very good.

That’s true for most banks though. In the past they have only been able to earn high returns by borrowing more money and taking on more risk, but regulators won’t tolerate that approach these days.

As for TSB, a low return on equity might be acceptable if it was all paid out in dividends. Sadly for TSB shareholders, they won’t get one until 2017 at the earliest. However, retail investors will get one free share for every 20 subscribed for – up to a maximum of £2,000.

Should you buy the shares?

Low returns should command low stockmarket valuations. It looks like this will be the case with TSB. At the middle of its valuation range – 255p – it would have a price-to-book– (net asset) value ratio of 0.8. This is about right, but does not mean the shares are cheap.

The other important point is that the remaining three-quarters of the company will have to be sold by the end of 2015. So anyone buying shares in the upcoming flotation will have to cope with a lot more shares coming on to the market. That doesn’t bode well for the share price.

All in all, TSB shares don’t really look that tempting. Growing its profits and returns is far from easy; there is no dividend and there are lots more shares to be issued. We’d steer clear.

However, if you want to buy some, then get in touch with your stockbroker. The offer closes at 5pm on Tuesday, 17 June.

Verdict: avoid

Key information
Offer price 220p-290p
Market capitalisation £1.1bn-£1.45bn
Net asset value (March 2014) £1.58bn
Price-to-book-value ratio 0.7-0.92 times
Equity as % of total assets 5.9%
Loans to deposits 99%
Dividend yield n/a