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Lloyds: Net CFO negative for 2017, 2018

Analysing companies' finances and value from their financial statements using ratios and formulae
TheMotorcycleBoy
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Lloyds: Net CFO negative for 2017, 2018

#259055

Postby TheMotorcycleBoy » October 20th, 2019, 8:56 am

Hi folks,

Hopefully a very quick post. So I'm eyeing potential stocks to enter into limit orders (e.g. the kind which fall with sterling (LLOY, NXT), and the kind which rise when £ falls (ULVR, DGE)). I had a very quick scan at Lloyds Plc (LLOY). Not exactly a really exciting share, but has good DY and (IMHO) seems "unlikely to ever fail", and a big bank, I guess is kind of a moat. Continuing along these lines I fed a spreadsheet with some numbers, and whilst it's nice to see EPS and DPS grow over past couple of years, I did notice -ve net CFO, for last couple of years, and I'm currently trying to figure out the cause is, and for now that probably means a pretty low figure on my limit order list. Anyway the FA:


Since Net CFO is effectively the reconciliation of operational profit against movements in working capital and non-cash charges such as depreciation, I observe that the two big negative numbers in the "Consolidated cash flow statement" page 176 are, "change in operating assets (4,472)‌‌" and "change in operating liabilities (8673)". In explanation of the calcs. for the NetCFO, the reader is referred to note 53 page 268, for example on FY2018 Annual Report.

We can see two groups of figures which sum to the "change in operating assets" and "change in operating liabities" in the summarised consolidation in the main FS disclosures, with two very large figures given in the Note:

Note 53: Consolidated cash flow statement
(A)‌‌‌‌ Change in operating assets
Change in financial assets held at amortised cost (27,038)‌‌

(B)‌‌‌‌ Change in operating liabilities
Change in derivative financial instruments and liabilities
at fair value through profit or loss (24,606)‌‌

I'm assuming that, given their relationship to the reconciliation of profit to cash, these are presumably a Bank's equivalent of change in payables and receivables. Which seems reasonable. However it's alarming to see their effect on cash from ops. Alas I've not managed to find much information on them in the 2018's notes. Page 291 on FY2014 report, seems more illuminating since there is mention of "repos", "reverse repos", "loans to customers" etc.

So I guess that these figures reflect part and parcel of a bank's operations, however it seems fishy to me that EPS is happily rising, but cash input from business is apparently not.

Comments welcome,
Matt

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Re: Lloyds: Net CFO negative for 2017, 2018

#259083

Postby GoSeigen » October 20th, 2019, 12:38 pm

Check that the negative CFO is not just a result of adoption of IFRS 9 and 15, see note 54 in the 2018 report.

Bank operations should be strongly cash generative over the coming years as mortgage amortisation payments accelerate.


GS

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Re: Lloyds: Net CFO negative for 2017, 2018

#259110

Postby TheMotorcycleBoy » October 20th, 2019, 3:28 pm

GoSeigen wrote:Check that the negative CFO is not just a result of adoption of IFRS 9 and 15, see note 54 in the 2018 report.

Hmm. It is quite possible that this is a/the reason for the negative impacts of operating assets and liabilities (presumably Bank speak for receivables and payables). I have to admit that I know little about IFRS 9, but I think you are probably correct, it is certainly suggested here that it will have a big impact.

(An interval of time elapses whilst I recognise how little I know of accounting, particularly with regard "fair value" and "amortised cost")

So I've googled with "lloyds negative cash flow" and found precious little and next to nothing which does anymore than just confirm what I had originally seen. But from looking a tiny bit more at the "Consolidated Cash Flow Statement", I'm wondering whether my latest observation is correct, and that is, if the "negative CFO" is *mainly* due to the adoption of IFRS 9, then if we compare the cash flows records from 2016-2018, we can see that as Net CFO becomes more negative, Net cash from investing becomes more positive. This, if true (i.e. that IFRS 9 merely moves liabilities between cells), then perhaps it just then change in accounting technique that has given rise to weird state of affairs?


(Apologies for my utterly sh!te grammar)

Conclusion: you are probably right, Mr. Seigen.

Matt

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Re: Lloyds: Net CFO negative for 2017, 2018

#259111

Postby TheMotorcycleBoy » October 20th, 2019, 3:31 pm

GoSeigen wrote:Bank operations should be strongly cash generative over the coming years as mortgage amortisation payments accelerate.

What do you mean by this? Are you just referring to as home-owners repay?

(But as an aside, won't strictly well behaved retail banks be struggling a bit in these low interest days, since presumably their main source of profitability is interest payments?)

Matt

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Re: Lloyds: Net CFO negative for 2017, 2018

#259140

Postby GoSeigen » October 20th, 2019, 5:01 pm

TheMotorcycleBoy wrote:
GoSeigen wrote:Bank operations should be strongly cash generative over the coming years as mortgage amortisation payments accelerate.

What do you mean by this? Are you just referring to as home-owners repay?

(But as an aside, won't strictly well behaved retail banks be struggling a bit in these low interest days, since presumably their main source of profitability is interest payments?)

Matt



Sorry, not 100% clear there. Yes I'm talking about the principal part of the repayments which is growing as a proportion of total payment because the loan size is decreasing. I'm guessing there will be two effects: first, continued subdued lending compared to when these mortgages were issued (in the noughties boom) which will positively affect cashflows into the business and secondly, the reduction of outstanding loans on the BS which will free up capital and result in cashflows to shareholders, IMO.

Low interest rates are a problem, but as many have remarked before, and finally I am starting to agree, they cannot really fall much further and may even go up, especially if we have a hard/no-deal Brexit. Even if they don't go up, banks will raise their income in other ways -- charging for account use, for example, aka negative interest. I think there is room for significant improvement in Net Interest Margin/profit margins for the banks over coming years.


GS

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Re: Lloyds: Net CFO negative for 2017, 2018

#259152

Postby TheMotorcycleBoy » October 20th, 2019, 5:44 pm

Thanks for your remarks, GS

It would interesting to do a comparison with Barclays sometime. Alas don't have the time to do so right this minute.

Matt

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Re: Lloyds: Net CFO negative for 2017, 2018

#259315

Postby TheMotorcycleBoy » October 21st, 2019, 6:08 pm

GoSeigen wrote:Sorry, not 100% clear there. Yes I'm talking about the principal part of the repayments which is growing as a proportion of total payment because the loan size is decreasing. I'm guessing there will be two effects: first, continued subdued lending compared to when these mortgages were issued (in the noughties boom) which will positively affect cashflows into the business and secondly, the reduction of outstanding loans on the BS which will free up capital and result in cashflows to shareholders, IMO.

No worries, I see what you mean, I think. And agree that lending (esp. remortgaging) must have subsided since the 00s. I had a little think about how a mortgage firms (i.e. bank) balance sheet could possibly look. Presumably mortgages held by their customers are on the bank's asset side, with their present value (PV) being equal to the sum of all the DCF of the future payments. I'm then assuming that each payment (made by cust to bank) is an inflow ("Cash from operations").

But further the bank does not have a forest of money trees, so I'm guessing that bank themselves presumably borrowed money from lenders of some form e.g. bond-holders, money market etc.. And these borrowings are on the liabilities side of the BS.

So going back to when you said principal part of the repayments which is growing as a proportion of total payment because the loan size is decreasing I'm not 100% sure that that's relevant regards the customers paying back their mortgage, and the ingress flow reducing the bank's asset and feeding the bank cash. What I believe is more relevant in terms of the banks cash generative properties is how their own repayments are structured regarding how much of current's periods inflows are needed to pay down just interest on their outstanding bonds, or the principal when the debt matures. But I guess with a firm like lloyds these must be fairly staggered into lots of different borrowings with varying maturities.

Low interest rates are a problem, but as many have remarked before, and finally I am starting to agree, they cannot really fall much further and may even go up, especially if we have a hard/no-deal Brexit.

You say that but in Germany the 10 year DE bond has -ve yield (-0.341%), so presumably they have v. v. low base rate. Also surely if the UK has a bad time post brexit, won't the BoE probably cut rates as a stimulant?

Matt

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Re: Lloyds: Net CFO negative for 2017, 2018

#259324

Postby GoSeigen » October 21st, 2019, 6:52 pm

TheMotorcycleBoy wrote:
GoSeigen wrote:Sorry, not 100% clear there. Yes I'm talking about the principal part of the repayments which is growing as a proportion of total payment because the loan size is decreasing. I'm guessing there will be two effects: first, continued subdued lending compared to when these mortgages were issued (in the noughties boom) which will positively affect cashflows into the business and secondly, the reduction of outstanding loans on the BS which will free up capital and result in cashflows to shareholders, IMO.

No worries, I see what you mean, I think. And agree that lending (esp. remortgaging) must have subsided since the 00s. I had a little think about how a mortgage firms (i.e. bank) balance sheet could possibly look. Presumably mortgages held by their customers are on the bank's asset side, with their present value (PV) being equal to the sum of all the DCF of the future payments. I'm then assuming that each payment (made by cust to bank) is an inflow ("Cash from operations").

Sorry, don't know the detail of the accounting, but the general description of the asset is correct.


But further the bank does not have a forest of money trees, so I'm guessing that bank themselves presumably borrowed money from lenders of some form e.g. bond-holders, money market etc.. And these borrowings are on the liabilities side of the BS.


I recall discussing this subject with you some time ago in connection with QE/money!

Sorry to say, it is still my view that the liability side of the transaction IS a money entry, usually a demand deposit. To put it in everyday language: bank agrees a loan with customer which means that customer promises to pay back the bank (the mortgage), whilst the bank agrees to credit customer's current account with cash (money).

So there is a money tree but but no-one called it that until they wanted to insult the labour party, or Keynesians!

Therefore it should be clear there is no money borrowed from lenders of any form to fund the mortgage. It really is just created. What DOES happen is that banks raise (and are required to raise) a small amount of capital in the form of bonds, hybrid capital, shares etc in addition to their monetary (deposit) liabilities which is a buffer against losses in their business and they purchase high quality assets alongside the mortgages to ensure adequate liquidity.


So going back to when you said principal part of the repayments which is growing as a proportion of total payment because the loan size is decreasing I'm not 100% sure that that's relevant regards the customers paying back their mortgage, and the ingress flow reducing the bank's asset and feeding the bank cash. What I believe is more relevant in terms of the banks cash generative properties is how their own repayments are structured regarding how much of current's periods inflows are needed to pay down just interest on their outstanding bonds, or the principal when the debt matures. But I guess with a firm like lloyds these must be fairly staggered into lots of different borrowings with varying maturities.


No really, most of the liabilities are customer deposit balances (money). Banks pay a lower rate on these than they demand from mortgagees. That is the main driver of NIM. When principal is repaid, both the loan asset AND the deposit liability decrease. This in and of itself does not generate cashflow as I accepted earlier BUT because the balance sheet is smaller the bank is required to hold less regulatory capital and/or the risk of its business decreases giving them access to cheaper reg capital. So these indirectly contribute to improved profitability.

Crude example of a bank balance sheet:

Assets:      (£m)
Mortgages 900 [interest rate 3%]
Gilts 100

Liabilities:
Deposits 800 [interest rate 1%]
Sub debt 100 [interest rate 6%, say]

Equity:
Shares 100


If net 100m of mortgage principal is repaid then the balance sheet is:

Assets:      (£m)
Mortgages 800
Gilts 100

Liabilities:
Deposits 700
Sub debt 100

Equity:
Shares 100

but the bank now has a larger proportion of capital than before. It can redeem some sub debt, reducing the 6% interest payments. Or it can swap the sub debt for 5% notes because it is safer than before, again saving some interest. Or it can buy back some of its shares (as LBG is doing), thus returning cash to shareholders.


Low interest rates are a problem, but as many have remarked before, and finally I am starting to agree, they cannot really fall much further and may even go up, especially if we have a hard/no-deal Brexit.

You say that but in Germany the 10 year DE bond has -ve yield (-0.341%), so presumably they have v. v. low base rate. Also surely if the UK has a bad time post brexit, won't the BoE probably cut rates as a stimulant?

Matt


Well I'm talking in broad terms here. Of course we could end up like Japan/Germany/Swiz but over the long term I think we must be near the lows of interest rates. If we Brexit without a deal I'd guess interest rates will be hiked magnificently to defend against capital outflows. Yes, devastating for the economy, but we all knew that, right? Any stimulus rate cut would be knee-jerk, short-lived, and a mistake needing to be rapidly reversed IMO.

GS

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Re: Lloyds: Net CFO negative for 2017, 2018

#259664

Postby TheMotorcycleBoy » October 23rd, 2019, 2:23 pm

GoSeigen wrote:
TheMotorcycleBoy wrote:But further the bank does not have a forest of money trees, so I'm guessing that bank themselves presumably borrowed money from lenders of some form e.g. bond-holders, money market etc.. And these borrowings are on the liabilities side of the BS.


I recall discussing this subject with you some time ago in connection with QE/money!

I remember. ;)

Sorry to say, it is still my view that the liability side of the transaction IS a money entry, usually a demand deposit. To put it in everyday language: bank agrees a loan with customer which means that customer promises to pay back the bank (the mortgage), whilst the bank agrees to credit customer's current account with cash (money).

Earlier on, I was viewing the customers mortgage with a bank, as an asset for the bank. Because it's basically a loan. So it's the reverse scenario, than when a customer makes a £££ deposit at a bank, which (I believe) is a liability on the banks side, since they are liable at some stage to have to return that money to the customer. (Apologies, I've just processed your later example Balance sheet, and I think we are in agreement on the point, perhaps our means of communication just clashed v. slightly in earlier exchanges)

Therefore it should be clear there is no money borrowed from lenders of any form to fund the mortgage. It really is just created. What DOES happen is that banks raise (and are required to raise) a small amount of capital in the form of bonds, hybrid capital, shares etc in addition to their monetary (deposit) liabilities which is a buffer against losses in their business and they purchase high quality assets alongside the mortgages to ensure adequate liquidity.

Ok. Sure I totally agree, with this. However, the creation of the capital, e.g. the bonds, surely result in a liability for the banks? I note Notes 29 and 30 from LBGs AR2018 I *think* refer to bonds of the kind you refer - which are present on the liability of the BS.

GoSeigen wrote:
TheMotorcycleBoy wrote:So going back to when you said principal part of the repayments which is growing as a proportion of total payment because the loan size is decreasing I'm not 100% sure that that's relevant regards the customers paying back their mortgage, and the ingress flow reducing the bank's asset and feeding the bank cash. What I believe is more relevant in terms of the banks cash generative properties is how their own repayments are structured regarding how much of current's periods inflows are needed to pay down just interest on their outstanding bonds, or the principal when the debt matures. But I guess with a firm like lloyds these must be fairly staggered into lots of different borrowings with varying maturities.

No really, most of the liabilities are customer deposit balances (money). Banks pay a lower rate on these than they demand from mortgagees. That is the main driver of NIM. When principal is repaid, both the loan asset AND the deposit liability decrease. This in and of itself does not generate cashflow as I accepted earlier BUT because the balance sheet is smaller the bank is required to hold less regulatory capital and/or the risk of its business decreases giving them access to cheaper reg capital. So these indirectly contribute to improved profitability.

Crude example of a bank balance sheet:

Assets:      (£m)
Mortgages 900 [interest rate 3%]
Gilts 100

Liabilities:
Deposits 800 [interest rate 1%]
Sub debt 100 [interest rate 6%, say]

Equity:
Shares 100


If net 100m of mortgage principal is repaid then the balance sheet is:

Assets:      (£m)
Mortgages 800
Gilts 100

Liabilities:
Deposits 700
Sub debt 100

Equity:
Shares 100

but the bank now has a larger proportion of capital than before. It can redeem some sub debt, reducing the 6% interest payments. Or it can swap the sub debt for 5% notes because it is safer than before, again saving some interest. Or it can buy back some of its shares (as LBG is doing), thus returning cash to shareholders.

A ha! I think I see what you were originally driving at: essentially reducing debt, means less reserve £££ is needed, therefore LBG can spend instead. (Thanks for taking time with the example.)

I *guess* that's why you proposed LBG would-be/is cash generative...........i.e. it's a result of the overall level of mortgage lending falling. (BTW what's NIM? Net income margin?)

However, the flipside, at least to me, which I also mentioned earlier: less new mortgages or new mortgages at lower IRs mean lower cash flows in the future?

And finally:
TheMotorcycleBoy wrote:
GoSeigen wrote:Low interest rates are a problem, but as many have remarked before, and finally I am starting to agree, they cannot really fall much further and may even go up, especially if we have a hard/no-deal Brexit.

You say that but in Germany the 10 year DE bond has -ve yield (-0.341%), so presumably they have v. v. low base rate. Also surely if the UK has a bad time post brexit, won't the BoE probably cut rates as a stimulant?

Matt

GoSeigen wrote:Well I'm talking in broad terms here. Of course we could end up like Japan/Germany/Swiz but over the long term I think we must be near the lows of interest rates. If we Brexit without a deal I'd guess interest rates will be hiked magnificently to defend against capital outflows. Yes, devastating for the economy, but we all knew that, right? Any stimulus rate cut would be knee-jerk, short-lived, and a mistake needing to be rapidly reversed IMO.

So how does this interest rates will be hiked magnificently to defend against capital outflows work exactly? Are you saying that what the BoE will do is raising the base rate, so that rich folk in the UK, will be more inclined to hold cash in regular banks accounts, cos they'll be getting better saving rates?

What exactly is meant by "capital outflows", is it 1) people withdraw money from uk banks 2) investors swap UK gilts for US TBills? and/or 3) investors ditch FTSE stocks in favour of foreign equities?

Apologies for all the questions at once!
later Matt

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Re: Lloyds: Net CFO negative for 2017, 2018

#259714

Postby GoSeigen » October 23rd, 2019, 6:51 pm

TheMotorcycleBoy wrote:Ok. Sure I totally agree, with this. However, the creation of the capital, e.g. the bonds, surely result in a liability for the banks? I note Notes 29 and 30 from LBGs AR2018 I *think* refer to bonds of the kind you refer - which are present on the liability of the BS.

Absolutely they are a liability. My only point here is that these bonds and other regulatory capital are only a fraction of the balance sheet, i.e. the bulk of the bank's lending is funded not by the capital but by the deposits that are "created" alongside the lending (and to be clear those deposits are not referred to as the capital of the bank -- they properly form part of the money stock of the country).


I *guess* that's why you proposed LBG would-be/is cash generative...........i.e. it's a result of the overall level of mortgage lending falling. (BTW what's NIM? Net income margin?)

However, the flipside, at least to me, which I also mentioned earlier: less new mortgages or new mortgages at lower IRs mean lower cash flows in the future?

Yes and yes, but remember I was talking about the specific scenario where there is net repayment of mortgages -- which I think is the most likely path for a while at least. However it is not the only scenario: Lloyds could choose to write a lot of new mortgages resulting in mortgage balances rising. I just happen to believe we are not at that point in the cycle (yet). As for the cashflows, yes, if IRs are low then cash generation will be low, but it's worth remembering that in the noughties banks were lending at stupid margins [e.g. base rate +0.5%, hence the banking crash] and in many cases they are still stuck with those low-margin loans on their balance sheets. It's possible that new mortgages, even at low interest rates, could be more profitable than the older ones!

So how does this interest rates will be hiked magnificently to defend against capital outflows work exactly? Are you saying that what the BoE will do is raising the base rate, so that rich folk in the UK, will be more inclined to hold cash in regular banks accounts, cos they'll be getting better saving rates?

What exactly is meant by "capital outflows", is it 1) people withdraw money from uk banks 2) investors swap UK gilts for US TBills? and/or 3) investors ditch FTSE stocks in favour of foreign equities?

Apologies for all the questions at once!
later Matt


In a hard or no-deal Brexit, I expect a severe economic slowdown accompanied by a degree of chaos in trading. I think this will result in stresses for certain trading businesses that might find themselves short of foreign currency. These effects in my view will drive a flight of capital from the UK to other countries and currencies. To defend Sterling and manage these flows the BoE will be compelled to raise rates. Of course if I'm correct the market will anticipate these events and those who can get their capital out of the UK will start to do so in advance (as some of us have done!!) creating a self-fulfilling prophecy. That's just how these things work. As rates rise, stresses on borrowers increase causing a fall in value of property and other leveraged capital. This exacerbates people's desire to sell the depreciating £-denominated stuff and acquire foreign currency. The government might even introduce capital controls to limit this behaviour by preventing the export of capital. This is merely a natural extension of the Brexit/nationalist agenda of closing our doors to foreigners, trade and now capital transfers.

The foregoing is my view on the hardest Brexit scenarios -- if we have a reasonably long transition period with gradual divergence from the EU then I expect the stresses to be far less. However I have partially hedged my own financial and political exposure against the worse outcomes while it is still cheap to do so... having been proved quite wrong in my assessment of how sensible the UK would be in sorting out the Eurosceptic question!


GS


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