After hitting a post-pandemic high last October, Lloyds (LSE:LLOY) shares then saw a sharp 15% decline. Investors sold off as fears mounted over its motor finance dispute, which could result in a hefty fine and impact the bank’s earnings.
Nonetheless, the stock’s since rebounded by a whopping 17%, as Chancellor Rachel Reeves looks to intervene, which has lifted sentiment. However, I’m approaching this development with cautious optimism.
Litigation nightmare
The UK’s Financial Conduct Authority (FCA) found Lloyds guilty for supposedly overcharging customers for car loans due to discretionary commission arrangements (DCAs). These arrangements allowed brokers to adjust interest rates on loans. This then allowed them to increase their commissions – and this wasn’t fully disclosed to customers.
But the bank has since appealed with the ultimate decision left to be made by the Supreme Court. As such, management’s allocated £450m aside to cover the potential charges. A final decision’s yet to be made by the Supreme Court. A hearing and verdict are expected before the autumn at the very latest. In light of that, a great amount of uncertainty looms over the outlook for Lloyds shares.
A hopeful outcome
According to RBC, the FTSE 100 stalwart could incur charges that could rack up as high as £3.9bn. In such a case, the lender would end up incurring huge litigation charges. This would undoubtedly affect its bottom line and growth trajectory.
The knife’s edge is that markets seem to have only priced in charges of £1.6bn-£2bn, and not the worst-case-scenario of £3.9bn – almost double of the priced-in estimate. Thus, a heavier-than-estimated fine could result in a further sell-off in Lloyds shares. On the other hand, a lower estimate could spur a relief rally, which has been seen recently.
This comes as the Chancellor wrote to the Supreme Court that it be allowed to give evidence in the case. Reeves stated that an unfavourable ruling could “cause considerable economic harm” to the wider economy. And given Reeves’ already delicate position as Chancellor given the recent spike in borrowing costs, she’s likely to try her best to sway the ruling in the favour of lenders.
Solid income strategy
In such an event, Lloyds shares would be a splendid investment to consider, in my view. The company’s structural hedges are set to provide a meaningful tailwind to its income from 2025 onwards, which will lift its revenue and earnings. This is because a huge chunk of Lloyds’ hedges will renew onto higher yields, thereby increasing its margins. And with rates coming down and a recession looking avoidable, the outlook for Lloyds looks rather bright on that basis.
Having said that, it’s also worth remembering that only less than £2bn worth of remediation charges have been priced into the stock. Hence, if the ruling turns out to be unfavourable, this could decimate the stock’s earnings. This would, therefore, imply a price-to-earnings-growth ratio (PEG) of 1.3. Given that the sector’s current PEG’s 1.3, that would suggest limited share price appreciation on that basis.
Nevertheless, having taken the amount of influence the chancellor has on the final decision, as well as Lloyds’ history of getting more favourable outcomes in litigation, I remain bullish on Lloyds shares and may consider adding more to my portfolio.
This post was originally published on Motley Fool
