HBOS plc Pre-Close Interim Trading Statement Conference Call
12 June 2007
Phil Hodkinson, Group Finance Director
Opening Comments
Good morning, everyone, and welcome to this conference call covering HBOS’ pre-close trading statement,
which was released this morning. I plan to say a few words about the divisional profit restatement, which
accompanied the trading statement, before turning to the trading statement itself and then throwing the call
open to questions.
Financial Reporting
Divisional Profit Restatement
The aim of the divisional restatement is to prepare the ground for the presentation of our interim results on
1 August. Of course, there is no change to our reported results for 2006 at a Group level, but there are
changes to the divisional splits as a consequence of the management reorganisation that we announced in
March, which moved responsibility for our European Corporate business from our International division to
our Corporate division. The other change incorporated into the restatement is that, following the timely sale
of our stake in Drive at the end of last year, we will now show the 2006 results for Drive as a separate
discontinued division, so as to make the comparatives for our ongoing International division more
meaningful. We have also restated some of our key metrics for 2006, such as cost:income ratio and net
interest margin, so as to take account of Drive and also to bring our definition of underlying income more
into line with others.
Current Account Refunds
In addition, we have also clarified today the way in which we intend to report the impact of current account
refunds this year. To be clear, the level of refunds we are seeing today is no different to what competitors
have said recently and is certainly not material in the context of the Group so, in that respect, we are no
different; indeed, with a smaller market share, we are probably better off, but we have had a number of
questions about our intended reporting approach in recent weeks. I hope today’s comments clarify that the
appropriate treatment is to exclude these refunds from today’s underlying performance as they relate
predominantly to prior years.
Detailed Questions
As ever, if you have any detailed questions on the restatement or our approach to financial reporting, the
Investor Relations (IR) team in Edinburgh will be more than happy to talk you through them over the next
few days.
Trading Highlights
Earnings per Share
Performance in the year to date supports the view that in 2007 we will meet the market’s upgraded full year
underlying earnings per share (EPS) consensus of 110.8 pence, in other words 10% up on 2006. In every
division aside from Retail, we are enjoying double-digit profit growth and, indeed, at the half year we expect
to report underlying earnings growth slightly higher than 10%, albeit this largely being down to timing
differences between the first and second half rather than signalling at this stage the potential for faster profit
growth for the year as a whole. In any case, as the England cricket team proved at the weekend, it is
always good to have plenty of runs on the board when there is still half a match to go. It is also worth noting
that, were it not for the disposal of Drive last year and the investment that we are making in our efficiency
programme this year, EPS growth in 2007 would be roughly 3% higher. At this early stage of 2007, the year
feels like it will be yet another strong year for overall value creation at HBOS.
Retail
Mortgage retention strategy
All of that said, there is no doubt that we made a slower than planned start to the year in the UK mortgage
market. You may remember that in the second half last year we introduced a range of measures to
encourage better retention in our intermediary business, in particular introducing fee incentives for mortgage
transfers and a range of pricing changes designed to reduce churn – in essence, trading an element of
gross lending share for better retention and thus principal repaid. This was felt to be particularly timely given
the high level of mortgage maturities expected during the first half of this year, which was something that we
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flagged at our results in February. In short, the new measures have not been as successful as we had
expected: we have seen no improvement in retention, our share of principal repaid staying at about 24% so
far this year, and our gross share having fallen to about 19% from the 21.5% that we enjoyed last year.
With every 1% shortfall on gross lending being roughly worth 3.5% on net lending, we know now that our net
lending share in the first half will be below 10%, my best guess being of the order of 8%, rather than the
15-20% range we were originally targeting.
Changes in pricing structure
We have of course taken action to address the shortcomings of our new retention measures, in particular
reversing out most of the pricing changes and also refining our approach to transfer fees. As a
consequence, we are now seeing a much-improved performance in the second quarter compared to the
first. As an illustration of this, last month our net lending share was back into the 15-20% range. Although
our net share at the half year will be lower than originally planned, having taken decisive action to correct
the position and with a much stronger pipeline of business, we are confident we are now back on track to
achieve a 15-20% share in the second half.
Elsewhere in Retail
Elsewhere in Retail we are enjoying good trading performance in savings and banking, and in related areas
such as bancassurance and home insurance, both in terms of sales and also margins. Retail revenue
growth in the first half, however, will of course reflect our slow start with mortgages in addition to the full-year
impact of the changes to credit card and mortgage exit fees in the second half last year. Retail revenue at
the half year will probably be more or less flat half-on-half.
All Other Divisions
In contrast, and balancing this slow start for Retail, in all other divisions revenue growth in the year to date
has been strong, hence our confidence that at the half year we will again be able to report revenue growth
ahead of costs growth for the Group as a whole.
Costs
On the costs front, I am pleased with the progress we are making. We were targeting costs growth of
around 7% for the year as a whole, with slightly higher growth likely in the first half due to the front-end
nature of the investments we are making. Nonetheless, I expect that we will report a further improvement to
our cost:income ratio at the half year which, as you know, is in my view a key test of the continued progress
towards a mid-30s ratio by 2010.
Credit Quality
Credit trends also remain as previously guided. In particular, in the secured market, credit conditions
remain benign and, in the unsecured market, IVA volumes have remained stable. Although we expect a
further rise in unsecured losses in the first half as we see the final seasoning of our credit card portfolio, we
now expect impairments are at close to their peak and hence will see a lower charge in the second half.
Elsewhere, in Corporate and in International, credit conditions continue to remain benign. In Corporate in
particular, we remain alert for signs of late cycle behaviour, continuing to sell down exposures rather than
diluting returns or covenants.
Summary
With five months gone we're trading in line with the market’s consensus forecast of 10% underlying EPS
growth for the full year. After a slow start in mortgages we are now back on track and, elsewhere in Retail
and in all other divisions, we are performing well. We are making further progress on cost efficiency, credit
conditions are very much running to plan and our capital ratios remain strong. Our share buyback is on
track with £262 million worth of shares bought back in the year to date.
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Questions and Answers
Jonathan Pierce, Credit Suisse
Could you clarify whether the income, costs and comments on International in the trading statement are
made on a 2006 basis excluding Drive? Will income be ahead of costs including and excluding Drive, or
just excluding Drive? Similarly, does the International double-digit profit growth you are flagging include or
exclude Drive?
Phil Hodkinson
In the restatement, we now present Drive in 2006 as a discontinued division so that, when we do the
comparisons for our International division and when we have commented on profit growth in 2006 versus
2007, we are making that statement excluding Drive. Our comment about double-digit profit growth for
International is made on a like-for-like basis excluding Drive from the 2006 numbers.
Jonathan Pierce, Credit Suisse
Does that apply to the Group income and costs numbers as well?
Phil Hodkinson
No, at the Group level, Drive is still part of our 2006 figures and so our comments about earnings growth,
revenue growth, costs and so on all include Drive. It is simply for the comparison of International's
performance that we have stripped out Drive. At the full-year results, we also gave key metrics such as
margins and cost:income ratios with and without Drive so you could see what impact that has had. To be
clear, the Group’s P&L and balance sheet will still include Drive in the 2006 comparatives.
Jonathan Pierce
On the mortgage position, what are the margin implications for the changes in pricing structure going into
the second half of the year?
Phil Hodkinson
I will just clarify what we are doing in mortgages. Having introduced some pricing changes in the latter part
of last year, we have essentially reversed most of those. We are returning our mortgage strategy to the
position that we ran with for most of last year. One important point is that we are not seeking, in going
forward, to recover or make up for lost ground. We accept that our net lending in the first quarter was below
our targeted levels; we are now back on track and will carry on running at that level for the remainder of the
year. We are not seeking to make up for lost ground and, therefore, will not be pushing for an
extraordinarily high level of gross share in order to recover lost ground.
In terms of margins, in common with most of our competitors we have been surprised that the level of
competition in the mortgage market has, if anything, intensified yet again. What we predicted for the year
was that we would see less margin erosion than we saw last year, primarily because of two effects last year:
one was the general competition for secured assets; the second was new entrants into the specialist
markets. Our expectation was that that would therefore see a repeat of the first part of that and not the
second part but, actually, what we have seen is strong competition and therefore greater margin erosion in
mortgages than we had expected. At a Retail level, that further erosion in mortgages has been balanced by
better margin performance in our other products – our savings and banking products. Overall, at a Group
level and at a divisional level, our guidance for the year remains intact, albeit that we have seen more
pressure in mortgages, balanced by better performance elsewhere.
Jonathan Pierce
My final question is a broader one on this statement versus the AGM statement, which, four months into the
year, led most in the market to believe that performance was going to be quite a bit ahead of consensus at
the time, which was 107.4p, yet you are now telling us that you are happy with 110.8p. We can debate
whether we should strip the penalty charges out, so it would be useful if you could quantify the penalty
charges year-to-date. More broadly, has something gone wrong in the last couple of months that has led to
less confidence in the full-year outturn, or was the AGM statement not meant to lead analysts to upgrade
numbers by the order of 5%? The number has gone up by 3-4%, but people thought that there could be a
bit more in the bag.
Phil Hodkinson
First of all, the market has got it right: that, having rightly upgraded from the AGM statement, we are now
saying that our trading so far this year is consistent with that market consensus. There were two reasons
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for upgrading the figures at the AGM: first, that people’s forecasts were below ours, by a sufficient margin for
us to comment; and, second, as we spoke to investors, it became clear that, while everybody understood
that Retail profit performance in 2007 would be slow, as it was in 2006, they also understated the extent to
which our other businesses would perform strongly and, therefore, once again, enable us to achieve a
higher level of earnings per share (EPS) growth than the market, at that time, was predicting. Therefore, the
importance of our comments at the AGM was as much about the understanding of the market as it was
about the actual number in terms of consensus. The fact that the market has got consensus about right
relative to our trading performance today is also reassuring.
On the point about bank refunds, we are in the same boat as everybody else and the amounts, year-to-date,
are not material. The purpose of us clarifying the accounting treatment is, first, because quite a few people
have asked about it and, second, because everybody recognises that it is going to be some time before the
Office of Fair Trading (OFT) market study comes to a conclusion and we are able to put estimates on the
level of refunds. There seems to be a strong correlation between the level of refund requests and the
publicity given to this topic; hence, in the last month or so, requests have declined slightly relative to earlier
months in the year. I would point out, however, that there is great difficulty, at this point, in knowing what the
outcome of the OFT market study will be. Taking the accounting treatment off the table, therefore, is helpful
for investors.
Tom Rayner, Citigroup
In terms of your mortgage strategy, you always claimed not to like the re-mortgage business, since it
ultimately entails lower-value customers. The strategy then seemed to change to trying to increase the
incentives to independent financial advisors (IFAs) to return your own re-mortgage customers back to you.
It now seems as though there is another change in thinking. Could you comment on whether you view the
IFA distribution channel as an attractive way of selling mortgages vis-à-vis your branches?
Why did the strategy not work? I understand that the retention strategy has failed, but I am struggling to
understand why. Were the fees that you were offering IFAs simply not high enough, was the strategy not
marketed, or did the IFAs care more about the systems and processes than they did about the fees? Could
you expand on those issues? Finally, why has the gross share suffered? It sounds like this was about
retention, whereas your gross share was down in the first half too.
Phil Hodkinson
The strategy had two elements to it: first, we wanted to ensure that there were financial incentives for
intermediaries to retain the business with us, rather than the way that the world worked prior to this, which
was that the only incentive for an intermediary was to move the business away from the existing provider.
To a certain extent, that part of our initiative has worked. We are now in the process of refining the
approach, having found that offering transfer fees has been of no value to those intermediaries who, in any
case, refund all of their fees to customers. However, for those who retain fees, it has made a difference,
and we have retained something like £5 billion of mortgages this year as a consequence of this strategy, so
I would not say that everything that we have attempted has been unsuccessful, since that part has worked.
However, the pricing changes were the primary area in which we were disappointed. We sought to make
the pricing for those already with us more attractive and, as a way of balancing the margin effect, we
increased the price for those who might be new customers transferring or re-mortgaging. The consequence
of this, to our disappointment, was that the level of retention improvement as a result of making prices more
attractive to existing mortgage holders has not been of any great significance, whereas the loss of new
gross lending, as a consequence of balancing the books by increasing pricing, has been more than we
expected. That is the reason why what was essentially a retention initiative has affected gross lending
share and, disappointingly, has not led to any material improvement in repayments.
In terms of your point about branch versus intermediary, what is evident, and something that is affecting the
whole market, is that the growth in specialist lending – and buy-to-let in particular, which is almost
exclusively intermediary – has been balanced by a reduction in first-time buyer business. We have seen
strong growth in buy-to-let this first half, with the market growing by an estimated 12%, and there has been a
corresponding reduction in first-time buyers, which have a much higher weighting towards branch business.
In keeping with the rest of the market, therefore, we will have seen a shift from branch to intermediary, which
has been a trend over the last five years. As we all know, intermediary business is still profitable, although
not as profitable as branch business, and there is a propensity for there to be higher levels of churn.
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All of these were key aspects of the characteristics of the market that we were seeking to change
behaviours around in setting the new pricing measures. We are now back at where we started, with the
knowledge that some parts have worked but that the vast majority have not. As I said in my opening
remarks, we are now seeing, importantly, our performance track within the 15-20% net lending range. In
May, we believe that we were firmly within that range.
Tom Rayner
Is it the case that you very much want to keep within that 15-20% range?
Phil Hodkinson
Yes, while improving retention at the same time. We still have plenty of actions and initiatives underway to
improve our retention, and we were entering a first half where there was a higher level of mortgage
maturities in our book than would ordinarily be the case, but we certainly have not given up on being able to
improve the position. Importantly, we have learned that the initiatives tried thus far have not all been
successful.
Tom Rayner
In terms of the materiality issue on the current account fee refunds, by being in the statement, even if it is
not material today, it has the potential to become material. Could you give us any more detail on that, in
terms of whether the post-AGM upgrade would have been noticeably smaller had we known then about this
issue?
Phil Hodkinson
I do not think that it would have made any difference to either today’s statement or the AGM trading
statement. I would, however, go back to what I said earlier, which is that there is some uncertainty as to
how the question of current account fees will ultimately be resolved by the OFT market study. The point of
being able to clarify the accounting treatment is entirely consistent with our approach to underlying earnings
in other respects; for example, last year, when we received a windfall profit of £180 million on Drive, we
excluded it from underlying earnings, since it really did not relate to current performance. The purpose of
clarifying the accounting treatment is as much to take it off the table and answer the question that a few
people were asking, rather than signalling that the issue is any different for us than it is for anybody else.
Indeed, because we have traditionally had a lower market share of current accounts than others, I would
expect that this is less of an issue for us than others.
Mark Thomas, KBW
Going back to the mortgage market, it looks to me as though the drop in gross share is causing two thirds of
the drop in net share. You have also talked about pricing, which I presume affects the prime market; has
there been any noticeable change in the gross share in the specialist books? In the Kensington-type space,
rather than buy-to-let, has there been a big drop-off?
Second, in terms of Corporate credit, I thought that the wording in the credit quality section was a little
unusual compared to peers. Is this just reemphasising that you are going to be selling down Corporate
books, or is this a heads-up that you might expect an increase in Corporate charges in the near term rather
than at some stage in the future?
Phil Hodkinson
In terms of the mortgage market, we do not play in the sub-prime Kensington space, so very little of our
business this year or last year relates to that. There was much greater competition for buy-to-let in the
second half of last year, but I do not think that we have seen any material change in the first half this year
relative to where we were in the second half last year. It is a market where the margins continue to be
better on a risk-adjusted basis than the prime market, so it is an attractive market, although I think that
people are waking up to that fact, as we have known for some time, given our greater presence in this
market. The average life of the mortgages in buy-to-let are shorter than in the mainstream market, simply
because it is so highly intermediated, and it is also an investment decision rather than a house purchase.
On the Corporate front, the only thing that we were signalling is the fact that we have said, for two or three
years running now, that credit conditions are so benign that we would be unwise to price on the basis that
they stay as benign as this. We wanted to flag that we continue to originate assets at a stronger growth rate
than we are prepared to hold and that we continue to sell down. We have not seen anything in terms of
credit experience that would lead you to feel that, for example, the charge in the first half this year would be
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any different to the charge in the second half last year. We are, however, concerned about the way in which
the market is willing to dilute returns, as well as covenants. One of the most reassuring comments that our
Corporate team made to me only a few weeks ago is that, thus far, HBOS has not adopted a covenant-light
approach on any deals. That is part of our discipline of wanting to maintain the strength of margins and
credit quality.
Mark Thomas
With regard to the element on the Corporate side, where you talk about ‘in the late stage of the cycle’, is it
the case that you feel that there is no change in that position compared to where you were before?
Phil Hodkinson
It is a very drawn-out late stage but, nonetheless, everything points to the fact that it cannot get much better
and we would be unwise to assume that things are not going to turn at some point.
Jon Kirk, Redburn Partners
Could you comment on your outlook for mortgage margins from here? Do you think that the intensity of
competition in the first half was a temporary issue or that there is a more structural change going on
perhaps in relation to Basel II?
Could you then comment on your confidence in your ability to take net share back up to normal levels in the
second half of the year? Is that based as much on the fact that the most intense point of mortgage
maturities was in the first half for you and will ease off somewhat in the second half?
Phil Hodkinson
On your second question, it is a little bit of that, but probably more importantly the fact that we have already
taken corrective action and are now trading back in that range. We said at the time, back in September,
when we announced the changes, that it was incumbent on the market leader to lead the way in terms of
being able to move to a better place in terms of the quality of the mortgage market. It is also a
demonstration of the power of being the market leader that we can take corrective action and move back
quickly to the normal run rate.
In terms of margin outlook, I am of the view that, although people might refer to Basel II as being the reason
why the market is competitive, the bigger reason is that there is no doubt that we and all other players in the
market are still reluctant to seek out unsecured assets and, therefore, there is greater competition for
secured mortgages and, thus, pricing competition. We have known that the capital requirements for
mortgages have been overstated in regulatory terms for many years now, which is one reason why the
market has been competitively priced for quite some time. Basel II, in a sense, reconfirms that, but most of
the pressure is simply that the demand for asset growth is high and that unsecured assets are not where
most people want to seek that growth, so many players – and particularly the monolines – will have no
choice but to go deeper into the secured market.
Jon Kirk
In terms of credit quality in mortgages, one of the concerns has been that the market as a whole is going to
see a lot of maturities this year and that, as borrowers see a payment shock, there might be some credit
quality worries. Clearly, you have had a lot of maturities in the first half of the year, and you are not flagging
anything to worry about?
Phil Hodkinson
Let me give you a bit of detail here. In the mainstream book, we are seeing improving credit trends; in the
specialist book, we are seeing some seasoning, clearly because the market has grown quickly, but nothing
untoward. Overall, therefore, our secured impairment position is very stable and we have seen no impact
from the increasing volume of maturities.
Stephen Andrews, UBS
In terms of the Corporate investment book, you said that gains were strong in the first half and that the book
value has gone up again. Could you talk about the ease of realising those gains going forward? The first
half has been very favourable, but in the real estate space, where you are proportionately more exposed,
things seem to have been getting much tougher over the past few weeks, with some deals that you are
involved in either being pulled or not achieving prices hoped for. Is that your experience and, if that trend
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continues, how would it impact you over the next 12-18 months in terms of your confidence in being able to
keep those gains running at current levels?
Phil Hodkinson
First, we are not at all surprised that the level of income from our investment book is increasing because, as
you know, from the Corporate Roundtables that we held in April, the gains and income that we are seeing
today relate largely to investments that were made over two or three years ago. Since we know that the
book has grown since that time, we would expect the income to grow over time too. Indeed, the book grew
again in the first half of this year, so this is a growing contribution from a growing book.
Specifically in relation to your point on where the gains in income are coming from, something very positive
is that the diversity of the book has been illustrated by the fact that no one area is commanding the lion’s
share of improved performance. For example, there have been relatively modest contributions from
property revaluations; the profits from joint ventures and associates do not appear to be proportionately
higher this year than last year. It is a good illustration of a book that, with over 600 investments, is
contributing on all fronts.
There have been one or two interesting notes recently on the subject of the accounting that lies behind the
investment book and, in the next few days, Charles and John, who have put together a very good summary
of the accounting methodologies, will be sending out a note to those who are interested. What that note will
do, as other analyst’s notes have confirmed, is to give some confidence that the accounting is appropriate
and that the gains are sustainable.
Specifically, on property, something to bear in mind is that less than half of our property book relates to UK
properties. Over the last two or three years, there has been a dramatic shift of activity from the UK to the
European markets, with valuations in the European markets being two to three years behind those in the
UK. Therefore, even if there is a tendency for property values to go up at a slower rate in the UK, that
feature is only part of the equation in our book.
Hopefully, that gives you some idea of how things are progressing. We are pleased with the performance
so far – it is not unexpected that the gains will increase – and I am confident that the investment book will,
again, make a strong contribution to Corporate’s results for the year as a whole.
Ian Smillie, ABN Amro
Returning to Corporate investment gains, could you confirm whether the comment ‘strong’ means that we
should be upgrading the £450 million number that you guided us to at the full year or whether that is simply
a reiteration of that sort of level of guidance?
Phil Hodkinson
For the year as a whole, what we established, as part of the Corporate Roundtables, was that you should
expect the income from our investment book to increase in line with the size of the book. At the start of this
year, the book stood at £2.5 billion, and I think that I am right in saying that, if you go back two years before
that, it was standing at £1.7bn- £1.8bn or so. In the last two years, then, you can see that it has grown.
That growth will not yet be kicking in very much income or gains, given that it normally takes at least a
couple of years before we start seeing some profits from the book, which is why the contribution is growing.
The best guide as to the rate of growth, given that we now have that extra information on the table, is the
rate of growth of the book as a whole.
Ian Smillie
Is that the rate of the growth of the book two years ago or today?
Phil Hodkinson
I do not want to be too precise, because these things are not quite that black and white, but the point is that
there is growth in the book that, in all probability, has not yet contributed to the growth in income, and that
growth relates predominantly to the growth in the last two years.
Ian Smillie
On the guidance that you give on ‘an improving cost:income ratio’ by the new definition of revenues, could
you give us a sense of whether, in the first half this year, revenues under your old definition will also be
higher than cost growth?
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Phil Hodkinson
The change in definition has really made no difference. To be clear, the change is simply that a number of
people have pointed out to us that many of our competitors include the income from joint ventures and
associates in their definition of underlying income and that, when we do comparisons of cost:income ratios,
this is evident to us. Therefore, in restating our cost:income ratio, we have allowed for two things: first, the
impact of Drive and, second, the change in definition of income. That has moved our 2006 cost:income ratio
from 40.9 to 41.0, so almost no change.
Equally, what I said earlier is that I am not expecting the contribution to income from joint ventures and
associates this year to be proportionately higher, as part of the total investment contribution, than last year.
I do not think that it would make any difference or add any distortion to the progression of income or the
cost:income ratio.
Ian Smillie
I can see why that would be true on a full-year basis, but in the first half of last year, there was a very low
contribution from joint ventures, so that would make a difference when you report your first half.
Phil Hodkinson
That might be fair. As you know, the contribution from these tends to be reasonably lumpy, so it would be
difficult for me to make that statement for every half year, but you can take it that, for the year as a whole, I
am not expecting joint ventures and associates to make a disproportionate contribution to profits. I accept,
however, that it was unusually low in the first half of last year, so there is some prospect that it may, in
percentage terms but not in absolute terms, make a bigger contribution in the first half this year.
Ian Smillie
It is, then, possible that revenue growth under the old basis in the first half of this year will be lower than cost
growth in the first half of this year.
Phil Hodkinson
No, it is not. I do not want to size the cost:income jaws – we will be able to do that at the half year – but I
am absolutely sure that the statement would be true with and without.
John-Paul Crutchley, Merrill Lynch
At the full year stage, you were more cautious than some of your peers in terms of the outlook for unsecured
impairments evolving over the course of this year. Earlier on today, you said losses up in the first half but
hopefully down in the second half; how does that compare to what you said at the beginning of the year? Is
that how you expected it to progress or is that any different from how you saw the position at the beginning
of the year? In other words, have things improved in terms of looking at the book from your perspective?
Phil Hodkinson
The difference is simply that we are much closer to the peak now, so it is slightly easier to call when it
happens. At the start of the year, however, there was still a degree of uncertainty as to whether or not the
quite recent stabilisation of individual voluntary arrangements (IVAs) would continue and just how quickly
the final seasoning of our credit card book would happen. I do not think that there is any change in
expectations, other than slightly greater certainty, now that we are closer to the event. It is, however,
positive that, although we will see a rise in the unsecured charge in the first half, we are now much more
confident that the charge in the second half will be lower. While we cannot be precise as to in which month
the peak will occur, it is evident that we will go past the peak by the end of the year.
John-Paul Crutchley
In terms of capital, one of the messages coming out of this is that, certainly in Retail, volume growth has
been more muted than you expected at the beginning of the year. You still sound cautious on secured, and
you are selling down more in Corporate than you want to sell down. Given that the first half is a fairly heavy
call on capital, due to the full-year dividend payment for 2006, how do you feel about capital ratios at this
stage? Are we likely to get an upgrade for buyback at the interim stage? How do you feel about the overall
capital position?
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Phil Hodkinson
We continue to have a strong capital position and, as you rightly suggest, the time for us to update the
market on the ratios and on our outlook for capital will be at the half year. To put this into context, although
we have made a slower start to net lending in the mortgage market, I am still expecting us to be reporting
asset growth for the Group as a whole in high single digits at the half year, so I would not, at this point, wish
to make any comments as to what the outlook would be for the second half. We are clearly going into the
interims with a momentum that is consistent with the overall objectives that we set for the year. When we
get to the interims, we will be better placed to give you views on all aspects of the outlook for the second
half and, in particular, the balance that we intend to strike between asset growth and returns for the
remainder of the year.
Mike Trippitt, Oriel Securities
You talked about the mortgage pricing structure, but is the IFA fee structure that you put in place for
retentions last year still in place?
Phil Hodkinson
We have refined it. We put in place a structure that applied to every intermediary in July 2006. By the end
of last year, we had already started to refine it, because we realised that, for those intermediaries whose
normal course of business is to refund fees to the customer, it really was having no beneficial impact on
behaviour, but just making the deal cheaper for the customer. A better way to do that would have been
through the headline rates. We are also refining it further. We are retaining those elements that have
worked and removing or altering those that have not. I do not think that I can be any more specific than that,
but it is not an ‘all or nothing’.
Mike Trippitt
In terms of margins, you have talked about outlook as previously guided and you have said, for this year,
tougher mortgage markets offset by the banking and savings margins. It strikes me that you have tougher
mortgage markets in the second half of the year, with banking and savings margins benefiting from higher
rates, suggesting that, going into next year, you are going to be a lower-margin business as a Group as a
whole. Is that a fair conclusion?
Phil Hodkinson
First, we should bear in mind that our guidance for the year as a whole was that we would probably see an
erosion of something like a handful of basis points in the Group margin. The major drivers of margin
movement are, internally, the mix of business within our International division, as we develop an increasing
presence in Retail markets, the mix change naturally brings down the margin. In addition, as expected, we
are seeing a modest level of margin erosion in Retail and Corporate, for the competitive reasons that we
have already mentioned. In Retail, that modest erosion is made up of strong erosion in mortgages,
balanced by better margins elsewhere.
I do not think that I want to change our guidance for the year as a whole but, clearly, at the half year, we will
be in a much better position to guide you for the second half. Importantly, of course, we should bear in mind
that, as we continue to improve our cost:income ratio, that still means that returns are being driven up. To a
certain extent, therefore, we are pre-empting and anticipating that the markets will become more
competitive. There also comes a point at which being the cost leader in the market is a big advantage,
since it means that we are able to be more competitive while still offering commensurate returns for
shareholders.
Mike Trippitt
In the Investment business, what do you mean by ‘a more selective approach to intermediary sales’?
Phil Hodkinson
One of the best examples of that is the announcement in early February that we were effectively
withdrawing from new business in the group pensions market, where our experience has been that margins
have been very finely priced. Therefore, we said to the market that that was not going to be an area that we
would focus on going forward. Our point is that we have been taking those decisions for good margin and
profit reasons, and that, despite making those decisions, we have seen good overall sales growth within our
investment business.
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Arturo de Frias, Dresdner Kleinwort
In terms of credit quality, you just told us that we are going to see the peak in unsecured impairments some
time in the first half. Going forward, the second half is going to be lower than the first half. What kind of
trend would you expect to see going forward? We are not too far from seeing a peak in rates in the UK, so
we might see a little less pressure in terms of unsecured impairments.
Phil Hodkinson
That is a sensible scenario to paint. There are different views – some believe that interest rates still have
one or two moves upwards, which might create some pressure – but I am not too pessimistic on this
because, of course, most unsecured pricing is either fixed in nature or, in credit cards, the rates are set quite
a bit higher than base rates. I think that the interesting question that flows from yours is: how long will it be
before, in those markets where margins are still good – credit cards being a good example – the appetite for
increased asset growth and increased lending returns? The UK consumer has now had a break from
increased lending for nearly three years in credit cards, and earnings have moved up by 4.0-4.5% per
annum. It will not be too long before consumers feel that they have more capacity to borrow and, as you
say, with a stabilised and improving position on unsecured impairments, banks might be willing to step back
into that market. I do not think that we are there yet, but it is something that is a consequence of both my
views and yours.
Closing Comments
Phil Hodkinson
Thank you very much for your questions. As ever, the Investor Relations team are available to answer
questions either on the divisional restatement or the trading statement. Thank you for joining the call.
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