International
continued
Europe & North America (‘ENA’)
Underlying profit before tax in ENA increased 39% to £393m (2005 £282m). Our Corporate businesses in both North America and Europe, together with our Investment business European Financial Services (‘EFS’), all delivered strong earnings growth. Retail continued to grow its lending while expanding its branch network in Spain and facing into increasing competitive pressures in the mortgage market in the Netherlands.
On 7 December 2006, we sold our 64.5% financial investment in Drive Financial Services (‘Drive’), a sub-prime auto finance receivables business based in Texas. Excluding Drive, which was consolidated as a subsidiary up to the date of disposal, underlying profit before tax increased by 41% to £303m (2005 £215m). The sale of Drive realised a gain on disposal of £180m which has been excluded from the Group’s underlying results and consequently does not feature in the divisional income statement set out here.
Financial Performance
| Year ended 31.12.2006 £m |
Year ended 31.12.2005 £m |
|
|---|---|---|
| Net interest income | 470 | 402 |
| Non-interest income | 714 | 321 |
| Fees and commission income | 110 | 92 |
| Fees and commission expense | (179) | (167) |
| Net earned premiums on insurance contracts | 467 | 171 |
| Change in value of in-force long term assurance business | 104 | 59 |
| Operating lease rental income | 15 | 9 |
| Investment and other operating income | 197 | 157 |
| Net operating income | 1,184 | 723 |
| Operating expenses | (654) | (313) |
| Staff | (106) | (83) |
| Accommodation, repairs and maintenance | (13) | (10) |
| Technology | (6) | (4) |
| Marketing and communication | (9) | (7) |
| Depreciation: | ||
| Property and equipment and intangible assets | (11) | (7) |
| Other | (59) | (43) |
| Sub total | (204) | (154) |
| Recharges: | ||
| Technology | (1) | (1) |
| Accommodation | (1) | |
| Underlying operating expenses | (206) | (155) |
| Operating lease depreciation | (8) | (6) |
| Change in investment contract liabilities | (1) | 120 |
| Net claims incurred on insurance contracts | (111) | (126) |
| Net change in insurance contract liabilities | (328) | (146) |
| Impairment on investment securities | (1) | |
| Operating profit before provisions | 530 | 409 |
| Impairment losses on loans and advances | (134) | (126) |
| Operating profit | 396 | 283 |
| Share of losses of associates and jointly controlled entities | (3) | (1) |
| Underlying profit before tax | 393 | 282 |
| Net interest margin | 3.70% | 4.09% |
| Impairment losses as a % of average advances | 1.13% | 1.26% |
| Cost:income ratio | 28.0% | 27.5% |
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The income statement includes a number of items which relate solely to policyholder payments and benefits in EFS. The ENA income statement can be simplified on an underlying basis as follows:
| Year ended 31.12.2006 £m |
Year ended 31.12.2005 £m |
|
|---|---|---|
| Net interest income | 470 | 402 |
| Underlying non-interest income | 266 | 162 |
| Underlying net operating income | 736 | 564 |
| Underlying operating expenses | (206) | (155) |
| Impairment losses on loans and advances | (134) | (126) |
| Share of losses of associates and jointly controlled entities | (3) | (1) |
| Underlying profit before tax | 393 | 282 |
Operating Income and Margins
Net interest income increased by 17% to £470m (2005 £402m) driven by a combination of strong asset growth across all of our banking businesses and Drive’s expansion into wider non-prime auto finance markets.
The reduction in net interest margin to 3.70% (2005 4.09%) reflects continued portfolio diversification within our Corporate businesses, a competitive Dutch mortgage market and the impact of the expansion of Drive’s activities in the wider non-prime auto finance market. In our Corporate businesses, the current high level of liquidity and competition created dynamic markets with increasing new business opportunities but with associated margin pressure. Additionally, our continued focus on diversifying our portfolio risk across a broader mix of sectors is evidenced in our anticipated trend of lower margin. Excluding Drive, the net interest margin reduced to 1.90% (2005 2.27%)
| Movement in margin | Basis points |
|---|---|
| Net interest margin for the year ended 31 December 2005 | 409 |
| Lending margin Corporate | (27) |
| Lending margin Retail | (6) |
| Lending margin Drive | (6) |
| Net interest margin for the year ended 31 December 2006 | 370 |
Underlying non-interest income increased by 64% to £266m (2005 £162m) which includes a full year’s consolidation of Heidelberger Leben (‘HLE’) within EFS. On a like-for-like basis, underlying non-interest income increased by 53%. In our Corporate businesses, increased activity levels, early redemptions and selective investment realisations have generated strong fee and equity gains.
Operating Expenses
Underlying operating expenses increased by 33% to £206m (2005 £155m). This increase is partly due to the full year consolidation of HLE and the acquisition of controlling interests in our Premier Distributors in Germany and Italy. Excluding these items, underlying operating expenses grew by 23% reflecting continued investment in people and systems, and the impact of our network expansion programme which has seen the number of BHH branches increase from 14 to 19 and a new corporate office established in Stockholm in July. However, despite these investments, the cost:income ratio increased only modestly to 28.0% (2005 27.5%).
Credit Quality and Provisions
Overall credit quality continued to improve in 2006 with the level of impaired loans as a percentage of closing advances reducing to 0.62% (2005 1.61%) and impairment losses as a percentage of average advances decreasing to 1.13% (2005 1.26%). Impairment provisions as a percentage of impaired loans decreased to 59% (2005 78%).
Excluding Drive, the level of impaired loans as a percentage of closing advances reduced to 0.62% (2005 1.22%). Impairment losses were £14m (2005 £32m) and as a percentage of average advances improved to 0.13% (2005 0.35%). Impairment provisions as a percentage of impaired loans decreased to 59% (2005 68%).
In the Corporate businesses, excluding Drive, our diversified portfolio risk approach coupled with established and proactive risk management techniques across a broader mix of sectors resulted in a significant improvement in credit quality. Impaired loans as a percentage of closing advances improved to 0.87% in 2006 (2005 2.01%) while impairment losses as a percentage of average advances improved to 0.14% (2005 0.54%). Impairment losses in 2006 benefited from a number of successful recoveries.
In Retail, credit quality also improved with impaired loans as a percentage of closing advances reducing to 0.34% (2005 0.40%) and impairment losses as a percentage of average advances improved at 0.12% (2005 0.14%).
Drive Financial Services
The table below shows the impact of Drive and its related earnings included in the overall divisional income statement up to the disposal on 7 December 2006.
| Year ended 31.12.2006 £m |
Year ended 31.12.2005 £m |
|
|---|---|---|
| Net interest income | 254 | 201 |
| Other income | (1) | |
| Net operating income | 253 | 201 |
| Underlying operating expenses | (43) | (40) |
| Operating profit | 210 | 161 |
| Impairment losses on loans and advances | (120) | (94) |
| Underlying profit before tax | 90 | 67 |
The sub-prime nature of Drive’s lending dominates certain divisional metrics and is also significant in the context of the Group. The following table sets out the key metrics for ENA and the Group with and without Drive included.
| Drive included % |
Drive excluded % |
|
|---|---|---|
| ENA | ||
| Net interest margin | 3.70 | 1.90 |
| Impairment losses as a % of average advances | 1.13 | 0.13 |
| Cost:income ratio | 28.0 | 33.8 |
| Group | ||
| Net interest margin | 1.78 | 1.72 |
| Impairment losses as a % of average advances | 0.48 | 0.45 |
| Cost:income ratio | 40.9 | 41.4 |
| As at 31.12.2006 |
As at 31.12.2005 | |
|---|---|---|
| Loans and advances to customers | £12.6bn | £11.1bn |
| Impairment provisions on advances | £46m | £139m |
| Impairment provisions as a % of closing advances | 0.37% | 1.25% |
| Classification of advances*: | % | % |
| Energy | 2 | |
| Hotels, restaurants and wholesale and retail trade | 1 | 2 |
| Transport, storage and communication | 2 | |
| Financial | 1 | 2 |
| Other services | 1 | |
| Individuals: | ||
| Home mortgages | 4 | 4 |
| Other personal lending | 8 | |
| Overseas residents: | ||
| Energy | 4 | 4 |
| Manufacturing industry | 5 | 5 |
| Construction and property | 20 | 14 |
| Hotels, restaurants and wholesale and retail trade | 3 | 2 |
| Transport, storage and communication | 1 | 1 |
| Financial | 4 | 2 |
| Other services | 12 | 15 |
| Individuals: | ||
| Home mortgages | 41 | 41 |
| 100 | 100 | |
| Impaired loans | £78m | £179m |
| Impaired loans as a % of closing advances | 0.62% | 1.61% |
| Impairment provisions as a % of impaired loans | 59% | 78% |
| Risk weighted assets | £11.7bn | £11.1bn |
| Customer deposits | £1.0bn | £0.5bn |
* Before impairment provisions.
Operational Performance
Lending and Deposit Growth
Overall, lending increased by 14% to £12.6bn (2005 £11.1bn). Excluding Drive, lending increased by 24% from a 2005 equivalent of £10.2bn, with strong growth experienced across all our lending businesses.
The portfolio remains well spread both geographically and by business with 53% of lending in Corporate and 47% in Retail.
| As at 31.12.2006 £bn |
As at 31.12.2005 £bn |
As at 31.12.2006 % |
As at 31.12.2005 % |
|
|---|---|---|---|---|
| Corporate | ||||
| North America | 2.5 | 2.2 | 20 | 20 |
| Drive | 0.9 | 8 | ||
| Europe | 4.2 | 3.0 | 33 | 27 |
| Retail | 5.9 | 5.0 | 47 | 45 |
| 12.6 | 11.1 | 100 | 100 |
In Retail, our lending portfolio is almost wholly in the form of residential mortgages while Corporate now benefits from a diverse portfolio spread across a range of specialist sectors. The largest overall concentration in our lending book continues to be in property with residential mortgages accounting for 45% and commercial property for 20%.
Risk weighted assets increased by only 5% to £11.7bn (2005 £11.1bn) reflecting the disposal of Drive and an enlargement of BOS Netherlands (‘BOSNL’) Candide mortgage securitisation programme. Overall, deposits increased to £1.0bn (2005 £0.5bn).
Corporate
Corporate Europe lending increased by 40% to £4.2bn (2005 £3.0bn) with continued focus on effective asset management and credit quality. Continued portfolio diversification towards a broader mix of sectors has resulted in an anticipated reduction in net interest margins, offset by increased new lending opportunities delivering growth of 55% in non-interest income through increased fees and equity gains. Corporate Europe brings together specialist expertise in sectors such as structured finance, commercial real estate and energy and utilities. Our Stockholm office established in July to take advantage of a buoyant economic environment in the Nordic region and expands our network to five Continental European offices.
Corporate North America also delivered strong growth in both the core business and in Drive. In the core business, lending increased by 14% (30% in local currency terms) to £2.5bn (2005 £2.2bn). North America has a clear focus on specialist sectors such as oil and gas, gaming and real estate where it benefits from long experience. It has a proven track record in joint venture activity and an expanding regional banking partnership initiative. This initiative identifies US regional banks with whom we can partner in commercial lending opportunities that would otherwise be beyond their lending limits. It now accounts for 17% of the total portfolio, growing by 97% from 2005. We operate through an office network based in seven major economic centres across the US.
Retail
BOSNL, our leading Dutch online and intermediary introduced residential mortgage provider, saw lending grow by 15% to £4.7bn (2005 £4.1bn) despite facing intense price competition in the Dutch market. BOSNL remains a market leader in online mortgage sales built up on the back of an innovative and low cost entry model, geared to operate at competitive margins. These are key credentials for continued growth in a competitive market.
The BHH roll out programme in Spain continued with a further five branches opened in 2006. Our expanded Retail branch network is located in areas with the maximum growth opportunities, targeting the expanding UK and Irish expatriate market. Lending grew by 33% to £1.2bn (2005 £0.9bn).
European Financial Services
Our investment business, EFS, has performed well given the continuing soft market conditions in the German market with sales up 30% to £103m APE (2005 £79m). Funds under management increased by 3% (6% in local currency terms) to £9.6bn (2005 £9.3bn).
With underlying profit before tax increasing by 57% to £102m (2005 £65m), EFS is well positioned to take advantage of improving opportunities in our core markets. In 2006 we completed the consolidation of the HLE business and increased distribution through the long term agreement with MLP AG. In addition, by securing controlling interests in our key Premier Distributors, we have been able to restructure and reposition our broker distribution channel, while at the same time strengthening our sales and management teams. This in turn enabled us to refresh and deliver new competitive product initiatives.
| Year ended 31.12.06 Single £m |
Year ended 31.12.06 Annual £m |
Year ended 31.12.06 Total £m |
Year ended 31.12.06 Total APE £m |
Year ended 31.12.05 Single £m |
Year ended 31.12.05 Annual £m |
Year ended 31.12.05 Total £m |
Year ended 31.12.05 Total APE £m |
|
|---|---|---|---|---|---|---|---|---|
| Life: | 186 | 63 | 249 | 81 | 166 | 46 | 212 | 63 |
| With-profit | 71 | 12 | 83 | 19 | 125 | 23 | 148 | 36 |
| Unit Linked | 115 | 38 | 153 | 49 | 41 | 15 | 56 | 19 |
| Protection | 13 | 13 | 13 | 8 | 8 | 8 | ||
| Individual Pensions | 3 | 22 | 25 | 22 | 1 | 16 | 17 | 16 |
| Total | 189 | 85 | 274 | 103 | 167 | 62 | 229 | 79 |
* APE is calculated as annual premiums plus 10% of single premiums.
| Year ended 31.12.2006 £m |
Year ended 31.12.2005 £m |
|
|---|---|---|
| Contribution from existing business: | ||
| Expected contribution | 44 | 30 |
| Actual vs expected experience* | 19 | 7 |
| 63 | 37 | |
| Contribution from new business | 36 | 25 |
| Investment earnings on net assets using long term assumptions | 3 | 3 |
| Underlying profit before tax* | 102 | 65 |
* The figures for 2005 have been re-analysed to reflect changes to the overhead allocation methodology.
New business profitability, now measured on the embedded value basis used for IFRS reporting purposes, was 35% APE (2005 32%).
Risks and Uncertainties
The key risks and uncertainties we face in pursuing our strategy include the weakening of economic conditions across our core markets, maintaining the balance between risk and returns at each stage of the economic cycle and changes in regulation and legislation.
If economic conditions weaken our credit growth and returns may fall short of expectations. In mitigation our business is diversified across a broad spectrum of retail, corporate and investment products and across a number of established geographies. The risk and impact of weakening economic conditions is continually reviewed through robust divisional operational and governance procedures where credit, market, liquidity and insurance and investment risks are actively managed.
In our markets margins are under continuous pressure with a resultant threat to the sustainability of appropriate risk and reward ratios. Rather than focus on volume and market share we employ a strategy of selective lending in sectors where we have established real knowledge and understanding. By concentrating on asset quality through robust credit processes, maintaining deep customer and introducer relationships and employing intelligent balance sheet management techniques we mitigate this risk.
Changes in regulation and legislation are key features in each of our businesses with a current focus on the requirements of the new Capital Requirements Directive in Europe and the market disclosure reform (VVG) in our German investment business. We respond positively to these challenges and seek opportunities to turn regulatory change to competitive advantage. We recognise the challenges these changes bring to our people, systems and infrastructure. In mitigation we deploy professional project management techniques and continue to invest to ensure ENA’s capabilities remain robust in the face of these changes.
Through our groupwide leadership commitment programme we deploy active human resource planning, succession management and talent development processes. This, together with an extensive learning and development programme, increases our ability to attract and retain quality people.
Prospects
We continue to pursue a strategy of targeted organic growth across our Europe & North America businesses by seeking to expand our footprint in new markets, and increasing the depth of our presence and relationships in our current markets. We will complement this expansion by developing our product range, increasing our range of specialist sectors and broadening our distribution reach.
We operate in established, affluent and accessible markets which are forecast to maintain robust growth and which suit HBOS products and risk appetite. The continued attractiveness of the economic, political and fiscal conditions in our markets will play a major role in the pace of our expansion, as will our ability to attract high quality talented colleagues. With our current low market penetrations the scale of the opportunity is substantial.
