Operating Review
Our performance in 2006
Profits
In 2006, our strategy delivered a strong performance with profit before tax increasing by 19% to £5,706m (2005 £4,808m) and underlying profit before tax increasing by 14% to £5,537m (2005 £4,842m). Our disciplined approach to capital management, which has seen us return a total of £2bn of capital to shareholders since we commenced the buyback programme in 2005, has combined with this profit performance to drive underlying earnings per share up by 16% to 100.5p (2005 86.4p).
Dividends
Integral to our capital management framework is our dividend policy which targets an underlying dividend cover of circa 2.5 times. Consistent with this framework, the Board is proposing a final dividend of 27.9p (2005 24.35p) which, together with our interim dividend, will result in a full year dividend of 41.4p (2005 36.1p), an increase of 15%.
Growth
Lending growth was at the upper end of our target range for the year, with advances to customers increasing by 10% to £376.8bn (2005 £343.8bn). We delivered strong growth in mortgages and right across our International businesses. However, we remain cautious about the returns available from the UK unsecured market and are selective in our hold appetite in Corporate given the continuing pressure on margins.
Our Investment Business continued to deliver growth in investment sales and is well placed to benefit from our leading savings franchise and the growing awareness of the UK population of the need to self-provide for retirement.
Returns
The Group post tax return on equity increased to 20.8% (2005 19.6%), driven by profitable growth in lending, our focus on cost efficiency and the benefits of the share buyback programme.
Margins
The Group net interest margin was broadly stable at 178bps (2005 180bps). In Retail, we saw a modest decline reflecting our greater appetite for mortgage lending together with increased competition in the Buy to Let market. Margins also fell in International reflecting a change in product mix. However, in Corporate, margins were higher, benefiting from our continued sell down strategy.
In the UK Investment Business, new business profitability (now measured by reference to the Full EV basis described on pages 20 to 24 of the Financial Review) improved to 27% (2005 24%) of APE.
Revenues
We continued to see underlying non-interest income growing at a faster pace than net interest income. Net interest income rose 8% and underlying non-interest income was up 10%, although, as expected, non-interest income growth in Retail has slowed, reflecting reduced commission levels from the sale of Repayment Insurance and the impact of lower Credit Card default charges, effective from 1 August 2006, in response to the Office of Fair Trading’s (‘OFT’) ruling.
Costs
Total underlying operating expenses increased by 5.7%, within our 6% target for the year, despite substantial ongoing investment in our International and Treasury & Asset Management businesses. Costs in our core UK businesses increased by 2.7%, below our 3.5% target.
The Group’s cost:income ratio improved in 2006 to 40.9% (2005 42.2%), with overall positive cost:income ‘jaws’ of 3%.
Credit quality
Credit performance has developed very much in line with previous trends. The Group’s impairment losses were £1,742m (2005 £1,599m) representing 0.48% of average customer advances (2005 0.49%). Impairments as a percentage of closing advances decreased to 2.18% (2005 2.37%). The coverage of impaired loans by provisions increased to 38% (2005 36%).
In Retail, our credit performance is driven by the concentration of well collateralised secured lending in our loan book which comprises 93% of Retail lending. The absolute level of secured arrears fell during 2006 and impairments as a percentage of advances fell to 1.84% (2005 2.21%).
The growth of impairments in our unsecured book moderated in the second half of 2006. However, impairment levels continue to rise in absolute terms and as a percentage of advances increased to 13.2% (2005 11.5%). We remain cautious about future trends given the continued growth in UK personal insolvencies.
Corporate credit experience continues to reflect the most benign credit environment for some 30 years. While we are not seeing any material signs of stress, we have maintained prudent exposure limits and we continue to price our lending without expectation of incremental returns from equity stakes. In International, credit conditions remain resilient.
Capital
During 2006 we bought back £982m of shares and cancelled 100m shares in issue. The Tier 1 ratio at 8.1% (2005 8.1%) remains above our 8.0% target level. The total capital ratio was 12.0% (2005 12.4%).
Divisional Performance
Retail
Underlying profit before tax increased by 4% to £2,364m (2005 £2,283m). Underlying net operating income increased by 4% with net interest income up 4% and a lower net interest margin at 178bps (2005 184bps), the latter reflecting a greater proportion of mortgage lending, and increased competition in the Buy to Let market.
Underlying non-interest income grew by 3%, the pace of growth being moderated in 2006 as a result of reduced Repayment Insurance commissions as a consequence of planned lower volumes of consumer finance products and the impact of lower Credit Card default charges.
Strong cost management ensured underlying operating expenses were held at the same level as 2005, delivering a 4% ‘jaws’ between revenue and cost growth and a further improvement in the cost:income ratio to 38.4% (2005 39.8%).
The 9% increase in lending was driven by growth in our secured book as we continue to take a cautious approach to the returns available from the unsecured market.
In mortgages, our gross market share was stable at 21% (2005 21%). Our share of principal repaid fell from 25% in 2005 to 24% in 2006. The combination of these factors has resulted in our share of net lending increasing to 17% (2005 14%), comfortably within the 15%-20% target we set at the start of 2006. The trend in the second half of the year was, as in 2005, impacted by mortgage cessations relating to prior periods of higher gross lending.
As the UK’s largest provider of savings products we are well placed to benefit from the increasing savings ratio in the UK. We acquired around 0.5m (2005 0.5m) new to franchise savings customers and increased customer deposits by 9% to £144.6bn (2005 £132.2bn) reinforcing our position as the UK’s largest provider of savings products with an estimated 16% (2005 16%) share of Household Sector Liquid Assets.
In Bank Accounts, we continue to innovate and differentiate ourselves. Our high profile product launches have enabled us to increase our estimated share of new bank accounts to 19% (2005 16%) well ahead of our share of stock of 13% (2005 12%).
The unsecured lending market has slowed as UK consumers adjust to higher levels of unsecured debt and we also continue to view certain parts of the unsecured market as currently uneconomic. As such, our reduced appetite saw Unsecured Personal Loan balances fall by 4% to £6.6bn (2005 £6.9bn) and Credit Card balances also fall by 4% to £7.0bn (2005 £7.3bn).
Impaired secured loans as a percentage of closing advances reduced to 1.84% (2005 2.21%). Secured loan impairments fell by 9% compared to 2005 reflecting an absolute fall in both mainstream and specialist mortgage arrears. Provisions coverage of impaired secured loans remained stable at 10% (2005 10%) reflecting the unchanged formulaic calculation of required provisions.
We continue to focus on strong asset cover in our secured book. Our retention strategy for existing customers and reduced appetite for lower return remortgage business resulted in a modest increase in the loan to value ratio (‘LTV’) of new lending to 64% (2005 60%). The average LTV across our entire secured lending book was stable at 44% (2005 43%) reflecting the positive contribution to collateral cover from improving retention.
Unsecured impairments continue to increase but the rate of growth moderated in the second half of 2006. Unsecured impairments as a percentage of closing advances increased to 13.2% (2005 11.5%) reflecting the residual seasoning of the pre 2004 Credit Card book and a reduction in balances. We continue to see an improvement in arrears emergence on business written more recently. The coverage of impaired unsecured loans reduced slightly to 71% (2005 73%).
