Why Lloyds Can't Stop Hunting

Even if it gets Abbey, it needs a European deal to keep growing

Peter Ellwood may be Europe's most frustrated chief executive. In the past four years, his ruthless cost-cutting and efficiency measures helped turn Lloyds TSB Group into Britain's largest and most profitable retail bank. By all rights, that should position Lloyds to be a European champion.

Not in finance. Not only do European regulators restrict aggressive foreign moves, but cultural differences make it hard for British managers to have a meeting of the minds with Continental bankers. So Ellwood's latest move is at home: a bid for Abbey National PLC, Britain's fifth-largest retail bank, a deal that Trade & Industry Secretary Stephen Byers is due to rule by Feb. 23. Ellwood launched the $27.6 billion offer to thwart merger talks between Abbey and Edinburgh-based Bank of Scotland. Most analysts expect Lloyds to succeed eventually, but buying Abbey won't solve the bank's larger problem: Where can it grow next?

MORE FIREPOWER. Ellwood has knocked fruitlessly on European doors for three years. Michael E. Fairey, deputy CEO, says that Lloyds has talked to "just about every major European bank group" without success. Now, Ellwood says he is pondering "a very big deal, a merger of equals" on the Continent. Such a combination would give Lloyds firepower for bigger deals. Fairey says Paris-based BNP Paribas fits the Lloyds mold. He also admires Spain's Banco Bilbao Vizcaya Argentaria for its retail-bank skills. (BBVA says it isn't in talks with Lloyds, and BNP won't comment.) Lloyds might also target a midsize bank that's ripe for cost-cutting such as Germany's Commerzbank.

To smooth Lloyds's Continental approaches, the bank just hired Maarten van den Bergh, a former president of Royal/Dutch Shell, as deputy chairman. He'll become chairman when Brian Pitman, who engineered the 1996 Lloyds-TSB merger, retires in April.

But it's far from clear that Lloyds could impose its signature cost-cutting regimen on most European banks and their strong unions. Executives at Commerzbank, for example, say they dread the thought of a knife-wielding Lloyds's team paring their fiefdoms. Ellwood insists Continental bankers are coming around: "We are confident that more people are thinking like we are."

Maybe. But time isn't on Lloyds's side. Its stock price has fallen nearly 40% from its high in April, 1999, as investors concluded that it had run out of room in an ever-more competitive British market. That, they feared, would spur the bank to seek an overpriced European deal. "The market is genuinely concerned about what Lloyds can and will do next," says Neil Woodford, a fund manager at Britain's Perpetual Investment Management Services Ltd.

The Abbey deal would take pressure off. The two banks would make a giant with a market cap of over $75 billion. Abbey management hasn't totally rejected the idea, but says the offered premium of 8% over the current share price is too low. "It all depends on what our shareholders want," says Abbey CEO Ian Harley. Another problem is Lloyds's share price. If it keeps falling, Lloyds may become an also-ran--or a target. Ellwood could lose his job, says one analyst: "He has positioned [Abbey] very much as his deal."

Most observers think that competition authorities will eventually O.K. the merger. The sticking point is likely to be that the duo would hog 27% of Britain's checking-account market. Whitehall frowns on combinations that soak up more than 25% of a major business line.

Lloyds's 2000 results, announced on Feb. 16, highlight its need for fresh blood. Pretax profits grew by only 7%, to $5.6 billion. Operating expenses rose 16%. Not that Lloyds is a write-off. Its after-tax return on equity of 29.1% and cost/income ratio of 46% are enviable. But the modest profit growth shows how tough British retail banking is. That's why Lloyds shelled out $10.9 billion last year for Edinburgh-based fund manager Scottish Widows. Mike Trippitt, an analyst at Bear, Stearns & Co. in London, says that's the right idea: "Real growth has to come from asset management and insurance products." But he complains that Lloyds's 2,300 branches don't push Scottish Widows products aggressively enough.

Meanwhile, Lloyds predicts that the Abbey merger will generate $1.3 billion more in profits per year by 2005, $942 million from cost-cutting. About 600 of Abbey's 700 branches, after all, are within a quarter mile of a Lloyds branch. Even if Ellwood lands Abbey, however, Europe will have to be his next move.

By Stanley Reed in London with David Fairlamb in Frankfurt

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