HBOS plc 2008 Interim Results

"The first half of 2008 has seen the dislocation in financial markets evolve into a wider economic slowdown. Recognising the importance of strong capital to the HBOS core customer proposition,we have now completed our £4.0bn Rights Issue, rebasing the Group to stronger capital ratios. We are repricing both new and existing business, to deliver margin stability. The Group is now well positioned to operate in the more challenging economic environment."Andy Hornby, Chief Executive Group Performance -    

-          Underlying profit before tax ('UPBT') excluding negative fair value-  adjustments (1) ('NFVA') down 14% to £2,546m (H1 2007 £2,962m). 

-         UPBT including NFVA(1) down 51% to £1,451m (H1 2007 £2,962m). 

-         Profit after tax down 56% to £950m (H1 2007 £2,139m). 

-         Underlying earnings per share ('EPS') excluding NFVA down 13% to47.4p (H1 2007 54.6p). 

-         Underlying EPS including NFVA down 52% to 26.4p (H1 200754.6p). 

-         Basic EPS down 57% to 23.5p (H1 2007 55.0p). 

-         Proforma Basel II capital ratios at 30 June 2008, adjusted for the proceeds of the Rights Issue: 

-         Tier 1 capital ratio 8.6%. 

-         Core Tier 1(2) capital ratio 6.5%. 

-         Total capital ratio 12.2%. 

�� A Capitalisation amount totalling £320m, currently equivalent to 6.1pper ordinary share will be allocated in respect of the 2008 interim dividend. It is intended that the final dividend will be paid in cash. 

�� Group customer lending in H1 has grown by an annualised 12%.Growth is however slowing as planned and we expect full year customer lending growth of mid-single digits. 

�� Group customer deposits have grown by an annualised 12%. Forthe full year, we expect the rate of growth of deposits to exceed the rate of growth in lending. 

�� Group net interest margin 155bps (H2 2007 158bps). 

�� Group post tax RoE excluding NFVA 16.6% (H1 2007 21.0%). 

�� Group post tax RoE 10.3% (H1 2007 21.0%). 

�� Group cost:income ratio (excluding NFVA) 41.2% (H1 2007 39.9%). 

�� Group cost:income ratio 49.6% (H1 2007 39.9%). 

�� Group impaired loans as a % of closing advances increases to2.35% (end 2007 2.03%). Impairment losses as an annualised % of average advances increases to 0.59% (H1 2007 0.50%). 

(1) Negative Fair Value Adjustments relating to certain traded debt securities in Treasury taken to the income statement were £1,095m (H1 2007 £nil)

2) Core Tier 1 excludes preference shares and preferred securities. 

Group Performance 

Profit

The results for the first half of 2008, and the comparison to the first half of 2007,have been significantly affected by £1,095m (H1 2007 nil) of negative fair value adjustments ('NFVA') taken to the income statement in respect of debt securities held in the Treasury Trading Book. In addition, £1,916m of NFVA (H1 2007 nil) o na post tax basis were taken through equity in the Available For Sale ('AFS') reserve, which are not reflected in reported profit or regulatory capital. Looking forward and as previously guided, we expect a stronger second half. Underlying profit before tax excluding NFVA decreased by 14% to £2,546m (H12007 £2,962m). Underlying earnings per share excluding NFVA decreased by13% to 47.4p (H1 2007 54.6p).Underlying earnings per share including NFVA decreased by 52% to 26.4p (H12007 54.6p). Underlying profit before tax including NFVA decreased by 51% to£1,451m (H1 2007 £2,962m). 

Interim dividend 

As announced on 29 April 2008, we believe that it is prudent to issue new ordinary shares to shareholders by way of a Capitalisation Issue in respect of the 2008interim dividend. We have therefore today proposed a Capitalisation amount of £320m, currently equivalent to 6.1p per ordinary share. The Capitalisation Issuep rice, which will be used to calculate shareholders entitlement to new shares, will be determined as the average of the middle market quotations for ordinary shares over the three dealing days starting on 1 October 2008.We believe that a payout ratio of around 40% is appropriate for 2008 and over the medium term, reflecting a prudent view of the expected ongoing capital requirements of the Group. We intend to pursue a progressive dividend policy, growing dividends in line with underlying earnings. We intend to pay the final dividend in cash, which together with the Capitalisation Issue results in around 40% of underlying profits attributable to ordinary shareholders being distributed. 

Capital

 Following the completion of the £4.0bn Rights Issue in late July 2008, the Group's capital ratios have been rebased to a higher level. Strong capital lies at the heart of the HBOS customer proposition and underpins our leading positions in liquid savings, deposits and investments. The Rights Issue is designed to achieve a step change in the ratios through the downturn. At 30 June 2008, the proforma capital ratios (calculated to include the £4.0bn of capital raised from the RightsIssue) were Tier 1 8.6%, Core Tier 1 6.5% and Total Capital 12.2%. These ratios are in the middle of our revised target ranges of 8%-9% for Tier 1 and 6%-7% forCore Tier 1.Excluding the proceeds of the Rights Issue, the actual Tier 1, Core Tier 1 andTotal capital ratios as at 30 June 2008 were 7.3% (end 2007 7.7%), 5.3% (end2007 5.7%) and 10.9% (end 2007 11.0%), respectively. 

Funding

We continue to fund successfully in the wholesale markets. At 30 June 2008 41.4% of our wholesale funding matures in more than one year (end 2007 41.0%).Our asset growth will continue to be selective and, over time, we will grow the relative share of customer deposits in our funding mix. 

Margins 

The Group net interest margin declined by just 3bps to 1.55% (H2 2007 1.58%).We expect to see relative stability in overall margins in the second half of 2008with the potential for improving margins in future years.In Retail, the margin increased by 3bps as asset spreads improved, more than offsetting the increased costs of both customer deposits and wholesale funding.  In Corporate, the margin declined by 5bps, despite wider spreads being achieved on new lending, reflecting slower turnover of the existing book. In International, the margin declined by 7bps primarily as a result of increased funding costs. 

Growth 

Advances to customers increased by an annualised 12% to £456.0bn (end 2007£430.0bn). We expect the rate of lending growth to slow in the second half of 2008, particularly in Corporate, and expect growth in the full year for the Group will be mid single digits.The rate of growth in the first half primarily reflects the pipeline of Corporate lending at the start of the year which, together with slower syndication markets, has seen Corporate lending grow by an annualised 14% to £116.9bn (end 2007£109.3bn). International's annualised growth of 34% to £78.5bn (end 2007£67.1bn) partly reflects the impact of foreign exchange translation. In Retail, lending grew by an annualised 2% to £255.8bn (end 2007 £253.4bn) in a smaller mortgage market. We continued our cautious approach to the unsecured personal lending market. Customer deposits increased by an annualised 12% to £258.1bn (end 2007£243.2bn). We expect that the rate of deposit growth will exceed the rate of growth in lending in the full year. General Insurance Gross Written Premiums ('GWP') increased 3% to £892m (H12007 £868m) reflecting strong performances in Household (up 7%) and Motor (up 43%) offset by lower Repayment insurance (down 13%). New sales combined with a focus on retention saw overall Household policies increase by 11% to 3.0m (H1 2007 2.7m) and Motor by 30% to 1.3m (H1 2007 1.0m).Volatile equity markets and changes in government tax policy saw UK investment sales decrease by 5% to £7,201m, Present Value of New Business Premiums ('PVNBP') (H1 2007 £7,574m). However, lower levels of lapses saw net fund flows increase by 33% to £1.2bn. Insight saw net inflows of £8.7bn (H1 2007 £6.0bn) increasing assets undermanagement by 3% to £112.0bn (end 2007 £109.1bn).

Efficiency

Underlying net operating income (excluding NFVA) was stable at £6,467m (H12007 £6,427m). Within this, underlying net interest income increased by 6%, reflecting growth in lending. Underlying non-interest income (excluding NFVA)decreased by 7%, primarily reflecting lower revenues from the Corporatei nvestment portfolio. Underlying operating expenses increased by 4% to £2,667m(H1 2007 £2,563m). The cost:income ratio (excluding NFVA) was higher at 41.2%(H1 2007 39.9%). 

Credit Quality

Consistent with a slowing economy, credit experience has seen some deterioration in the first half of 2008. Impaired loans as a % of advancesi ncreased to 2.35% (end 2007 2.03%). Impairment losses increased by 36% to£1,310m (H1 2007 £963m, H2 2007 £1,049m) representing 0.59% (annualised) of average advances (H1 2007 0.50%, H2 2007 0.50%). In Retail, impairment losses increased to 0.57% (annualised) of average advances(H1 2007 0.57%, H2 2007 0.49%). Secured lending impairment losses totalled £213m (H1 2007 £(12)m, H2 2007 £40m) and unsecured lending £509m (H1 2007£690m, H2 2007 £576m). The decline in house prices in the first half of 2008 has driven an increased secured provisioning requirement. Secured credit quality continues to be underpinned by significant equity in the book where the average LTV is 48%. Consistent with our reduced appetite for unsecured lending for the last 3 years, we saw a decline in unsecured losses in the first half of 2008. In Corporate, impairment losses increased to 0.83% (annualised) of average advances (H1 2007 0.51%, H2 2007 0.71%) reflecting the weakening economic climate.In International, impairment losses increased to 0.33% (annualised) of average advances (H1 2007 0.19%, H2 2007 0.21%) primarily reflecting a small number of higher value corporate loans in Australia and North America. 

Outlook

 The reduced availability of credit and a slowing housing market are now part of a wider economic slowdown. We expect UK GDP growth to remain positive in 2008 but with a risk to the downside in 2009. Consensus forecasts, for the decline in house prices, is now in the range of 15-20% over 2008 and 2009 combined. Despite inflationary pressures in evidence today, we expect that signs ofs tabilisation will be sufficient for the Monetary Policy Committee to allow interest rates to remain relatively unchanged for the remainder of the year. The slowing economy is likely to see a modest rise in unemployment from its current lows.We remain cautious on the outlook for global wholesale funding markets and do not expect any significant reopening of securitisation markets in 2008 or the first half of 2009. Asset growth will therefore slow in the second half of 2008 and we expect to deliver lending growth for the Group of mid single digits in 2008. We will also consider selective asset disposals to improve our deposit to loan ratio. Group risk weighted assets are expected to grow at a faster pace than lending growth in the current economic environment. However, we expect to operate comfortably within our target capital ranges.The net interest margin outlook is more positive than for some time. New lending pricing has increased significantly during the first half and this is increasingly offsetting the higher funding costs. We expect relatively stable margins in the second half of 2008 with the potential for improving margins in 2009. In light of the deteriorating economic environment, we expect to see upward pressure on impairment losses. Mortgage arrears are on a rising trend from historic lows but are supported by strong employment. In Corporate, we are not currently seeing material signs of tenant default but the deteriorating economic climate is likely to put some further pressure on impairments.In the Investment markets, whilst short-term volatility and tax policy changes are likely to impact new sales across the industry for the remainder of 2008, this does not change our view of the overall attractiveness of the market and the significant growth potential for our multi-channel Investment business where we also expect to see continued emergence of profits from our in-force book. In Insurance, we expect H1 trends to continue with the strength of our brands and propositions contributing to good growth in household and motor whilst a more cautious outlook for the unsecured lending markets will see further reductions in repayment sales.In our International businesses we will be more selective in asset growth as we expand our business with an increasing focus on growing liability products. In summary, HBOS continues to take a cautious view of the outlook for global financial markets and we are adapting our business model for a tougher economic environment. In particular;

- We are concentrating on the re-pricing of new and existing business to deliver margin stability;

- We have re-based the Group's capital ratios following the Rights Issue;

- We are adjusting the Group's funding mix, over time, to continuously improve the deposit to loan ratio; and

- Cost management will remain extremely tight in light of the economic circumstances.Post the Rights Issue, and with stable and potentially improving marginsunderpinning pre-provisioning profitability, we are well placed to compete in tougher markets.