2nd UPDATE: Lloyds Post Small Profit, Cautions On Economic Outlook

Lloyds Banking Group PLC (LYG) Tuesday said it eked out a GBP2 million net profit in the first quarter, as the group put aside extra cash to cover claims from customers wrongly sold payment protection insurance and said it is bracing itself for a period of economic stagnation in the U.K.

The part-government-owned lender said total income net of insurance claims came to GBP4.88 billion for the quarter, down 6% on the same quarter in 2011. A year earlier, the lender recorded a net loss of GBP2.44 billion, when it was hit by a hefty charge to cover the sale of payment protection insurance.

On an adjusted basis, which includes factors such as the integration of mortgage lender HBOS and other one-off charges and asset sales, profit before tax came to GBP628 million, up from GBP284 million a year earlier. Lloyds said that the adjusted figures better reflect the performance of the group.

"Our results reflected the subdued U.K. economic environment," CEO Antonio Horta-Osorio said. Like several of its U.K.-based peers, Lloyds--which is predominantly a retail bank--is suffering as the British economy sinks into recession. The combination of low interest rates, slack demand for loans and increased regulatory pressure has weighed on the bank's share price in recent months.

Horta-Osorio said that he expected the U.K.'s economy to remain flat for the rest of the year and interest rates to remain low. However, the CEO down-played statistics showing the U.K. economy had entered a recession. "We think it is not very significant," said Horta-Osorio. "I really think that this number doesn't mean anything, as there was an additional day of holiday in the quarter. We continue to think that it will be a tough year... with 1.5% to 2% GDP growth in 2013."

Lloyds said that it was hoarding the GBP11.4 billion of cheap loans it tapped from the European Central Bank in the event that the macroeconomic situation worsens or that a sector review conducted by Moody's leads to a ratings downgrade for the bank, which would increase funding costs.

At the group's full-year result, Lloyds said its target of on return of equity between 12.5% and 14.5% would be delayed beyond 2014. The group also said, without being specific, that it expects 2012 revenue to be lower than it was in 2011, as the bank continues to slim down its balance sheet. On Tuesday, Lloyds said it was "confident" it could meet its financial goals for the year.

The lender also continues to be haunted by mounting claims by customers who were missold payment protection insurance. On Tuesday, the lender said that it was increasing by GBP375 million the amount of cash it is putting aside to cover eventual claims for misselling PPI. Last year, the bank put aside GBP3.2 billion to cover PPI claims.

The insurance covers buyers' mortgage or credit-card payments if they lost their jobs or became ill and was widely sold to people who didn't need it. In recent months, the number of misselling claims spiked as companies helping process claims from customers upped their requests, Horta-Osorio said. As a result, Lloyds had to follow in the footsteps of Barclays Group PLC (BCS) and increase the pot of cash used to pay off customers.

"While other banks have recently taken additional charges, we were more optimistic for Lloyds on the basis that its original charge appeared more prudent, so this is disappointing," said Gary Greenwood, an analyst at Shore Capital.

Lloyds was more upbeat about the progress it is making in slimming down its balance sheet. The bank increased its guidance for the non-core asset reduction it expected to achieve in 2012 by GBP5 billion to at least GBP30 billion and said that it is expecting to reach its 2014 target in 2013.

As part of this process, Lloyds is expected to sell off 632 branches. The sale is mandated by the European Union because Lloyds was bailed out by taxpayers and has to be completed before the end of 2013. Lloyds recently ended exclusive negotiations with the Co-operative Group as regulators questioned whether the banking-to-food group was a suitable buyer.

NBNK PLC (NBNK.LN), an investment vehicle set up by financial sector veterans to create a challenger bank in the U.K., has since expressed interest in the branches. On Tuesday, the group reiterated that it was continuing its discussions with both NBNK and the Co-op and was still confident it could part with the branches before the end of 2013. Horta-Osorio said that Co-op was still the preferred bidder but that the bank was taking NBNK's bid seriously. The CEO denied press reports that the bank was looking to sell its Scottish Widows insurance and investment-management business.

At 1125 GMT, Lloyds shares were up 2 pence, or 5.1%, to 32.6 pence in a higher day for U.K. financials.

- By Max Colchester, Dow Jones Newswires; [phone], [e-mail]