“Not So Defensive After All”

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This story features COMMONWEALTH BANK OF AUSTRALIA.
For more info SHARE ANALYSIS: CBA
The company is included in ASX20, ASX50, ASX100, ASX200, ASX300 and ALL-ORDS

By Greg Peel

The credit crunch has proven a double-edged sword for the big Australian banks. Depositors and borrowers have flocked back to the traditional pillars, having either been burnt by, or in order to avoid being burnt by, smaller banks and non-bank financials who have proven vulnerable since the collapse of securitised intermediation…

The big banks have been forced to wear cost of funds increases for a while to help precipitate this prodigal transition, and although having raised lending rates recently they will continue to suffer from lower earnings margins for a while yet.

But that’s okay if the result is stronger business growth in a new credit market regime. This is the main reason many banking analysts have been positive on the big banks – at least as defensive plays in an otherwise weak market. The theme has been short term pain for long term gain.

Another underlying theme has been the general balance sheet health of a lot of Aussie corporates, in stark contrast to conditions prevailing in the early nineties and which led to the deep recession of the time. As such, analysts have generally been unconcerned about a significant jump in bad loans. Only JP Morgan has been banging the bad loan drum, as part of a sector Underweight call.

But JP Morgan has also been championing Commonwealth Bank ((CBA)) as the best of a bad bunch, suggesting CBA should be less affected than the others by the credit crunch and that its capital base is the most stable. So even JPM got a shock yesterday when the CBA half-year earnings result came in 5% below the analysts’ expectation. Ironically it was an unexpected jump in bad loans that made all the difference.

All banking analysts were caught out, to varying degrees. The result was about 4% below consensus. The announced interim dividend of 113c also fell 1-3c below expectations. Bad loans weren’t the only culprit, with weaker retail bank revenue growth and higher overall cost growth adding to the pain. CBA has long enjoyed a valuation premium to its peers, and guidance from management is that performance should continue to either meet or exceed peers. Deutsche Bank believes this claim “no longer seems credible”.

GSJB Were has never been happy with the premium CBA attracts, and yesterday’s result did nothing to change the analyst’s Underperform rating. Credit Suisse actually upgraded from Underperform to Neutral believing yesterday’s shock sell-off brought CBA back to reality, and some. Mind you, all banks were sold off so there wasn’t necessarily much premium collapse. Macquarie posted the only downgrade – from Outperform to Neutral – suggesting the market’s risk appetite has greatly diminished and bad debts don’t help. The analysts also believe CBA’s premium vis-a-vis the other banks is now under threat.

That puts the Hold count in the FNArena database at seven out of ten. Analysts acknowledge that CBA’s bad debt result has put the frighteners through the market. Until this half, Australian banks’ bad debt ratios were at all-time lows. Investors are nervous, and it could be a while before solid buying returns to the banking sector.

Out of the experts who issued an update this morning, only JP Morgan retained Outperform (within the sector). While JPM acknowledged that even it managed to underestimate what it had been expecting for a while, it still sees the other big banks as likely poorer performers. We won’t know that for a while as the rest of the group report in April/May. JPM notes CBA should be least affected by the credit crunch and has a more sustainable dividend payout ratio which is also higher than its peers.

All brokers reduced their FY08 earnings expectations this morning, around 2-3%. The most noticeable change, however, was in target prices.

The average target price in the FNArena database fell from $56.69 to $52.11. If you take out a so far silent UBS ($60.00) that average becomes $50.98. The share price had bounced 1.7% to $46.98 at midday, so analysts are still looking for some of the positives to kick in by twelve months down the track.

So what of the other banks? GSJB Were actually believes the overall result for CBA was a positive for the banking sector in general, with the caveat that one-off corporate defaults remain the wildcard risk. The good points for the sector are that underlying credit quality is still strong, loans and deposits are growing solidly, margin declines have not been that dramatic despite the increased cost of funds, capital positions are strong (on contrast to the US, for example) and wealth management income, although receding in a weaker market, is still supported by solid inflows.

However, Weres also believes now is not the time to be piling in, despite yesterday’s sell-off. We have until April/May to learn more about the others and the market at present is jumping at shadows. Unless you are an aggressive investor, it might be best to sit tight.

The CBA result has been a wake-up call for some analysts stuck on the “banks are defensive” cliche. The global credit crunch has not yet played out. When it has, and all casualties are known, then it should be time to be more positive. Hopefully that will be some time in the second half, and 12-month targets on CBA support that view. But it is with trepidation that analysts will look towards April. Stand by for some more conservative reviews of earnings and targets on the other big banks.

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