Rudi On Thursday

This story features ANZ GROUP HOLDINGS LIMITED, and other companies. For more info SHARE ANALYSIS: ANZ

(This weekly editorial was initially published late on Wednesday, November 12 and made accessible for paying subscribers only. It is now re-published to make it available to everyone.)

The All Ordinaries closed at 3883.60 today; 43% below its peak (6808.20) from October 29 last year. The ASX/S&P200 index closed at 3954.90, some 42% below its peak of 6828.70 recorded on the first day of November 2007.

Can you believe there are still plenty of market strategists and other financial experts out there who dare to challenge the view that Australian shares are offering plenty of value by now, or that the share market could possibly not go much lower from here?

Twelve months beyond the hazy, crazy days of October-November 2007, more than 40% of the market’s value has evaporated since (with many stocks having performed much worse), and the market is still divided by one single question: have we finally reached bargain territory yet?

It all has to do with company profits and how much investors are willing to pay for a slice of these profits. The latter factor is better known as Price-Earnings Ratios, or PEs. Because both company profits and PEs decline significantly during an economic downturn, the differences in share price valuations can be enormous too.

I always use the banks as an example, they’re easy to pin down, and everyone can instantly relate to what I am talking about:

ANZ Bank ((ANZ)) reported earnings per share (EPS) of $2.13 for fiscal 2007. Because times were buoyant investors were prepared to pay more than a PE multiple of 15 for the shares at the time. This allowed the share price to move beyond $31. (The shares peaked at $31.33 in late October last year).

The tide has turned for the banks, however, and especially so for ANZ. Current EPS forecast for fiscal 2009 is no higher than $1.69. OK, that is a big difference and that’s what economic downturns do to profits of banks; they eat into it. Fifteen times $1.69 equals a share price of $25.35. However, ANZ shares closed at $15.40 today; roughly $10 lower.

How is this possible?

Because when things go pear-shaped investors are no longer willing to pay a similar multiple. History shows that when things go brilliant for the economy, and for Australian banks, PE ratios for the sector tend to rise to 13-14, sometimes they can even reach as high as 15 (as was the case in late October last year). But when things are far from brilliant these PE multiples sink to 10-11.

ANZ shares are currently valued near 9 times forecast earnings per share for the current fiscal year. All of the above would thus indicate there is currently plain and obvious value up for grabs.

And here’s where the market division starts.

Look back through the history since late October last year and you’ll see that ANZ shares at $17 (in July) were in exactly the same situation as where they are today. Back then they had fallen to a low multiple of 9  (at times even lower) and the market proved equally divided between those who would exclaim “value” and those who still had their doubts.

What has happened since then?

Market forecasts were lowered and ANZ’s PE multiple automatically rose, to the point where they no longer could be categorised as “cheap”, and thus more selling was needed to put the shares back on a correct PE multiple of 10-ish.

You can see where this is going don’t you?

ANZ shares at 9 doesn’t automatically imply the shares have become too cheap. It can be a sign of more bad news to come, which essentially translates into lower profits for ANZ this year. Lower profits means the multiple goes up. If ANZ profits move too low today’s share price might still be too expensive, similar to what happened in July.

If I take the above calculations as an example, ANZ profits would have to fall another 9% (from current consensus expectations) to instantly move the shares from “cheap” to “low, but fairly valued”. Is this a reasonable threat?

Well, last financial year profits actually fell by 26%. The current consensus forecast implies growth of around 9% this year. So we would effectively have to assume no growth for ANZ this year. Does this sound a bit too bearish?

At face value, yes. But look a bit further and a different picture emerges.

From a simple profit perspective, ANZ Bank is almost certainly going to do better this year than last, but since all the banks, including ANZ, are supporting their dividend ratios via underwritings and capital raisings (see National Australia Bank ((NAB)) for example) this growth in profits does not translate equally into EPS growth. And this is where banking stocks all of a sudden start looking a lot less attractive.

In the case of ANZ Bank this is probably best illustrated by the fact that total profits are currently expected to surpass the level reached in FY07 by FY10. That is in less than two years from now and three years after the previous peak. One could say this looks reasonably “normal”. Well done, ANZ.

In EPS terms, however, not even FY11 is, on current expectations, expected to come close to the $2.13 reported in FY07. Most analyst reports don’t contain forecasts further than three years into the future so it is at present impossible to predict when ANZ Bank’s EPS will again match the level of FY07. Let’s for the sake of this study assume that FY12 will see ANZ Bank return to an EPS of $2.13.

That is in another three years from today; five years after FY07.

Why is it important to highlight this difference between group profits and profits for shareholders (in other words: earnings per share)? Because it explains why some foreign fund managers refuse to see compelling value in Australian banking shares. In their view, the banks are sacrificing a substantial part of their future recovery potential in order to please local retail shareholders in the short term.

Make no mistake, the differences in share price potential are enormous. Were ANZ to return to its FY07 EPS by FY10 already this should translate into a share price of at least $21.30 (multiple of 10) and potentially as high as $29.82 (multiple of 14).

Compared with today’s share price of $15.40 this would imply a potential investment return between 38% and 93% -ex-dividends- in two years.

Current dilution of shareholder profits, however, to safeguard dividends, means these potential returns will only be reached after four or five years. This means instead of a potential return of 19% per year (ex-dividends), or higher, the prospective return has effectively been reduced to 7.6-9.5% per annum (equally ex-dividends).

Two things emerge from all this: it is easy to understand the argument that Australian banks are giving up an important part of their future potential through safeguarding their dividends in the short term.

It also shows the longer term potential for investors once we get through the worst of this global recession and financial crisis.

Two things should be kept in mind: none of the above is set in stone and given that economic indicators are still pointing south it should be expected that worse conditions are still ahead of us. This means that profit forecasts, including for the banks, can still move lower, and they probably will. As such, all calculations mentioned above can easily face dilution by one full year.

It cannot be excluded that worsening conditions might still force the banks to cut their dividend payouts, regardless of the dilutive policies in place.

I think all this also explains why the market remains highly divided about the apparant value question. To a certain extent, it does come down to what investment horizon we’re talking about. Because ANZ shares can still become cheaper, and they probably will.

With these thoughts I leave you all this week.

Till next week!

Your editor,

Rudi Filapek-Vandyck
(as always firmly supported by Greg, Grahame, Joyce, Chris, Pat, George and Andrew).

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