Brokers Reassess The Banks

This story features COMMONWEALTH BANK OF AUSTRALIA, and other companies. For more info SHARE ANALYSIS: CBA

The company is included in ASX20, ASX50, ASX100, ASX200, ASX300 and ALL-ORDS

By Greg Peel

Over the last week we have seen first half earnings results from Commonwealth Bank ((CBA)) and Bendigo & Adelaide Bank ((BEN)). The other three of the Big Four banks report on an off-cycle, but as such provide quarterly trading updates to coincide with the regular reporting season. Westpac ((WBC)) provided such an update this week with National Bank ((NAB)) due to follow tomorrow and ANZ Bank ((ANZ)) next week.

From late 2007 to now, bank analysts have cycled through phases of first not believing Australian banks to have anything to fear from a US subprime crisis, to believing they had everything to fear and more from a GFC, to suggesting things aren't so bad after all but it will be FY11 before real earnings growth recovers, to realising earnings growth is recovering rather quickly.

There have always been several factors underlying analyst opinions, including credit demand, market share, margins, funding costs and government stimulus, but of most importance in considerations has been the level of bad debts banks were likely to suffer. Bad debts are a leveraged bank's worst enemy, as emphasised by Westpac's near death experience in the recession of 1992.

Bad debts were expected to impact on the banking sector in three phases. First would come the big name implosions, such as we had in late 2007 and early 2008, then would come a wave of aggregate smaller business implosions, followed finally by a consumer wave featuring credit card defaults. Eventually analysts were forced to admit the level of bad debts might match or even exceed the lofty peaks of 1992, and that a long tail of defaults, even after the economic tide had turned, would mean little opportunity for healthy earnings until at least FY11, assuming the Australian economy recovered from recession.

In the meantime, banks would be forced to set aside sufficient provisions against debt defaults from the what meager earnings were dribbling in, having also cut dividends and madly raised fresh capital. Over the past two years there has been a lot of wailing and gnashing of teeth over whether or not each bank was sufficiently provisioned.

What has since happened is that Australia has avoided a (technical) recession, government housing stimulus has landed right in the big banks' laps, depositors and borrowers have run screaming to the safety of the big banks and away from small and non-bank lenders, thus pushing up Big Four market share, and the economy has recovered far more swiftly than anybody ever imagined. This has been particularly manifested in a mere blip in unemployment, which is important given unemployment is a key driver of mortgage and credit card defaults.

As a result of all of the above, Australian banks were sold down very heavily in 2008 and have bounced back very strongly in 2009 in stock price terms. Behind a lot of this price rebound, particularly in the Big Four, have been moves by analysts to all but discount FY10 and “look through” to FY11 and even FY12 for valuation purposes. FY10 was expected to be a turnaround year featuring the aforementioned tail of bad debts and a slow return to credit demand, while FY11 was perceived as the year of strong rebound out the other side.

Which, flippantly, might beg the question “why don't we just take FY10 off then?” If banks are already priced for FY11 and beyond, then what upside exists for shareholders as FY10 plays out?

As flippant as this question may be, the point is that at various stages of the rally over 2009, analysts often declared bank stocks to already be fully or even overvalued. Yet prices kept rising, all the way through to January – at least as far as CommBank and Bendigo are concerned. All other bank share prices peaked in October last year and have been on a sliding path since. We have since January had somewhat of a market correction, so the task at hand now is to ascertain whether the market is fully set up for FY11 or whether the events of FY10 can still push those valuations higher before we move closer to FY11 (which will begin in six month's time).

Overriding all decisions at present is also a small matter of European debt concerns – a situation which many in the market fear has similar overtones to the subprime crisis becomes Bear Stearns becomes Lehman Bros story. But we'll leave that aside for now, other than to note CBA reported on a day when global sentiment was weak and Westpac on a day when global sentiment had much improved, and that as such specific share price movements on the day were qualified.

Bank analysts have largely been surprised by the results posted by CBA and Westpac. While market share has increased and margins have improved, and trading profits have been strong due to market volatility, the bad debt situation has not reached the sort of heights most recently assumed. One might say therefore that the recovery expected in FY11 is sneaking forward into FY10.

The swing factor is bad debts. If the timing of the peak in bad debts has now moved forward, then FY10 earnings forecasts should merely improve at the expense of FY11. But if the extent of the peak of bad debts is now assumed to be less than previously forecast, earnings forecasts should rise across both years. In a nutshell, this is what has happened.

Analysts have raised their earnings assumptions in both FY10 and FY11. However, the extent of absolute increase in FY10 has mostly been greater than the extent of absolute increase in FY11. This implies that analysts have been forced as a response to solid bank results to assume both the timing of the peak of bad debts will be earlier and the extent of the peak of bad debts not as great. In absolute terms earnings forecasts have moved up, but in relative terms some of the anticipated earnings growth spurt has been brought forward into FY10.

It is important to note here that while analysts may still be anticipating FY11 as the year of more emphatic recovery in earnings, the further out in time the greater a discount must be applied to that valuation given the sheer uncertainty of what could happen in between. It is only when analysts receive confirmation, such as an interim earnings report, that they can reduce the discount applied to outer forecasts and “roll forward” their valuations. When applying ratings, analysts are still only looking about six months ahead, so even if they see a big earnings jump in the future they will not assume such a jump as a given until we get closer to that period and the numbers stack up.

It's here that ongoing guidance from management is useful, but specific bank guidance and commentary in the current round of updates has not been a great deal of help. CBA remained downbeat, warning that while the bad debt situation was improving it would be foolish to hastily assume it was all but over. Westpac was a lot more upbeat on the other hand, largely seeing bad debts as no longer the threat they had been. Is one being too conservative or the other too bold?

Bank analysts also warn that the Big Four in particular have enjoyed a purple patch of increased market share and margins, monetary and fiscal stimulus, and extra-ordinary trading profits. As stimulus now subsides, and the economy recovers by itself, margins will tighten. There will not be as much volatility ahead from which to enjoy trading profits. So while Australia's economy is turning around, this actually becomes somewhat of a headwind for the banks.

CBA and Westpac also enjoy a premium to the sector, given their size and solid branding and “safe haven” attraction over the GFC, which should mean they head into FY11 best placed. But how much of a premium is too much? Premiums have already blown out.

The biggest premium is enjoyed by CBA, and thus while analysts upgraded their earnings forecasts for the bank only one rating upgrade was recorded among the FNArena broker database, from Sell to Hold. Two brokers downgraded to Hold from Buy, suggesting all that should be priced in already has been.

Westpac, which enjoys a slightly smaller premium, nevertheless scored two upgrades from Hold to Buy and one from Sell to Hold, with one downgrade to Hold. Westpac was the bigger “surprise”, and offered the more upbeat commentary, but then Westpac shares have flown these last couple of days.

From the ten brokers and researchers in the FNArena database, CBA now scores a Buy/Hold/Sell ratio of 2/8/0 to Westpac's 5/5/0. This suggests some brokers see upside in both but the majority believes current prices are set around fair value. This is despite general forecast earnings upgrades following the results.

The smaller Bendigo was expected to suffer a lot more than the Big Four, having lost market share, lost funding sources, and not having put all that much aside for bad debts. But again the bad debt blow-out has not been as bad as expected, so Bendigo, too, has managed to surprise brokers with a solid result. And thus it enjoyed two upgrades to Buy, leaving a ratio of 5/4/1. Yet brokers remain concerned Bendigo is under-provisioned.

Those analysts sitting back on Hold ratings have also warned of other factors. The world is currently assessing an overhaul to bank regulations, which is unlikely to be positive to bank bottom lines whatever the outcome. The local wealth management business is also undergoing a regulatory overhaul. And the better the big banks perform in Australia, the more ire they draw politically. This, suggest some analysts, only means building up a risk of some retaliation.

So as we move into the next quarter and half, it's all eyes on those bad debts. If bad debts peak earlier and at a lower level than previously expected, we have upside. Watch unemployment, as that is key. There is also overhanging regulatory risk and a likelihood that the extraordinary margins and trading profits of the tumultuous 2009 period will begin to subside.

Analysts are still predicting big things for FY11, such that current bank share prices provide quite low FY11 PE multiples and thus imply “cheapness”. But for CBA and Westpac in particular, the majority of brokers are happy to remain cautious and watchful, suggesting current prices are about right when one contemplates the near term. There is supposedly plenty of upside available in the not-quite-so-near-term, but more confirmation will be required.

We now await updates from NAB and ANZ.

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