Australian Banks Overpriced, Except Perhaps For NAB

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

The two main constituents of Australia's bank lending market are home lending and business lending, of which home lending currently represents around 57%, within what is known as “system total lending”. From 2003 to 2008 Australia experienced a boom in lending which saw a peak of monthly lending growth of 16.3% in December 2007. Home lending had led the charge early in the period, but business lending took the baton in the later stages.

By November 2009, that rate had fallen to just 0.8%. Yet the bank analysts at RBS note that home lending growth managed to remain resilient throughout the GFC, expanding every month in stark contrast to the comparative markets of the US and UK.

Those offshore markets are comparative not just for the obvious reasons, but also for the fact all three regions were registering record-high household debt ratios prior to the GFC which were particularly impacted by overstretched mortgage commitments. When the US housing market turned, it seemed inevitable that both the UK and Australia must suffer the same fate.

The UK did, but Australia didn't. This can be put down to a number of factors, including a lack of seriously “subprime” lending in Australia, a more stable banking system and a shortage of housing. But clearly the swift and substantial response of the Reserve Bank to cut its cash rate and the government to pour in fiscal stimulus funds for new home buyers was significant.

In the meantime, business lending was left to wallow. Australia's Big Four banks went on a mission to capture the bulk of stimulated growth in the new home mortgage market at the expense of underfunded competition, but once bitten twice shy, banks backed away from the risky business of business lending. By January this year, business credit outstanding was 10% below the November 2008 peak, notes RBS.

This plunge brings back memories of the 14.7% drop in business lending from February 1991. Despite a rebound in housing demand and house prices, the post-GFC decline in business lending has not yet bottomed, albeit the month-on-month rate of decline has begun to slow. RBS notes Australia's year-on-year business lending growth rate is now lower than it was in the period 1991-92.

But things are looking up, are they not? Australia's economic rebound from what was never an actual recession anyway has astounded all and sundry, from offshore commentators to the governor of the Reserve Bank. For that reason, one can understand why analyst consensus is forecasting a rapid rebound in system total lending, suggesting 8% growth in FY11 and 9% in FY12. These are the sorts of numbers being factored into valuations for Australia's Big Four banks.

RBS does not agree with the consensus, however. Looking back at both the major recession in Australia in 1991-92 and the minor recession in 2001-02, the analysts note it took three years in each case for business lending growth to recover to the 10% level. Even with a more positive outlook now developing for business lending, they suggest recovery will be only sluggish and double-digit growth will not be reached again until the end of 2012.

Holding back business lending growth will the high level of debt still being carried by businesses, as measured by the business debt to GDP ratio, and a delay in the lead for lending provided by capital investment. In January, the level of monthly business loan approvals as a percentage of outstanding loans sat at 4% which is well down from the 7% of the 2007 peak, RBS points out. The analysts expect a return to only 5% in FY11-12, which would match the average for the period 1995-2000.

RBS also believes home lending will struggle to reach double-digit growth levels for the next few years. For starters, interest rates are now back on the rise at a solid pace and government stimulus has been wound down to far less stimulating levels. But RBS also notes that Australia's household debt burden remains at high levels, as does the mortgage debt to GDP ratio in particular. Moreover, there remains an absence of home building activity to provide a greater opportunity for Australians to buy an affordable house.

And there remains the issue of bank funding costs. Realistically, the Big Four should once again be increasing their mortgage rates above and beyond increases suggested by RBA rate hikes, given the increase in the banks' own cost of borrowing money. But the banks are wary of doing so in an election year as it would be popular for either party to whip up further anti-bank sentiment and propose retaliatory regulation changes.

Either way, Australians are now facing higher mortgage repayments, and RBS suggests housing loan growth will remain in the band of 3-8% “over the long term”.

All up, RBS is forecasting system total lending growth of only 6% in the period FY11-12, compared to the consensus of 8-9%. This forecast represents a downgrade from the analysts' earlier forecasts of 7.5% for FY11 and 8.5% for FY12. The analysts now feel any strong rebound for business lending in particular will not emerge before 2013.

To that end, RBS has this morning clipped its bank earnings forecasts and share price targets. The broker currently recommends Hold on Commonwealth Bank ((CBA)) and Westpac ((WBC)) and Buy for ANZ Bank ((ANZ)) and National Bank ((NAB)).

Among the Big Four, it is NAB which is struggling to find many friends. A quick glance at the following comparative one-year chart clearly highlights NAB's recent sector underperformance (14% in the last six months).

So why is NAB so unloved? The analysts at Citi can rattle off a few reasons.

The first is, quite simply, track record. NAB management has developed a poor reputation based on execution risk with its foray into the UK as a prime example. Secondly, a pall of uncertainty still hangs over NAB's UK exit strategy given the bank may need to ride out the bad debt cycle and the currency devaluation before an opportunity arises.

Thirdly, NAB's retail banking strategy has left many perplexed in comparison to the strategies of peers, even if NAB's intention is to align for the future rather than rushing out to capture immediate market share with competitive pricing.

And finally, the market is not sure exactly which way NAB's bid for wealth manager AXA Asia-Pacific ((AXA)) will play out. (I note that at the time of writing both NAB and AXA have entered a trading halt, suggesting an announcement is afoot.)

All of this adds up to NAB being the least favoured of the Big Four, in particular contrast to the much loved and sought after CBA – the Big Friendly Giant of the bunch.

But it also adds up to Citi believing NAB is now offering a valuable buying opportunity. And Citi is not alone in its opinion.

“While we see some justification,” say the analysts, “for disappointment in the performance of the business – a legacy of a decade of often poor decision-making and execution – we think investor decision making is also now reflecting a healthy dose of emotion”.

Execution risk has been a problem in the past, but Citi suggests concerns are somewhat overdone. While NAB will need to pay a full price for AXA A-P, and there have been several less expensive post-GFC acquisition opportunities passing by, this deal [should it come to fruition] would deliver a position of leadership in the high-growth wealth management market, Citi believes.

Despite applying a number of risk adjustments to its valuation model, Citi suggests NAB still looks inexpensive. To that end, it has this morning upgraded its recommendation to Buy from Hold and lifted its share price target from $27.70 to $30.50. Citi now has a Buy on each of the majors except CBA (Hold).

The FNArena broker database now shows five Buy ratings, one Hold and one Sell for NAB. Three of ten brokers are currently on restriction from making a recommendation, suggesting their involvement in the AXA bid one way or the other.

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