They’re A Bit Ambitious in Queensland

This story features BANK OF QUEENSLAND LIMITED, and other companies. For more info SHARE ANALYSIS: BOQ

By Greg Peel

It's tough being a small fish in a big pond, even if the states of Queensland and Western Australia to which you are most exposed boast all the underground goodies. And those states aren't without their debt problems.

Bank of Queensland ((BOQ)) yesterday surprised analysts by announcing in its FY10 result that its bad and doubtful debt levels had actually increased. Every other bank reporting to date has declared better than expected drops in BDDs.

It was also a surprise to most that BOQ's net interest margin – that simple bank metric of loan interest minus funding cost – had fallen a substantial 10 basis points in the period. This was largely a reflection that BOQ has had to fight, and fight hard, to attract deposits. The Big Banks may be crying poor on increased funding costs but for the tiddlers, offshore funding costs are even more expensive given greater risk. And while there are tentative signs the loan securitisation market is attempting to be Phoenix-like, it's a long way back to a reliable source of cheap funding, if ever.

BOQ could, nevertheless, solve a lot of its problems in one fell swoop if it just put up its standard variable mortgage rate independently of any RBA cash rate hike, but then it can't risk losing any more market share to the big boys. It is now considered inevitable by the market that the Big Four will have to make ex-RBA SVR hikes but the staring competition just seems to go on and on. It looks like they are waiting to move under cover of an RBA hike (ie add an extra 15bps or so to the RBA's 25bps) and so perhaps November will be the month.

BOQ has a greater leverage to an SVR hike than others.

It is also BOQ's ambition to take the bank's return on equity level to 15%. Given it achieved only 7.9% ROE in FY10, this seems like a lofty goal. Indeed, management has shifted the timing of this target out to FY12 now, instead of FY11, but analysts suggest FY13 might be more realistic, if at all.

On the plus-side BOQ is set for a big ROE boost from its recent CIT and St Andrew's acquisitions which are yet to make an impact in the accounts. BOQ needs asset growth if it is going to hit the magic 15%. But asset growth is one side of the equation – the cost of it is the other. Realistically, BOQ will not get to 15%, analysts argue, if it doesn't eventually see a lower funding cost along with a higher SVR. And that's a big ask in the time frame.

Moreover at 7.25%, BOQ's tier one capital ratio is only a snip above the new Basel III requirements, meaning that further acquisitions (which management is targeting) will likely mean a capital raising or two. This would dilute earnings per share and ROE. And all the while BOQ needs to get those BDDs under control or provisions will also soak up earnings.

It's always a good idea for everyone to have a goal in life, even if there might be some pie in the sky. But the question is as to whether it really matters whether BOQ actually gets to a 15% ROE as hoped, or not. And the answer to that question lies in whether the market is currently pricing BOQ for success.

It isn't.

Credit Suisse is one broker among those pointing out BOQ trades on only a 1.0x book value and a forward PE of 9.7x. By comparison, regional compatriot Bendigo & Adelaide ((BEN)) is trading on a 10.1x PE. Historically, BOQ trades at a 2% premium to BEN but is currently at a 4% discount, and is also at a full 12% discount to the biggies.

It is on that basis that only one FNArena database broker has a Sell on BOQ. BA-Merrill Lynch is largely alone in suggesting BOQ's current PE suggests full pricing.

The other seven all agree the ROE goal is a bit steep, if not totally at least in the timing. But the four Hold raters balance this against what they believe is a sufficient valuation discount, and the three Buy raters are also putting faith in both the impressive BOQ management team and the upside potential offered by the resource states of Queensland and WA.

Uncertainties surrounding bad debts, funding costs, rate rises and credit demand have seen broker bank valuations grow in volatility post GFC. The spread should be relatively tight compared to, say, a risky mining stock, but for BOQ the FNArena database target prices range from $10.30 (Merrills – Underperform) to $14.04 (JP Morgan – Overweight).

The resulting consensus target is $11.91 and BOQ shares are trading around $10.50 today.

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