Australian Bank Earnings Review

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By Greg Peel

When FNArena provided a preview of the bank interim result season back on April 14 ("Australian Bank Earnings Preview"), ANZ Bank ((ANZ)) remained the leading choice amongst database brokers with a Buy/Hold/Sell ratio of 5/3/0. ANZ's point of difference is its Asian deposits which had helped the bank to a sector-beating net interest margin. Could that position be maintained?

National Bank ((NAB)) was second in the field on 3/4/1, offering potential reward from a turnaround in the UK in its toxic asset position but also thus the riskiest of the Big Four. Westpac ((WBC)) matched NAB on 3/4/1 with margins on the improve, albeit the St George lending book lingered as an issue.

Commonwealth ((CBA)) does not report on the same cycle as the others (but will provide a quarterly update shortly) but it was in last position on 1/6/1. Analysts felt that while CBA is strong and solid, it had also reached fair value.

This was the state of play back on April 14:

Last week as each of three reported, again the popular press was quick to jump on some big profit numbers. Politicians began to salivate ahead of the release of the Senate banking competition inquiry on the Friday. But for bank analysts, results were pretty much as expected on the headline numbers. The break-downs, however, were not quite as straightforward.

ANZ's profit was in line with expectation but strong trading profits (investment bank broking and proprietary activity) masked the fact that the bank's Asian-derived net interest margin advantage had slipped. For Westpac, quality was questioned given the level of bad debt provisions returning to the bottom line which masked sluggish improvement in net margin. It was NAB, nevertheless, which came out the winner.

NAB had been performing above-peer in the lead-up to the result season, with a strong push into mortgages aided by a clever, if not annoying, advertising campaign which took the Mickey out of the whole competition debate. But analysts were not convinced this momentum would hold.

Yet it did, and NAB's headline result beat consensus by about 5%. Its dividend payout was also better than expected, suggesting confidence from management. The quality of the result was nevertheless undermined somewhat by provision returns and toxic asset hedge profits, but what analysts liked is that usually NAB's toxic asset hedges lose money. There was no new news on the UK, which was also favourable given the news from the UK is usually bad.

NAB has now moved to the top of the table. There have been a handful of ratings changes from analysts in the lead-up to the results, and another handful following the results. ANZ has seen one downgrade to Hold from Buy and one to Sell from Hold and Westpac has seen three downgrades to Hold from Buy. On the other side of the coin, NAB has seen two upgrades to Buy from Hold and one to Hold from Sell. (And for good measure, CBA has seen one upgrade to Buy from Hold).

The table now looks quite different:

Looking at the sector as a whole, analysts have decided that while profit growth was reasonable there's not a lot to get excited about. Net profit growth was 7.1%, UBS calculates, but revenue growth was a sluggish 3.3%. At the end of the day, notes UBS, banking is a “GDP industry”. While the economy continues to deleverage, the consumer remains cautious and non-resource industries struggle along, expectations for credit demand growth are muted. House prices also seemed to have peaked for now, suggesting lower mortgage demand.

The difference in profit and revenue was provided by more returns of bad debt provisions, better than expected trading profits in a volatile market, and (in NAB's case) some asset revaluation. Cost control was nevertheless solid, albeit a lot is now being spent on IT improvements (with NAB looking at quite a task). Trading profits are not considered “quality”, because what the Lord giveth he can just as easily take away. Analysts prefer to see “real” profits generated from the business of borrowing and lending.

There are also a couple of issues surrounding those returned provisions. First of all, the March quarter was one of unprecedented natural disaster both in Australia (mostly, but not all, Queensland) and in New Zealand. The question is as to whether the inevitable increase in bad debts post-disaster are now known and contained, or whether there might yet be lingering pain. A couple of brokers picked up on another rather ominous development, with UBS becoming particularly concerned.

There was a sudden and significant jump in mortgage delinquencies in the range of 30 or 60 days in arrears across the sector. While 90-day arrears levels were not a lot different, clearly there is a risk they, too might be in for a sharp increase. The real concern stems from in which cohort of borrowers these delinquency increases came.

They were the 2008 first home buyers – those wide-eyed and inexperienced aspirants who could not previously afford a mortgage but suddenly could when Kevin Rudd handed out deposit boosters of up to $21,000 and Glenn Stevens chimed in with an emergency cash rate of 3%. The RBA has since raised the cash rate to 4.75%, most of the banks also added an out-of-cycle mortgage rate increase last November, and as noted, house prices have at least stalled and may now be teetering.

The RBA has hinted at another rate rise very soon. The offset is Australia's very strong employment situation, which should provide some comfort in terms of mortgage servicing capacity. But then not every Australian is working in the mines. Those in sectors such as retail, and anyone in small business generally, are finding it tough. And the strong Aussie dollar is also as good as another rate rise.

Is it, thus, a good time to be bringing back greater than expected bad debt provisions into the earnings line?

One thing remains fairly certain and that is little sign ahead of a big turnaround in credit demand. Business lending is starting to tick up just a tad, but it has been beaten down ever since the GFC and it's a long road back. The banks have generally managed to eke out improvements in local net interest margins, helped by that November rate hike and an easing in competition for term deposits, but funding costs are still rising while revenue growth remains subdued. It is not a climate of stock market outperformance.

Bank analysts have now rolled forward their models from the known interim results and FY12 has long been expected to show solid improvement over FY11. But with the exception of NAB, little in the way of target price changes have followed. NAB has seen its consensus target rise to $29.88 from $27.66, but ANZ's has slipped to $26.27 from $26.36 and Westpac's has slipped to $25.37 from $25.54 (CBA remains on $55.93).

NAB has become top pick in the hope that the long-awaited turnaround might now be underway. On that basis NAB is still the riskiest proposition, but thus showing reward potential. There has been a fair bit of general market price volatility since April 14, but a comparison of the two tables above show not a huge amount of movement in terms of upside to target. The exception is ANZ, which is now showing the widest (13%) gap yet has slipped to second choice on a net basis among analysts.

It may be a while yet before analysts again have much reason to alter those targets, so if the stock market does recover from the recent sell-off and bank shares follow along, FNArena will be watching out for a closing of the upside-to-target gaps which signifies fair value and little chance of more upside.

Which brings us to Friday's release of the Senate committee report into bank competition. One can only presume that focus group politicians would have been somewhat disappointed.

They may take heart in the report's suggestion of another, wider inquiry that should follow (presumably chaired by Sir Humphrey Appleby) but little else was contained therein to provide politicians with any told-you-so headlines. First up, the report recommended the ban on exit fees imposed by the government should be lifted.

The implication is not that exit fees should be allowed to run riot, but rather that the comprehensive ban was an ill-conceived, knee-jerk reaction. While the Big Four might see earnings slightly trimmed the regional and smaller institutions, with much higher funding costs, would be harshly penalised. In a sense, this works against the promotion of competition.

The other very notable commentary in the report was that which basically supported the banks against the politicians when it came to out-of-cycle interest rate rises. The report pointed out what one might call the bleeding obvious, and that is that the RBA's overnight cash rate actually has little to do with where the banks source their funds, ie from deposits and longer term (eg five-year) bond issuance. If the cost of borrowing rises offshore, then of course the banks are justified in raising their lending rates accordingly, the report implied, whether the RBA moves or not.

Outside of these clangers, the rest was pretty much as one might expect. There were a lot of exit fee suggestions, a lot of talk of greater disclosure (both of bank profit margins to the public and of greater explanation of borrower obligations). There were suggestions made as to how foreign banks might be enticed back alongside an endorsement of the Four Pillars policy.

There was also a lot of discussion on the subject of securitisation. Once upon a time, ie pre-GFC, the securitisation of prime mortgages was a major source of bank funding, particularly for smaller institutions. The funding cost generated from on-selling mortgage interest streams was much lower than that obtainable through direct borrowing of funds from offshore. The GFC made securitisation a dirty word of course, albeit there was little impact felt in Australia's highly regulated mortgage market. There was almost nothing in the way of “sub-prime” downunder.

So the securitisation market has been all but shut down ever since, impacting heavily on smaller institutions, which in turn affects competition (or lack thereof). It is no surprise that post-GFC borrowers all rushed to the safety of the Big Four, and that the aforementioned new mortgages were mostly absorbed by the behemoths Westpac and CBA.

The Senate committee thus went to great length to make suggestions for revitalising the mortgage securitisation industry, and even recommended extending securitisation across other loan classes. 

If these recommendations are acted upon, it will be a boost not just for smaller banks but for the whole banking sector, and lower funding costs mean lower lending rates for customers. But given the Senate has also recommended another, wider inquiry should follow, one can only conclude that any changes would come “in the fullness of time…” 

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