Oz Banks: Results, Outlook, Premiums And Dividend Yields

This story features NATIONAL AUSTRALIA BANK LIMITED, and other companies. For more info SHARE ANALYSIS: NAB

– APRA imposed rules will only have minor impact on banks' profits
– Subdued outlook forces banks into cost control
– Overall reliance on offshore funding declining further
– Question marks about CBA's natural market premium

By Greg Peel

Australia's banks breathed a sigh of relief last week when the Australian Prudential Regulation Authority unveiled its new liquidity requirements in light of the Basel III international regulatory amendments made as a result of the GFC. Basel III included strict new rules providing not just capital requirements for banks but also liquidity requirements which force banks to hold a level of quality liquid assets on their balance sheets, such as sovereign bonds.

(A lot of good sovereign bonds have done the European banks prior to the new rules even being in place, one might say.)

The issuance of sovereign bonds nevertheless requires a government to need to borrow, which in turn implies a budget in deficit. Problems thus arise for countries in which the budget is in surplus or heading back to surplus, such as Australia, suggesting limited bond issuance and thus difficulty for banks to comply with liquidity rules. Anticipating this issue, Basel III makes provision for other assets to be deemed eligible by local authorities, which APRA has addressed. What banks have been more concerned about, however, is just what penalty cost APRA would impose on banks for assets outside Basel's guidelines given the Authority had flagged its own stringent approach that would be potentially even stricter than that of Basel's.

The good news is that while the banks and bank analysts had feared a charge of anything up to 50 basis points, the 15 basis point charge announced by APRA falls well short of even the low end of expectations. Residential mortgage-backed securities (RMBS) have been included as eligible and APRA's rules have diverged very little from Basel III. Bank analysts are in agreement that the cost to the Big Four banks will be minimal, in the order of 1% of earnings.

Over the past few weeks ANZ Bank ((ANZ)), National Bank ((NAB)) and Westpac ((WBC)) have reported full-year results on their September year-end cycles and Commonwealth Bank ((CBA)) has provided a first quarter update on its June year-end cycle. All up the results came in a little below analyst expectations but not to the extent of being a major concern. The main source of earnings miss was weaker than expected investment bank trading profits which is hardly a great surprise with market activity currently very depressed on low volumes. This is a swing factor which clearly can rebound at the first sign of a rebound in market confidence. It is also the primary source of income for Macquarie Bank ((MQG)) which has been duly suffering as a result.

As far as commercial banking operations are concerned, the word “subdued” is popular among analysts and bank managements. Demand is subdued and outlooks are subdued with a widespread lack of consumer and business confidence clearly the driver. This means profit growth has stalled providing flat quarter on quarter results and pressure on margins. On the positive side, the banks are pushing to control costs and bad and doubtful debt charges are back to manageable mid-cycle levels after the great scare of the GFC.

The one bank that bucked the trend to some extent was NAB, which sequentially grew profit and expanded returns and margins. NAB's result reflected its aggressive competitive stance taken earlier in the year. That stance has further been rewarded by the RBA's November rate cut given three of the Big Four have passed on all of the 25 basis points to variable rate mortgage customers, while NAB only handed back 20 basis points, providing a nice little 5bps buffer.

NAB's 5bps buffer will also help the bank ride through the next financial year, suggests Credit Suisse, when history suggests the aggressive loan growth of FY11 will become a drag on margins in FY12. In FY09 it was Westpac and CBA who went in hard on the back of the government's first home buyer stimulus which came back in their faces with greater than peer margin declines in FY10. Of the Big Four, NAB is also the bank which will be worst impacted by increasing funding costs, but in that instance the new covered bond initiative will help to reduce reliance on offshore funding.

Indeed, this shall be the case for all banks. While RMBS in the US in the form of CDOs were largely to blame for the GFC, there is no reason a “prime” RMBS, featuring quality mortgages, low loan-to-value, full documentation etc cannot be a viable AAA-rated security issued by a AA-rated Australian bank. It's just that all mortgage securities have now been tainted. However, another problem with the US market was that of beneficial ownership, such that even today the US courts are still trying to sort out who actually ended up with the risk on mortgages within defaulted CDOs.

Covered bonds are an alternative in which the bank does not package up mortgages and on-sell them, thus relieving themselves of the risk, but instead keeps the mortgages and the risk and simply on-sells the interest payment income stream to yield-thirsty investors. Covered bonds have long been popular in Europe and are now allowed to be issued in Australia, thus offering Aussie banks with another means of reducing their reliance on offshore funding (note also that covered bonds can be issued on assets other than mortgages, such as car loans etc).

This reduction of reliance on offshore funding was another major theme of the recent bank reporting season, and the main offset to otherwise dreary outlooks. Australian banks were caught in the GFC holding little in the way of deposits (Australians were borrowing, not saving) and a lot in the way of RMBS and dirt cheap offshore funding. The GFC sent offshore funding costs through the roof and shut down the RMBS market, forcing Australian banks to cut dividends and raise dilutionary capital as they put aside large chunks of funds for the bad debt explosion they feared was about to hit.

Today Australian banks boast much higher tier one capital ratios and significantly higher levels of deposits which they've achieved through aggressive competition for Australia's now historically high rate of savings. Covered bonds will provide another source of domestic capital to help insulate Australian banks from an onerous need to source offshore funding at a time those rates are rising again due to the European debt crisis. Were we to see “another Lehman” in Europe, this time around the Big Four are in a much safer position.

In actual fact, the more subdued Australia's credit demand growth is, the less offshore funding the banks will need. It's not exactly the sort of trade-off you want but right at the moment it's probably better to bungle along in a “subdued” environment on lower risk than to increase funding risk in the face of what might dangerously transpire.

On that basis Macquarie notes European concerns have meant Big Four credit default swap (CDS) prices are now back where they were a couple of months ago when markets went into a tailspin over Greece and the US credit rating downgrade. What Macquarie points out, however, is that CDS prices are an unreliable indicator for Australian bank funding costs which are typically 30-40bps cheaper than CDS prices imply. Macquarie also notes the benefit of covered bond issuance is worth around a 50-70bps buffer over unsecured wholesale funds as well.

The implication is that were the Big Four to come up against much elevated offshore funding costs again when they come to roll their 2012 maturities, they would suffer only a minor and manageable few basis points of margin decline. More of a concern would be any related drop in Australia's terms of trade (global recession, lower Chinese exports, lower Chinese imports from Australia) which would see the RBA cutting more aggressively and bank deposits losing their appeal for Australian investors.

As we stand now, Australian banks share prices have rebounded quite sharply out of the European-led depths of earlier months which saw yields at must-have levels. As far as JP Morgan is concerned, for one, we can no longer argue that the Big Four are “cheap”. On the other hand, Deutsche Bank is happy to boldly take an above-consensus stance.

Deutsche's bank analysts believe Big Four bank valuations are still “compelling” as they expect double-digit returns over the next 12 months. They are looking for 9% earnings growth in FY12 and 7% in FY13 on better than expected margin performance, cost controls and ongoing bad debt reductions and the prospect of increased dividend payouts. Deutsche's earnings forecasts are sitting 5% above consensus.

A consistent theme to come out of the earnings season was nevertheless agreement that CBA's performance was the least inspiring. While analysts have been suggesting for a couple of years now that CBA's traditional premium for size over the others, which translates into a higher afforded PE ratio, means CBA shares offer the least value, now there is a general view that premium is no longer justifiable and should erode.

The flipside to CBA is NAB, and here brokers remain positive with the caveat that NAB remains the most risky given its UK exposures. ANZ's story is still one of what it might be able to derive from its Asian expansion (with deposits important here) while Westpac is all about spending to improve systems while cutting costs on the other side.

FNArena last updated the banking sector in late September when global markets were in a particularly volatile state. At that time our stock analysis table looked like this:

It's now late in November and in the interim we've seen quite a sharp bounce, only to see that bounce again under threat as European and US debt issues continue to weigh. Today our table looks like this:

There have been only slight changes to consensus target prices and from a rating perspective, NAB has lost one Buy rating and CBA has gained one Sell since September. These moves have not changed the overall consensus order of preference and it's not hard to see why, with analysts setting a target for NAB 20% above yesterday's closing price compared to only 6% for CBA.

The stand-out column remains those fully-franked yields on the right hand side which have proven very tempting for many investors. The problem is, of course, that no matter how many times it is pointed out that Australian banks are in a much safer position than many elsewhere it will not stop the market, and particularly foreign investors, selling down Australian bank shares in times of macro panic.
 

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