Australia | Mar 28 2012
– Surprisingly large provision increases and capital raising from BOQ
– Balance sheet fixed, earnings growth in question
– Lower TD rates provide big banks with earnings upside
– Negative equity creeping into Oz housing
By Greg Peel
It's a common tale. A new CEO steps into a major listed corporation, has a look at the books, and then announces a major profit warning. History suggests such a tactic is almost inevitable. The purpose is to blame the downgrade on previous management while at the same time providing a much lower base from which the company can grow and the new CEO can look like a champion.
So it was that yesterday Bank of Queensland ((BOQ)) made an unscheduled announcement which lowered first half cash earnings expectations to a loss of $72m. At plus $98m, JP Morgan was the lowest prior forecaster. This was a surprise. But the bigger surprise was the announcement of a $450m capital raising. The raising itself was not a surprise – analysts had been expecting one – but the magnitude prompted whistles of awe across dealing rooms.
The raising represents a 32% increase of BOQ shares on issue. That's serious dilution. The primary reason behind the first half loss and capital raising was another big raising, that of bad debt provisions. Analysts had been worried that BOQ's provisioning was looking a bit thin but again the size of the new provisions came as a surprise.
The extent of dilution is so substantial that analysts have now lowered their earnings per share expectations by 70, 80, even 90%. Yet while seven of the eight brokers in the FNArena database have updated their forecasts and mostly slashed their target prices for BOQ, not one lowered its rating. Only JP Morgan has a Sell (Underweight) rating on the regional bank. Deutsche Bank has actually upgraded to Buy, to provide a total of four Buys and three Holds.
The perceived balance sheet “gap” has long been the big issue hanging over BOQ, with previous management suggesting capital was sufficient but the new CEO rather making a mockery of that claim. That issue is now well and truly dead. With one fell swoop, BOQ's tier one capital ratio has jumped from 6.4% to a peer-leading 8.6%. The raising swallows up the redemption of remaining tier two convertible notes and otherwise provides the buffer for provision increases.
And substantial provision increases they are. A $328m direct charge has been taken with another $160m taken to generally cover the risk of further Queensland economic weakness. The size of these provisions is what surprised analysts and led to BOQ's cash loss.
Regional banks have been much more victims of the GFC than the Big Four. With their solid credit ratings, the Big Four can attract offshore funding at much better rates than the regionals. With their nationwide branch networks and general clout, the Big Four have been able to sacrifice margins to offer very attractive deposit rates and shore up their capital positions for a lot less cost than a dilutionary raising. With their size, the Big Four can spread their activities across mortgages, businesses, institutional and trading activities.
The smaller regionals suffer from lower credit ratings and thus higher funding costs. They tend to be weighted towards mortgages, given the local community spin they exploit, as well as localised commercial property lending. This was fine when securitised mortgages were all the rage, but the GFC killed that market off. The regionals struggle to compete with the Big Four's sexy term deposit rates. For BOQ the plot thickens, given the bank's specific regional weighting towards South East Queensland. Despite its resource sector dominance, the state of Queensland has been doing it tough economically – no more so than in the densely populated SEQ area which, to top things off, was hit by successive flooding last year. Commercial property prices in the area are under serious pressure.
The above tends to suggest investors would do well to shy right away from regional banks and simply stick with the biggies. However, regionals can also be impressive little movers that can outpace the lumbering behemoths when the sun is shining brighter. In BOQ's case, the majority feeling among analysts is that while the magnitude of the raising was a surprise, and the magnitude of the provisioning was a surprise, BOQ is now in a much better place.
“We regard the magnitude of balance sheet actions and adjustments to business strategy as in all likelihood constituting decisive action here,” says Credit Suisse (Outperform). “Combined with much improved provisioning and capital levels we believe this makes BOQ significantly more investable,” offers UBS (Neutral). “Investors can be comfortable the bank should be able to grow and improve returns off this base,” believes BA-Merrill Lynch (Buy). RBS Australia (Buy) is a little less sure on returns but is positive nevertheless, stating “Although we remain in the dark on management's strategy to boost returns, we think at 0.65x book value the bank remains a Buy”.
Deutsche Bank, in upgrading to Buy, suggests “We think the bank now looks a more attractive investment proposition. With earnings rebased, provisioning bolstered, core tier one ratio at the top end of peers, and a strong management team at the helm, the valuation discount (27% on the raising) now looks too attractive to ignore”.
The question remains over the Queensland economy in general and SEQ in particular. BOQ really does not want anymore La Nina events, washed out businesses, reduced commercial property demand and struggling mortgage holders. But if that is to be the case, it has now built itself a very big buffer. RBS also notes the Queensland treasury is forecasting 4% economic growth in FY13, for what that's worth, and the analysts suggest the maintenance of the 26c dividend despite the big downgrade is testament to management confidence.
The real challenge is nevertheless to improve return on equity from single digits to at least the bank's 12% cost of capital. Macquarie (Neutral) remains concerned over what it still sees as a “deteriorating Queensland economy”, BOQ's underinvestment in new systems and intermittent pressures on funding. BOQ would also not appreciate it if Europe rears its ugly head again. Macquarie is not confident on the ROE question.
JP Morgan (Underweight) is less confident. A bank in rude health should be able to grow earnings off a solid capital base while a struggling bank must rely on earnings growth off a base of funding costs. BOQ may be raising a big lump of fresh capital, but JPM sees the amount as largely being absorbed by the convertible note redemptions and by the new provisioning. Thus BOQ remains more in the latter camp than the former.
As a result of the profit downgrade and capital raising, the average analyst target price for BOQ has fallen to $8.14 from $9.02. The range is nevertheless very wide for a bank, with Macquarie on $6.85 (below JPM on $7.00) and RBS on $10.50. Deutsche actually raised its target to $7.85 from $7.75. Citi is yet to update.
While investors weigh up the value of freshly diluted BOQ shares, Deutsche Bank believes the tide may be turning for the Big Four banks. The ebb is beginning to transform into a flood.
The GFC brought an end to cheap bank funding in the form of loan securitisation, and sent offshore funding costs soaring. Those costs were expected to be much lower by now, but we've had the European Crisis in between to ensure costs have remained elevated for some time. Wholesale costs are now finally starting to reduce, but in the meantime the banks have been forced to turn to the old fashioned funding source of customer deposits. To attract those deposits the banks have had to markedly raise their deposit rates at a time when loan growth is stagnant, cutting heavily into net margins.
Investors scared away from risk assets by rolling financial crises have thus been able to enjoy portfolio-saving term deposit investment at very reasonable returns. However, now that the banks have significantly increased their deposit funding ratios as a result, and have seen wholesale funding costs start to fall, the need to offer such hefty rates is diminishing. This process has already begun, notes Deutsche, with average short term deposit rates falling 20-30 basis points in the past three weeks. Prior to the GFC the gap between wholesale funding and deposits averaged 200 basis points, but that gap had fallen to as little as 80bps in the subsequent race to secure deposits – a gap Deutsche suggests is sustainably too low. Deposit rates have nevertheless now started to be wound back and the analysts see plenty more room for reduction.
Deutsche Bank analysis suggests every 20bps reduction in term deposit rates represents a 5-7bps improvement to bank margins which implies an average 3-4% upgrade to earnings per share expectations. The timing is difficult to nail down, the analysts suggest, but the potential for significant upside profit surprise is increasing.
Banks may yet have reason to be concerned, however, about Australia's softening average house prices. Industry bodies have warned of emerging negative equity in the housing market, meaning mortgage obligations exceed sale prices. Macquarie analysts might seem a tad understated when they suggest “This would appear to be unhelpful for domestic majors”. If a homeowner falls into arrears on his mortgage payments (job or business lost, perhaps) then outside of work-out financing the ultimate solution is to sell the house. But if the sale value will not cover the mortgage obligation, foreclosure becomes the likely result. This is not good news for banks.
The reason Macquarie is not so concerned relates to recent history. The UK has seen some devastating house price collapses, back in the nineties recession and more recently in the GFC. Negative equity reached a high of 12% in the UK in the GFC, topping the 11% peak in the nineties. Yet GFC mortgage write-offs were 70% lower in the GFC.
Those who remember the nineties recession anywhere in the world will remember that mortgage rates were in the double digits because central banks had not yet learned to use monetary policy to control inflation, while unemployment was rampant because of a more intense labour base in the economy and a more keen propensity to sack.
By contrast, the GFC saw rapid and decisive central bank interest rate cuts, easing the pressure on mortgages, and a less labour intense economy saw fewer direct lay-offs as employers opted to reduce workers' hours instead and exploit more casual labour. Some employers even took a year without pay rather than ruining their employees lives. In many cases it was simply a case of trying to hang on and not lose valuable trained staff.
Macquarie believes that negative equity in Australian homes would only become an issue were unemployment to rise and interest rates to rise as well. Such a scenario seems almost impossible, given rising unemployment would be a catalyst for the RBA to lower rates, not raise them.
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