Australian Banks: Strong Balance Sheets, Benign Earnings

This story features COMMONWEALTH BANK OF AUSTRALIA, and other companies. For more info SHARE ANALYSIS: CBA

– Bank results solid on face value
– Balance sheets very strong
– No pre-provision earnings as yet
– Target prices increased

By Greg Peel

Bank reporting season came to a conclusion last week with a quarterly update from Commonwealth Bank ((CBA)), following on from full-year results for ANZ Bank ((ANZ)), National Bank ((NAB)) and Westpac ((WBC)). On face value, results once again looked solid. Yet breakdowns revealed flat “pre-provision” earnings growth.

Underlying earnings growth once again eluded the majors, with earnings per share increases entirely attributable to bad debt reductions. Banks put funds aside (provisions) on their balance sheets to cover risks from bad or doubtful debts (BDD), with those funds returning to the earnings line once risks have passed or eased. UBS notes BDD reductions accounted for 2.1% of net 3.2% earnings per share growth, and a lower net tax rate accounted for 1.3%, implying earnings from normal banking activities registered minus 0.2%.

Revenue growth remained subdued, rising just 1.1%, UBS notes. Margins were flat, with increased costs stripped 1.3% from earnings per share. Credit growth was 3% stronger but mostly due to currency movements. Treasury operation contributions (trading, broking and so forth) were soft, reducing net revenues by 0.6%, but analysts don’t like it when too high a proportion of bank profit is due to playing around in volatile markets.

On a profit & loss basis, it’s hard to be at all excited. The story is a lot brighter, nevertheless, when one turns to balance sheets. Strengthening capital ratios were an “outstanding feature” of the result season, Citi suggests, with the capital ratios of all three reporting majors beating the broker’s estimates. And what does a strong balance sheet mean? Room for higher dividend payouts. And don’t investors love it. A further expansion in payouts took dividends up 4.3%, UBS notes.

Credit “quality” also pleased analysts. Better credit quality implies lower potential for BDD increases. This is important given Australia faces another year of relatively weak domestic demand and below average GDP growth, which can impact on the capacity of businesses and individuals to repay loans and mortgages. It is also important because we may now be nearing the end of a post-GFC cycle which has seen the gradual unwinding of GFC-related provisions (no one knew exactly how bad things were going to get back in 2008, so banks spent 2009 shifting significant funds into provisions), and subsequent earnings growth in the face of low demand for credit.

The result season showed major bank loan impairment charges (cost of writing down bad loans) in the second half of FY13 ranged from 0.15% at Westpac to 0.32% at NAB. Westpac’s charge was the bank’s lowest since the 1990s recession. Morgan Stanley suggests loan loss “normalisation” in Australia and New Zealand is now largely complete, hence year on year impairment charges reductions will not be as big a profit growth differentiator in FY14 as they were in FY13. The analysts point out net 0.32% impairment charges were reported in FY07, pre-GFC.

Citi remains upbeat on the banks’ capacity to grow underlying earnings. Credit growth is strengthening, the analysts note, term funding costs are falling, and housing and SME (small/medium enterprise) margins are stable. Citi expects mid-single digit earnings growth in FY14, and suggests the banks are still in a “very sweet spot” in the cycle.

UBS is not quite so upbeat, seeing a lack of core earnings growth (pre-provision) in FY13 as a concern. Ongoing improvements in balance sheets were a highlight for UBS, but while strong balance sheets underpin dividend payout capacity, it is earnings from which the banks “pay out”. If BDD reductions are coming to the end of their post-GFC run and core earnings growth remains subdued, further dividend increases will be difficult to deliver. As UBS notes, the market seems to be investing in banks in a belief dividends will rise ad infinitum.

While balance sheets are strong, and among the strongest in the world, there is still a possibility capital conservation will need to continue from here, Macquarie warns. Next year sees the enforcement of the Basel III global bank requirements, and one of those requirements is that of a Domestic Systemically Important Bank charge. The DSIB charge is basically the newly introduced cost of being “too big to fail” in one’s own country. There has been talk recently that the DSIB charge may not be 0.5%, as assumed, but 1.0-1.5%. Anything greater than 1.0% will mean Australia’s banks will need to continue with capital conservation through a mix of dividend investment plans, which are really backdoor capital raisings, and lower dividends.

Special dividends would be an obvious first victim, but Macquarie notes special dividend specialist Westpac is actually in the best position of all the majors and thus the less likely to need to cut its dividends. CBA is next best, followed by NAB, with ANZ most vulnerable given faster-than-peer growth.

Which brings us to a breakdown of how the bank’s faired individually in FY13.

Let us first have a look at the FNArena bank table from prior to the result season, as highlighted in Upside to Oz Bank Earnings?:
 

 

The most notable column in this table is that of percentage upside to target. All four banks were showing negative upside before results were posted, implying each was trading ahead of its consensus target. When all banks run ahead of target one of two things can happen. Either the brokers raise their targets or bank share prices, having stretched themselves, have a bit of a pullback. Given bank analysts will always adjust their forecasts after an earnings result, it was possible we would see some target increases forthcoming rather than share price tumbles.

And indeed we did. The following updated table, based on yesterday’ closing prices, shows only CBA remains at a share price above target after all four banks saw net target price increases, while ANZ, NAB and Westpac paid out their final dividends.

 

 

CBA almost always trades above target given its greater popularity with investors than analysts and subsequent premium to peers. We can also see a reasonable share price increase in the interim for CBA, and an increase for ANZ, while NAB and Westpac have seen share price reductions (since the last update).

Forecasts have now shifted from FY13-14 to FY14-15. We see no change in consensus order of preference (and indeed there has been no change for some time) but the spread of recommendations has become more centred. The pre-season total Buy/Hold/Sell ratio of 14/11/7 has shifted to 12/14/6 post-season.

What is nevertheless clear from these numbers is that individual broker orders of preference are diverse. Just as an example, Macquarie’s order of preference is NAB, WBC, ANZ, CBA. Citi suggests CBA, WBC, ANZ, NAB, while Credit Suisse prefers ANZ, NAB, CBA, WBC. Each broker puts a specific case for its order of preference, usually focussing on different aspects of the banking outlook, and these are only three of the eight brokers in the FNArena database.

A confused investor might be tempted to invest in all four, if bank investment is sought, or a relevant ETF (exchange traded fund).
 

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