Australian Banks: The New Defensives

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By Greg Peel

When FNArena last took a look at the Australian banks, before the results and update season just passed (Australian Banks: The Outlook For 2014), the ASX Financials Ex-REITs index (XXJ) was tracking below the ASX 200 (XJO) due to a renewed interest in higher risk, cyclical exposures, including resources, and analyst warnings the Big Banks were looking rather well valued. The XXJ has continued to track below the XJO but in lock-step through February and right up to this week when the iron ore price plunge sent investors high-tailing out of the miners.

It must be noted the banks have an in-built safety net in the form of their fully-franked dividend yields which imply a floor price in any weakness. The Big Four spent 2014 handing out capital returns like candy. But it is that candy which has thrown up an interesting conundrum for the big lenders, and thus investors, in 2014.

2013 was been another year in which the banks wound down provisions put in place after the GFC to cover the rush of bad debts expected at the time, as well as to cover more general market risk in that volatile period. Default levels were not quite as bad as expected and as each year has gone by, the number of bad and doubtful debts on bank balance sheets has quietly reduced, thus reducing the need for said provisions.

Provisions were originally set aside from retained earnings so when no longer needed they come back onto the earnings line to add to earnings generated from actual business. The banks then decide what to do with this capital. Under normal circumstances there’s little doubt – capital must be allocated as backing to new loans the bank is providing to customers and shareholders must be paid out their share. The thing is, though, the banks are writing very little new business. If there’s very little new business to write, requiring capital deployment, then there’s a lot of money sitting around that might as well be used to keep shareholders happy and to look good at a time yield is highly sought after.

Hence the candy, in the form of dividend payout ratio increases, special dividends, and neutralised dividend reinvestment plans (DRP), meaning no shareholder dilution. But now comes the twist.

If credit demand in Australia does start to pick up, then while bank earnings forecasts will rise, so will the draw on bank capital as backing for these new loans. Broker views vary, but there is a feeling the post-GFC provision reduction period has now run its course, meaning “earnings” distributed as dividends will actually have to be earned through normal business. Thus, even if bank earnings do improve, there is little real possibility of the banks further extending their capital distributions. As CLSA puts it:

“Sadly the sustainability of the much increased (~75%) dividend payout ratios of the Australian banks is a function of the prevailing low loan growth environment (ie less requirement to retain capital to keep capital ratios steady on a slower growing asset base)”.

So what investors might have gained on the swings they can lose on the roundabout, ironically under improved economic conditions. At the very least, this conundrum does rather imply that the days of hard-running bank share prices have likely passed, and from here on the banks will once again, for the first time in about a decade, become “defensive” stocks.

There has already been a pick-up in loan demand in recent months, as evidenced in the great property investment house price boom. Over the twelve months to January, housing lending has risen 5.6% and represents around 60% of all outstanding bank loans. There has also been a slight pick-up in business credit demand, although at 2.0% this remains in the “subdued” range. Business lending represents around 34% of outstanding loans.

[I am reminded at this point that bank analysts first began expecting a post-GFC bounce in business credit demand in 2010, or if not in 2010 then definitely in 2011. It’s 2014 and counting…]

With respect to the conundrum explained above, housing loans represent a literal “bricks & mortar” investment and as such require a lower ratio of regulatory capital backing from the lender. Business loans, on the other hand, require levels of capital ranging from more to much more depending on the risks involved. In other words, the recent rise in lending for housing is not having a lot of impact on bank capital available for dividends. When the day finally comes and business credit demand starts to take off again (and it should not be too far away in this low interest rate environment), that’s when the dividend payout dilemma will really kick in.

The low capital intensity of housing loans has allowed the banks to offer strong dividend yields and the reporting season has shown net interest margins have held up despite the competition amongst the banks for this new business, given the competition for deposits has now eased off on the other side of the margin ledger. Anyone who suggests there is no competition between the banks is either ignorant or a politician. The risk ahead is that a pick-up in business loan demand will again see the banks at each other’s throats in a higher capital intensity segment and at a time provision write-backs are done and dusted. Indeed, increased business loan books naturally imply a return to increasing provisions hence net interest margins are likely to be the victim, along with shareholders expecting more and more candy.

And not only have the regional banks and non-bank lenders re-entered the home loan fray via the resurrection of the mortgage securitisation market, previously killed off by the GFC, but the European banks have become emboldened enough to start sniffing around Australia’s business lending market once more.

Zombies attack.

The wash-up from the interim report and quarterly update season is that the banks have performed reasonably well and in line with expectations. Net interest margins, as noted, have held up, rising costs have been kept under control with discipline and wealth management businesses have found a new lease of life on the back of the rising stock market. Provision write-backs have been converted into shareholder candy. Some proportion of profit has nevertheless been of lower “quality”, with Commonwealth Bank ((CBA)) in particular enjoying a lift in market trading profits (which are volatile) and currency benefits.

Westpac ((WBC)) has made a concerted push back into mortgage lending after shying away for a couple of years while between the two smaller Big Banks, National Bank ((NAB)) is closer to finally exiting its disastrous UK foray and can look forward to provision write-backs from offshore (NAB has been a bit behind in the candy race), while ANZ Bank’s ((ANZ)) offshore push has potentially turned from bonus to drag as Fed tapering threatens emerging market currencies.

As far as current bank share price valuations are concerned, BA-Merrill Lynch points out the carry trade is “alive and well” and can only thrive on falling volatility. The “carry trade” is a reference to offshore investors, such as in the US, who can borrow funds at very low rates of interest and invest in AA-rated Australian banks for a 5-6% yield (no franking, but a big spread anyway). The lower the volatility of the general market, the less likely those investors will do their dough on a fall in share price, and/or a collapse in the Aussie dollar. The carry trade harks back to the earlier suggestion the banks offer a natural safety net in the form of their dividend yields.

Volatility markedly reduced over 2013 as the ghosts of the GFC appeared to all but fade away. Of course it doesn’t take much (see: China, Cold War II) to bring it back.

Prior to February the only bank appearing to be "overvalued" against the consensus target price of FNArena database brokers was CBA, but then CBA is almost perennially "overvalued". The biggest Big Bank is consistently awarded a premium over the other banks, including close rival Westpac, and despite years of analyst insistence that premium gap must close, it never actually has. So we can take CBA "overvaluation" with a grain of salt, but we can pay attention to history and note the market tends to lose interest in CBA once its gone ex-dividend (February and August), preferring to anticipate fresh capital management announcements from the other three (May, November).

The following table is updated based on yesterday's closing prices. As we can see, CBA retains its fourth preference position with no Buy or equivalent ratings from FNArena brokers and a target price sitting 2.93% below the trading the price. But we also see Westpac has now joined CBA in the "overvalued" camp. ANZ and NAB both show plenty of upside potential between them, largely suggesting analysts are more confident than the market at present. ANZ's exposure to Asia is acting as a drag given fears over Chinese slowing and the aforementioned impact of Fed tapering on emerging market currencies and bond rates. NAB has for a long time now carried a "UK discount", and despite the outlook appearing a lot more positive in the UK the market is yet to give NAB the benefit of the doubt.
 

Indeed, while it is likely the other three banks have used up most of their candy fire power for now (we note CBA disappointed at its recent result, although Westpac may yet have a little left to sweeten the pot), NAB was unable to match its rivals last year given its UK risk overhang. But with the UK economy firing on all cylinders, and the British government having begun the process of divesting of its 2008 "bail out" equity in the UK majors, it may well be possible NAB can reconsider a sale of its UK assets. Notwithstanding a sale, the reduction in risk in NAB's bad and doubtful UK loan book suggests provisions can now be written back and taken as earnings. Hence of all the Big Four, NAB has the only real potential to provide increased distributions in the next year or two.

Yet the market continues to apply a risk discount in pricing NAB. It's largely a "once bitten" hangover.

As the table shows, all four banks continue to offer 5-6% yields before franking. This is safety net territory, as indeed was evident yesterday on the Australian market when the buyers galloped in later in the day after the morning saw a China-related capitulation in bank stocks.

Yield support, but no great distribution upside potential from here, a subdued earnings growth outlook, and a tit-for-tat trade off in distribution capital against operating capital if credit demand picks up and translates into a brighter earnings outlook.

There will be some in the market who won't recall the days when bank stocks were considered "defensive". In 2007, when the GFC will still but a young Credit Crunch, bank analyst after bank analyst assured investors there was nothing to fear given bank stocks are "defensive" and always hold up in volatile markets. They were proven very, very wrong and indeed, naive. Over five years on, they might now be right.

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