Australian Banks: Whereto From Here?

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– Lack of revenue growth
– Ongoing regulatory risk
– Overstretched valuations
– Yield support

By Greg Peel

FNArena’s previous Australian Banks report was published in November, following the bank full-year reporting season for Westpac ((WBC)), National Bank ((NAB)) and ANZ Bank ((ANZ)) and first quarter update from Commonwealth Bank ((CBA)). We have since seen a full-year result from CBA in the general February reporting season, and quarterly updates from the other three.

There were three factors which stood out in the previous report: bad debts, capital and valuation.

Earnings growth in the FY14 banking year was driven mostly by further reductions in bad and doubtful debt (BDD) provisions rather than any underlying growth to speak of. Some brokers assumed this well must soon dry up given not only were bad debts back to pre-GFC levels, they’d fallen all the way to historically low levels. Bad debts must now begin to normalise, they argued, meaning grow once more.

But other brokers argued the case, suggesting historically low interest rates – the RBA had just cut to 2.5% — implied bad debts could still fall further.

Capital was a clear issue given the pending, at the time, release of the David Murray-led Financial Services Inquiry. The subsequent release did not hold any great surprises, but in the interim analysts largely decided the banks were showing sufficient capital generation to render additional capital requirements less imposing, and they could also deploy dividend reinvestment plans (DRP).

Valuation was an issue. Analysts were torn between the obvious attraction to longer term investors of solid, fully-franked yields and a lack of earnings upside despite strong share price runs. As the table below from that period indicates, CBA was already trading above its consensus target and Westpac was nearly there, with the smaller, riskier banks showing some limited upside potential.
 

Yet CBA was still the brokers’ second preference, which was an unusual place for Australia’s biggest bank to find itself. Usually, brokers despair at CBA’s overstretched premium to peer valuations, but in the context of potential additional capital requirements, CBA stood out amongst the group as least exposed.

Fast forward to today, post fresh results, and little has changed in terms of those factors hanging over the banks. Analysts are still arguing over bad debts, given they have come down even further. The FSI is yet to be dealt with by the treasurer, who seems to have other things on his mind, like survival, and suing Fairfax. And if valuations were arguably stretched back in November, the rubber band is really straining now.
 

We see that consensus target prices have risen slightly, but share prices have run well ahead (based on yesterday’s closing prices). All four banks are now trading above target, with Westpac markedly so. CBA is back in its more familiar position as least favoured, given its valuation premium, and the others have all shuffled around in terms of broker preference. In November the total Buy/Hold/Sell count was 9/15/8, today it is 10/11/11.

So if bank share prices are exceeding consensus targets, why are there any Buy ratings at all? It’s because different brokers have different views. Some still expect bad debts to now turn upward again, despite low rates, others believe “this time it’s different” because of low rates. Some warn of capital raisings ahead once the FSI recommendations are adopted, and macro-prudential controls with respect to mortgage lending are introduced, others believe the banks can safely absorb the risk. At least one broker believes all four banks are quite simply overvalued, and thus has a Sell on all four, while others believe yield support and some earnings growth potential means further upside for certain names.

Macquarie has just become the first broker to put a $100-plus price target on CBA — $101 to be precise.

Citi, the broker with a Sell on all four banks, summed up the recent bank results as follows:

“Disclosures reveal evidence of capital generation having peaked, revenue growth slowing as mortgage competition builds and credit quality improving but credit costs [BDD] no longer driving much improvement in earnings.”

Credit Suisse notes that the bulk of any credit growth was mostly related to the falling Aussie rather than normal business. System credit growth is edging higher but in a low interest rate environment (now lower still since last month’s RBA cut), net interest margins continue to disappoint. Cost growth appears uncomfortably high, as the banks spend up on technology updates, compared to revenue being generated. The cycle of returning BDD provisions to earnings has likely run its course. Risk-weighted capital growth (mortgage lending for example) was “notably” high and thus underscores the spectre of regulatory risk.

UBS notes housing credit growth remains strong but appears to be nearing a peak. The broker suspects the latest RBA rate cut, and any yet to come, will not lead to mortgage holders reducing their payments in line with a drop in the variable rate, but rather maintaining payments to pay off the principal faster. This means little benefit to the banks of RBA rate cuts, now rates are so low.

Despite the attraction of the banks’ high yields in a climate of benign economic growth, UBS believes banks valuations, at a net 15x FY15 price/earnings, are overstretched.

However, UBS made this assessment after all the banks had updated last month and we have since seen some share price pull-back. Indeed as I write, bank share prices are slipping once more. But the above table was based on yesterday’s closing prices, which already represent a fall from the peak. FNArena’s long-tested rule of thumb is that if bank share prices exceed consensus target prices, most likely the banks are in for a period of de-rating back to more realistic valuations.

The problem is that under “normal” circumstances, if such a thing actually exists in markets, investors tend to sell banks when their valuations become stretched and switch into something else – usually resources, and/or cyclical industrials. But in today’s world, not only are commodity prices weak but the big miners and energy companies have become dividend payers to rival the banks. And many a large cap industrial has become a sought after yield stock.

The pullback currently underway in the market is due to a more uniform driver of all yield paying stocks having become overvalued. Thus selling in banks will not likely pop up as buying elsewhere in the stock market. What is more likely is that most everything will sell down until investors again decide – weak bank earnings growth outlooks and weak commodity prices aside – yields are simply too attractive on both a local (RBA cash rate at 2.25%) and global (German ten-year bond yield at 0.28%) basis.

Thus the banks, and other yield payers, have a share price safety net. As to where that net is will be determined by just how far investors will allow prices to fall (happily, so they can get in to stocks they missed out on in the rally) before someone blinks and the buyers all plough in again.

In terms of preferences between the four majors, every broker has a differing view, as the above tables indicate. But we can find consensus with regard certain aspects.

CBA is the stand-out bank. Problem is, it’s just too overvalued. NAB offers the most relative upside within the group given the ongoing work-out of its long-troubled UK business, which should allow for some dividend catch-up. ANZ offers the greatest risk given its exposure to a slowing Asian economy. Westpac sits somewhere in the middle.

Morgan Stanley continues to bang the capital raising drum, warning that increased capital requirements and macro-prudential controls will force the banks to go the market for equity. MS also notes that while bank exposure to lending in the mining sector is relatively low, compared to mortgages for example, it is not insignificant.

Net bank exposure to miners and mining service providers adds up to less than 2% of loan books, the broker notes, but it could lead to material increases in group loan losses from bottom of the commodity price cycle levels. On that basis, Morgan Stanley believes the banks’ net earnings upgrade cycle has ended.

On the other end of the scale, Macquarie sees strong potential upside in bank lending to small & medium enterprises (SME). The broker’s view is based on the availability of new platform technologies servicing cash flow lending, and of the under-use to date of the business broker channel, which banks are now beginning to exploit.

So there’s an awful lot of moving parts one must consider with regard bank valuations. Not that investors are really all that focused on such nuances. Investors are focused on yield.

As our first table shows, back in November banks were yielding around 6%, with CBA closer to 5%, plus franking. As of yesterday’s closing prices, they were all around 5%, with CBA at 4.8%. If the sell-off currently underway runs a little further, the buyers will happily return. Offshore buyers will enjoy a lower Aussie.

If, indeed, the banks are forced to raise additional capital due to regulatory requirements, there may well be a few takers.

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