Where’s The Joy In ANZ?

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This story features ANZ GROUP HOLDINGS LIMITED, and other companies.
For more info SHARE ANALYSIS: ANZ
The company is included in ASX20, ASX50, ASX100, ASX200, ASX300 and ALL-ORDS

By Greg Peel

The first question to ask is: What on earth was going on yesterday? The banks kicked off a very strong week on the back of Citigroup’s disastrous result and have kept climbing ever since, bolstered yesterday by a disastrous ANZ Bank ((ANZ)) result, the grim details of which had already been revealed. It would appear that not losing more money than management expected two weeks ago, and maintaining a discrete dividend as it suggested then too, were a green light.

The simple answer, of course, is that this market is currently looking for any excuse to buy, just as the US is experiencing. So a result no worse than expected thus becomes a great result. A couple of months ago most bank analysts might have agreed with the market, but they’re not quite as positive anymore. A quick list of the various headlines accompanying analysts’ ANZ reports this morning sums up the views:

“A tough one for even the best spin doctor,” said Citi. “It’s unclear if the decks are now clear,” noted UBS. “Overhanging risks,” said bank bull GSJB Were, agreeing with Deutsche Bank who noted “Risks remain,” and Merrill Lynch who suggested “Credit and costs issues linger”. Credit Suisse called it a “Provision building exercise” and ABN Amro “Shaking the tree”. Among the more bearish (the sector) Macquarie asked “Ahead of the curve?” while JP Morgan suggested “Potholes in the rear mirror, but speed bumps ahead!”

Now, if all brokers agree to be bearish it is often one of the most powerful Buy signals. However, what ANZ’s result highlighted, as a proxy for all the big banks, is that uncertainty of earnings is still very much in focus. The cash profit of $1.65bn was in line to behind forecasts, but given the result was pre-empted there was never much scope for major up/downside surprise. Asset growth was strong, which was again expected due to the rush back to traditional banking since the securitisation market froze, but it is the unknowns that were foremost in analyst interpretations, not the knowns. The two big unknowns are bad loans and funding costs.

ANZ recently near tripled its bad loan loss provisions to $975m. It was this figure that turned an otherwise healthy operational profit increase of 11% into a 14% bottom line decrease and a fall in earnings per share of 17%. The increased provision is a forward-looking exercise, and not a rear-looking result. It is thus a guess. It is eminently possible ANZ will recover on most of its wobbly loans at some time in the future, in which case that provision will “come back” into profit. But in the meantime a very dark looking local economic horizon, where both consumer and business confidence has fallen to multi-year lows, where inflation is running rampant, and where interest rates are forcing a jump in mortgage foreclosures, is not one in which one might lean towards the positive. As the analyst headlines suggest, there could be more provision increases to come.

And there could simply be a surge in loans going bad. At this stage it is not beyond the realms that the RBA could increase the cash rate another 25bps next month, although even if it doesn’t there is little chance of a rate cut until well into 2009. JP Morgan notes that only a small proportion of ANZ’s business loan portfolio has been “re-priced upwards” for the bank’s higher cost of funding and that there are “clear indications” of credit rationing. This implies ANZ has its fingers crossed for a fall in the cost of funding such that it doesn’t have to raise business loan rates further, but rather will ration available funds until such time as cost of funding eases.

ANZ noted cost of funding had “stabilised”. While this was offered as a positive the fact remains it has stabilised at a very high level. The result suggested an 18 basis point decay in the margin, which UBS described as “severe”. At least deposits are growing at this level. If the cost of funding does not fall meaningfully, or worse, increases again, then the floodgates will have to open on lending rate increases. A fall in the funding cost will help, but as the cash rate remains at 7.25% for the year all banks expect their asset growth to slow (ie less hands up for loans). This means less from which to bolster earnings.

While Bear Stearns my yet go down in history as the turning point in the great 2007-08 credit crunch bear market the fact remains there are yet no clear signals of the unfreezing of any credit market. The Libor rate is still challenging levels it shot to back in August. Either something else monumental has to happen before markets begin to open up again and credit spreads fall, or it’s going to be a long, slow, drawn out process of restoring confidence. Even then, rates will never fall back to early 2007 levels in this generation.

To date, the extent of the bad loan provisioning has come from Australian business risk. Everything from the Centro ((CNP)) implosion to the Opes Prime debacle is testament to this provision, but as yet there is no real provisioning for the possibility of consumer credit losses or even the NZ in ANZ. New Zealand’s economy is not as strong as Australia’s.

It was a positive, as far as many were concerned, that ANZ did not announce a capital raising. What it did do, however, was maintain a discrete dividend of 62c. Dividends are the life blood of the financial sector investor, and banks typically pay on a ratio-of-earnings basis. If ANZ were to maintain its previous ratio then the dividend would have been lower and investors unhappy. By holding the dividend discrete the bank has effectively increased its payout ratio (you could say to infinity given the half saw a loss) but this still had to be paid out of cash. Unless, of course, ANZ can encourage investors to reinvest their dividends into new stock via the dividend reinvestment plan.

And so, as is usually the case in the banking sector, ANZ has offered a DRP with a 1.5% discount as the teaser. Yet by simply offering a DRP there is no guarantee shareholders will take it up, so in order to avoid actually having to pay out any cash at all the bank has turned to underwriters. Thus the DRP effectively becomes a rights issue by any other name.

Despite this capital raising, analysts are not convinced ANZ’s capital base is secure against the bank’s preferred capital ratio or even international minimum requirements. And yet management is still talking about  possible investment in Asia. Will this require a raising? All will increased bad loans enforce one anyway?

It’s all a case of heightened uncertainty. And not only have we not heard from the rest of the pack, aside from early reporter Commonwealth ((CBA)), ANZ has been the only bank to update ahead of its result, so far. Most brokers are expecting increased provisions from the field, although all note ANZ’s position is arguably the most perilous. Similarly, most expect the others to follow suit with underwritten DRPs.

Credit Suisse was the only broker to change its rating on ANZ this morning, downgrading from Outperform to Neutral. This takes the B/H/S ratio to 3/7/0. UBS suggests ANZ’s discount to peers is enough to put a sector Buy on the stock, while similarly JP Morgan’s Overweight is a rating within the sector. JPM is Underweight on the banking sector. Aspect Huntley upgraded ANZ to Buy ahead of even the earlier update and has yet to respond.

There was some target price fiddling, both up and down, with the result being a slight increase on the average to $24.31. Last trade $21.79.

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