The Silver Lining Of The Banks’ Clouds

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

This story was first published two days ago in the form of an email sent to registered FNArena readers.

By Rudi Filapek-Vandyck, Editor FNArena

Wait until August 13 has become the new credo of many a share market expert in Australia. Australian banks were supposed to be a safe haven amidst global credit turmoil, and their direct exposure to poisonous US mortgage-based financial constructions almost negligible, but shareholders have seen the value of their bank shares fall ever so lower since November last year.

Now part of the professional investment community is out for redemption. Australian banks have been treated too harshly, they maintain, the banks have fallen victim to indiscriminate selling on the back of quasi-unprecedented problems for peers in the US and Europe. But on August 13, when the Commonwealth Bank ((CBA)) reports its full year financials for the year to June 2008, all those who have doubted the unique quality of Australian banks will be proven wrong and investors will again be able to fully embrace the sector as the profitable quality safe haven it has been since the mid-1990s.

Yet, three weeks before the pivotal event two major stockbrokerages in Australia have taken an axe and slashed their earnings forecasts for all major banks for this year, next and the one thereafter. This doesn’t really bode well for August 13, does it?

Let’s go straight to why analysts at Citi and Macquarie reduced their earnings forecasts for Australian banks as the motivation behind their decision is something I have been highlighting myself so many times now that I lost count: the global credit squeeze is only one problem that is plaguing the sector, and most likely it will be the least damaging one too. Next comes the global economic slow down, and that is really going to impact on the financial figures of banks in Australia. This is exactly why Citi and Macquarie haven’t waited until CommBank will release its annual report. The economic slow down is coming and nothing CEO Ralph Norris can do, or say, to stop it from arriving.

Says Macquarie: “The end of any monetary tightening cycle does not afford banks great operating conditions. In Australia, credit growth will slow and the Reserve Bank is likely to wait for further signs of consumer slowdown before the easing process begins.”

Says Citi: “A vicious cycle of tight capital, slowing lending growth and rising defaults introduces multiple challenges for banks globally, from which the Australian banks will not be immune.”

Many months ago already I suggested that as Australian banks were facing the headwinds of a global credit crisis and of slowing economic growth on both sides of the Tasman Sea, it wouldn’t take much imagination to see their earnings per share (EPS) growth fall to zero, or even turn negative. Now, both Citi and Macquarie agree: both either cut EPS growth to nil, almost to nil, or into negative territory for fiscal 2009.

The scene seems to be set: the upcoming results season is unlikely to mark the trough for bank earnings in this cycle. The logical conclusion would thus be that the sector will see things worsen first before better times might follow. The good news amidst all this doom and gloom is that those experts in support of owning bank shares will be proven partially correct: Australian banks are different from their international peers, they are likely to keep their dividend payouts intact.

Assuming share prices will remain subdued as long as global financial problems persist, and with the prospect of no EPS growth in the year ahead, this should guarantee unusually high dividend returns for shareholders willing to sit through the next phase of the global bear market for equities.

The flipside is, of course, that with no, or almost no, immediate improvement in EPS ahead, any further share price improvements will need to come from higher price/earnings (P/E) ratios than current. Citi analyst have taken the view this is rather unlikely, hence they downgraded National Australia Bank ((NAB)) and ANZ Bank ((ANZ)) to Sell, while rating CommBank ((CBA)), Westpac ((WBC)) and St George Bank ((SGB)) no higher than Hold.

Macquarie, however, hasn’t given up hope. From the moment it will become clear that operational headwinds for Australian banks will loosen, or turn out not to be as tough as expected, Australian bank shares should be able to rally, the analysts surmise. They specifically single out impairment costs: “any indication impairment risk has eased could allow for a significant shift in sentiment, potentially accompanied by improved capital management potential.”

Macquarie suggests the first six months of calendar 2009 will probably prove to be the most challenging for the banks. After that, things should gradually turn brighter, even though the broker still categorises FY10 as likely to be still “difficult” overall for the sector. By then however, the likes of CommBank and Westpac should be back at reporting high single digit EPS growth (making FY11 the first possibility for double digit EPS growth again for the banks).

A few weeks ago I wrote that at times of economic headwinds bank shares as a group tend to trade at PERs between 9 and 11. Macquarie’s projections for the year ahead seem to have incorporated the same principle with ANZ shares projected to trade at PERs between 9.1 and 10.1, National between 9.3 and 10.1, Westpac between 9.5 and 11.6, CommBank between 10.3 and 12.1 and St George between 11.1 and 13.5.

If we leave out St George (take-over candidate), Macquarie’s PER projections suggest the challenging environment for the sector has separated the outstanding from the less outstanding; in other words CommBank and Westpac are perceived as carrying less risks than National and ANZ. This underlying view is also implicit in Citi’s report, in other broker reports, as well as in recent relative share price developments.

However, the recent relative outperformance of CommBank has left the shares with less upside potential than its peers. Investors may want to keep this in mind for when the clouds start disappearing for the sector. Current average price target of $43.43 suggests there’s only about 1% in potential share price appreciation left. Mind you: this is pre the upcoming results release, but even assuming CommBank’s report would trigger increased broker targets, compare this with the implied upside for the other banks: 14.1% for Westpac, 12.5% for National and 22.7% for ANZ.

Implied (non-grossed up) consensus dividend yields are currently: 7.6% and 8.0% (FY08 and FY09) for ANZ, 7.1% and 7.5% for National, 6.9% and 7.2% for Westpac and 6.3% and 6.6% for CommBank. So far, only National and ANZ’s payout is seen as modestly at risk with both banks expected to continue underwriting their Dividend Reinvestment Plans, which effectively amounts to minor capital raisings with dilutive consequences for shareholders.

(All calculations in the previous paragraphs as at closing prices and targets on July 22, 2008).

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