Not Every Bank Bear Has Turned

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By Greg Peel

In late 2007 when the US credit crisis began to intensify, veteran bank analyst Brian Johnson was a lone voice amongst his peers. While most analysts trotted out an automatic response of “banks are safe havens in a crisis”, Johnson, who was then with JP Morgan, became immediately very negative on the outlook for the Australian banking sector.

When FNArena interviewed Johnson in early 2008 as to why he alone seemed to be calling it right while his peers were still stuck in some form of denial, Johnson offered a simple answer – he was older than all his analyst peers.

At the beginning of what was to become the GFC, most bank analysts looked back at ten year’s worth of comparative data and decided the risk of bad debt increases would not impact too heavily, even if bad debts reached the level of the 2002 recession. But what ten years of data missed was the enormous spike in bad debts experienced in Australia during the 1992 recession. By comparison, 2002 was a mere wobble in economic growth. Unlike most of his peers, Johnson was practising the art of bank analysis way back then. He had lived through it once and could see the writing on the wall once more.

As 2008 unfolded, slowly but surely the bank analyst community began to fall into line with Johnson. Indeed, many became very bearish, and also began making comparisons with the 1992 recession as a benchmark.

As we moved into 2009 however, the extent of Australian bank share price falls – circa 50% – was enough to encourage the odd analyst to start looking at value. At very low multiples on a historical basis, and even including anticipated capital raisings and dividend cuts, the banks were beginning to look cheap. They looked very cheap if one assumed the GFC and its lingering hangover would be gone by FY11. Then the “green shoots” rally began.

Having remained stoically bearish in late 2008 and early 2009, most analysts remained that way in the early stages of the rally from March. But as economic data both internationally and locally began to improve – and Australia specifically avoided a “technical” recession the March quarter – analysts began to quietly change their tune. Looking through an expected peak in bad debts in FY10 and on to the upside potential of FY11 earnings, suddenly analysts were upgrading to Buy ratings once more. In this second leg of the rally, from June, one by one analysts have switched to a now positive view.

Over the last two weeks, the last remaining stoic bear in the FNArena broker universe turned. RBS now has Buy ratings on ANZ ((ANZ)) and National ((NAB)) and Hold ratings on Westpac ((WBC)) and Commonwealth ((CBA)), having staunchly defended Sell ratings on all four for many months. With tongue somewhat in cheek, FNArena had previously suggested that if RBS ever flipped and all brokers became bullish it would be time to sell (using the old contrarian argument).

Johnson left JP Morgan in early 2009 after 14 years service (he was a Mac-banker previously) and took up an offer to join globally expanding Credit Lyonnaise Securities Asia (CLSA). As Johnson had been off the radar for a couple of months in between, the market was keen to learn whether in April, with a rally now gaining pace, he would return a bull.

It was not to be.

Indeed, Johnson opened his CLSA account with yet another very bearish report and a subsequent banking sector Underweight rating. Even his old shop JP Morgan has since turned more bullish. With many in the market desperate for a positive view, the added kudos Johnson had garnered from his early bearish stance was being challenged. And now here we are in an ongoing rally with bank share prices having risen around 50% from their lows, outperforming the index.

But Johnson is not someone to be swayed by market sentiment. This week he issued his latest banking sector report, and he maintained an Underweight rating on the sector.

Johnson admits such a strong rally and a driving return to positive sentiment brings his view sharply into question. But while he now suggests bad debts will not reach the same levels experienced in 1992, he does believe talk of a bad debt peak being only six months away is misguided. The 1992 bust was all about previous sloppy lending on commercial property. Australian bank exposures to commercial property were smaller this time around, but Johnson suggests banks “have not recognised future losses which will appear as declining rents fail to cover interest”.

To that end, he believes bad debt levels will remain elevated right through to the first half of 2011.

But that’s not all of the story. Johnson maintains Australian banks will continue to face earnings headwinds from slowing credit growth, declining fees, necessary IT capex, and burgeoning share count increases due to capital raisings. He also maintains there will be further cuts to “still bloated” dividend payout ratios.

All said, Johnson believes bank valuations are now stretched on a historically comparative basis. He does concede that bank PE multiples have not yet risen as much as resource sector multiples, suggesting there could still be some upside pressure on bank share prices if there is any market rotation out of surging resource stocks. He also concedes the outlook for the banks is now “less challenging than previously expected”, thus justifying some multiple expansion, and to that end he has changed the inputs to his valuation model to produce 12-month target prices increases of around 25% for the Big Four.

These adjustments nevertheless leave Johnson’s targets still well short of the FNArena database averages (in CBA’s case 27% lower), and even further short of current share prices. Hence the continuing Underweight rating on the sector.

Johnson has thrown down the gauntlet once more.

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