Widespread Downgrades For Bank Of Queensland

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By Greg Peel

Those looking in from the outside have always found Queensland a slightly strange place. Maybe it's because the state symbol is Bob Katter's hat. But realistically Queensland is presently caught a bit betwixt and between. The problem is it's Western Australia on the east coast.

Queensland has its coal mines and its burgeoning CSM LNG industry, as well as plenty of other mineral projects. WA also has lots of mineral projects including gold and dominant iron ore, and a massive offshore LNG industry. But while Queensland has the Gold Coast and – let's face it– little pockets of Gold Coasts all the way up to Port Douglas, WA only has a handful of resorts. WA's population is young and enthusiastic. Queensland is Australia's Florida.

WA's economy is booming. Queensland's economy has been in a slump since 2008. So much so that the government has been forced to sell off the family silverware, the latest being QR National. WA couldn't really care less about a rising Aussie dollar. Queensland's inbound tourism industry has been crippled. Even its interstate tourism industry is suffering given everyone's been to the Gold Coast and it doesn't cost much more now to go to Europe. And to top things off, in Queensland it is beautiful one day, bucketing down the next.

An immediate and ongoing victim of the GFC has been the Queensland commercial property market. Not just residential tower blocks and anything Gold Coast, but right down to shopping centres. Over the last two years, notes UBS, Suncorp-Metway ((SUN)), St George Bank ((WBC)) and BankWest ((CBA)) have all announced material losses from commercial property exposures in the Sunshine (?) State.

Bank of Queensland ((BOQ)), on the other hand, has seemed blissfully immune. Indeed, BOQ has managed to pick itself up out of the GFC ashes pretty quickly and expand its loan book and expand its net interest margin. Funding has always been an issue for the regional banks as they don't have the size of the Big Four (and the Big Four have their own funding issues), but with the Comrade Hockey-inspired bank sector regulatory review now going on, all analysts expect that regional banks can only be a beneficiary of any measures designed to support increased competition.

All of the above has meant that BOQ shares have run pretty hard of late, indeed outperforming the sector by 16% since CBA announced its big rate hike, JP Morgan notes.

But with the AGM coming up today, BOQ management had decided recently, over a pot of Four-ex, it might probably be prudent just to check up on its commercial property loan book. The review was prompted by two particular shopping centres on the books which were suffering from the retail downturn. This proved to be rather a wake-up call.

Those two loans were in trouble, and as such BOQ undertook a review of its top 250 commercial property loans, representing about one third of its overall CP loan book. The end result is an additional bad and doubtful debt impairment charge of $97m, of which the two big shopping centres represent 70%. BOQ has now increased its BDD guidance for the first half FY11 to $85-90m from a previous $53m.

The market has every right to be concerned that, to date, only a third of the loan book has been “forensically” reviewed. While the guidance update represented an extrapolation of that third, there is a growing feeling of unease that BOQ management has been fiddling as Logan burns.

Stock analysts have responded with forecast earnings downgrades of some 10-15%. Three out of eight FNArena database brokers have downgraded their ratings – two from Buy to Hold and one from Hold to Sell. Morgan Stanley has also downgrade from Hold to Sell. BOQ has gone from a B/H/S ratio of 2/5/1 to 0/6/2.

The news at the update was not all bad. Management announced that net interest margins had returned to levels of a year ago at a time when the Big Four are struggling to achieve any increases (out-of-cycle hikes notwithstanding). Costs are under control. Macquarie notes that the new impairment expense should have represented a profit guidance downgrade of 10%, but as the downgrade was only 5-8% it suggests BOQ's underlying operations are performing above expectations.

Indeed while having only reviewed a third of CP loans, management is confident that its BDD exposures will see “significant improvement” in the second half. It was at pains to point out the bank has limited exposure to the risky areas of high-rise residential blocks and anything on the Gold Coast. Macquarie notes BOQ's commercial loan book leans towards secured retail and business assets which tend to have lower losses.

Macquarie does not think the real issue for regional banks is bad debts. BOQ's current BDD impairments represent only 37 basis points which is well below the cycle peak of the Big Four at 80-90bps. Macquarie has been beating BOQ's drum of late, and is a little lonely in its dismissal of BDDs. Other brokers are less sanguine. Yet even Macquarie has decided that Outperform is no longer an appropriate rating.

Citi suggests that while BOQ's underlying numbers might look to be improving, the BDD shock is indicative of a rushed effort to lift the bank's return on equity from its current level around 8-9% to a target 15%. Citi notes BOQ has been expanding into higher risk segments such as leasing and equipment finance. Can management successfully handle greater risk?

Citi also believes the market has become a bit too carried away with BOQ's prospects from a mandated increase in bank competition. Credit Suisse suggests that if the government succeeds in supporting regional bank competitiveness, Bendigo & Adelaide Bank ((BEN)) is better placed anyway given its Adelaide Bank mortgage originator.

RBS is worried about further BDD stress, Deutsche Bank can't see any catalysts for outperformance, JP Morgan believes the risk/reward trade-off has now become more balanced and Goldman Sachs can't see any reason to buy while the shares trade at a premium to the majors.

Those white shoes are looking a little faded.

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