Bank Result Wrap

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

– Bank results largely meet with expectations.
– Not a lot of earnings upside post results.
– High funding costs mean banks are actually better off not writing new business.

By Greg Peel

Over the past twelve months, bank analysts have in general been wrong on two counts. The first was the expectation that the level of bad and doubtful debts (BDD) on bank loan books would not drop rapidly post-GFC but would instead provide a “long tail” of decline. The second, in some ways counter to the first, was that the lack of recession in Australia and rapid return to low unemployment would mean consumer spending would bounce back quickly and that business credit demand, which was still in steady decline, would very soon bounce sharply.

Six months ago analysts were caught out when the big banks made big cuts to the BDD provisions rapidly set aside in 2009. The cuts were made possible mostly because there was not the level of follow through into small and medium enterprise (SME) bad debts as had initially been feared at the height of the GFC, given the lack of actual recession. The banks had thus over-provisioned and were now able to bring some of those provisions back into earnings. Hence bank earnings appeared to make huge jumps out of their GFC depths, and hence the media, the public and politicians erroneously assumed banks were making too much money.

They weren't. Indeed, they were really just making accounting adjustments. But it didn't get any better at the last quarterly round of earnings updates, three months ago, when the banks again posted strong results which were again assisted by more provision reductions. They also made big increases to their mortgage rates, given rising funding costs. We know just how the public responded to that news.

Bank analysts had long expected the banks to raise rates irrespective of RBA policy and the increases in reality were long overdue. At the same time banks became very competitive on deposit rates too, on the other side of the coin, but those with savings aren't the target of political spin doctors.

Having conceded that banks were able to reduce provisions faster than first thought, analysts had to also admit the long expected business credit bounce was still missing in action. And consumer spending was not bouncing back. If anything, it was going backwards, and credit card balances were dropping. The retail sector – as Gerry keeps telling us, a major employer – was in trouble. Outside of the resource sector, everyone's business was subdued.

Now another three months on, retailers claim they are in the worst recession they've ever seen. Worse than 1992. Data show that Australia's manufacturing sector is contracting and doing so a quickening pace. The same is true for the services and construction sectors. If not for the resources sector, with which banks conduct little business given its inherent risks, Australia would be looking a lot more like the US and Europe and a lot less like China.

Bank analysts are still waiting for credit demand to return, and for consumers to start spending again. What growth there has been has been fought over by the big four like hyenas on a carcass. The analysts still think both will occur, eventually. In the meantime, Australia's housing market seems to have stalled, leading to lower auction clearance numbers which should imply lower mortgage demand.

All the while bank funding costs continue to rise given the roll-off of term funding struck on pre-GFC rates to be replaced by GFC-period term funding on substantially higher rates. Not until next year will bank bonds begin to roll back down in interest cost. But as UBS points out, in light of the recent round of bank results, a lack of credit demand and lending growth has actually been a good thing.

It's not the way you'd want to run a business continuously, but it has bought some time. Banks need more funding when they write more loans. If they're not writing loans they don't need more funding. At the moment, funding costs are expensive, both on the basis of offshore interest costs required and on domestic competition for deposits. The fewer loans the banks write, the less funding they need at high cost and the less they need to fight each other with attractive deposit rates. Pressure is thus taken off margins for new business, allowing current margins to remain for the business already on the books.

In other words, it might actually be better for the banks if the long awaited bounce in credit demand held off for another year and instead coincided with the peak in funding costs.

It's a Catch-22, as UBS declares, although it does make strange sense. But what it also thus means is there is not a lot of upside to get excited about for the banks over the next twelve months. If credit demand grows, margins will tighten again, acting as a dampener on earnings. If credit demand does not grow, margins remain steady which helps offset lack of earnings. Only when credit demand rises and funding costs come down will the banks be back in the box seat they once enjoyed.

In the meantime, if BDDs have peaked then the banks can continue to top up earnings with provision reductions. However, since the first reductions in provisions occurred a while back, analysts are now taking account and the market has factored in such reductions.

The latest round of bank results once again had politicians screaming and there were even calls again for a super tax on bank profits. Yet percentage increase comparisons were being made with the same period last year, not the last period, and thus again provision returns made the results look good alongside what little pick-up in loan demand there was. As far as analysts were concerned, on a net basis all bank results came in pretty well on expectation. The results were solid, but there were no real surprises.

Overall, analyst target prices for the Big Four ticked up a bit on consensus. There is nevertheless some “roll over” effect here. If your forward earnings forecasts improve with time (and for banks they should given anticipated credit demand growth and funding cost reduction) then your twelve-month target price will respond to a shift out along the forecast curve when reset.

Indeed, there is a general consensus among bank analysts that the market is now fairly valuing the banks, leaving not a lot of room for upside in the shorter term. At least there wasn't last week at the height of bank prices post-results (when I first prepared for this bank sector update) but we have since had a couple of biggish down days.

Nevertheless, the following table shows the fresh set of consensus targets from the eight brokers in the FNArena database compared to the highest closing prices of each bank just before the Libyan unease. As you can see, bank prices were already within a couple of percent of targets or, in Commonwealth's ((CBA)) case, above target.

FNArena has noted over many years that whenever bank share prices reach or exceed consensus targets after those targets have been recently reassessed, inevitably the banks are overbought and a pullback will soon ensue. As sure as night follows day. Sometimes such a pullback might simply reflect funds (particularly offshore funds) switching out of now expensive banks and into cheaper resource stocks, but in the current case we have had an exogenous trigger in the form of Libya which is not really sector-specific. So thus we have another set of prices based on yesterday's close:

We thus now have 4-7% price gaps, with ANZ ((ANZ)) bearing the brunt. Yet ANZ remains the top pick on analyst consensus. ANZ has at least one benefit in being able to source funding from deposits in Asia. CBA is the bank that always trades at a “size” premium to the others (even though Westpac ((WBC)) is actually bigger now) and analysts have long been querying whether the extent of that premium is still deserved, hence its lowest ranking.

So on the assumption we have now seen as much of a correction as the market requires to account for the Arab world issue, there is some upside in current bank prices but only to a limit before valuations look about fair again. If the Arab world issue is set to cause more strife, well then it's not a time to be buying banks.

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