Upgrades For Australian Banks

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– Analyst bank target prices unchanged despite global disruptions
– Several ratings upgrades in the past week
– ANZ's Asia strategy sets it aside from the pack

By Greg Peel

I lasted updated the Australian banking sector a month ago just after all the interim and quarterly results were in. At that point analysts felt the results had been reasonable without being spectacular, and market prices were now at or near fair value. Eventually the bounce in business credit demand will come, the analysts suggested, as will a return to somewhat better retail spending. But in the meantime things will remain fairly subdued, they said, given a stalled housing market and ever increasing funding costs.

I note that Westpac ((WBC)) CEO Gail Kelly has been deliberately getting her face on television a lot lately, with one intention being to suggest mortgage rate premiums will definitely come down as soon as funding costs peak out in late 2012. That suggests, of course, about another 18 months of pain and subdued bank earnings growth.

Just before unrest developed in Libya, the shares of each of ANZ Bank ((ANZ)), National Bank ((NAB)) and Westpac were trading near consensus analyst 12-month price targets and Commonwealth Bank ((CBA)) had just exceeded its consensus target. FNArena has oft pointed out that such convergence either means analysts need to raise those targets or a sell-off is due. Analysts had just updated their targets post results, so the latter seemed inevitable.

As it was, the sell-off was sharp and severe. Usually, all things being equal, a sell-off might be sparked by foreign investors deciding to cash in on now fully valued bank stocks and switch back into resources instead, for example. This time it was MENA, and then Japan, which is not usual. But a sell-off is a sell-off.

As of yesterday's closing prices, NAB, CBA and Westpac shares are all 10-11% below consensus target prices and ANZ shares are 15% below. Bank analysts have not changed their targets from a month ago, which suggests they see no specific effect which will change earnings forecasts for the local banking sector based on what has transpired globally. Even the impact of the Christchurch earthquake is containable.

So something else thus has to give, and hence there have been a slew of broker upgrades to bank stock recommendations over the past week.

Post the result season, a fully priced CBA could draw only a 0/7/1 Buy/Hold/Sell ratio from the eight major brokers in the FNArena database. Following an upgrade to Buy from Hold, CBA has moved to 1/6/1.

Westpac has seen two upgrades to Buy from Hold to take it from 1/6/1 to 3/4/1 while NAB, with its greater exposure to the UK, remains stuck on 3/4/1. ANZ has seen two upgrades – one to Buy from Hold and one to Hold from Sell – to take it from 4/3/1 to 5/3/0.

ANZ's latest rating upgrade came this morning in the wake of the bank's strategy update held yesterday, and saw Citi moving to Buy from Hold. ANZ, claims Citi, is simply the “best growth story within the sector”.

Which begs the question as to why ANZ shares have been the most beaten down in the recent market sell-off, particularly given ANZ boasted the highest B/H/S ratio after the results season as well as now. The market is perhaps focusing on ANZ's smaller size, its comparative lack of exposure to the burgeoning Wealth Management sector, the current fierce competition between the banks for business on both sides of the ledger (loans and deposits), the investment being made by CBA and Westpac in particular in new IT systems, and ANZ's acquisitional aspirations in Asia at a time when bank capital ratios are under more pressure since the Basel III accord. And you can probably throw in the Christchurch earthquake, given the NZ in ANZ.

In short, whenever things go a bit pear-shaped in the world it seems ANZ is always the one to be sold off hardest.

But it is ANZ's Asian aspirations which most excite bank analysts, and establish that which differentiates ANZ from its other Big Four peers. Aside from NAB's disastrous foray into the UK which it now wishes would just disappear, the other banks have otherwise remained firmly rooted in Australasia. So one might suggest that it is ANZ Asia, or more correctly its APEA (Asia, Pacific, Europe and Americas) division that has polarised investors on one side and bank analysts on the other.

The biggest problem facing the Big Four at home, to put it in a nutshell, is to reestablish the double digit and even better than 20% return on equity (ROE) levels they once enjoyed. When we began to bounce swiftly out of the GFC, analysts assumed that ROEs could be quickly improved from shattered levels (which required large bad debt provisions and capital raisings) as credit demand swiftly returned. But demand has not returned, funding costs have remained a crush on margins and over time analysts have been quietly pulling back in their ROE growth assumptions.

(Ex-JP Morgan bank analyst agitator Brian Johnson, now with CLSA, has stated emphatically post-GFC that Australian banks will simply never return to the sort of extraordinary growth they enjoyed in the heady free money days of the pre-GFC boom.)

It is ROE growth potential that differentiates ANZ, as far as analysts are concerned.

UBS suggests that yesterday's strategy update was actually “uneventful”, in that ANZ's strategy did not actually change at all, but this the analysts declared to be “a good thing”. What did change, nevertheless, was the bank's outlook horizon. Prior to yesterday, ANZ had set a target of 20% of profit growth to be emanating from the APEA division by 2012. Yesterday ANZ CEO Mike Smith extended that figure to 25-30% by 2017.

Now a year is a long time in banking, so six years is an eternity. On that basis, analysts have been quick to point out that such long-dated aspirations (and Smith acknowledged that we're talking aspirations, not hard and fast forecasts) are all well and good but not brimming with realistic substance. Obviously anything can happen between now and 2017 and probably will. But that does not detract from the fact that in APEA, ANZ has growth engine with upside potential.

If one assumes the current compound annual growth rate (CAGR) of the rest of the business of 6%, says Deutsche Bank, that implies an 18-22% CAGR for APEA over the period. ANZ has indicated it hopes to achieve the great bulk of this aspiration through organic growth, but that is not to say further M&A opportunities will be ignored if the price is right. (ANZ recently missed out on one bid, suggesting prices are normalising in Asia post-GFC.)

Crystal ball gazing aside, bank analysts largely agree with ANZ that its APEA strategy is that which makes the difference. Deutsche, for one, believes ANZ could indeed lift its ROE from around a current 14% to 18-20% in the medium term. But this will still require careful management at home.

At home, analysts are still impressed with ANZ's strategy. Smith has indicated he does not want to go diving in to the current battle between peers for limited retail banking opportunities (unlike NAB, for example, with its painful “you're dumped” campaign). Little ANZ was never going to be a big winner in that cat fight. Instead, he sees solid scope to improve Wealth Management market share and to keep the focus on commercial banking. In so doing, note analysts, ANZ is improving its opportunity to grow “non interest income” – that which is not so beholden to funding costs, the RBA, moronic politicians and media pressure.

It's not all beer and skittles, and ANZ still has challenges ahead. But at least it is doing something different to the other three rather than just sacrificing margins by fighting them. Analysts thus see ANZ as unique within the sector, and with Asia providing the major opportunity analysts are positive on the stock, particularly since the recent sell-off.

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