Weighing Up Australia’s Bank Results

This story features NATIONAL AUSTRALIA BANK LIMITED, and other companies. For more info SHARE ANALYSIS: NAB

By Greg Peel

FNArena last updated analyst views on the banks on August 3, in light of what by that stage had become a 13% market correction in the wake of renewed Greek sovereign debt fears and emerging fears over Spanish and Italian debt, as well as weak growth and political bickering in the US.

At that point bank analysts had been lowering their credit demand growth expectations for the Australian banking sector, however this was a reflection of the weak state of the Australian non-resource sector economy and not a response to offshore issues. Business demand had remained very subdued despite long held expectations of an eventual post-GFC rebound, house prices had become flat to weaker, and the Australian consumer was all but missing in action.

Bank analysts had agreed at that point that weaker credit demand would not translate into equivalently weak earnings growth. More realistically, earnings growth would become sluggish but positive as lower credit demand remained weak because such weakness would reduce the need for further expensive offshore funding, reduce the potential for bad debt growth, and encourage more deposit funding from Australians. In reality, the banks would simply return to being the “defensive” stocks they used to be rather than the high-beta cyclicals they had become in the noughties credit boom.

Hence while analysts had slightly trimmed their bank target prices, they had not done so by much and as a result upside-to-target percentages from prevailing share price levels had blown out quite considerably as the following table from August 3 indicates. This had also meant an increase in the number of net broker Buy ratings in the FNArena database to 17 from 14 since the previous update in June.

Yet while global stock markets were looking somewhat weak around August 3, it was late on Friday, August 5 when Standard & Poor's downgraded the US and all hell was unleashed. It's now history that the Australian market plunged on the Monday and plunged again by 5% on the Tuesday, before staging an astonishing intraday comeback featuring a 7% rally from the low point. The market, many investors had decided, had become simply too oversold, and nowhere was there better value on offer than among the Big Four banks. At the lows on Tuesday, the banks were showing FY12 yields of up to 10% – fully franked.

What's more, those yields were pretty safe. Unlike 2008, Australia's banks are now well capitalised, have seen off the worst of bad debt issues, are still carrying provisions against further uncertainty and are not stretched on their dividend payout ratios. And clearly the Australian economy is, thanks to China, relatively strong at least in some sectors, and unemployment is low.

That extraordinary Tuesday was also, as it turned out, the day National Bank ((NAB)) had scheduled for its June quarter trading update. NAB's result matched analyst forecasts on the bottom line, the balance sheet had grown, bad debts had fallen, and on an individual note the bank had exited more of the toxic US assets it's been carrying since before the GFC. The result helped to encourage bargain hunting in the banking sector at that point and analysts agreed, suggesting Australian banks were oversold and all the anxiety had proven unfounded. NAB's result, they suggested, would provide a positive “read-through” for the other three.

That view seemed to be confirmed when the following day Commonwealth Bank ((CBA)) posted its full-year result for FY11. This time the result exceeded analyst expectations and the big profit figure evoked typical mass media hyperbole. Most notably for bank analysts, CBA's net interest margin had continued to improve.

CBA's perennial problem is, however, that its size and strength means the market has always maintained a premium share price relative to the other three banks including the also large Westpac ((WBC)). The premium may be well deserved, but it has also meant for some time that greater upside potential lies with the other three and particularly the smaller two, as far as bank analysts have been concerned.

For a while there it looked like the Australian stock market had weathered the US downgrade storm and was ready to resume rallying once more, but then along came the Westpac result. Having been lulled into assuming all the bank results would be impressive, the market was caught out when Westpac's result came in below consensus forecasts. The legacy of the St George acquisition was apparent given a sector-contradictory increase in bad debts, and it was clear to both bank analysts and bank management that Westpac needed to start an extensive cost cutting initiative.

Westpac's shares were subsequently trashed on the day, but Deutsche Bank, for one, believed this was a bit overdone (and no doubt reflective of heightened market anxiety). Deutsche noted Westpac's shares had been solidly bought in anticipation of a result matching those of NAB and CBA, so the subsequent sell-down meant correcting that premium. The analysts also noted Westpac had already begun to “clean up” its bad debt problems in the June quarter, suggesting the September quarter would provide a better outcome.

The last word was left to ANZ Bank ((ANZ)), which provided its quarterly update last Friday when European debt issues had flared yet again. Like Westpac, ANZ's result came in below expectations.

A breakdown of the numbers showed the “miss” was all about lower market trading profits in a time of increased volatility rather than any issue with traditional banking. The Macquarie analysts noted ANZ had elected to reduce its risk appetite in the quarter in market activities and this led to reduced profit opportunities. This fresh attitude will make it difficult for ANZ to match earnings growth numbers in the short term, but in the longer term management was at pains to point out the upside potential from that which differentiates ANZ from its peers, being its Asian growth initiatives.

Analysts agree there is longer term upside to be had, while also noting increasing competition in Asia as well as the slowing global growth environment will make short term profits more difficult to come by.

That slowing global growth factor has become more of a threat since FNArena's last bank update on August 3. Australian bank analysts have not changed their views on subdued local credit growth and sluggish earnings growth, but they have been forced to reduce their bank target prices to account for weaker global sentiment and thus lower PE multiples. However, the extent of the target reductions has not matched the extent of recent net share price weakness, so those upside-to-target numbers that looked so enticing in the above table now look even better:

Moreover, one might note the pre-franking yields that looked so attractive in the previous table also look even better in the fresh table.

In terms of recommendation changes, one must remember that bank analysts tend to rank the Big Four against each other more so than they do against the general market. On that basis, NAB has gained another Buy rating, further cementing its net preference among analysts, while ANZ and CBA have both lost a Buy rating. Westpac has kept its Buy ratings but gained a Sell so there has been no change in the net preference of one through four.

It's a story of contrast from the smaller and riskier NAB which the analysts feel in general is always oversold when market fear is heightened, through to the big, safe CBA which always ends up with an over-extended premium to the other three.

There is, of course, ongoing risk of a deteriorating debt situation in Europe and a deteriorating GDP situation in the US. Global funding costs, as benchmarked by the London Interbank Offer Rate (Libor), have finally begun to increase having previously managed to remain relatively stable through the chaos. This could mean a return to higher offshore funding costs for Australian banks.

The good news is that expensive funding from the GFC period has been rolling off and should be gone around mid-next year. Subdued local credit demand in the meantime means the banks do not need to access too much in the way of offshore funds, and the big jump in household savings and investor cash positions has meant a big boost in cheap local funding from deposits. The outlook for earnings may be utility-style “boring” ahead but Australian bank balance sheets are now among the strongest in the world and dividend levels appear under no threat. It is clear to see why bank analysts continue to see ever more attractive value in the Big Four.

The other problem we have to worry about, nevertheless, is the penchant for big US funds to dump on Australian banks as if they were still cyclicals every time Wall Street takes another tumble. This suggests we could still be in for a rough ride ahead. By the same token, all one hears now out of Wall Street is “buy dividends” so Australian banks can also be just as sought after from offshore on the good days.
 

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