Australian Banks: For And Against

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– Banks in a bubble, says UBS
– No they're not, says Citi
– Bank dividends are not annuities, warns UBS
– They're not being priced as annuities, argues Citi
 

By Greg Peel

In a report this morning, the UBS bank analysts quoted Citigroup former CEO Chuck Prince: “As long as the music is playing, you’ve got to get up and dance”. Across town in the Citi office, the bank analysts entreated in their own, separate report: “Come join the ‘dance’”. Both were making reference to what many fear might be an Australian bank share price “bubble”.

Yet UBS and Citi have diametrically opposed views on whether there is a bank bubble at play.

Yesterday’s FNArena report ANZ Result: Stock And Sector Implications highlighted UBS’ outspoken view on bank share prices in the wake of the ANZ Bank ((ANZ)) interim result and subsequent share price surge. The surge, all brokers agree, was nothing to do with the fact ANZ posted a profit result which slightly beat consensus forecasts and all to do with an announced dividend increase and increase to future payout ratio target. It was all to do with yield.

The yield argument is far from lost on UBS. The analysts are conscious of the “bull case” for Australian yield stocks based on increasing global quantitative easing (QE), RBA rate cuts, falling bank term deposit rates and increasing fund manager allocation into equities in general, not to mention (in the case of banks in particular) added domestic attraction from franking credits. They also acknowledge that Australia’s banks are “very good companies”, being profitable, resilient, well-managed and shareholder-focused within a strong industry and regulatory structure. What they struggle with however, in terms of bank share valuation, is the risk side.

Whereas once banks conducted conservative businesses which offered defensive earnings streams, today banks are far more competitive and exposed to economic cycles. Over the past thirty years households in Australia and New Zealand have become significantly more leveraged than in earlier generations, but have eased off on the leverage hunger post GFC. Hence at this point banks are “low growth” while remaining heavily exposed, notes UBS, to offshore funding markets and domestic house prices and unemployment levels.

Citi, on the other hand, sees the banks in a slightly different light. The Citi analysts believe Australian banks are amongst the lowest risk, highest returning in the world. Underpinning this risk/reward is “favourable” sovereign balance sheet, sound management, improved competitive dynamics and market structure, the analysts argue, along with better funded individual balance sheets, and higher capital ratios and lower credit risk mix than at any time in the past ten years (of boom and crisis).

The last time Australian banks were trading at record price/earnings ratios (PE) was in the pre-GFC lending frenzy – a time when it seemed as if the party would never end. UBS argues the banks are now looking at legacy high leverage in their customer base coupled with cyclical risk, meaning lower growth on higher risk than the traditional bank model. Yet the Big Four banks today have reached a new record high average PE of 14.9x, with Commonwealth Bank ((CBA)) the stand-out at 16x.

“To argue that a stock is expensive relative to historic levels,” says Citi (and remember these guys are not arguing face to face; they are writing independent reports), “is somewhat akin to saying ‘don’t buy a loaf of bread today because it was cheaper ten years ago’”. Looking to historic precedent of absolute levels of valuation is only appropriate if all else, such as inflation, economic policy, risk tolerance and so forth, is equal, the analysts argue, and nothing is ever equal.

“Relative, not absolute, is important,” Citi declares.

UBS strongly believes the market is looking at bank dividends as if they are annuities (known income streams such as fixed-rate term deposits), but they are not annuities, the analysts insist, given the risk of not being fixed. Citi agrees wholeheartedly that bank dividends are not annuities, but does not believe the market is valuing them as such.

Bank dividend yields are trading with an implied risk premium of around 200 basis points over ten-year government bonds and around 170 basis points over the same bank’s (government guaranteed) term deposit rate, and those premiums remain “well above” historical averages, Citi points out. Add in franking credits for domestic investors and dividends are even more attractively priced.

Coming back to whether bank PEs are unrealistically high or not, UBS notes some argue that because banks can source cheaper funding for their businesses, because they are banks, than your average corporate, this lower cost of capital should translate into a higher PE multiple. But if the banks were to subscribe to this argument, say the analysts, and think of themselves as low cost of capital corporates, then they will be more inclined to bid more aggressively for business and accept lower net interest margins will eventually produce lower returns on equity and lower dividends. They will lower growth while increasing the volatility of bad debts and become even more cyclical, rather than defensive. It’s a negative feedback loop. “This has already been seen overseas,” they warn.

Australian banking is a highly concentrated industry, Citi fires back, with high barriers to entry and thus a higher degree of pricing power.

There is one thing UBS is forced to admit, with respect to the nature of all asset bubbles. “They can go higher and higher and for longer than many expect”. As long as the banks’ near-term earnings outlook is solid, there is nothing stopping the market buying bank shares all the way to their previous historic low dividend yield of around 4.5%, which implies another 10% share price upside, the analysts point out. It is at this point UBS draws upon Chuck Prince’s suggestion, “As long as the music is playing, you’ve got to get up and dance”.

“Come join the dance,” says Citi. “High dividend yields will continue to attract investors while alternative investments provide significantly lower returns and the earnings and dividend outlook for the sector remains solid near term”.

“All we can say is buyer beware,” concludes UBS.

“All we can say is Buy ANZ, CBA and Westpac ((WBC)) today!” concludes Citi.

Yes, Citi does use an exclamation mark and yes, I think there might be one bank missing as well. And yes, it’s uncanny: you’d swear one report was written in direct response to the other.
 

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