Australian Banks: What Comes Next?

This story features WESTPAC BANKING CORPORATION, and other companies. For more info SHARE ANALYSIS: WBC

– CommBank widely expected to announce additional capital management in August
– Big Four Bank shares widely seen as fully valued, but brokers reluctant to take a negative stance
– Thirst for yield might still push up share prices higher
– Questions whether Big Four Banks are currently in a sweet spot

By Greg Peel

Last week Commonwealth Bank ((CBA)) provided a brief update of its position post the March quarter. The update provides bank analysts with a chance to contrast/compare all four major banks following the interim reports offered earlier by each of ANZ Bank ((ANZ)), Westpac ((WBC)) and National Bank ((NAB)). CBA is the odd bank out in accounting on a June year-end while the other three account on a September year-end.

This reporting mismatch has arguably never been as significant as this time around given CBA announced its interim dividend in February while the others have announced their interims this month. Never before has a market been so obsessively focused on yield, and such a focus has come to a head in 2013. To that end, ANZ and Westpac have played to the crowd and announced an increased payout ratio (ANZ) and a special dividend (WBC). No doubt NAB would have liked to have followed suit, but for the capital impact of bad debts in NAB’s UK business. CBA’s earlier interim dividend was nothing out of the ordinary, so the pressure is now on for the bank’s final dividend, to be announced in August, to deliver.

Unlike the other three’s interim profit reports, CBA’s quarterly update was scant on detail, yet there was enough for analysts to suggest the bank’s quarterly profit largely matched the “run rate” of second half forecasts, and to suggest its breakdown was similar to peers. UBS echoed other brokers in summing up the highlights as soft revenue, given low growth across the Australian banking system, improved net interest margin, given loan repricing (not passing on RBA rate cuts in full), reasonable trading income, well managed cost control, and lower bad debt charges. CBA’s asset quality remains benign, UBS suggests, and organic capital generation is strong.

The simplest split to make between the Big Big Banks (CBA, WBC) and the Small Big Banks (ANZ, NAB) is that the former lean more towards retail banking and the latter towards business banking. We recall that CBA and Westpac went somewhat berserk snatching up mortgages in 2009-10, both by acquiring smaller banks and non-bank loan books and by attracting the bulk of government-subsidised first home buyer stimulus. Once loaded to the gunwales, both then backed off by actively being less competitive on mortgage rates. JP Morgan notes that after three years in the wilderness, CBA is back to growing its mortgage book. This has helped to offset a lack of growth in the business book.

That’s all well and good, but of course for investors the question is: what about yield? Will CBA match peers, come August, in announcing an increase in capital return?

The Australian credit market is very subdued, with the long process of post-GFC deleveraging still continuing from both households and businesses. Earnings growth is therefore hard to come by from traditional operating income. BA-Merrill Lynch acknowledges that we might at least be seeing the beginnings of a more sustained recovery in housing finance, but the response to date has been less than typical of what one might expect from 200 basis points of RBA cash rate cuts. While credit demand has not yet rebounded from the GFC, offshore funding costs have fallen considerably from GFC panic rates and GFC-inspired bad debts are rolling off.

The banks have also been on a concerted drive to attract deposits over the last few years, and term deposit investments have proven very popular. Cost cutting has also been prevalent, outside of IT upgrades which ultimately provide greater efficiency. The bottom line is that if we take increased deposits, cheaper funding, fewer bad debts and lower costs on the one hand, and subdued credit demand despite low base interest rates on the other, Australia’s banks effectively all dressed up with no place to go. They have the capital security to invest in the “normal” business of offering loans, but customers are few and the outlook does not yet suggest a rebound in demand. What, then, to do with the excess money?

Return capital, of course. What we have witnessed in this six-monthly bank reporting season is a demand for yield from the market and the capacity to provide such yield from the banks. NAB is the exception, albeit brokers assume that NAB will also be able to join in the hand-outs shortly as its UK bad debts run off. CBA is yet to deliver its capital gift, if it is to do so, because the bank reports on a different cycle.

At its quarterly update, CBA management noted that “shareholders want the payout ratio optimised”. The bank’s current dividend policy, dating back to the February interim report, is to deliver a payout ratio of 70 to 80%. The interim dividend announced in February represented a ratio closer to 70%. Analysts are now assuming CBA will either lift its payout ratio come its full-year report, al la ANZ, or offer a special dividend, a la Westpac.

For shareholders, an increased payout ratio is more attractive than a special dividend, and for the banks the opposite is true. “Special” means what it says, and implies “this is a bonus only and don’t think there’s necessarily more down the track”. A lift in payout ratio, on the other hand, sets a precedent. Banks are heroes when they lift their payout, but villains when they reduce them, as they did in 2009. Right now, in a yield hungry market, the banks are being taunted into lifting their payouts and were they to reduce their payouts later, they would be crucified by the angry mob. Westpac’s payout ratio was already peer-leading, so a special made sense rather than a further lift. ANZ’s payout was bottom-of-peer, given the bank was using capital to develop its Asian business, so it made sense for ANZ to lift its ratio.

CBA lies in between. Hence analyst opinion lies in between. Morgan Stanley, for example, believes CBA will lift its payout to 78% for the final dividend. JP Morgan is also now assuming 78%. Citi, on the other hand, suggests “the bank may be in a sufficiently strong capital and franking credit position at FY13 to be able to add a small special dividend to shareholders,” while Macquarie suggests that while a special final dividend is possible, it depends whether CBA would then be comfortable with a lower capital ratio than peers and whether the bank is happy to use its franking credit surplus.

The franking credit issue is not an insignificant one. Australian investors have grown used to Australian banks not only offering attractive nominal yields, but offering fully franked yields. Yet each of the four Big Banks has at least some level of offshore operation; in New Zealand for example, and in NAB’s case the UK and in ANZ’s case Asia. It is only because the banks have been accumulating large levels of franking credits in the post-GFC years that full franking has been maintained. With higher payout ratios and special dividends, those credits are being consumed. The day is not far off when bank dividends will only be partially franked, particularly if domestic lending remains subdued for some time.

And the subdued domestic credit market also offers up an interesting conundrum. As Macquarie puts it, “there is a risk of return to higher growth”.

As noted above, the banks are currently in a position to return capital and thus appease shareholders because they cannot use the capital to provide “normal” lending while credit demand remains subdued. The yield feast could thus prove short-lived if – heaven forbid – the Australian economy picks up and credit demand begins to grow again. This is why bank analysts are not jumping in to simply assume increased payouts or specials or any other form of capital management. They were mildly surprised by ANZ’s extensive lift in payout and by Westpac’s special. They were not completely surprised, because they suspect an element of “pandering” to shareholders and their yield demands at this time.

On the other side of the coin, there’s also an element of “pandering” to the great unwashed and ranting politicians in reversing earlier mortgage repricing policy (that is, keeping some of the RBA rate cut back to offset high offshore funding costs), to a new competitive policy (cutting SVRs by even more than the RBA rate cut). All up, the banks are trying to avoid the usual negative attention they really do not wish to draw.

This is important when we return to the subject of yield. An increased payout ratio implies a higher percentage of earnings paid out, not a higher absolute cash payment. Were bank earnings to be lower in FY14, absolute dividend payouts would also be lower. Yields may still look hefty, but only if share prices fall to account for reduced earnings.

Which is not to suggest the banks are all about to lose money. Earnings growth is subdued at present, not negative. But if there is one point bank analysts largely agree on, it’s that the first half of FY13 (or the six months to March) may prove a sweet spot for the banks. Credit Suisse sums up the view:

“For the sector the result suggests the optimisation of bank earnings is now reaching its limit: bad debt charges are as feasibly low as they can get for a couple of the major banks, margin expansion and the pace of productivity improvements is fading, and capital management initiatives have now been announced”.

NAB still has scope to increase its dividend, assuming UK bad debts continue to run off quickly. CBA is expected to announce some form of improved capital return when the time comes. Thereafter, we can assume further improvement in capital return initiatives are less likely. We can also assume the franking credit pool will begin to run down. Over the past six months, the banks have made very little money out of “normal” banking. They have made money from reduced bad debt costs, from improved trading profits in a more risk tolerant financial marketplace, from reduced funding costs, and from operational cost cutting. For everything outside of “normal” banking, things cannot get much better, as far as analysts are concerned.

Which brings us to the obvious question: are the banks overvalued? Here, broker opinion is divided. Let us first peruse the following table:

The first thing we notice is that the eight FNArena database brokers are collectively ascribing a total of eleven Buy (or equivalent) ratings on the Big Four, thirteen Hold ratings and eight Sell ratings. On a simple Buy-to-Sell basis the conclusion should be that the brokers remain slightly bullish. Among post-season reports are comments such as these:

“We see bank stocks as fully valued on a PE [price/earnings] basis, slightly above fair value on a book multiple basis, and approaching full value on a dividend yield basis. The key risk to our view here is that share price momentum could see valuations become even more stretched.” – Credit Suisse.

“The major banks are currently trading on 2.3x NTA [net tangible assets] which is a 4% premium to our sustainable target price/NTA multiple of 2.2x. We therefore see valuations as full. However, we are hesitant to be too negative on the sector given low relative earnings risk, potential for further capital management, and the relatively stable outlook for long bond yields” – Goldman Sachs.

“[The] banks may be seen as ‘expensive’ but not out of kilter with historical ranges. The move to a lower 10% cost of capital [reduced funding costs] has increased our price targets by ~15% and now sees them approximating fair value” – JP Morgan.

JP Morgan has raised the subject of target prices, and if we return to the table we see that, based on yesterday’s closing prices, only ANZ is offering upside to target. CBA is well over target, NAB is a bit over, and Westpac is about right. Yet there are more Buy ratings than Sell ratings.

The problem for bank analysts is that by any traditional metric, be it price/earnings, price/book value, premium/discount to peers or whatever else, the banks are overvalued. But on a comparative yield basis, the picture is not so clear. Yields do not now exceed 6% even out to FY14, but that’s still a solid premium over the bond rate, and a hefty premium over offshore bond rates. Australian banks are looking at low growth but they are, on a comparative basis, solid as rocks in the ocean of global banking. The conclusion from analysts therefore might be put as: “Everything I’ve ever learned or experienced to date tells me the banks are overvalued, but I am reluctant to stand between bank stocks and the market’s thirst for yield”.

As to preferences within the sector, among the Big Four, the picture is even cloudier. For example, UBS states clearly: “Our concerns with CBA relate purely to value” and is far from alone in that opinion. On the other hand, JP Morgan upgraded its call on CBA to Overweight post update. Macquarie believes the business banks (ANZ, NAB) are offering more potential ahead than the retail banks (CBA, WBC). Most believe CBA and NAB still have the capacity to surprise on capital management. Quite simply, different brokers have different views on different banks, as they always do.

As the Australian economy moves through cycles over time, fund managers typically respond to those cycles by being defensive in weak times and pro-risk in strong times. Given the Australian share market is heavily weighted towards a limited number of sectors, a typical trend over time is to buy banks in weakness and resources in strength, switching between the two. While the resource sector currently has its own issues regarding the peak in the mining boom, we have still witnessed the stuttering beginnings of a switch into cyclicals this past month. It’s been very stop-start, and quite volatile at times, but with bank valuations now looking stretched, and resource sector companies now concentrating harder on offering yield, such activity is on the rise.

It could all reverse again tomorrow of course, with some bad news out of China/Europe/the US, but right now the outlook for the bank sector appears to be one of “how much further can this really go?”
 

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