Upside To Oz Bank Earnings?

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

– ANZ, NAB, CBA to report shortly
– An upgrade in earnings forecasts expected to follow
– Brokers bemoan stretched valuations
– Brokers retain a positive ratings bias
 

By Greg Peel

Commonwealth Bank ((CBA)) accounts on a June year-end and reported its FY13 result in February. The other three majors account on a September year-end and as such ANZ Bank ((ANZ)) will report its FY13 result on October 29, National Bank ((NAB)) on October 31, and Westpac ((WBC)) on November 4. Stock brokers have begun to preview the earnings season.

The major banks were stars of the Australian stock market in the pre-GFC boom, only to suddenly find themselves desperately raising fresh capital, cutting dividend payouts and significantly expanding provisions against bad debts in particular and further macroeconomic catastrophe in general in 2009. Assistance came in the form of the Rudd government’s GFC stimulus package which included attractive incentives for first home buyers and resulted in an expansion in mortgage books, particularly for the big mortgage banks Westpac and CBA.

As each year has passed since the GFC, the banks have been able to ease out of provisions and increase their capital bases to levels which satisfy new international standards. Earnings growth has come in the form of provision reductions, a gradual fall in offshore funding costs, and the capacity to reprice mortgage rates by less than ongoing cuts to the RBA cash rate. Deposit competition has nevertheless been fierce, keeping a lid on margins, but all up the banks have sufficiently recovered to once again raise dividend payouts without risking capital positions.

The GFC may now be five years behind us but macroeconomic concerns have remained prevalent, with the European recession and Chinese slowdown prime among them. Yet the US stock market is now exploring fresh all-time highs as global quantitative easing keeps interest rates at historical lows. In Australia, hopes of a rapid post-GFC rebound in consumer spending and housing construction gradually faded over the period, meaning the banks were looking at little in the way of organic earnings growth in the nearer term. Realistically they were treading water, but as high-yield stocks on solid credit ratings, their dividends have been highly sought after for the past year or two.

Thus Australian banks prices have continued to rise in recent times despite little in the way of earnings growth upside. Bank analysts have been forced to concede that historical PE multiples are not a relevant gauge in this new yield-hungry world, but even taking dividends into account, analysts continue to be concerned that bank prices are overstretched.

But now, as we head towards the FY13 result season, something is changing.

The Australian economy is in a transition phase as the end of the mining spending boom focuses attention on the ability of the non-mining economy to recover from five years in the wilderness, driven by easier RBA policy and a lower Aussie dollar. With the macroeconomic picture remaining unsettled, economists have feared the “gap” would be too wide, such that Australia may fall into recession before any recovery in the domestic economy was able to overcome lost mining investment. Yet the change of government in September has thrown a new light upon the domestic economy. It is not that a Coalition government is necessarily better for business in particular and the Australian economy in general (empirical evidence suggests little correlation between economic performance and governing party), not even, arguably, that the new one wants to repeal the carbon tax. It’s just that the outgoing government proved so dysfunctional over the past six years, made worse by a hung parliament in the last three, that Australian businesses and consumers became unwilling to commit to borrowing and spending.

This fear was exacerbated when then prime minister Julie Gillard set an election date some nine months ahead, and the situation degenerated further when the Labor party began to implode. So the fact we now have a new government is not important in terms of what stripe, just that we have a government that appears (so far at least) to be stable and able to exploit a sufficient parliamentary majority. Uncertainty is a stock market’s greatest enemy.

A survey of around 1000 businesses conducted by Macquarie post-election found an improving borrowing outlook for business over the next twelve months, particularly among small/medium businesses (SME) and in NSW. As confidence grows, there is also upside risk to mortgage credit growth, Macquarie suggests, as suggested by the analysts’ mortgage lead indicators.

Macquarie’s domestic credit growth assumption currently sits at 5-7% per annum. But while mortgage growth would likely be capped at 7%, the analysts believe, business credit growth, which has been weak for some time, could see “substantially” more upside given business credit growth tracks a more volatile up/down range. Macquarie sees three potential drivers of credit growth upside. Firstly, eagerness from housing “upgraders” and investors. Secondly, baby boomers’ desire to release wealth by selling their houses, met by a need for the buyers of those houses to “gear up” to meet today’s prices. And thirdly, the business capex cycle.

Under Macquarie’s more bullish forecasting, an increase of bank earnings of 2-7% over the next three years is possible. This would translate into sector revaluation of 7-19% and a sector total shareholder return of 12-30% plus. The analysts’ base case is that credit growth improves to match GDP growth levels, with the swing factor being corporate/SME credit growth. Here Macquarie suggests NAB and Westpac are best placed.

Citi is also expecting forecast earnings upgrades to flow from the bank reporting season. A combination of strengthening credit growth, moderating funding costs and still-improving credit quality point to modest upgrades to consensus estimates, the analysts suggest. The market will nevertheless be keeping an eye on capital positions, Citi warns, given modest balance sheet growth and a harsher regulatory environment once Basel III is adopted in January.

UBS believes there should be few issues to offer concern arising from the bank results and is expecting second half sector earnings per share growth of 2.7%, taking FY13 growth to 7%. Conditions remain subdued, UBS concedes, but strong corporate balance sheets and hard asset price inflation provides earnings protection near term, and is driving return on assets towards peak cycle levels. Earnings risk for the banks thus appears lower than for other sectors, the analysts suggest.

That’s the good news. The bad news is the issue of share prices. The following table provides some insight.

On the basis of yesterday’s closing prices, if we compare those to current consensus target prices we see all of the four majors are now trading ahead of consensus targets, by 3-4%. (Add in today’s sector performance and those gaps increase.) We also see gross dividend yields now down to the low to mid five percent range.

We also see an order of consensus preference largely unchanged since the last bank reporting season, with the two smaller banks preferred over the two larger banks and ANZ holding top spot. And, somewhat surprisingly, we see a net fourteen Buy or equivalent ratings from eight FNArena database brokers against eleven holds and only seven Sells.

Yet UBS suggests that, short of more monetary or quantitative stimulus, it is difficult to build an upside case for the banks from these levels. The banks have delivered a 50% total shareholder return (price plus dividends) over the fifteen months since ECB president Mario Draghi said “whatever it takes” and the Fed fired up QE3. Add in RBA rate cuts and the bank sector is now posting historically high multiples of 14.1x FY14 earnings forecasts and 2.9x tangible book value, despite being forecast to deliver only a 4% earnings compound annual growth rate from FY14 to FY16.

Earlier this month, JP Morgan declared the major banks to be fully valued heading into the reporting season, trading at the top end of their long-run fair value trading range. The banks did see a pullback a couple of months ago when global stock markets in general pulled back on Fed tapering concerns, JPM notes, but have since grinded higher once again.

This morning JP Morgan reiterated its Underweight rating on ANZ (JP Morgan sets ratings on sector relativities rather than index relativity). ANZ’s point of difference is its exposure to banking in Asia, which the bank began to establish in 2007. In the post-GFC period, this was assumed to provide ANZ with an advantage over its peers given exposure to a high growth centre when the developed world represented a low growth centre. Yet on current numbers, the 23% of capital ANZ has committed to Asia is delivering only 17% of net returns, and that gap is widening, JP Morgan has found.

Last week Macquarie downgraded its rating on ANZ to Neutral from Outperform. The analysts support ANZ’s Asian expansion as a longer term growth strategy but suggest margins will be under pressure near term due to currency sensitivity and a mix-shift to lower margin products. Until this impact washes through, the broker does not see enough upside to suggest an Outperform rating. On the other hand, CIMB Securities believes the market is not taking sufficient account of the fact ANZ has the lowest ratio of impaired assets among the majors, and retains an Outperform rating. And as noted, ANZ remains the most preferred among the four on consensus.

Citi is not alone in looking forward to more news from NAB with regard to the divestment of UK assets. The UK has been the albatross around NAB’s neck during the post-GFC period and write-downs in the value of UK assets have offset domestic earnings and prevented NAB from offering up the same level of dividend gifts as its peers. Yet since the London Olympics, the UK economy has rebounded at a speed that has caught everyone by surprise. The British government is now exiting from equity positions it was forced to acquire in UK banks when post-Lehman bankruptcy threatened. NAB eventually gave up on trying to find a buyer for its troubled holdings but the new lease of life means UK impairments have been reduced and, just maybe, a buyer might now emerge.

On the subject of UK banks, Westpac caused a scare last week when it announced the acquisition of Lloyds Bank’s Australian motor and equipment finance business. Might this mean another special dividend is now off the cards? No, said brokers. The acquisition was only small and brokers remain convinced another 10c special dividend will be announced at the November result. Indeed, Credit Suisse is forecasting special dividends for the next three periods along with dividend reinvestment plan (DRP) buybacks.

CBA remains an enigma, being most loved by the market, as evidenced by its constant premium valuation to peers, yet the most unloved by brokers. Many a bank analysts has nevertheless been mown down by a CBA leviathan that just keeps lumbering ever upward. Clearly the rubber band must one day stretch too far, but as to when that might occur is not clear. Particularly when brokers such as Macquarie and Citi are forecasting an uplift not only in business credit growth, but also in mortgage credit growth.

JP Morgan may have declared the banks overvalued in general, yet the broker followed this up with an upgrade to CBA to Neutral from Underperform. The timing of dividends is cited by the analysts (CBA’s second half dividend has now been paid but its closest peer, Westpac, is yet to announce its dividend) as the reason for the upgrade.

We thus head into the bank reporting season with a bit of a conundrum. Brokers are generally upbeat over the possibility of improved earnings forecasts flowing from the FY13 reports but struggle, as a group, to see share price upside. All four majors are now trading above consensus targets yet still the brokers rate the four with a net 14:7 Buys to Sells.
 

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