Australian Banks: Result Season Preview

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

– Solid FY14 earnings expected
– Capital uncertainty nonetheless the issue
– Are bank valuations no longer stretched?
– Bank analysts argue the toss

By Greg Peel

This story naturally follows from “Will The Majors Need To Raise Capital?” published on October 2.

At the time the above story was published, the ASX200 Financials sector index had fallen 6% from its post-GFC high established in early September. In the interim, the index has experienced extensive volatility. It bottomed out on October 13 and has since rebounded. As at this morning it was down 5% from the September high.

Aside from bargain hunting amongst domestic investors lured by the effective increase in bank dividend yields at lower prices, expectations of a sooner-rather-than-later Fed rate rise have not only diminished, they’ve all but swung back the other way. This would in theory imply that which triggered the Sell Australia trade that began in September, of which the large-cap banks were very much primary victims, no longer applies.

But does this mean the big banks are now “cheap”, given how far they’ve fallen? Well that depends on just how “expensive” they’d actually become, and on domestic industry factors which were really not part of the Sell Australia consideration from the foreign perspective.

It’s been a tough couple of years for bank analysts, given all their prior experience of bank valuation has had to be compromised to acknowledge the fact solid and safe dividend yields have been the primary, if not the only, driver of bank share prices until recently. Yet even taking this on board, bank analysts became increasingly uneasy as Big Four share prices pushed up to their post-GFC highs in early September. Valuations, they just had to suggest, looked “stretched”.

Which is why this 5% pullback for the Financials index has come as somewhat of a relief. It has taken a lot of that “stretch” off the table, leaving bank analysts to focus more on traditional banking fundamentals. But fundamentals, too, have had to take a back seat, given the biggest issue confronting banks at present is the risk of forced capital increases due to new regulatory requirements. As the above linked article suggested, the banks may even be forced to raise fresh capital, just as they did in the immediate wake of the GFC. But ask three bank analysts of their opinion, and you’ll likely get three different answers.

Three of the Big Four are about to report FY14 earnings results, for their financial years to end-September. National Bank ((NAB)) will report on October 30, ANZ Bank ((ANZ)) on October 31 and Westpac ((WBC)) on November 3. Commonwealth Bank ((CBA)), which trades on an end-June financial year, will provide a September quarter update on November 5. If there is one thing bank analysts do agree upon, it’s that earnings results should be pretty solid.

UBS expects revenue growth will be the highlight, and the broker’s 5.8% forecast increase would represent the best result to date in the post-GFC recovery. Net interest growth should be the driver, UBS suggests, alongside solid balance sheet growth and tempered by only modest net interest margin compression. Wealth divisions have had a good year, although weaker trading income in second half will provide some drag.

Asset quality issues should remain benign, although UBS suspects there is no further downside for bad debt reduction. The broker forecasts 9% earnings growth for the sector, not taking into account NAB’s recent asset write-downs.

CIMB also expects a benign bad debt outcome, but does suggest trading income should have picked up in the fourth quarter from a weak third. The declining loan volume growth rate should have bottomed during the second half, and cost controls should also help boost earnings, CIMB believes. There is nevertheless a risk amortisation costs of the banks’ various new software investments will provide a headwind from here.

It all sounds very rosy, but Morgan Stanley believes the post-GFC earnings upgrade cycle is coming to an end. Over that period, the banks have enjoyed the benefits of bad debt losses falling back to normal levels, re-pricing of their variable mortgage rates, lower funding costs, and better operational cost discipline. Bad debts, as UBS agrees, have likely now troughed, the RBA is on-hold and not offering mortgage re-pricing opportunities (and the next move in the cash rate could possibly be up), funding costs have returned to more normal levels and operational costs have now been squeezed pretty hard.

Morgan Stanley is forecasting an 8% increase in sector earnings in FY14, but a fall back to 5% in FY15.

The reality, however, is that earnings forecasts are not currently the major factor behind bank valuations. Capital is. And on that basis, the banks have entered FY15 under a capital cloud, awaiting news of possible, if not likely, regulatory tightening. FNArena’s past two Australian Bank updates (follow the links from above) have explained these possible regulatory changes in detail.

A quick summary is that the banks will have to hold more capital as a buffer against general financial risk in a volatile world, as determined by the Murray Inquiry, and, separately, more capital against their investment housing loan books, as encouraged by the RBA, given the risk of an investment housing bubble. In the first case, the banks will either need to increase their “too big to fail” capital buffers through increased tier one capital generation or through increased “bail-in” unsecured debt issues. In the second case, the banks may be forced to hold capital representing up to 20% of the value of their investment mortgage books.

“We think higher capital targets will lower structural returns and constrain growth,” suggest the CIMB analysts, echoing the views of their peers. Even taking this recent share price correction into account, CIMB believes the banks are still trading at 15% above intrinsic value on a price to net tangible asset basis and on a price to earnings basis. The broker also warns that yield-based support from foreign buyers will continue to wane if the Aussie continues to fall.

Morgan Stanley continues to believe investors are underestimating the downside risk to bank returns on equity from the Murray Inquiry (aka Financial System Inquiry). The analysts are expecting David Murray will recommend the revision of major bank capital requirements to enhance financial stability, so that the banks remain at the forefront of emerging international standards and global best practice, and to help restore competitive neutrality in the domestic mortgage market. And on top of that, APRA will require the banks to meet more onerous mortgage-related capital requirements over the next few years.

All up, Morgan Stanley sees bank returns on equity around 1.5 percentage points lower than they are today. The analysts expect new requirements to lead to dilutive equity issues and concern about sustainable dividend payout ratios. On that basis, the broker suggests current price to earnings and price to book value ratios “still look full”.

Hold your horses, says Deutsche Bank.

“We believe that the concerns around higher capital coming from the FSI report have been materially overplayed with large increases in capital difficult to justify at this point.”

The Deutsche analysts believe an increase of around $5-10bn for the sector over 3-4 years is more realistic, and that this level of capital can be easily met through organic capital generation and will not require equity raises, and nor will it impact on return on equity estimates. They see the FSI following previous reviews in being more principle-based. They do not see the best tool for loss absorbance, the target of “too big to fail” buffers, as being increased tier one capital, rather they see bail-in bonds as more effective.

[Bail-in bonds represent senior unsecured debt the holders of which can, in the case of financial trauma, be forced to “take a haircut”, ie accept cents in the dollar on maturity, to avoid a government “bail-out” using taxpayer funds.]

Deutsche further notes Australian bank capital levels are already at the top end of international peers and believes an increase in mortgage capital would not be that significant. Moreover, history suggests ensuring the banks have the highest capital in the world provides only an incremental benefit while at the same time imposing a substantial cost on the local economy, the broker points out, and this is unlikely to be politically palatable.

On the basis that the market is already pricing in material equity raising necessity for the banks (Morgan Stanley suggests it isn’t), Deutsche believes the banks look attractive on a valuation basis at this point.

No one can argue, at the very least, that the sector is not facing significant regulatory uncertainty at this time. To that end, Citi prefers to stay on the sideline at present. “We hope to get more involved at lower prices,” say the analysts.

Credit Suisse is another broker taking a wait-and-see approach. Bank valuations have improved of late, notes CS, but do not appear to be outright compelling. They appear to be historically attractive relative to the ASX200 and compared to government bonds, but are still historically expensive based on dividend, price/earnings and underlying profit multiples.

Given the uncertainty, Credit Suisse does not see the upcoming results season as a likely positive catalyst for the banks and would like to wait until NAB, ANZ and Westpac all go ex-dividend, around the time the Murray Inquiry report is due to be tabled.

UBS believes that while the Murray Inquiry remains a point of risk, the likely impacts are quantifiable. Following the recent share price corrections, the UBS analysts’ key concern regarding bank valuations has been diluted. “Australian banks do not look cheap,” says UBS, “however, unless the economic situation deteriorates, we think the case for a material Underweight stance in the banks now appears harder to justify”.

With results season looming, we can now assess broker preferences among the Big Four using FNArena’s trusty bank table. And OMG, can it be true?

For many years, CBA has traded at a premium to its Big Four peers at a level bank analysts have almost perennially found overstated. FNArena regularly updates on Australian Banks but not any fixed timetable. Suffice to say, the above is the 29^th version of FNArena’s comparison table which was introduced shortly after the GFC. Never before now has CBA appeared in second place on a Buy/Hold/Sell ratio basis.

CBA did once, briefly, pop up into third, but beyond that it had seemed Australia’s biggest bank’s place was cemented at the bottom of the table, suggesting the greatest overvaluation. Now when we look at both upside-to-target and dividend yield comparisons, we find CBA neatly lined up with its peers.

It must be noted that a rather reliable trend, for those investors playing Australia’s banks off against each other, is that once CBA goes ex-dividend after its own FY14 result in August, traders like to sell CBA and buy the other three ahead of dividend payments after their October-November results. (And vice versa after November.) Thus, historically, now is a good time to buy CBA on a sector relative basis.

If not so on an absolute basis.

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