Australian Banks: Stuck In The Middle With You

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– Overvalued but not against interest rates
– Earnings growth lacking
– Capital requirements influential
– Neutral ratings popular
 

By Greg Peel

Australia’s big banks will all report earnings next week. Westpac ((WBC)) kicks off proceedings on Monday, May 4, with its half-year result, ANZ Bank ((ANZ)) follows on Tuesday and National Bank ((NAB)) on Thursday, with Commonwealth Bank ((CBA)) squeezing in a quarterly update on the Wednesday.

Overvalued?

Following a strong share price performance in February, the banks have since stalled. The ASX200 has gone effectively sideways over the period, having three times failed to breach the 6000 level. Given the Big Four banks represent around one third of the market cap of the index (and the financials sector in general, including wealth managers, insurers and so forth, a little under half), bank share price movements are a driving force within the Australian “stock market”.

The failure to breach 6000 no doubt has a lot to do with perceptions of bank stock overvaluation. But are bank stocks really overvalued?

On just about every popular metric, including price/earnings, the banks are overvalued by historical measures. But as analysts are quick to point out, the RBA cash rate has never been as low as it is now in history. Subsequently, government bond rates and term deposit rates are not offering investors viable returns so dividend-paying stocks are the place to be. The banks are considered safe and stable and are yielding an average 5%.

But all stable dividend-paying stocks have been well sought after, so as Morgans points out, the banking sector is trading in line with its long-run average relative to all non-bank industrials. By this relative measure, they are not overvalued, but then one might argue all yield stocks are overvalued. Given low, zero and even negative interest rates across the developed world, Australia’s yield stocks and the banks in particular are well sought after by foreign as well as domestic investors, despite foreigners not enjoying franking benefits.

For this reason, Morgans finds it hard to envisage a situation in which bank valuations would unwind. On the other hand, it’s also difficult to see bank valuations rising further. The broker has initiated coverage of the bank sector with a Neutral rating.

Subdued Growth

Since the GFC killed off credit demand, banks have struggled to grow earnings. The exception has been investment mortgage demand growth, fuelled by the low cash rate and lack of alternative investment solutions, and pretty much feeding on itself. But given stiff competition amongst lenders for their share of mortgages, as well as stiff competition on the deposit side of the ledger to build statutory capital, low net interest margins have crimped meaningful earnings growth opportunity.

The banks’ greatest source of earnings growth as the GFC has faded away has been the return of bad debt provisions, no longer needed as risk subsided. Bringing these provisions back onto the balance sheet has given the appearance of earnings growth, and has allowed for the payment of attractive dividends – the primary driver of bank stock popularity. But six years later, the provision accounts are now pretty much back to where they should be. The banks can no longer rely on this source of earnings. Without earnings growth, dividend growth is difficult.

For Citi, the ability of the banks to see further share price gains comes down to their ability to continue to drive dividend growth. CBA’s half-year back in February and the other three banks’ December quarter updates indicated further dividend growth will likely be problematic now bad debt provisions have run their course and net interest margins (NIM) have continued to contract.

NIM contraction is offsetting benefits from the hot mortgage market and from a long awaited return to growth in demand for business loans. The banks should see good results from their wealth management businesses given the market’s run-up in the March quarter and a possible bounce-back in trading income from playing the money markets. But trading opportunities have been reduced, UBS notes, as the banks ensure they qualify for new liquidity regulations.

Analyst forecasts for average first half earnings growth range from 3% to 4.5%, which by bank standards is subdued. Without provision returns, analysts agree the banks will continue to build towards new capital requirements through the use of dividend reinvestment plans (DRP). If not neutralised through debt issues, DRPs are really just forms of backdoor capital raising, implying the dilution of dividends per share.

Another issue for the banks is that they have all been updating their technology of late, which is a time consuming and costly business. CBA led the charge but the others are now catching up. This means there won’t be much in the way of cost relief on the other side of the P&L.

Given an assumption the RBA will cut again sometime soon, and that the first Fed rate rise will be later rather than sooner, analysts find it difficult to see much downside risk for bank share prices. But nor can they envisage much upside risk.

Which Bank?

Picking the winner amongst the four banks has always been a head-spinner for investors given there’s usually not a lot of agreement among analysts. Just as an example, in their results previews Morgans and Goldman Sachs have both cited a preference for ANZ, but UBS has ANZ last. And UBS has a Hold rating on ANZ. Four other FNArena brokers have Sell ratings.

It comes down to whether analysts see ANZ’s Asian exposure as a source of longer term growth or a hindrance as China slows. Everyone agrees CBA is the stand-out bank through sheer size and capital generation, but only one FNArena broker (Macquarie) has a Buy equivalent rating on the stock given its lofty price. Everyone also agrees NAB has the greatest potential for upside surprise depending on the progress of its UK exit. Westpac is a major beneficiary of the mortgage boom but is lagging behind in capital.

As the following table indicates, all four banks are (as of yesterday’ closing prices) trading above their FNArena consensus target prices. The Big Two of CBA and Westpac by a margin, hence fewer Buy ratings. Total database ratings are running at 8 Buy, 14 Hold and 10 Sell. Following the February result season, that ratio was 10/11/13. The brokers have clustered further into the middle, or neutral zone.
 

Which underscores the argument it’s hard to see the banks much going up or down. But there may be a more elevated downside risk when the three half-year reporters go ex-dividend.

In most earnings cycles we a see a typical trend of investors buying up CBA ahead of its earnings report, and then selling after the stock goes ex for a switch into the other three ahead of their earnings reports. When the three go ex, investors switch back into CBA and the cycle repeats.

There is a growing belief all four banks have probably now dished out about as much as they can, and without provision returns or much in the way of organic earnings growth, and the spectre of more stringent capital requirements hanging around, further dividend increases are now unlikely. Never more so thus, now is the time to take the money and run – sell ANZ, NAB and Westpac once they go ex. But lower prices will draw in more longer term investors who don’t play cyclical games.

Then again, Greece may exit the eurozone and spark a global stock market correction, so nothing’s ever certain.
 

Technical limitations

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