Australian Banks: Beyond Reporting Season

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– Earnings results disappoint
– Regulatory concerns ongoing
– Dividends at risk
– Yield hard to ignore

By Greg Peel

Earnings

In the wake of recent FY15 earnings results from ANZ Bank ((ANZ)), National Bank ((NAB)) and Westpac ((WBC)), and a first quarter FY16 update from Commonwealth Bank ((CBA)), one word has been bandied around extensively – “disappointing”. Such disappointment follows the impact recent regulation-driven capital raisings have had on bank share prices.

Sector average earnings per share for the second half fell 1.6%, UBS calculates, to mark the second consecutive half of decline.  Sector revenue growth was 1.9%, but cost growth averaged 3.6%. All bank trading desks suffered through the tough period that was August but ANZ was particularly hard hit.

Net interest margins expanded for retail banking but business banking margins came under pressure, mostly impacting on NAB.

Analysts have long expected bad and doubtful debt levels to begin to rise again around now, following the long period of decline from the GFC peak. This is yet to prove the case however, as BDDs have largely “banged along the bottom,” UBS notes, of post-GFC lows. The exception is ANZ, where the bank’s Asian exposure comes into play. New impaired loans are on the rise, particularly in Indonesia.

Up until recently the biggest factor within the banks’ requisite costs was IT upgrading – bringing systems kicking and screaming into the 2010s. But most recently the big issue has been ever tighter global and domestic regulatory controls and the costs associated with compliance. Unfortunately that story has yet to run its course.

UBS does nevertheless conclude that recent capital raisings, driven by regulatory requirements, have had only a partial impact on valuations.

For at least a couple of years, bank analysts wailed that bank share prices were too high and price/earnings ratios were overblown for the sector. Analysts then came to acknowledge that in a world made hungry for yield due to low interest rates both at home and abroad, traditional PE comparisons were not necessarily helpful. A premium was required in valuation models to account for this post-GFC trend.

But back in April, when the ASX200 took a look at 6000, analysts wailed that bank PEs were now overblown even if one does take such a premium into account. Earnings growth would be minimal ahead, they said. Dividends would have to stop growing and special dividends were no longer an option. Moreover, the growing tide of global capital consideration, and the implications of the Financial System Inquiry released late last year, suggested capital raisings were quite possibly on the cards.

Well, they were right. Bank shares have since corrected, to extent as part of the China-led market correction but further still on sector-specific and Australia-specific issues. The banks are now trading around a 12.3x PE which is in line with the 20-year average, and thus they are no longer “expensive”.

But are they “value” at this level?

Regulatory issues are yet to reach a conclusion, so the risks of higher costs and lower returns on equity persist on this front. Bad debt levels will eventually have to rise. But the recent round of tit-for-tat mortgage repricing indicates a “strong industry structure’” UBS suggests, given the banks have been able to pass on risk management costs to customers.

And there is scope for more of the same. While the jury is still out on timing, most bank economists expect the RBA will eventually be forced to make at least one more cash rate cut, if not two, in the year ahead. Analysts have little doubt the banks will use such a cut(s) as another opportunity for mortgage repricing, by not cutting new rates by as much as the 25 basis point increments the RBA adopts.

On this basis, and the fact retail banking net interest margins are growing rather than falling in the face of repricing, UBS prefers the two big retail banks – Westpac and CBA – over the two smaller banks, despite their sector premiums. ANZ looks cheap on 10.7x but Asia is the issue. For NAB, competition in business banking is unlikely to abate.

Credit Suisse agrees that retail banking appears to be “in rude health” while corporate banking is “struggling somewhat”.

Regulation

It’s hard to believe Lehman Bros fell seven years ago but only now are banks being forced to address the concept of “too big to fail”. TBFT falls into two categories – global and domestic.

Global risks give us the G-SIB – globally systemically important bank – which are your US, European and UK Big Bank multinationals for example, such as a Citigroup, or a Deutsche Bank, or a Lloyds. Domestic risks give us the D-SIB, or domestically systemically important bank, the failure of which may not bring down the world but may bring a country to its knees. Locally we call these the Big Four.

The Big Four are big in Australia but nowhere near as big as the multinationals, yet Australia does tend to fight above its weight in global financial markets as well as sport. Thus the aforementioned FSI suggested the Big Four needs to not only carry sufficient capital to cover against another GFC event, but more than other global banks given Australia’s relative size.

The FSI suggested Australia’s banks needed to be “unquestionably strong”. Problem is, it didn’t outline the questions, so no one is exactly sure just what tier one capital ratio heads off all doubts. The Inquiry also suggested Australia’s banks should be in the “top quartile” globally, but no one’s quite sure just how one measures the quartiles across all of the world’s banks.

Recently the US Federal Reserve proposed not only a tier one capital ratio requirement against loan books, but a “total loss-absorbing capital” requirement (TLAC) which then extends to tier two capital, which is upper level debt. This brings up the issue of “bail-in” bonds.

In the GFC, bank bondholders (ie lenders to banks) were at risk of losing their money when TBFT banks threatened to F. They did not in the end fail, because they were bailed out, across the globe, by taxpayer funds. This meant bonds could be repaid in full but governments put it to bondholders that were it not for government bail-outs, they would have lost their investments. It would only be fair, therefore, that they take a “haircut” (some amount cents in the dollar).

The bondholders pointed to their original prospectuses and highlighted the sanctity of “the contract”, being the foundation of all capitalism. They were then paid in full. But this experience has given rise to the possibility of the creation of the “bail-in” bond. At the time of another major financial market disaster, some trigger would turn bail-in bonds into equity, forcing bondholders to shoulder the burden.

Tier one capital is, in simple terms, ordinary shares. Tier two capital would include bail-in bonds were the likes of Bank of England governor Mark Carney to have his way. Tiers one and two would make up TLAC.

The global Financial Stability Board has decided upon TLAC targets of 16% and 18% by 2019 and 2022 respectively. It is not yet clear just what the Australian Prudential Regulation Authority (APRA) will individually require, but either way APRA has assured the banks they’ll be given plenty of time to comply.

This provides some scope, suggests Credit Suisse, for the required residual capital to be generated organically in the interim. But just how it all fits into “unquestionably strong” and “top quartile” remains an unknown. Thus Ord Minnett suggests “we expect earnings growth to remain pressured with banks continuing to be reliant on repricing to maintain their return on equity”.

The banks may have successfully passed on new capital requirements costs through mortgage repricing for now, but for how much longer?

Dividends

At the end of the day bank valuations are all about dividends, given earnings growth outlooks are weak. Morgan Stanley notes that Australian bank dividend payout ratios (dividends/earnings) are “elevated”.

Indeed, the latest round of earnings results and subsequent dividend declarations reveal that despite increased capital requirements and recent declines in bank returns on equity, payout ratios have continued to increase since 2011. Morgan Stanley is forecasting a period of flat payouts from here but warns “the probability of dividend cuts is rising”.

The recent round of results suggests ANZ and NAB have less margin for error than Westpac and CBA. ANZ’s ratio has already risen above the bank’s 65-70% payout target range, and the new CEO might just take the opportunity to respond. NAB’s payout is only near the top of its 70-75% payout range but Morgan Stanley does not believe the range is sustainable.

Were bad debts to begin rising once more, as every bank analyst expects they will, against a backdrop of ever increasing capital requirements, then Morgan Stanley suggests all four banks would have to review their dividends.

Different Story

The last FNArena banking sector update was published in June, and entitled The (Negative) Implications Of Forthcoming Regulatory Changes. At that point the ASX200 had retreated from its May high of 6000 into a 5500-5800 band, with concern over bank capital requirements a factor within that move.

Analysts were not, at that point, screaming overvaluation but they were highlighting the possible risk of necessary capital raisings which the market in general seemed to ignore. In June, our bank analysis table looked like this:
 

August’s China-related sell-off was a market-wide de-rating which brought the banks back to levels which looked pretty attractive on a yield basis, compared to where they came from. Buy ratings on the FNArena database outweighed Sells by 11:7. But then came the capital raisings, and then came the disappointing earnings results. Based on yesterday’s closing prices, our table now looks like this:
 

The tone of all of the issues discussed above would tend to imply analysts are not that keen on the banks at present, given weak earnings growth forecasts, ongoing capital issues, the risk of dividend cuts and so on. Yet those same analysts now have a Buy to Sell ratio of 14:2.

Two elements stand out: the now yawning gap between trading prices and target prices and the very attractive yields (which do not reflect full franking). The suggestion here is that for all the issues confronting the sector at present, a skittish market has panicked too much on the downside.

Also notable is a changing of the guard, with Westpac now number one (can’t remember when this was last the case) and NAB relegated to least favoured. While CBA remains analysts’ preferred bank on paper, its ever present premium to peers (note the difference in target price upside) keeps it in third spot.
 

Technical limitations

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