Australian Banks Post Reporting Season

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– Overall soft results from Australian banks
– Positives among the negatives
– Capital yet to be addressed
– Risks ongoing
 

By Greg Peel

Ahead of this month’s bank reporting season, which featured first half results from Westpac ((WBC)), ANZ Bank ((ANZ)) and National Bank ((NAB)), the greatest concern bank analysts had was uncertainty surrounding financial distress suffered by some high-profile corporate names in the period, including the likes of Dick Smith, Slater & Gordon, Arrium and Peabody. It was not an unfounded fear.

As FNArena’s Australian Bank Reporting Season Preview highlighted, there was also some concern bad and doubtful debt (BDD) issues would also surface more generally in Australia’s mining states, and within New Zealand’s struggling dairy industry.

Analysts also suggested that any benefits arising from mortgage repricing in the period would be eroded by funding costs and competition, and that dividends may well be under threat from weaker earnings, increased debt provisions and the upcoming (albeit as yet unquantified) need to increase tier one capital.

Bank analysts proved spot on with their concerns, but not spot on the mark in terms of quantum. BDD provisions were actually larger than expected, except for NAB, and provided the source of initial bank price weakness in the week when Westpac was first to fess up. Most analysts did not expect dividend cuts this time around, but were not too surprised by ANZ’s move. Citi correctly predicted ANZ’s cut but also had NAB pencilled in for a cut, which was not forthcoming.

All up, the season provided some negatives, but positives as well.

Average earnings among the three fell 2% in the half, UBS notes, once adjusting for ANZ’s one-off items and NAB’s Clydesdale spin-off. This compares to a 1.6% fall in the previous half, and was a greater decline than consensus forecasts suggested. The “miss” was down to those greater than expected single-name impairments, but also down to much lower than forecast non-interest income, meaning fees, trading income and so forth.

If you want to get technical, Goldman Sachs notes pre-provision operating profit (PPOP) across the sector was down 0.2% on last year’s first half. That sounds underwhelming, except that it’s the worst PPOP return on risk-weighted capital since the first half 2009. And we all remember what was going on back then.

While the increase in BDD provisions for single-name exposures were worse than feared across the banks, the good news is credit quality elsewhere was quite good. Loan issues in the mining states and NZ dairy were no worse than expected, while general small and medium enterprise loans, commercial real estate loans and loans in NZ outside of dairy provided no scares.

As expected, earnings headwinds provided by mortgage repricing in the period (lifting variable mortgage rates despite no change to the RBA cash rate in the half) were more than offset by the tailwinds – BDDs, weak non-interest income and also a rise in short term funding costs — as analysts had anticipated. The good news is that costs did not rise as much as was feared, although a lot of that was due to staff reductions. And loan growth was actually solid.

Then there’s the issue of capital. At some point, the banks are going to have to increase their tier one capital ratios to comply with yet to be finalised Basel 4 international “too big to fail” requirements, and APRA’s own “unquestionably strong” additional requirement, which at this stage remains little more than a throw-away qualitative line lacking any quantitative certainty.

One way to increase capital is not to give as much of it away as dividends. The banks know all too well that their shareholder appeal lies solely with yield in this low interest rate world, so dividend cuts are a big risk. If the banks keep their quantum of dividend (cents per share) steady as earnings fall, dividend payout ratios rise. All the banks have target payout ratio ranges, but in some cases ratios have crept out to the upside. Assuming earnings don’t suddenly improve, which would also require BDDs to suddenly swing back the other way, at some point the banks are going to have to address their dividend policies.

ANZ, of course, has.

The share price response was immediate. Westpac had been first cab off the rank, reporting on the Monday, so it had the task of informing the market single-name BDDs were actually worse than you all thought. All bank shares were sold down on the day. ANZ then reported before the bell on the Tuesday, announcing its dividend cut, and ANZ shares copped another hiding. But at 2.30pm on that day, a big, shiny white mare jumped over the hedge, ridden by Glenn Stevens. ANZ shares closed higher on the day.

The surprise RBA rate cut shifted the bank playing field tectonically. By the time NAB reported on the Thursday, economists were rushing to pencil in another RBA rate cut in August. By the time Commonwealth Bank ((CBA)) provided its quarterly update the following Monday, banks were back in favour with investors.

It should be noted that banks earn less in a low interest rate environment than they do in a high interest rate environment, because their net interest margins (the difference between what they borrow at and what they lend at) gets smaller and smaller on lower numbers. So why are RBA rate cuts positive for Australian banks?

Well firstly, the lower the prevailing interest rate (and this is benchmarked by the rate on term deposits as an alternative investment), the more appealing are high-yield bank shares. Secondly, RBA rate cuts always provide banks with a backdoor opportunity to reprice their mortgage rates by not passing on all of the 25 point cut. And thirdly, lower mortgage rates encourage more punters into the market, allowing for loan growth.

When NAB did finally report on the Thursday, it did not announce a dividend cut, which didn’t shock analysts, but it did announce only a slight uptick in BDD provisions, which left analysts perplexed. NAB is just as exposed to the Dicks and Slaters of the world as its peers.

“NAB stood out with a very low BDD charge,” noted UBS, “which looks low given its well-known corporate exposures. We expect this to increase in 2H16”.

“We were surprised that NAB’s newly impaired single names weren’t higher,” said Deutsche Bank. “Its low group bad debt to loans ratio implied unsustainably low impairment expenses in its core business banking portfolio”.

Reading between the jargon, analysts are suggesting NAB may yet be found out to have been a bit blasé about its BDD exposures.

It also means NAB’s dividend payout ratio is now above management’s target. While management is of the belief the ratio can come back down again on earnings growth, analysts are not so confident. Macquarie, for one, believes the Big Banks should all be able to sustain their dividends at their full year results, except NAB.

Macquarie’s belief is predicated on an assumption bad debts don’t get any worse than the broker expects. Not the well-known single names, as they’ve been provided for (ex NAB), but BDDs in general. Prior to this reporting period, BDDs have been on a long trajectory downwards since the GFC, and indeed never reached the scary heights banks were fearing back in 2009 when they materially topped up their BDD provisions.

The return of these provisions to the bottom line has allowed the banks to push up their dividend payouts to historically high levels these past few years in order to feed the hungry mob. Analysts assume BDDs, in general, have now reached the end of this cycle and will now start cycling back the other way, or “revert to mean”.

Mind you, bank analysts have been assuming such for quite some time now, and have yet to be proven right. Take out the single-name issues in this reporting season, and yet again, general BDD growth was below expectation. But like a stopped clock, they must eventually be right.

Which brings us back to capital again. While analysts are just as in the dark as the banks themselves as to what “too big to fail” and “unquestionably strong” will translate into in actual numbers, there is no doubt banks will need to increase their tier one capital. The question remains as to whether they can do this organically – unlikely when earnings growth is minimal – or satisfy requirements through dividend reinvestment plans.

Mind you, when the banks all raised fresh capital one after the other last year, many analysts believed then that DRPs would suffice.

One who did not believe so was Morgan Stanley. And again the broker has been left scratching its head:

“We were surprised that the banks didn’t make more effort to improve CET1 [common equity tier one] ratios at the 1H16 results given that they generally expect capital requirements to move higher”.

Bank investors have already had a rough year on share price falls. A 6% yield is cold comfort against a 10% capital loss. But still they keep coming back, and doubling down, given lower share prices plus sustained dividends equal even better yields. Over the next two to three years, Goldman Sachs expects dividend per share growth to be lower than earnings per share growth as dividend payout ratios are reduced. They will have to be reduced, Goldman believes, because return on equity will fall as a result of higher capital requirements.

Moreover, if the banks do try to avoid or minimise actual dividend cuts by boosting capital through DRPs, dividends per share fall anyway, given DRPs increase the bank’s share count.

All sounds a bit grim really. So should you buy the banks?

The sector looks inexpensive relative to the industrials sector, Deutsche Bank suggests, “but positive catalysts are lacking and downside risks outnumber upside risks in our view”.

Goldman Sachs believes the sector outlook will remain “difficult” in the second half.

“We retain a negative stance on the major banks,” says Morgan Stanley.

“We believe there are limited prospects for growth or higher returns over the short to medium term,” says UBS.

Ahead of the bank reporting season, Macquarie believed there was little downside risk given bank shares prices had already been sold down. Sure enough those share prices have since bounced, with a little help for the RBA. “Following recent re-rating the sector’s absolute valuations appear more closely aligned to our fundamental valuations,” Macquarie now offers.

Yet despite the doom and gloom implicit from these broker views, among eight brokers on the FNArena database and four Big Banks, the database shows 13 Buy ratings, 16 Hold ratings and only 2 Sell ratings. Seems incongruous.

It gets more incongruous when we look at the following updated table.
 

All of CBA, ANZ and NAB are afforded three Buys and almost the same balance of Holds and Sells, yet CBA is (as of yesterday’s close) only 1% away from consensus target, ANZ is 9% away and NAB is 2% above. Only Westpac, with five Buys and no Sells, seems justified on 8% to target.

We must take into account that a preponderance of Hold ratings and few Sells reflects the fact analysts know that however subdued the outlook, the banks will continue to be supported by yield. With regard the number of Buys despite dour views on the sector as a whole, we must acknowledge that broker ratings among the banks tend to be more relative than absolute. And do not fall into the trap of believing the table above suggests all brokers prefer Westpac first and NAB last. Broker preferences among the Big Four cover just about all the available permutations.

Happy investing.
 

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