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Are Australian Banks Overpriced?

Australia | Mar 14 2024

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

Australian major bank share prices have been pushing ever higher recently despite lower forecast earnings and elevated PE multiples.

-Australian banks have been outperforming the index
-Earnings forecasts lower across FY24-25
-PE multiples have expanded
-Bad debts have surprised positively

By Greg Peel

Bank share prices have continued to rally in recent months, Macquarie notes, despite broadly consistent negative consensus views amongst investors and sell-side analysts (stockbrokers).

To that point, of seven brokers either monitored daily or regularly by FNArena, six have Sell or equivalent ratings on Commonwealth Bank ((CBA)) – some recent downgrades and other longstanding – while only one has a Hold rating. CBA’s share price has nonetheless hit all-time highs.

Banks are looking expensive in absolute and relative terms, Macquarie suggests, after some 6% relative outperformance versus the broader market in the second half of 2023 and a further 8% since the beginning of this year.

The analysts thus pose the question: what are we missing?

Bank earnings expectations are more reasonable now, Macquarie suggests, but not overly conservative. The broker sees potential upside risk to earnings from rates remaining at current levels for longer while the economy remains resilient.

However, should rate cuts come through as expected, which is arguably the key driver of higher valuations in recent months, Macquarie sees downside risk to earnings, believing it will be difficult for banks to offset margin headwinds associated with lower rates.

Given the current political landscape and increased focus on social aspects, Macquarie thinks it will be difficult for banks to reprice mortgages, particularly in an election year (2025).

The broker sees limited scope for banks to materially surprise the market in the medium term and hence sees limited fundamental reasons for a structural re-rating. While accepting a lower risk profile for the sector, Macquarie believes it comes at the cost of lower margins and returns over the medium term.

Macquarie’s response? “Underweight everything”. The broker has downgraded all of Westpac ((WBC)), ANZ Bank ((ANZ)) and National Bank ((NAB)) to Underweight, joining CBA. Westpac suffered a double-downgrade from Outperform, while the other two are down from Neutral.

Not Alone

UBS goes a step further in noting bank share prices have rallied over 20% since November which the broker suggests has been driven by a soft-landing scenario, implying lower expected credit losses, and signs of lessening competitive pressures in deposits and lending.

Yet consensus currently has bank earnings declining by -8% in FY24 and -3% in FY25, and PE multiples have expanded to 16.1x forward during this period from 13.2x, UBS notes.

This broker acknowledges Australian banks are defensive, while capital returns underpin the investment case, but subsequent returns at these PE multiples have proven to be below market in the longer term.

UBS has ANZ on a Neutral rating, and the other three on Sell.

The Elephant in the Room

For many investors, CBA’s performance in the mortgage market creates a significant amount of discussion and debate, Citi notes, as CBA continues to significantly lag major bank peers.

While much of the debate has been about cashbacks and front-book discounting, what is interesting from Citi’s perspective has been the decline of CBA’s broker channel performance.

With broker service levels no longer a point of differentiation, Citi believes only aggressive pricing will see CBA’s share revert to market growth in the near term.

Recent rhetoric from management suggests it isn’t likely we will see this anytime soon, as CBA laments its fixed-price mortgage strategy in the post-pandemic period which has inadvertently dragged down returns across the market.

This leaves CBA in the difficult position of waiting until others decide to ease off the current very competitive pricing, which could potentially take a while, Citi warns.

Citi has a Sell on CBA, and on NAB, and is Neutral on Westpac and ANZ.

But Wait…

Consensus has cut major banks’ FY24 bad & doubtful debt forecasts by -44% since September 2022, Jarden notes, and another -20% for FY25-26. This has partly offset earnings headwinds from lower net interest margins and higher costs but how much lower can BDDs go?

Jarden sees further scope for BDDS to positively surprise (trend lower) given excess provisions held by banks against BDDs and growing prospects of a soft landing for the economy.

The broker’s analysis continues to suggest a supportive housing/employment backdrop for asset quality, while RBA rate cuts are also likely over the next year. Jarden is forecasting a first cut in February 2025, which is at the “hawkish” end of consensus.

The banks are well placed, Jarden notes, with some $5.8bn of potential surplus provisions against BDDs, which could be used to absorb losses or boost earnings. If the excess provisions are fully released, it could boost FY25 group profits by around 14%, the broker estimates, with CBA and NAB best placed and ANZ least.

Overall, with bank earnings risk skewed to the upside, in the broker’s view, improved capacity for dividends and more reasonable bank valuations (post the broker’s own upgrades), Jarden maintains a “constructive” neutral sector stance.

Preference is with NAB and Westpac, both afforded Overweight, followed by ANZ on Neutral and CBA on Underweight.

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