Australian Banks Post First Half Results: Sugar Hit

This story features ANZ GROUP HOLDINGS LIMITED, and other companies. For more info SHARE ANALYSIS: ANZ

The market responded positively to bank earnings results, but looking under the surface, analysts see a different picture.

-Bank earnings fall in the half
-Buybacks and dividends drive positive responses
-Bad debts remain benign, for now
-Analysts negative on the sector

By Greg Peel

Looking at share price responses, one can easily be forgiven for thinking Australian banks had a great reporting season. However, sector analysts at Macquarie conclude the underlying fundamentals tell a different story.

Banks' pre-provision earnings declined by -1-4% (or -4-10% excluding the positive contribution from markets trading income) with headline earnings supported by ongoing cyclically low impairment charges. The key positives in this reporting season for Macquarie were balance sheet strength, a favourable economic backdrop, a solid business lending pipeline, and the banks essentially meeting or slightly exceeding rebased (lower) consensus expectations.

In contrast with rebased earnings expectations, banks' share prices have rallied by some 30-40% since the middle of 2023, leaving current valuations hard to justify, in Macquarie’s view, particularly given the backdrop of the underlying earnings trends.

ANZ Bank ((ANZ)), National Australia Bank ((NAB)) and Westpac ((WBC)) all reported first half FY24 earnings results this month, while Commonwealth Bank ((CBA)) provided a third quarter update.

Downward Trend

While the banks reported “sound” results for the first half, Wilsons suggests, performances were generally a touch ahead of consensus expectations across key line items, but the sector’s medium-term earnings outlook still remains challenged.

Following modest forward upgrades, consensus forecasts still point to negative earnings per share growth for the ASX200 Banks Index in both FY24 and FY25, Wilsons notes.

Weaker net interest margins (NIMs) have been the biggest headwind to bank earnings over the last twelve months. NIMs remained under pressure in the first half amidst competitive pressures in the mortgage and deposit markets, which has more than offset, Wilsons notes, the benefits of a higher interest rate environment.

Still, improving market dynamics support a stabilisation in NIMs over the second half and FY25, with further downside seemingly limited from here, this broker believes. All of the major banks have pointed to easing levels of mortgage competition supported by a more stable interest rate environment, and a declining level of fixed rate expiries.

Remember the “mortgage cliff”? We were all doomed, as fixed rate loans acquired at levels as low as 2% expired amidst rapid RBA rate rises, automatically switching borrowers from 2% fixed to a standard variable rate, which today will cost a borrower around 6%.

That risk is now declining, as the number of remaining expiries winds down.

In any case, Wilsons’ central view on the outlook for margins remains unchanged. While NIMs are likely to stabilise over the medium-term, risks remain skewed to the downside, with limited upside potential amidst ongoing political pressure on loan rates and RBA rate cuts still likely over the next 12-18 months.

Upside potential could be provided by another RBA rate hike, all else remaining equal, but at this stage economists see that outcome as highly unlikely.

Despite cost of living and mortgage cost headwinds, housing credit growth has been sound this year, Wilsons suggests, albeit below-trend, which has been a reasonable outcome. During the first half, market leaders CBA and NAB took a step back from the highly competitive (and therefore less profitable) mortgage market, while ANZ, Westpac and Macquarie Group ((MQG)) continued to gain share.

Business credit growth was much stronger with the leading business bank NAB, for example, reporting 9% business credit growth in the first half.

“Business pipelines are bursting!” Barrenjoey declared. NAB and Judo Capital ((JDO)) both called this out, with agriculture, metals, health, defence and the onshoring of manufacturing offering opportunities.

Wilsons’ outlook for credit growth remains unchanged, with trend to slightly above-trend credit growth likely over the medium-term, but this broker also believes this has already been adequately reflected in consensus expectations, albeit sooner-than-expected RBA rate cuts could drive moderate upgrades over FY25-26.

A lot hangs on whether the RBA can deliver a rate cut this year.

Even though recent margin trends and management commentary have been more encouraging, Morgan Stanley believes the major banks continue to face a weak revenue growth outlook. This broker forecasts revenues to be down -1% half-on-half in the second half FY24, and then increase 2.5% year-on-year in FY25. Key swing factors are likely to include front book mortgage pricing (new loans) and market share, deposit competition and mix, and SME loan growth.

In recent years, the major banks have skewed their business mix more towards retail banking at a time when this segment's profitability has been under pressure, Morgan Stanley notes, weighing on group returns on equity.

In this broker’s view, it will be difficult for retail bank margins to expand and profitability to improve given the ambitions of the five largest banks. Morgan Stanley believes this limits the potential for a strong recovery in earnings per share and dividend growth, or an increase in sustainable returns.

Bad Debts

When the RBA began hiking its cash rate at a rapid pace from May 2022, it was assumed by all and sundry a rash of bad debts must surely follow.

In particular, this harks back to the so-called mortgage cliff, which reflected borrowers confidently locking in fixed rate loans because, according to then RBA governor Philip Lowe, there would be no rate hikes before 2024. The sudden jump in mortgage cost burden that households would be hit with would simply be too much to bear for many.

Two years later, looking at first half of FY24, credit quality trends modestly deteriorated, Macquarie notes, being loans in arrears and impaired assets (loans written off). However, impairment charges remained at cyclically low levels.

Strong provision coverage against bad debts is supportive of charges remaining low, and banks further increased their coverage in the first half (excluding ANZ, which kept it flat due to the acquisition of Suncorp’s ((SUN)) bank). Macquarie continues to see the current level of charges as unsustainable and remains surprised that consensus has largely accepted the narrative that banks have completely de-risked themselves.

Loan arrears are unsurprisingly increasing, Wilsons notes, though impairments have so far remained relatively low and surprised to the downside in the first half, offering a small degree of support to earnings.

Nevertheless, Wilsons points out there is a broad consensus among the banks that bad debts will follow arrears higher over the medium-term amidst weakening credit quality from the ongoing impact of higher interest rates on households.

While conservative provisioning provides a buffer to earnings against deteriorating credit quality, in Wilsons’ view there is insignificant upside to consensus earnings from potential provision releases with arrears still tracking higher and generally above historical averages.

The key swing factor, as noted, will be the ultimate timing and magnitude of RBA rate cuts.

The major banks' non-performing loans increased by around 10% in the March quarter from the December quarter, Morgan Stanley points out, but credit quality generally remained sound. In contrast to their capital management approach (buybacks and dividends), the banks did not bring forward provision releases.

Morgan Stanley believes “excess” provisions will be used to mitigate the earnings impact of higher underlying loan losses, support loan growth, and maintain “buffers” over the next two-three years.

Jarden is similarly sanguine about credit quality.

While measures of stress such as arrears did increase modestly in the first half, they remain below pre-covid levels, Jarden notes. Elsewhere, there were pockets of stress in mid-market/institutional lending but these seem to be single-name specific, rather than a sign of systemic risks. Looking forward, Jarden sees further upside to earnings as bad debts are revised lower and collective provisions released.

Web-based measures of financial stress rose modestly in March, Jarden found, with unique visits to websites associated with financial stress up 8% month-on-month, yet down -8% year-on-year. This is broadly consistent with visits to major bank hardship sites, with visits to CBA’s and Westpac's hardship sites up in March.

At the business level, monthly insolvencies continue to move higher, Jarden notes, with March insolvencies up 17% month-on-month to a record 1,134 and up 41% 2024 to date (and up 46% versus 2019). However, looking at insolvencies as a share of companies, the lift is more modest, with March's “record” number actually below 2015 levels given significant growth in businesses (registered businesses are up 22% since end-2019).

By industry, the biggest drivers remain construction and hospitality, but insolvencies are broadening out to other sectors, with insolvencies excluding construction and hospitality running at record highs, up 46% year on year so far in 2024 and up 25% versus 2019.

Capital Management

All of the majors remain very well capitalised by global standards on a CET1 (common equity tier 1) ratio basis, Wilsons notes, and are comfortably above their APRA minimum thresholds, which has underpinned $5bn of additional capital returns announced by the majors in the last month.

While capital returns will be modestly accretive to earnings in the near-term, this ultimately represents a temporary “sugar hit”, Wilsons believes, that fails to address the still lacklustre medium and long-term earnings growth outlook facing the sector.

Major banks' capital levels remain healthy and loan growth has been weak, Morgan Stanley notes, which has allowed boards to accelerate buybacks and pay higher dividends in the recent reporting season. Active buybacks could provide some share price support, but the broker believes they are incremental to valuation, and already captured in investors' expectations.

At the same time, ordinary dividend payout ratios have moved towards the top end of the banks' target ranges. Morgan Stanley thinks this reflects increased comfort in the operating environment, but it also limits future dividend growth prospects and flexibility.

Low bad debt charges and inorganic capital benefits supported banks' capital positions paving way for higher-than-expected capital management, Macquarie points out. But despite low bad debt charges, organic capital generation was low across the sector.

With declining pre-provision profits and potentially higher impairment charges, Macquarie believes it will be challenging for the sector to maintain the current level of dividends. Based on banks' sustainable payout ratios, this broker estimates ANZ Bank, NAB and Westpac's 5-6% headline dividend yields will fall to around 4%.

Valuation

What would sustain current bank share prices into the medium term?

Citi thinks a return to sustainable core profit growth would be required. In this past result season, the market learned that technology upgrade costs are set to drive banks’ operating expense growth back above inflation into the medium term. This is at a time when core lending and deposit spreads are expected to continue to decline, albeit at a slower pace than what investors have endured over the last twelve months.

Against this backdrop, Citi remains comfortable with its Sell call across the sector.

The majors delivered 23% total shareholder return (inclusive of dividends) over the last six months as macro concerns subsided, Barrenjoey notes. The majors are now trading on a 17.5x price/earnings ratio. This is within touching distance of all-time highs seen in March, and 94% PE relative to the All Industrials, which is the highest post GFC.

This comes despite the banks offering -6% earnings growth over the next three years on Barrenjoey’s forecasts. This broker remains “very cautious” on the banks, but acknowledges any large sector moves will likely be driven by macro factors.

Such as an RBA rate cut.

In Morgan Stanley’s view, the major banks' trading multiples are elevated and pricing in the potential benefits of a soft landing and a less competitive retail banking environment. This broker thinks earnings and dividend growth prospects are modest, with material upgrades unlikely.

In the context of a weak earnings growth outlook, on the whole bank valuations remain “highly uncompelling,” warns Wilsons.

Given the tepid earnings outlook, the sector’s valuation premium is excessive, Wilsons believes, and implies the market expects consensus earnings upgrades. The current sector valuation implies the market is pricing in some 20% earnings growth in FY25 compared to consensus of -1%.

This is highly unlikely to eventuate in Wilsons view without a dramatic shift in RBA policy rate expectations and the economic outlook, demonstrating the extent of the sector’s current valuation excesses.

As noted at the beginning of this article, Macquarie finds current valuations hard to justify, particularly given the backdrop of the underlying earnings trends.

FNArena Major Bank Data					FY1 Forecasts				FY2 Forecasts
Bank	B/H/S Ratio	Previous Close $	Average Target $	% Upside to Target	% EPS Growth	% DPS Growth	% Payout Ratio	% Div Yield	% EPS Growth	% DPS Growth	% Payout Ratio	% Div Yield
SUN	4/1/1	16.13	16.61	2.77	16.6	24.6	70.5	4.6	2.5	19.2	82.0	5.5
MQG	1/3/1	193.20	193.08	– 1.33	17.8	6.0	62.9	3.5	7.8	3.3	60.2	3.6
JDO	1/2/2	1.27	1.20	– 6.09	3.0	N/A	0.0	0.0	11.7	N/A	0.0	0.0
BEN	1/1/3	11.08	9.82	– 10.89	2.5	4.9	71.0	5.8	– 2.0	1.6	73.6	5.9
BOQ	1/0/5	6.04	5.69	– 3.89	100.0	– 16.1	75.0	5.8	2.1	5.6	77.5	6.1
ANZ	0/4/2	28.31	27.59	– 3.60	– 4.7	– 5.7	73.1	5.8	0.2	1.4	74.0	5.8
NAB	0/3/3	34.71	30.41	– 12.60	– 5.9	0.9	75.7	4.8	1.1	0.7	75.4	4.9
WBC	0/2/4	27.07	25.23	– 6.78	– 7.9	18.8	89.2	6.2	2.0	– 7.9	80.6	5.7
CBA	0/1/5	121.79	93.15	– 23.33	– 3.3	1.8	78.4	3.8	– 1.7	1.3	80.8	3.8

There are three main points to note concerning the above table, which reflects forecasts, target prices and ratings of brokers monitored daily by FNArena.

Firstly, for those familiar with past tables, the list has now expanded to include other listed banks.

The second is that post this expansion, all four majors are sitting at the bottom. Why? That’s the third point. There is not one Buy rating for any of the Big Four banks.

A year ago, following first half FY23 earnings results, brokers applied six Buys, fourteen Holds and four Sells (or equivalent) ratings. Following FY23 full-year results, that had slipped to three Buys, fifteen Holds and six Sells.

Now we have no Buys, ten Holds and a whopping fourteen Sells. Sells exceed all other ratings.

In the current economic climate, it is interesting to note a rare occurrence of the two “major minors”, Bendigo & Adelaide ((BEN)) and Bank of Queensland ((BOQ)) faring better than the majors in at least attracting one Buy each.

The same is true for Judo Capital and Macquarie Group, but Judo is a growth story and is yet to pay dividends, while Macquarie, although increasing its exposure to the mortgage market, is primarily a global investment and proprietary trading bank.

Suncorp is, of course, primarily an insurance company, and is about to pass its bank over to ANZ.

Technical limitations

If you are reading this story through a third party distribution channel and you cannot see charts included, we apologise, but technical limitations are to blame.

Find out why FNArena subscribers like the service so much: "Your Feedback (Thank You)" – Warning this story contains unashamedly positive feedback on the service provided.

FNArena is proud about its track record and past achievements: Ten Years On

Click to view our Glossary of Financial Terms