- Lack of revenue growth
- Ongoing regulatory risk
- Overstretched valuations
- Yield support

By Greg Peel

FNArena’s previous Australian Banks report was published in November, following the bank full-year reporting season for Westpac ((WBC)), National Bank ((NAB)) and ANZ Bank ((ANZ)) and first quarter update from Commonwealth Bank ((CBA)). We have since seen a full-year result from CBA in the general February reporting season, and quarterly updates from the other three.

There were three factors which stood out in the previous report: bad debts, capital and valuation.

Earnings growth in the FY14 banking year was driven mostly by further reductions in bad and doubtful debt (BDD) provisions rather than any underlying growth to speak of. Some brokers assumed this well must soon dry up given not only were bad debts back to pre-GFC levels, they’d fallen all the way to historically low levels. Bad debts must now begin to normalise, they argued, meaning grow once more.

But other brokers argued the case, suggesting historically low interest rates – the RBA had just cut to 2.5% -- implied bad debts could still fall further.

Capital was a clear issue given the pending, at the time, release of the David Murray-led Financial Services Inquiry. The subsequent release did not hold any great surprises, but in the interim analysts largely decided the banks were showing sufficient capital generation to render additional capital requirements less imposing, and they could also deploy dividend reinvestment plans (DRP).

Valuation was an issue. Analysts were torn between the obvious attraction to longer term investors of solid, fully-franked yields and a lack of earnings upside despite strong share price runs. As the table below from that period indicates, CBA was already trading above its consensus target and Westpac was nearly there, with the smaller, riskier banks showing some limited upside potential.
 

Yet CBA was still the brokers’ second preference, which was an unusual place for Australia’s biggest bank to find itself. Usually, brokers despair at CBA’s overstretched premium to peer valuations, but in the context of potential additional capital requirements, CBA stood out amongst the group as least exposed.

Fast forward to today, post fresh results, and little has changed in terms of those factors hanging over the banks. Analysts are still arguing over bad debts, given they have come down even further. The FSI is yet to be dealt with by the treasurer, who seems to have other things on his mind, like survival, and suing Fairfax. And if valuations were arguably stretched back in November, the rubber band is really straining now.
 

We see that consensus target prices have risen slightly, but share prices have run well ahead (based on yesterday’s closing prices). All four banks are now trading above target, with Westpac markedly so. CBA is back in its more familiar position as least favoured, given its valuation premium, and the others have all shuffled around in terms of broker preference. In November the total Buy/Hold/Sell count was 9/15/8, today it is 10/11/11.

So if bank share prices are exceeding consensus targets, why are there any Buy ratings at all? It’s because different brokers have different views. Some still expect bad debts to now turn upward again, despite low rates, others believe “this time it’s different” because of low rates. Some warn of capital raisings ahead once the FSI recommendations are adopted, and macro-prudential controls with respect to mortgage lending are introduced, others believe the banks can safely absorb the risk. At least one broker believes all four banks are quite simply overvalued, and thus has a Sell on all four, while others believe yield support and some earnings growth potential means further upside for certain names.

Macquarie has just become the first broker to put a $100-plus price target on CBA -- $101 to be precise.

Citi, the broker with a Sell on all four banks, summed up the recent bank results as follows:

“Disclosures reveal evidence of capital generation having peaked, revenue growth slowing as mortgage competition builds and credit quality improving but credit costs [BDD] no longer driving much improvement in earnings.”

Credit Suisse notes that the bulk of any credit growth was mostly related to the falling Aussie rather than normal business. System credit growth is edging higher but in a low interest rate environment (now lower still since last month’s RBA cut), net interest margins continue to disappoint. Cost growth appears uncomfortably high, as the banks spend up on technology updates, compared to revenue being generated. The cycle of returning BDD provisions to earnings has likely run its course. Risk-weighted capital growth (mortgage lending for example) was “notably” high and thus underscores the spectre of regulatory risk.

UBS notes housing credit growth remains strong but appears to be nearing a peak. The broker suspects the latest RBA rate cut, and any yet to come, will not lead to mortgage holders reducing their payments in line with a drop in the variable rate, but rather maintaining payments to pay off the principal faster. This means little benefit to the banks of RBA rate cuts, now rates are so low.

Despite the attraction of the banks’ high yields in a climate of benign economic growth, UBS believes banks valuations, at a net 15x FY15 price/earnings, are overstretched.

However, UBS made this assessment after all the banks had updated last month and we have since seen some share price pull-back. Indeed as I write, bank share prices are slipping once more. But the above table was based on yesterday’s closing prices, which already represent a fall from the peak. FNArena’s long-tested rule of thumb is that if bank share prices exceed consensus target prices, most likely the banks are in for a period of de-rating back to more realistic valuations.

The problem is that under “normal” circumstances, if such a thing actually exists in markets, investors tend to sell banks when their valuations become stretched and switch into something else – usually resources, and/or cyclical industrials. But in today’s world, not only are commodity prices weak but the big miners and energy companies have become dividend payers to rival the banks. And many a large cap industrial has become a sought after yield stock.

The pullback currently underway in the market is due to a more uniform driver of all yield paying stocks having become overvalued. Thus selling in banks will not likely pop up as buying elsewhere in the stock market. What is more likely is that most everything will sell down until investors again decide – weak bank earnings growth outlooks and weak commodity prices aside – yields are simply too attractive on both a local (RBA cash rate at 2.25%) and global (German ten-year bond yield at 0.28%) basis.

Thus the banks, and other yield payers, have a share price safety net. As to where that net is will be determined by just how far investors will allow prices to fall (happily, so they can get in to stocks they missed out on in the rally) before someone blinks and the buyers all plough in again.

In terms of preferences between the four majors, every broker has a differing view, as the above tables indicate. But we can find consensus with regard certain aspects.

CBA is the stand-out bank. Problem is, it’s just too overvalued. NAB offers the most relative upside within the group given the ongoing work-out of its long-troubled UK business, which should allow for some dividend catch-up. ANZ offers the greatest risk given its exposure to a slowing Asian economy. Westpac sits somewhere in the middle.

Morgan Stanley continues to bang the capital raising drum, warning that increased capital requirements and macro-prudential controls will force the banks to go the market for equity. MS also notes that while bank exposure to lending in the mining sector is relatively low, compared to mortgages for example, it is not insignificant.

Net bank exposure to miners and mining service providers adds up to less than 2% of loan books, the broker notes, but it could lead to material increases in group loan losses from bottom of the commodity price cycle levels. On that basis, Morgan Stanley believes the banks’ net earnings upgrade cycle has ended.

On the other end of the scale, Macquarie sees strong potential upside in bank lending to small & medium enterprises (SME). The broker’s view is based on the availability of new platform technologies servicing cash flow lending, and of the under-use to date of the business broker channel, which banks are now beginning to exploit.

So there’s an awful lot of moving parts one must consider with regard bank valuations. Not that investors are really all that focused on such nuances. Investors are focused on yield.

As our first table shows, back in November banks were yielding around 6%, with CBA closer to 5%, plus franking. As of yesterday’s closing prices, they were all around 5%, with CBA at 4.8%. If the sell-off currently underway runs a little further, the buyers will happily return. Offshore buyers will enjoy a lower Aussie.

If, indeed, the banks are forced to raise additional capital due to regulatory requirements, there may well be a few takers.

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.

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-Focus on volume, share
-More earnings downgrades?
-But dividend yield appeal
-Youi growing scale
 

By Eva Brocklehurst

Premium growth rates have eased for the major Australian insurers. Australian personal lines make up the bulk of Insurance Australia Group's ((IAG)) and Suncorp's ((SUN)) gross written premium (GWP), with the majority of increases in recent years from the home insurance segment. Brokers observe volume and market share now becomes the main focus in determining whether these insurers hit or miss their targets.

Large domestic insurers have underperformed significantly in recent months and Credit Suisse has restructured its preferences. QBE Insurance ((QBE)) experienced the largest consensus earnings downgrade after reporting season but the lack of significant bad news has meant its share price has re-rated. Credit Suisse now prefers Suncorp over IAG over QBE, noting the valuation gap has closed significantly in recent months. In the broker's view IAG and Suncorp actually delivered slightly better-than-expected volumes in their results. 

While acknowledging they all have challenges, across personal lines, Credit Suisse remains comfortable in the ability of IAG and Suncorp to hold onto their portfolios in a soft market. Margins are being watched to determine the success of cost saving initiatives. IAG has historically delivered the highest margin but, after acquisition of the Wesfarmers' ((WES)) business, margins are diluted to below that of Suncorp. Credit Suisse urges caution about focusing solely on underlying margins, as these are open to manipulation of base assumptions.

QBE's new structure protects it from two large events but the broker notes downside risk becomes significant after two events. Credit Suisse envisages upside risk to dividends from all three large insurers. QBE's result did not impress, the broker hastens to add, but if reserving is no longer an issue then the large discount at which it was trading is no longer justified. Overall, there appears to be relative value in the three stocks but Credit Suisse is not getting carried away, remaining unconvinced that earnings downgrades are complete.

Deutsche Bank is also cautious, observing that growth in Youi's Australian market share in home and motor insurance - now 3.6% - has come largely at the expense of IAG and Suncorp. This increase in scale enhances Youi's underwriting margins and capacity for growth, which in turn supports a view that current underlying margins will deteriorate in FY16 for both Insurance Australia and Suncorp.

With lower premium growth ahead and margin pressures emerging, Deutsche Bank believes it will be difficult for both IAG and Suncorp to generate earnings growth over the medium term. Despite this, the broker retains a Hold rating on both stocks. This reflects a low growth outlook that is already captured in the price, as well as the dividend yield appeal. QBE has a Buy rating and remains the broker's top pick among Australian general insurers.

Youi is here to stay. The South African based company's first half result revealed its disruptive impact on personal insurance lines in Australia, UBS observes. The company grew GWP by 42% compared to the contractions reported by Suncorp and IAG. Youi now represents 44% of parent Outsurance's GWP, highlighting to UBS the significance of the company's presence in Australia. Its growth in this country has not been all smooth sailing, with substantial natural peril losses reported for recent events in Queensland, while the company's loss ratios ex catastrophes appear to UBS to be quite volatile half on half.

Outsurance has referred to Youi as its main growth driver and expects that brand to continue delivering strong premium growth and economies of scale. Youi moved into New Zealand last year and expects that market to provide a meaningful contribution to earnings. UBS observes, with over 60% of market share in NZ personal lines, Insurance Australia will have its work cut out across the Tasman for the next few years.
 

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-Doubles size of NZ book
-Diversifies exposure
-A catalyst for re-rating
 

By Eva Brocklehurst

Leasing and lending business Flexigroup ((FXL)) has added another layer to its services in New Zealand. The company has purchased Telecom Rentals, which provides IT and telco equipment leasing to the commercial and government sector. Brokers applauded the acquisition, which builds on the company's most profitable market, doubling the size of its NZ book.

The acquisition provides increased scale, enhanced distribution and a diversified exposure in Credit Suisse's view. While little earnings impact is expected in FY15, the broker expects around 3% earnings accretion in FY16. With this acquisition Flexigroup expands from a mostly retail exposure to government and enterprise. Synergies should come from the benefits of lower cost of funds when applied to the expanded book. Telecom Rentals has a leading market position in New Zealand and there is also first right of refusal on the former owner's, Spark Digital, business.

When combined with Flexigroup's existing leasing business, this acquisition makes it the leading player in SME/enterprise leasing in New Zealand, a strong position in an attractive market, brokers contend.The price of NZD106m comprises NZD92m in net tangible assets and goodwill of NZD14.5m, with an existing receivables book of NZD97m.

The acquisition fits a low risk/high return capital allocation that has worked well for Flexigroup, in Deutsche Bank's view. Despite being in a phase where organic growth will be harder to achieve the broker maintains the company still boasts significant market opportunities along with the capability to execute. Cost controls are good and the lower funding rate provides a tailwind. Valuation metrics of the stock are undemanding and Deutsche Bank believes this acquisition is a catalyst for continued re-rating.

Profit metrics for Telecom Rentals appear below Flexigroup's own metrics, implying room for significant uplift in profit and returns. Deutsche Bank is confident Flexigroup can operate this business more efficiently, noting the higher profitability it achieves in its Australian enterprise business which involves a more competitive market.

The NZ business remains a relatively small part of of the overall portfolio but has stood out in terms of growth rates since FY11, UBS observes. Having said that, the broker notes the margins of this latest acquisition are a lot lower than Flexigroup's existing NZ portfolio. Still, the outlook bodes well for Flexigroup generally, with the more diverse suite of products now on offer. UBS finds the stock supported by an attractive yield, low funding costs and a benign bad debt environment. The risks lie with the solar and enterprise business beyond FY15, while margin compression and competition remain ongoing issues.

On FNArena's database Flexigroup has four Buy ratings and two Hold. The consensus target is $4.10, suggesting 11.9% upside to the last share price. Targets range from $3.56 to $4.66. Dividend yield on FY15 and FY16 forecasts is 4.8% and 5.3% respectively.
 

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-10% return on equity unlikely
-Special dividend still probable
-Should hazard allowance be raised?
 

By Eva Brocklehurst

Cyclone Marcia battered the Queensland coast last month, dampening expectations insurers would get through this season relatively unscathed. Suncorp ((SUN)), being the largest insurer in the Sunshine State, has advised on the likely claims impact. The company now considers its 10% return-on-equity target for FY15 is unlikely to be achieved.

Approximately 10,000 claims are in train from Marcia, the majority relating to damaged homes. Suncorp's costs are around $120-150m net of reinsurance recoveries. As a result, catastrophe claims are now trending above budget. Following Brisbane's hail storm claims in the first half and now Marcia, Suncorp has disclosed its natural hazard expenses for FY15 to date are in the range of $690-720m. This is in excess of the FY15 allowance of $595m.

Even without another major event, Deutsche Bank expects the remaining four months of the financial year will push Suncorp above its second half budget. As a result the broker downgrades FY15 earnings forecasts by 3.2%. The broker is not surprised the 10% return target has been ditched. Even before Marcia the broker assumed a normal catastrophe budget in the second half would make for a 9.7% return in FY15.

The above-budget costs will dent the surplus and, although a special dividend is still highly likely, Deutsche Bank reduces the amount allowance. The potential for a meaningful FY16 special dividend now appears more reliant on Suncorp convincing the regulator and rating agencies of the merits of its diversification benefit, in the broker's opinion. Macquarie, too, does not expect material changes to the dividend without another significant event and forecasts a 20c special dividend payment at the August result.

UBS considers over-runs in natural peril allowances as largely cosmetic but a more conservative tack on allowances may be an initiative for the incoming CEO and the impact will, the broker assumes, have implications for underlying margins. In JP Morgan's view, the 10% ROE target was always in doubt. The broker has a bearish stance on the stock, with a weak general insurance outlook on the back of the cycle pressures affecting commercial insurance, and unsustainably high margins in personal lines based on significant market share losses in home and motor. The broker acknowledges this is offset somewhat by the prospect of capital management initiatives.

Hazards were always going to be a risk to targets, in Citi's opinion. This will be the ninth year out of ten that the insurer has exceeded its hazard allowance, which suggests that the allowance is inadequate and also implies the true underlying insurance margin may be lower than current disclosures. Citi now forecasts a return on equity of around 9.2%.

Outstanding reinsurance issues in relation to 2011 also cloud the outlook, as these are still subject to legal debate and the cost to Suncorp appears unlikely to be zero, although Citi acknowledges it will be probably lower than the maximum $118m net tax. If this case is not settled completely in Suncorp's favour then the excess above allowances will rise. The broker suspects there is some risk from exceeding allowances relating to the make up of the final dividend but has made not changes to estimates, moving forecasts instead to reflect a pay-out ratio of 84%, above the 80% desired maximum.

With a slowing top line and transition to a new CEO, Citi envisages the risks around the stock are rising. Citi also doubts whether Suncorp can tolerate more hits to its margin before the final dividend is threatened. A possible offset is the possibility that reserve releases will be higher in the second half. There is a strong dividend yield which should remain a source of support for the stock in this low interest rate environment. That said, the broker considers the stock fair value and retains a Neutral call.

There are no Buy ratings for Suncorp on FNArena's database. Rather, there are five Hold and three Sell. The consensus target is $13.90, suggesting 1.9% upside to the last share price. targets range from $13.00 to $14.69. The dividend yield on FY15 and FY16 forecasts is 7.35 and 6.5% respectively.
 

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