-Abandons retail book guidance
-Questions over further regulatory risk
-Setback but there are offsets
 

By Eva Brocklehurst

Australia's Department of Social Security has dealt a blow to Challenger Financial ((CGF)), signalling an intention to reverse the favourable means testing - ruled in 2012 - of the company's aged care annuity product. Challenger has reduced its guidance for life cash earnings by $10m to $525-535m and effectively abandoned retail annuity book growth guidance of 10-12%, stating it was not in a position to confirm growth at this stage.

The product allowed those in residential aged care to benefit from reduced aged care costs and increased age pension payments. These benefits rose as a result of the product being deemed a capital return, providing a deduction under social security means tests. Clients, now, would likely experience a reduction in their age pension and an increase in care fees, making the product unattractive. Challenger suspended sales on November 28, pending an appeal of the decision.

In FY14 Challenger sold $279m of these annuities, accounting for 46% of the total sales in lifetime annuities and 10% of total retail annuity sales. With an enlarged market opportunity in FY15, extended to those in home care, this was the company's fastest growing annuity product. The implementation of the new rules is not backdated and will commence on January 1, 2015. Technically, the product has a penalty and policy cancellations are an earnings benefit to Challenger but, in good faith, brokers expect the company will return funds if the ruling is not reversed.

Despite the uncertainty created by the tax issue most are reasonably upbeat about the stock, with the exception of Deutsche Bank which retains the only Sell rating on the FNArena database. Otherwise, there are three Buy and four Hold ratings. The consensus target is $7.39, suggesting 17.9% upside to the last share price, and compares with $7.67 ahead of the announcement. Targets range from $6.20 to $8.70 and the dividend yield on FY15 and FY16 forecasts is 4.7% and 5.1% respectively.

This is - or was - Challenger's highest growth, highest margin product and, while Deutsche Bank has no doubt the company will pursue all avenues to overturn the decision, it will put a significant dent in future earnings outlook. While the company estimates a worst case FY15 earnings impact of negative 2.3%, outer year profit implications are greater, in the broker's opinion. Deutsche Bank was always suspicious of the risks in this product, given the average purchase age of 87 meant the recipients were likely to die within the first 10 years and the product offered a 100% capital return on death.

Worst case scenario is where liquid lifetime annuities are also scrutinised by the government, although JP Morgan considers this is unlikely as the customer base is very different, and the risk of residual values being understated is much smaller. The broker considers the company has many offsetting positives, none the least being the upcoming Financial Systems Inquiry, and, given the underperformance of the stock in recent months, upgrades to Neutral from Underperform.

Morgans also considers the share price decline has made the stock more attractive, although given the uncertainty around a key product, retains a cautious outlook and Hold recommendation. The broker notes initial aged care annuity sales were impressive and a strong contributor to recent annuity sales growth. More significant, in this broker's opinion, is the potential for the ruling to raise customer/financial planner concerns about regulatory risks associated with structured annuities.

It is the hit to reputation that has potential to do the most damage, in Credit Suisse's view, as questions will be raised regarding further potential regulatory risk. That said, and while regulatory risk is to the upside, the broker considers the stock attractive at current levels and maintains an Outperform rating. Morgan Stanley also believes brand damage is the greater concern. With the government able to review the rulings, uncertainty regarding future income and asset treatment could be a headwind to future sales. The risks to the value of lifetime annuity sales now reduces some of the margin cushion the company enjoyed. These products lengthen duration, allowing Challenger to extract a premium in longer-dated property infrastructure assets.

The decision is a setback, given the knock-on impact for retail liability growth, in Citi's view. Challenger's capital levels are now elevated and the necessary investments to deliver sales growth will increase shorter term costs. Longer term, rowth potential remains intact because of the relatively short average duration of aged care annuities relative to the liquid lifetime annuity product. Citi also notes that, given sales of aged care annuities were expected to accelerate in FY15 because of reforms which became effective from July 1 2014, overall retail annuity sales are now growing at a slower rate. Still, the broker believes the company's dividend should hold up and provide some yield support.
 

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.

-Aust business margins improve
-Buffer in mortgage margins
-Strong competitive advantage
 

By Eva Brocklehurst

Australia's major banks are in a stronger position than the recent headline numbers suggest. With the exception of National Australia Bank ((NAB)), momentum is robust, on Deutsche Bank's calculations. NAB, meanwhile, has more heavy lifting to do to get to the level of its peers in FY15. Headline growth for the sector was relatively poor at 0.8% for earnings and 0.9% for revenue in FY14. Growth came from retail and business banking, with institutional banking offering little growth and New Zealand lagging Australia. One-off provisions, asset sales and investments distorted the headline number as well as abnormally low trading income, the broker notes.

Deutsche Bank's number crunching suggests the banks are still generating similar levels of growth to recent years, adjusting for the lack of volatility. While not at their highest starting point for a financial year, the banks are still well placed. Business credit appears to be improving and asset growth is likely to be reasonable, in the broker's view. Banks should enjoy improved margins in Australian business, as wholesale funding costs are now well below 3-4 years ago and the average duration for the mortgage book is substantially longer than the average duration of the funding book. Institutional margins are at greater risk but, the broker notes, institutional banking is becoming a smaller proportion of the group as a whole.

Regulatory risk is the main issue facing the banks, as they are expected to have to hold more capital once the financial system inquiry's recommendations are handed down later this year. Mathematically, this reduces return on equity (ROE) and the capacity to keep raising dividends. Nevertheless, Morgans observes the Big Four should be able to pass on regulatory costs to the consumer which, while not helpful for consumers, reveals the pricing power of the banks. The banks have impressive mortgage margins and, when cash rates were last cut, they did not pass all the savings to the consumer. At the time it was stated that wholesale funding costs were exceptionally high, but Morgans also notes these costs have fallen significantly over the past few years.

That is not to say the broker believes the banks should be forced to hold more capital because of the problems of international peers, nor that ROE around 16%, while impressive, is a super profit. In this the broker compares the banks with BHP Billiton ((BHP)) which generated a ROE of nearly 30% in 2012, although this is expected to fall to 14% in FY15. Australia's banks are great investments, in the broker's opinion, able to extract higher returns at a time when housing credit growth was subdued. This strong competitive advantage is why Morgans believes Australia's four majors are in the top ten highest rated banks in the world.

Defensive earnings, pricing power, lower relative share price volatility and an ability to gradually increase dividends is why the banks should be an important part of every portfolio, in the broker's opinion. On the subject of NAB, Morgans believes, once divestments are made, investors will be left with a quality domestic business with a focus on small to medium business and mortgage lending.

Morgan Stanley expects tougher capital requirements will emanate from the inquiry but also that a transition period will ensure this is manageable. The broker suspects mortgage risk weightings will be lifted and assumes new tier one capital targets are reached by the end of FY17, estimating the major banks will be short of a new minimum of 9.75%, based on pro forma FY15 estimates. Large capital raisings in 2015 are possible as the banks are likely to need to find $38bn in capital via dividend reinvestment plans, asset sales and share placements. Lower home loan discounting and term deposit rates are also highly likely, even if standard variable rates are not re-priced.

The broker forecasts that ROE will decline for the majors by around 1.5 percentage points in the medium term. Dividend growth is expected to average 4% per annum over the next three years. The broker believes the probability of dividend cuts is low, but flat dividends are possible if more onerous rules are implemented.
 

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.

- Solid net earnings increases
- BDD provisions still the primary driver
- Additional capital requirements anticipated
- Valuations again looking stretched
 

By Greg Peel

If we exclude National Bank’s ((NAB)) asset write-downs and UK provisioning, Australia’s Big Four banks delivered 9.7% underlying earnings growth in FY14 according to UBS, the strongest result since FY10. Such strength seems in contrast to earlier expectations of weak bank earnings growth in a tepid and transitioning Australian economy. However, one must drill down to contributing factors.

Revenue per share growth was solid at 5%, UBS notes, but 1.8% is attributable to the lower Aussie dollar. Market trading income, forever volatile, basically squared itself out between a strong first half and weak second half. Efficiency gains were negligible, which means 4.5% of earnings growth was attributable to further reductions in bad & doubtful debt (BDD) provisions, by UBS’ calculation.

A year ago, bank analysts were already calling a trough to BDDs. Hefty provisions against BDDs were put in place in 2009 when everyone expected the sky to fall on the Australian economy during the GFC, but not only did Australia survive and BDDs never reach the lofty levels feared, by last year BDDs had fallen back to historical averages, implying the GFC was “over” and no more provisions would be brought back as earnings.

Indeed, many an analyst expected BDDs to drift upward once more as the Australian economy entered its difficult transition phase away from mining investment at a time the Aussie dollar remained stubbornly high.

But here we are, and lingering BDD provisions are still being brought back onto bank P&Ls as earnings. In fact UBS notes that a second half BDD of a net 15 basis points is the lowest level ever recorded by the majors, just edging out the second half of 1995. The broker now suggests “the tailwind from BDD charges has likely run its course”.

JP Morgan does not necessarily agree. This broker believes we may be yet to see the low point in the BDD cycle, given new impaired asset formation is continuing to improve and global liquidity is driving asset values, thereby allowing troublesome exposures to be “worked out”.

In other words, while BDD levels are now very low relative to history, so are interest rates. It is in the interest of banks to keep borrowers afloat rather than take a hit on their bad loans, so it is in both parties’ interest to refinance restrictive loans at a lower interest payment for an extended maturity, thus allowing borrowers to work through their difficulties. We’ve already had to throw the history book out the window with regard global interest rates (QE has no precedence), so why not throw the BDD history book out with it?

Citi concurs. This broker believes BDDs could continue to decline for yet another year. The adoption of new international bad debt provisioning standards may mark the bottom of the cycle, Citi suggests, but its implementation will occur over a one to two year time frame.

While falls to historically low interest rates (including the RBA’s unprecedented 2.5% cash rate) may have provided relief on the bad debt side, they have by contrast put pressure on bank net interest margins – the bread and butter of bank earnings. The NIM is effectively the difference between the rate a bank borrows at (debt issues and deposits) and the rate a bank lends at (across its spectrum of loans). If we consider a NIM as a consistent percentage on top of the borrowing rate, then clearly a lower interest rate implies lower earnings.

NIM declines were being exacerbated in recent years by the banks’ urgent requirement to build up deposit books to satisfy liquidity limits after having pumped up their mortgage books post GFC (through takeovers of smaller banks and demand created by the then government’s first home buyer stimulus package). A deposit war broke out, squeezing NIMs ever further. But as offshore borrowing costs gradually declined, as GFC fears eventually eased in the US in particular, the banks were able to stop competing and indeed start widening out their deposit spreads. This was particularly the case when term deposits became all the rage as the go-to retirement investment.

JP Morgan observes that “flattish” rather than declining NIMs seem to be the new norm. The fall in offshore borrowing costs and improved deposit spreads have provided enough tailwinds to offset ongoing competition among the banks in mortgages and institutional lending, the broker suggests. The broker also suggests there is not likely to be much in earnings per share growth for banks in FY15, given the drag provided by easing BDD benefits and the need to rebuild capital through dividend reinvestment plans (DRP) which increases share counts.

Capital. This is currently the dirty word in bank land, and the great unknown. So much so that it overwhelms any assessment of bank earnings results to date. FNArena has written extensively on this topic in recent bank sector reviews (start with Australian Banks: Result Season Preview and work backwards) so there’s no point in going over it all again. Suffice to say the Financial Systems Inquiry, aka the Murray Review, may be handed down as early as this month and will probably require banks to increase their capital bases on a “too big to fail” basis. Separately, growing concern from the RBA and APRA with regard Australia’s runaway investment mortgage market could, any day now, lead to new requirements for bank capital holdings against their mortgage books.

Increased bank capital requirements will reduce return on equity, earnings per share and thus by default, dividends per share.

There are two elements to the Great Bank Capital Debate, and brokers hold slightly differing views. The first is simply a matter of whether or not the banks be required to hold more capital, and how much more, and the second is whether or not the banks are already in sufficient capital positions to minimise the impact.

In the case of increased capital ratios against mortgage books specifically, brokers are largely in agreement that something will have to be done. One need only look at yesterday’s September mortgage data (owner occupier loans, 6.7% year on year growth; investment loans, 24.7%) to arrive at this assumption, particularly considering the next RBA rate move is likely to be up rather than down (although not everyone agrees). As to what the extent of that something is, and what period of time the banks will have to adjust, is a point of debate.

In the case of general “too big to fail” capital increases, (let’s call that TBTF) brokers are similarly in disagreement over extent and timing but more and more in unison with regard a creeping inevitability. Last week, APRA chairman Wayne Byres dissected the regulator’s 2014 bank stress test results and concluded “there is scope to further improve the resilience of the system”, which might be considered code for “how much more of a hint do you want?”

In light of current G20 analysis of the TBTF issue, APRA’s 2014 bank stress tests were more severe than those of four years ago, Macquarie notes. The regulator concluded that, in a downturn, Australia’s big banks would survive but the banking system would not be “fully functioning”, causing issues with bank funding costs and credit extension. This implies they would need a taxpayer bailout, Macquarie suggests, reading between the lines, which is exactly what Mr Murray is charged with avoiding through his Review recommendations.

In other words, another GFC would look no different to the last one, in which Australia’s banks survived but required taxpayer support (albeit in the form of deposit guarantees in 2008 and not any directly funded bail-out as was the case in the US, UK, Europe and elsewhere).

Macquarie suggests Byres’ comments send “the clearest signal yet that the regulator believes more capital is required so as not to ‘sail too close to the wind’ in the event of a downturn”. The broker’s conclusion is that the majors will be forced to hold additional levels of mortgage capital. Commonwealth Bank ((CBA)) boasts a higher capital starting position and superior organic capital generation than its three peers, hence it is the only bank Macquarie is prepared to put a Buy rating on at present.

CIMB retains an Underweight stance on the banking sector. The issue for CIMB is one of bank share price overvaluation, with or without new capital requirements. The market sell-off in October went some way to restoring intrinsic bank valuations to more realistic levels, which most brokers agree upon, but now bank share prices have bounced right back again. Throw in the capital threat, which will lower structural returns and constrain growth, CIMB points out, and the banks are over-overvalued.

Morgan Stanley is quite simply “negative” on the banks due to the capital threat. The broker’s base case is for the TBTF additional capital requirement to be lifted from the international requirement of 1% to an Australia-specific 2%, adding the need for an additional $15bn in capital among the Big Four. With regard the investment mortgage issue, Morgan Stanley believes another $15bn will be required to accommodate the new 20% capital ratio requirement the broker assumes APRA will impose.

Not all brokers are assuming 20%, with 15% another suggestion. And there are other capital solutions the Murray Inquiry could provide for, such as so-called “bail-in bonds”, which has led to further debate among brokers. (See aforementioned previous FNArena articles for explanation.) And then there’s the issue of whether or not the banks have positioned themselves sufficiently up to this point to absorb new capital requirements without too much pain.

“Based on our expectations for new capital requirements, all the major banks look relatively comfortably positioned,” says Citi. “We reiterate our view that the Australian banks are well positioned if capital requirements move higher on the back of recommendations from the Financial System Inquiry,” says Goldman Sachs.

While the majors may have clocked up relatively pleasing FY14 earnings results, second half results were weaker than first, Macquarie notes. Taking this into account, and the potential capital overhang from the Financial Services Inquiry and RBA macro-prudential moves, “it’s difficult to get excited about the sector,” the broker believes.

Within the sector itself, brokers largely agree that ANZ Bank ((ANZ)) posted the best prima facie earnings result for FY14, but CBA wins best all-round result once capital generation is included in the mix. Bear in mind that CBA reported its FY14 result in August and has now reported its first quarter FY15 result, whereas the other three have all just reported FY14. Westpac ((WBC)) posted a better result than brokers had feared, while NAB let the side down irrespective of its asset write-downs and UK provisioning in posting an earnings decline.

Then it comes down to valuation, as previously noted.

“After the recent sell-off and recovery,” says JP Morgan, “the major banks are back to approximating fair value”. But from UBS’ point of view, “The share price bounce in October has removed the valuation appeal”.

When last FNArena published its Major Bank table, CBA surprised by jumping into second place following a long term tenure in last, implying “most overvalued”. NAB has ignominiously fallen to last after often holding top spot. Before the bank results season, upside to consensus share price targets sat in a tight range of 3-6% (NAB to ANZ).

Updating the table for yesterday’s closing prices (below) indicates ANZ retains number one and CBA number two, with NAB moving up to nudge out Westpac following its relative share price fall. We also see much greater divergence in upside to target measures, with ANZ blowing further out and CBA returning to a more familiar target breach, despite retaining its number two consensus preference.
 

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.

-Bullish targets maintained
-Capital returns feature
-More competitive product offer
 

By Eva Brocklehurst

Suncorp ((SUN)) has showcased the perennial problem of managing bank margins while maintaining growth. With benefits from more favourable funding costs and lower deposit spreads, the net interest margin in Suncorp's banking division improved to the top end of the company's 1.75-1.85% target range in the first quarter and management expects this will be sustained in the near term. Credit quality was strong and gross impaired loans were down 16%. However, the total loan book contracted 0.9% in the quarter and growth was sub-system in all segments.

Suncorp expects overall loan growth to resume in the second quarter and has reaffirmed bank division guidance, with the cost-to-income ratio now expected to be nearer 50%. UBS expects Suncorp is headed for a solid first half and, along with Credit Suisse, surmises that no update on the general or life insurance front must be a positive (given updates in recent years have been invariably negative). Nevertheless, UBS highlights the bullishness that is reflected in the company's growth targets, and this is one of the factors behind the broker's Sell rating. Credit Suisse believes, with general insurance earnings coming under pressure, Suncorp will require bank and life division growth to fill the earnings gap.

The first quarter fell short of the company's growth ambitions and UBS wonders whether Suncorp can really deliver both growth and margin targets. Deutsche Bank, too, considers the company has sacrificed growth for margins in the first quarter and questions whether top line growth of 4-6% will be achieved. The mortgage market backdrop remains competitive but as management is more attuned to expanding margins, this suggests some upside risk to short-term earnings if similar attention is paid to the larger general insurance division. Deutsche Bank gives Suncorp the benefit of the doubt and retains a Hold rating.

Asset quality within the bank is improving and the company has confirmed shareholders should expect further capital returns, but the share price has had an exceptionally strong run and Bell Potter now believes a Hold rating, downgraded from Buy, is more appropriate. The broker considers the revised rating still adequately reflects the company's "cash" status and capital returns should feature in the medium term. Bell Potter also presumes, should underlying trends and benign weather patterns prevail, Suncorp has the capacity to sustain a yearly 15c special dividend over the next 2-3 years.

Citi believes a return to growth in the second quarter is a reasonable expectation and that Suncorp will reach its return on equity target of 10% in FY15. This will need a major improvement in bank profit but higher net interest margin, lower impairments and lower cost-to-income ratio should help. The reason the broker is confident regarding a return to growth is that there is a now more competitive product on offer with lower risk, while higher quality lending is also in the mix. The product offer was only released at the end of September so the contribution to growth should appear in the second quarter, and there were signs in October that its reception was strong. The first tranche of the banking platform replacement should be live at the end of November and Citi expects, should all go to plan, the banking cost-to-income ratio will be on track for the 53% FY15 target.

JP Morgan envisages profit will remain strong in the near term but at some point the growth issue will need to be confronted. The broker acknowledges pressures on lending in the September quarter primarily stemmed from a sharp reduction in the proportion of very high loan-to-value ratio loans, which the bank indicated was an effort to improve the risk mix and get ready for the eventual adoption of advanced accreditation. Nonetheless, the broker expects in the longer term, growth will necessitate margin contraction while a weak general insurance outlook may weigh on investor sentiment in the short term. The main upside for the stock is likely to come from capital returns and cost reductions. At best, Suncorp is an FY16 story for JP Morgan.

On FNArena's database Suncorp has one Add rating, five Hold and two Sell. The consensus target is $13.98, suggesting 6.8% downside to the last share price. The dividend yield on FY15 forecasts is 6.4% and 6.0% on FY16 forecasts.
 

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.

-Competitive pressure mounts
-Road to recovery taking longer
-Is a valuation premium justified?
 

By Eva Brocklehurst

Growth rates in insurance industry premiums continue to moderate and QBE Insurance ((QBE)) is actively reviewing exposures and selectively renewing accounts, in turn putting pressure on premium growth. The company acknowledged in its recent European and North American investor presentations that pressures in this regard were mounting. QBE reported a contraction of 10.1% in gross written premium (GWP) in the first half of 2014. Several brokers are now more cautious on the outlook and have put a return to premium growth on the back burner.

Macquarie does not expect GWP growth until 2016, and notes reinsurance rates are also under pressure while third party capital continues to move into the sector, expanding market capacity and putting pressure on prices. Morgan Stanley, too, highlights this feature. QBE Lloyds remains a market leader in Europe but disintermediation is driving investment in regional hubs and global underwriting capacity.

Morgan Stanley also observes the challenges in rebuilding the franchise are entrenched. As premium rates fall, the company appears to be hoping for a turnaround...but not until 2017. The broker notes the London market franchise is strong but it needs investment, while the road to recovery in the US may take even longer. In the US the rising expense ratio is hurting the insurer but QBE's distributor ties and the litigation that is under way are seen likely to inhibit any sale.

Against global peers, QBE has de-rated from parity to a 10% discount on Macquarie's index since September. This discount has occurred on only a small number of occasions over the past eight years. The de-rating has been driven by the underperformance in the share price. Are there any offsets? Cost cutting and increased investment risk could provide some mitigation. Macquarie is Neutral on the stock but this outlook includes a risk for a more positive investor response to the potential for higher interest rates and lower Australian currency.

In evaluating the key risks to QBE, Morgan Stanley is also mindful of the sensitivity to rising yields but concedes, given softening premium rates and record low yield environment, top line growth is difficult. To return to its glory days QBE needs insurance margins over 15% and hardening rates, as well as acquisitions in regions where it is underweight, in Morgan Stanley's view. Management is re-basing margins and reducing risk and the broker still considers the insurer's 14% long-run insurance margin remains achievable. Morgan Stanley's base case also incorporates abating risks around gearing and negative rating agency views. The broker suspects 2014 will be another year of transition but retains some leverage in its base case view to rising US yields and a falling Australian dollar.

Credit Suisse observes, too, that following some years of margin improvement QBE now faces softening premium rates and its tasks are getting tougher. The broker cautions against expecting a significant improvement on the 10% margin that is currently in place. GWP pressure is becoming more competition based and, hence, QBE is targeting selective growth. Credit Suisse is more confident that reserving issues are being addressed but notes this comes at a cost. The broker no longer believes QBE's returns justify a valuation premium to peers. If anything, a discount should be expected. Longer term, Credit Suisse finds the stock an interesting investment proposition. At present the broker retains a Neutral rating.

FNArena's database contains five Buy ratings and three Hold. The consensus target is $12.18, suggesting 5.8% upside to the last share price. Targets range from $11.60 to $13.00.
 

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.