- Solid FY14 earnings expected
- Capital uncertainty nonetheless the issue
- Are bank valuations no longer stretched?
- Bank analysts argue the toss

By Greg Peel

This story naturally follows from “Will The Majors Need To Raise Capital?” published on October 2.

At the time the above story was published, the ASX200 Financials sector index had fallen 6% from its post-GFC high established in early September. In the interim, the index has experienced extensive volatility. It bottomed out on October 13 and has since rebounded. As at this morning it was down 5% from the September high.

Aside from bargain hunting amongst domestic investors lured by the effective increase in bank dividend yields at lower prices, expectations of a sooner-rather-than-later Fed rate rise have not only diminished, they’ve all but swung back the other way. This would in theory imply that which triggered the Sell Australia trade that began in September, of which the large-cap banks were very much primary victims, no longer applies.

But does this mean the big banks are now “cheap”, given how far they’ve fallen? Well that depends on just how “expensive” they’d actually become, and on domestic industry factors which were really not part of the Sell Australia consideration from the foreign perspective.

It’s been a tough couple of years for bank analysts, given all their prior experience of bank valuation has had to be compromised to acknowledge the fact solid and safe dividend yields have been the primary, if not the only, driver of bank share prices until recently. Yet even taking this on board, bank analysts became increasingly uneasy as Big Four share prices pushed up to their post-GFC highs in early September. Valuations, they just had to suggest, looked “stretched”.

Which is why this 5% pullback for the Financials index has come as somewhat of a relief. It has taken a lot of that “stretch” off the table, leaving bank analysts to focus more on traditional banking fundamentals. But fundamentals, too, have had to take a back seat, given the biggest issue confronting banks at present is the risk of forced capital increases due to new regulatory requirements. As the above linked article suggested, the banks may even be forced to raise fresh capital, just as they did in the immediate wake of the GFC. But ask three bank analysts of their opinion, and you’ll likely get three different answers.

Three of the Big Four are about to report FY14 earnings results, for their financial years to end-September. National Bank ((NAB)) will report on October 30, ANZ Bank ((ANZ)) on October 31 and Westpac ((WBC)) on November 3. Commonwealth Bank ((CBA)), which trades on an end-June financial year, will provide a September quarter update on November 5. If there is one thing bank analysts do agree upon, it’s that earnings results should be pretty solid.

UBS expects revenue growth will be the highlight, and the broker’s 5.8% forecast increase would represent the best result to date in the post-GFC recovery. Net interest growth should be the driver, UBS suggests, alongside solid balance sheet growth and tempered by only modest net interest margin compression. Wealth divisions have had a good year, although weaker trading income in second half will provide some drag.

Asset quality issues should remain benign, although UBS suspects there is no further downside for bad debt reduction. The broker forecasts 9% earnings growth for the sector, not taking into account NAB’s recent asset write-downs.

CIMB also expects a benign bad debt outcome, but does suggest trading income should have picked up in the fourth quarter from a weak third. The declining loan volume growth rate should have bottomed during the second half, and cost controls should also help boost earnings, CIMB believes. There is nevertheless a risk amortisation costs of the banks’ various new software investments will provide a headwind from here.

It all sounds very rosy, but Morgan Stanley believes the post-GFC earnings upgrade cycle is coming to an end. Over that period, the banks have enjoyed the benefits of bad debt losses falling back to normal levels, re-pricing of their variable mortgage rates, lower funding costs, and better operational cost discipline. Bad debts, as UBS agrees, have likely now troughed, the RBA is on-hold and not offering mortgage re-pricing opportunities (and the next move in the cash rate could possibly be up), funding costs have returned to more normal levels and operational costs have now been squeezed pretty hard.

Morgan Stanley is forecasting an 8% increase in sector earnings in FY14, but a fall back to 5% in FY15.

The reality, however, is that earnings forecasts are not currently the major factor behind bank valuations. Capital is. And on that basis, the banks have entered FY15 under a capital cloud, awaiting news of possible, if not likely, regulatory tightening. FNArena’s past two Australian Bank updates (follow the links from above) have explained these possible regulatory changes in detail.

A quick summary is that the banks will have to hold more capital as a buffer against general financial risk in a volatile world, as determined by the Murray Inquiry, and, separately, more capital against their investment housing loan books, as encouraged by the RBA, given the risk of an investment housing bubble. In the first case, the banks will either need to increase their “too big to fail” capital buffers through increased tier one capital generation or through increased “bail-in” unsecured debt issues. In the second case, the banks may be forced to hold capital representing up to 20% of the value of their investment mortgage books.

“We think higher capital targets will lower structural returns and constrain growth,” suggest the CIMB analysts, echoing the views of their peers. Even taking this recent share price correction into account, CIMB believes the banks are still trading at 15% above intrinsic value on a price to net tangible asset basis and on a price to earnings basis. The broker also warns that yield-based support from foreign buyers will continue to wane if the Aussie continues to fall.

Morgan Stanley continues to believe investors are underestimating the downside risk to bank returns on equity from the Murray Inquiry (aka Financial System Inquiry). The analysts are expecting David Murray will recommend the revision of major bank capital requirements to enhance financial stability, so that the banks remain at the forefront of emerging international standards and global best practice, and to help restore competitive neutrality in the domestic mortgage market. And on top of that, APRA will require the banks to meet more onerous mortgage-related capital requirements over the next few years.

All up, Morgan Stanley sees bank returns on equity around 1.5 percentage points lower than they are today. The analysts expect new requirements to lead to dilutive equity issues and concern about sustainable dividend payout ratios. On that basis, the broker suggests current price to earnings and price to book value ratios “still look full”.

Hold your horses, says Deutsche Bank.

“We believe that the concerns around higher capital coming from the FSI report have been materially overplayed with large increases in capital difficult to justify at this point.”

The Deutsche analysts believe an increase of around $5-10bn for the sector over 3-4 years is more realistic, and that this level of capital can be easily met through organic capital generation and will not require equity raises, and nor will it impact on return on equity estimates. They see the FSI following previous reviews in being more principle-based. They do not see the best tool for loss absorbance, the target of “too big to fail” buffers, as being increased tier one capital, rather they see bail-in bonds as more effective.

[Bail-in bonds represent senior unsecured debt the holders of which can, in the case of financial trauma, be forced to “take a haircut”, ie accept cents in the dollar on maturity, to avoid a government “bail-out” using taxpayer funds.]

Deutsche further notes Australian bank capital levels are already at the top end of international peers and believes an increase in mortgage capital would not be that significant. Moreover, history suggests ensuring the banks have the highest capital in the world provides only an incremental benefit while at the same time imposing a substantial cost on the local economy, the broker points out, and this is unlikely to be politically palatable.

On the basis that the market is already pricing in material equity raising necessity for the banks (Morgan Stanley suggests it isn’t), Deutsche believes the banks look attractive on a valuation basis at this point.

No one can argue, at the very least, that the sector is not facing significant regulatory uncertainty at this time. To that end, Citi prefers to stay on the sideline at present. “We hope to get more involved at lower prices,” say the analysts.

Credit Suisse is another broker taking a wait-and-see approach. Bank valuations have improved of late, notes CS, but do not appear to be outright compelling. They appear to be historically attractive relative to the ASX200 and compared to government bonds, but are still historically expensive based on dividend, price/earnings and underlying profit multiples.

Given the uncertainty, Credit Suisse does not see the upcoming results season as a likely positive catalyst for the banks and would like to wait until NAB, ANZ and Westpac all go ex-dividend, around the time the Murray Inquiry report is due to be tabled.

UBS believes that while the Murray Inquiry remains a point of risk, the likely impacts are quantifiable. Following the recent share price corrections, the UBS analysts’ key concern regarding bank valuations has been diluted. “Australian banks do not look cheap,” says UBS, “however, unless the economic situation deteriorates, we think the case for a material Underweight stance in the banks now appears harder to justify”.

With results season looming, we can now assess broker preferences among the Big Four using FNArena’s trusty bank table. And OMG, can it be true?

For many years, CBA has traded at a premium to its Big Four peers at a level bank analysts have almost perennially found overstated. FNArena regularly updates on Australian Banks but not any fixed timetable. Suffice to say, the above is the 29^th version of FNArena’s comparison table which was introduced shortly after the GFC. Never before now has CBA appeared in second place on a Buy/Hold/Sell ratio basis.

CBA did once, briefly, pop up into third, but beyond that it had seemed Australia’s biggest bank’s place was cemented at the bottom of the table, suggesting the greatest overvaluation. Now when we look at both upside-to-target and dividend yield comparisons, we find CBA neatly lined up with its peers.

It must be noted that a rather reliable trend, for those investors playing Australia’s banks off against each other, is that once CBA goes ex-dividend after its own FY14 result in August, traders like to sell CBA and buy the other three ahead of dividend payments after their October-November results. (And vice versa after November.) Thus, historically, now is a good time to buy CBA on a sector relative basis.

If not so on an absolute basis.

Technical limitations

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-Synergies yet to be realised
-Upside from new equities fund
-Stock now inexpensive
 

By Eva Brocklehurst

Financial services firm Perpetual ((PPT)) is considered by most brokers to be a bastion of stability. On the surface, fund flows were strong in the September quarter but opinions diverge is on just how much of the improved flow will translate to the earnings bottom line, and when.

September quarter inflows totalled $1.1bn, ahead of expectations, but several brokers observe the majority of this inflow was in lower margin cash and fixed interest products. The quarter was characterised by increased volatility towards the end, with strong gains in the fist two months reversing in September. Deutsche Bank also notes funds were sourced mainly from institutional clients, while the $300m net flow into Australian equities partly included reinvestment of the "abnormally" large distributions that were paid in the fourth quarter of FY14. Deutsche Bank retains a Buy rating but downgrades earnings forecasts by 1.6% in FY15 and 2.3% in FY16 because of weaker equity markets.

While the first quarter fund flows were the strongest for several years and the company's new equity investment company and global share fund should contribute to net flows in coming quarters, Citi lower earnings forecasts as well, by 3% and 6% for FY15 and FY16 respectively. The broker concludes that the company's strategy should eventually produce improved fund flows. The question for Citi is how long this may take.

Macquarie believes the company is well placed, benefitting from cost cutting and synergies from the Trust Co acquisition. To this broker Perpetual is a stable operation in the face of more challenging conditions and deserves an Outperform rating. JP Morgan acknowledges the positives and the clear path to near-term earnings growth via improved investor sentiment and acquisition synergies, but believes these are yet to drive meaningful results for the company. The broker prefers Magellan Financial ((MFG)) in the listed fund manager segment. JP Morgan also views Perpetual's establishment of the new global equities fund as a positive step.

To Morgan Stanley the company's valuation has been undemanding for some time. Prior to the September quarter report, the stock was trading at just a 5% premium to the ASX200. The broker observes the growth hurdle is being cleared and this should support a price/earnings recovery. Morgan Stanley believes there is the opportunity for the stock to re-rate further by demonstrating traction with its new global share fund. There was no update on the flows into this fund but it won approval from a large wealth management group in the quarter and Morgan Stanley believes this will support flows via financial advisers going forward. The broker also maintains earnings benefit will come from the Trust Co acquisition, offsetting an overweight footprint in Australian equities.

For Credit Suisse there is potential upside to earnings estimates if Perpetual completes a successful capital raising for its investment company. Inflows were strong but the broker noted a slowdown later in the quarter. Credit Suisse also remarks that equity flows benefitted substantially from the reinvestment of the June distributions. Still, the broker maintains the stock is inexpensive as it offers the highest earnings growth outlook among its peers. The broker forecasts earnings growth of 8% in FY15 and 14% in FY16, underpinned by funds growth, costs and synergies.

On FNArena's database there are five Buy ratings and three Hold. The consensus target is $48.50, suggesting 9.5% upside tot the last share price, and compares with $49.48 ahead of the quarterly report. Dividend yield on FY15 forecasts is 5.1% and 6.3% on FY16 forecasts.
 

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-Slow US growth pressures valuation
-Medium-term estimates reduced
-Acquisitions may fill product gap
-US sales model needs to change
 

By Eva Brocklehurst

Xero ((XRO)), the New Zealand-based cloud accounting software company, is having a tough time in the US. First half operating statistics revealed 22,000 US customers. The company has spent the money but is yet to gain a material foothold in the US market. In contrast, Australian customers have reached 158,000, with the company recording its fastest growth yet in an individual market.

There have been some teething problems with take up in the US, but Xero has a number of accountancy partners and further deals are expected. Still, Credit Suisse believes time is running out to fix early issues before the incumbent competition, Intuit, extends its lead. Intuit is well resourced and the broker fears Xero could become insignificant in the US market. Despite the company confirming 80% revenue growth guidance for FY15, Credit Suisse has decided to cut away the "blue sky" in valuing the stock. Substantial downward revisions are made to medium term estimates and probability weightings for the US scenario.

Valuation falls sharply, hence the broker's target is lowered to NZ$27.00 from NZ$43.00. The broker has downgraded FY16 customer expectations for the US as well. The US is now a top priority for management, with the potential for growth expected to emerge in FY17 once new leadership and strategic direction are established. That said, the broker acknowledges that Xero has, eventually, executed well in other markets and the US exposure is still at an early stage. An Outperform rating is maintained.

Goldman Sachs is also disappointed at the slow growth in US subscribers and believes structural factors will lead to slower growth, at a time when Intuit is having renewed success with QuickBooks Online. Diminished US growth prospects could put further pressure on Xero's trading multiple and the broker downgrades Xero to Sell, believing that medium term consensus sales estimates need to be reduced. Target is lowered to NZ$18.00 from NZ$35.00. Goldman has also pulled back its assessment of the US payroll opportunity with the emergence of cheaper "do-it-yourself" products such as Zen payroll, which deliver a similar service at a lower price than legacy providers. One positive counterpoint to the disappointing customer numbers was average revenue per subscription increased to NZ$309 per annum from NZ$304, driven by the strong growth in the higher-priced Australian market.

Expectations need to be modified, in Deutsche Bank's opinion. To justify its lofty 18 times FY15 revenue multiple Xero needs good momentum in the US market. The broker does not envisage the US foray will be easy going, with the company still needing to develop a full product suite that is customised to that market, as well as build a management team. This is a much larger market compared with the two relatively small markets in which the company has had much success, namely Australia and NZ. Growth has been exceptionally strong in Australia and firm in NZ. The UK business also grew in the first half and the broker expects that market growth will be weighted more to the second half.

Xero had 371,000 customers at the end of September, up 31% from March. Deutsche Bank has reduced its overall FY15 customer year-end forecast to 487,000 and pushed out expectations for the US growth ramp-up . Reductions in in earnings forecasts, by 10% for FY15, are partly cushioned by the recent fall in the New Zealand dollar. Xero has made small acquisitions in the past but now, as it is better funded, a larger acquisition that fills a gap in product capability, such as payments or tax in the US, could lead Deutsche Bank to take a more positive view on growth prospects. In the meantime, a Sell rating is retained with a target of NZ$18.50.

Xero has typically addressed its market via a sales network of accounting partners, but Goldman notes the US market is unique in terms of distribution. Some estimates indicate as few as 30% of small-medium businesses have an established relationship with an accountant. In contrast, in Australasia and the UK almost all small businesses file tax returns through an accountant. The broker believes this may be a cultural factor or, possibly, Intuit has disintermediated successfully to the accounting channel over time. Irrespective of the mix of these two factors, the broker believes Xero's sales technique is likely to be less successful in the US as a result. The broker acknowledges the company has recognised this situation and is changing its strategy to incorporate more direct marketing, and targeting of niche markets where it can gain a competitive advantage.
 

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- "New World" for banks might see increased need to raise extra capital
- Westpac most exposed to investment housing mortgages
- CommBank seems to have lost its premium
- All Big Four now trading well below consensus price targets
 

By Greg Peel

This article follows on from Australian Banks: Is It All Over? published on September 10.

As at yesterday’s close, the ASX200 had fallen 5.7% from its early September high. The ASX200 Financials sector index, which is dominated in market cap by the four Big Banks, had fallen 6.1%. As mega-caps on an Australian scale and high-yield on a global scale, the Big Four have been leading targets in this past month’s Sell Australia trade, which has seen foreigners exiting Australian equities in anticipation of a Fed rate rise.

A Fed rate rise would narrow the yield gap between the US and Australia and thus render Australian stocks less attractive to foreigners, but in the case of the Big Four there are also domestic forces at work. As the above article explained, local bank analysts are no longer pre-occupied by earnings forecasts per se but by domestic regulatory issues that could force the banks to increase their capital ratios.

Indeed, local analysts are now assuming increased capital requirements to be inevitable.

The regulatory attack is on two fronts: RBA concern over the domestic investment mortgage bubble and Financial System Inquiry (FSI) concern over capital safety buffers for Australian banks deemed “too big to fail”. On both counts the Australian Prudential Regulation Authority (APRA) is clearly keen on increased regulatory measures.

In order to stop the investment mortgage bubble getting out of hand, with Sydney and Melbourne the leading offenders, a 20% risk weighted asset floor for investment (as opposed to owner-occupier) mortgages is being touted. What this means is that the banks must hold a minimum 20% capital buffer against the value of their investment mortgage books, restricting leverage to five to one.

In order to account for the “smallness” of the Australian banking sector on a global scale relative to the “largeness” of Australia’s commodity-based (and therefore subject to heightened volatility as experienced recently, for example, with falling iron ore prices) economy and subsequent reliance on offshore funding, the FSI is leaning towards Australia’s Big Four holding an additional level of tier one capital beyond that already required by the Basel III global banking requirements.

In each case, and APRA is onside with both arguments, the Big Four would be required to increase their capital ratios beyond current levels, which are already above global averages. In very simple terms, more capital on the balance sheet means less money “going to work” and thus lower earnings potential. More capital reduces the opportunity for excessive dividend hand-outs.

But there is more than one way banks can increase their capital ratios without actually going to the market with new raisings, as was the case back in 2009. As to how the banks might respond to their requirements is a matter of great discussion among bank analysts.

Credit Suisse notes that investment housing lending represented 12.2% of all Australian system lending as at August. The prospect of “macro-prudential policy” being introduced through APRA, that is minimum required capital coverage of investment lending books, has increased and that in turn would impact adversely on the momentum of such lending, the broker warns.

Within the Big Four, Westpac ((WBC)) is overweight the sector in investment housing exposure, Credit Suisse notes, Commonwealth Bank ((CBA)) is sector-weight and National Bank ((NAB)) and ANZ Bank ((ANZ)) are both underweight.

Macquarie concurs that Westpac is most at risk, given 44% of its mortgage book is exposed to investor lending and it has the dominant position in NSW. The broker is now factoring in a 15% risk weighted asset (RWA) floor, rather than the full 20% being touted to date, which for Westpac and CBA affects a 1-3% value dilution and 2-6% reduction in the broker’s target prices.

Turning to the likelihood of additional capital requirements on the separate “too big to fail” issue, Macquarie sees a low to mid case scenario of 1-7% dilution and 1-14% valuation downside. Here Macquarie sees CBA as best placed to cope with the “new world” given its higher capital starting point, superior capital generation and superior deposit base. NAB is also better placed given its “self-help” capital plan, while the regionals, Bank of Queensland ((BOQ)) and Bendigo & Adelaide Bank ((BEN)) won’t be impacted by a RWA floor.

As to how the Big Four would come up with the additional capital required, Macquarie suggests lost return on equity would be recovered through deposit repricing. It is depositors who are the beneficiaries of any capital increase on a “too big to fail” basis, as they are the losers from failure. Hence the broker suggests they will need to pay this impost through reduced interest rates paid on deposits.

Citi has run its numbers on the assumption of the full 20% RWA floor. The broker estimates the Big Four will each require between $2.1bn and $4.1bn of additional core capital to meet such a requirement. Citi is another noting the more retail oriented banks Westpac and CBA, will be most impacted while the more business banking focused banks, ANZ and NAB, will be least impacted, along with the regionals.

Citi is assuming the banks would be granted a 3-5 year window within which to meet any new requirements, and has considered the means of raising such capital from the point of view of increased mortgage rates. Given increases of 45 basis points would be needed to achieve this, on the broker’s calculation, Citi believes the banks would only resort to acquiring half the necessary capital using mortgage rates, with the other half acquired with repricing across all of retail banking from mortgages, to deposits and consumer finance.

Citi is not at this stage factoring in additional capital on the “too big to fail” issue.

Morgan Stanley is certainly acting on a “too big to fail” impost assumption and has another spin on how the banks might raise the necessary capital. The broker estimates the banks will need some $39bn of additional capital to meet new requirements and believes they will primarily use dividend reinvestment plans (DRP) to do so up to 2017.

An underwritten DRP creates new shares to satisfy those shareholders who elect to take their dividends as shares rather than cash.

However, Morgan Stanley also sees an alternative capital raising scenario – large share placements in 2015.

The broker estimates that some $25bn of new capital can be raised via DRPs, leaving the banks $24bn short come the end of FY17. Thus the broker thinks it is possible the banks could undertake large capital raisings to meet the new requirements in 2015, despite any 3-5 year window provided by APRA. NAB is best placed to lift its tier one capital through asset sales but will still look to raise the balance in the market, Morgan Stanley assumes.

Indeed, Morgan Stanley suggests, given NAB’s new leadership team, the bank could justify a capital raising as early as the FY14 result in November. The post-GFC experience of 2009 showed the first in got the best price.

CIMB is assuming the combination of both regulatory changes will see the banks having to increase their tier one capital ratios from a current 8.0-8.5% to 10.5-11.0%. This would cut bank intrinsic values by 16-20%. Indeed, CIMB’s estimates of intrinsic valuation under a “new world” regulatory scenario are some 30% below yesterday’s share prices, and the broker expects the ongoing exit of offshore yield investors as the Aussie falls and US interest rates rise.

CIMB has moved the sector to Underweight.

Macquarie is less dramatic, suggesting the correction in bank share prices to date is starting to, albeit not yet fully reflecting the potential new valuation reality – except for CBA. The perennially “overvalued” member of the Big Four has now seen its share price fall to the bottom of its historical trading range versus its peers.

This becomes evident when we look at FNArena’s Major Bank Data tables. The table below was updated for the previous article (linked above) on September 10, which was just when offshore selling started to pick up.
 

Note that ANZ’s share price was still 3% shy of the consensus target price, while NAB and Westpac were trading very near and CBA, as it almost always does, was trading above. However brokers have since adjusted their target prices to some degree but not to an extent which reflects the past month’s fall in share prices. Hence in the new table, updated to yesterday’s closing prices, we see a different picture.
 

ANZ still remains furthest short of its target, at 9%, but the other three are now lined up like ducks around 5-6%. For CBA to be on an equivalent percent-to-target level as peers is almost unheard of.

Of course, of all the speculation laid out by brokers above, little is yet to be fully factored into analyst valuations and targets given it is just that at this stage – speculation. The FSI recommendations are due from November, but could be delayed until into next year. On the matter of mortgage controls, one gets the feeling something could happen any moment, but these things usually take time.

So where does this leave Australia’s bank shareholders? Given yesterday’s solid bounce in bank share prices one would have to suggest “eyeing off those 5-6% fully-franked yields”. But the speculation from brokers above would tend to suggest bank prices may well have lower to go, and if the banks did raise capital (directly or via DRPs), those yields would be diluted.

Technical limitations

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