- Results mostly positive, except NAB
- Capital rule changes restrict further dividend increases
- Overvalued, but understandably so
By Greg Peel
When Westpac ((WBC)) delivered its interim profit result earlier this month, management revealed it had just been advised by the Australian Prudential Regulation Authority of another change to its calculation of Common Equity Tier One (CET1) capital which removes a previous accounting anomaly. I defer to CLSA’s bank analysts to define the change:
“Until [the] announcement the reported Level 2 capital ratios of Australian banks deducted the equity invested in non-banking subsidiaries after netting out Non-Recourse Debt, which in effect meant that NRD issued in a life subsidiary reduced the regulatory capital deduction in the holding company thus effectively creating CET1 in the bank”.
What the gobbledigook means in simple terms is that banks have been for years pulling a bit of an accounting swifty, without APRA’s interference, whereby the netting out of debt held in wealth management/life subsidiaries implied, via some smoke here and a mirror there, a rise in the tier one capital ratio on the other side of the group ledger. That game is now up.
This is an important development in the Australian banking sector as it comes on top of new Basel III regulations which require all global banks considered to be D-SIBs (domestic, systemically important banks, or in colloquial terms, “too big to fail”) to maintain a tier one premium over non D-SIBs and a decision by APRA to add an additional capital buffer requirement locally. This means the Big Four have to increase their capital ratios even further than they had previously assumed.
The flipside of being required to hold more capital is potentially the inability to hand capital out, such as in the form of special dividends or increased dividend ratios. Less onerously, the banks may be forced (if they haven't already) to stop “neutralising” their DRPs (dividend reinvestment plans), such that DRPs herewith taken up by investors create new capital which dilutes earnings per share, or perhaps to divest of assets.
Clearly, required capital ratios, no matter how befuddling in their calculation, are vitally important to bank investors as they are instrumental in determining funds available for distribution, and thus yield, for shareholders.
It is important to clear this up before assessing bank performance as revealed in the recent round of interim profit results, or in Commonwealth Bank’s ((CBA)) case, quarterly update. Investors aren’t impressed by dollar figures that provide healthy fodder for a sensationalist mass media, they are interested in knowing how much do I get in terms of handouts – now, and in the future. And that all comes down to just how much capital the banks are holding.
The new D-SIB plus buffer requirements have taken required Big Bank tier one ratios up to 9.00-9.25% rather than the 8.25-8.75% ratio previously assumed. The new APRA accounting rule affectively adds even more by eliminating a double negative. Different banks will nonetheless be impacted differently. Brokers have calculated this double negative in the form of a capital ratio “headwind”, measured in basis points. CBA has the biggest headwind, at around 65bps, National Australia Bank ((NAB)) is next on 53bps followed by ANZ Bank ((ANZ)) on 20bps. Westpac has no debt in its subsidiary and hence will suffer no headwind.
The risk is that in the wake of the bank’s recent results, their focus will now have to shift away from popular capital management and back to mundane task of rebuilding tier one capital. Before the Australian banks started handing out the candy these past months they, and the market, had assumed their capital ratios were at levels that were more than sufficient to satisfy the new regulations.
The banks do, nevertheless, have some levers they can pull before the candy is withheld.
CBA (current CET1 8.5%) carries a big debt position in its Colonial funds management subsidiary but can reduce its headwind by around 30bps with proceeds from the sale of its property platforms and management rights in Commonwealth Property Trust, 15bps by selling its Visa shares and another 20bps with its already activated DRP. That’s 65bps. CBA also boasts strong organic capital generation.
NAB’s (8.4%) organic capital generation is relatively weak, and it carries debt in its NAB Wealth Management subsidiary. The new rules will likely force the hurry-up of the sale of UK assets, an exit from life insurance and the activation of a DRP.
ANZ’s (8.3%) capital is already under pressure given the growth of its risk-weighted assets in Asia and relatively weaker organic capital generation. The bank may have to sell down some Asian partnerships or reconsider its payout ratio.
Westpac (8.8%) is the winner all round, with a peer-leading CET1 and zero headwind from the rule change. The bank will retain its DRP neutralisation.
Put it all together and the Big Two are pretty safe on the capital front, while the Small Two will feel the squeeze. With that in mind, we can now take a look at the banks’ result performance.
Overall, sector revenue growth was impressive, suggests UBS, although if you take out positive forex movements and a rebound in volatile proprietary trading profits, underlying revenue growth was only a little better than the previous half. Profit growth was nevertheless “healthy”, aided by operating efficiencies and yet another reduction in bad and doubtful debt (BDD) charges.
ANZ’s result was “solid”, the broker believes, although stronger growth in Asia offset a softer than expected result in A&NZ. ANZ tried to thrill the market with an increased dividend payout but this failed to impress given a “very light” CET1. See above. NAB’s result was “not pretty”, given weaker revenue. The business bank is under pressure and the personal bank has lost momentum. NAB’s result was only saved by lower BDDs.
CBA’s result was “impressive” on strong revenue growth. Indeed, CBA generated 80% of incremental banking system revenue and is in a good position ahead of its full-year result. Westpac’s result was “solid, clean and predictable”, although while the business is performing well, WBC is not generating the revenue growth of CBA. The bank’s asset quality and capital levels are nevertheless sector-leading.
Citi found the bank’s earnings to be largely in line with expectations on a net basis, but compositionally a little weaker. Institutional and commercial lending spreads have contracted leading to lower net interest margins (NIM) for the banks (their bread-and-butter profit spread between borrowing and lending rates), which were masked by those aforementioned reductions in BDDs.
One day in the not too distant future, post-GFC BDD reductions will finally bottom out, leaving banks dependent on those traditional lending spreads once more and thus dependent solely on growth in credit demand. CLSA’s analysts sat through all the result presentations and could not help but wince at an a dangerous degree of “optimism into perpetuity”, with managements seemingly expecting loan losses to forever stay low and finding capital requirements a mere distraction. The analysts also sensed, given the decline in NIMs, the beginning of another price war among the Big Four to win market share in a low credit growth environment.
While Citi sees bank valuations as presently “full”, the broker also sees strong bank share prices as inevitable given global liquidity trends, record low interest rates and the global investor’s search for yield. CLSA warns bank share prices continue to be driven by the global macro environment rather than local micro and stock-specific factors. Underlying share prices is global QE, with Japan the newest member of the club (and Europe about to ramp up again).
Indeed, CLSA would not be surprised if bank dividend yields fell from their current levels of around 5% (via further share price appreciation) towards the “QE-compressed” local ten-year bond rate of 3.8%.
BA-Merrill Lynch is maintaining a cautious stance. Given valuations are indeed “full”, the banks are offering little in the way of a defensive buffer if things turn a bit pear-shaped in global markets once more. Low volatility favours the relative performance of major banks and the volatility index (VIX) is nearing seven-year lows. “We suspect a reversal is not far away,” says Merrills, and Wall Street is looking just a little shaky.
So how do the Big Four line up in relation to one another, post the result season? Well as always, rarely do two brokers agree on an order of preference. But FNArena’s Stock Analysis provides a consensus view. As usual, we’ll look at where the banks sat in consensus terms leading into the season, and compare that to the state of play thereafter. The first table is the pre-season summary:
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The standout in this table is the fact other than NAB, the banks were all trading above consensus targets before their result releases. When this happens, either share prices must fall, or analysts must raise their targets, or in this case, a bit of both. If we now take another snapshot based on yesterday’s closing prices, this is what we see:
Consensus targets have risen for ANZ, WBC and CBA but fallen for NAB. On a before and after basis, closing prices are lower for ANZ, NAB and WBC but higher for CBA. Thus only CBA remains at a level above the consensus target, and not by much. But CBA almost always trades above target.
The market appears to be least optimistic about NAB compared to the consensus analyst view, despite analysts lowering their targets.
In terms of ratings, the order of preference remains entrenched although NAB has lost a Buy rating. On a net basis, ratings before the season totalled 11 Buys, 13 Holds and 8 Sells, and after the season the totals are 10 Buys, 14 Holds and 8 Holds.
In other words, despite all the talk of overvaluation, growing macro risk and so forth, the only change post season (net) is one Buy falling to a Hold.
Technical limitations
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