- Banks no longer way overvalued
- Yield support on offer
- Credit outllook subdued
- Earnings growth outlook minimal
 

By Greg Peel

While weak data and credit squeeze ramifications in China have provided one driver for the Australian stock market’s correction from the May highs, speculation and then confirmation that the US Federal Reserve is considering just when it might begin to ease back on its bond purchases and slow down QE have effectively burst Australia’s manic yield bubble. Local investors have been eager to put their money in bank, telco and other high-yield shares as the RBA cash rate, and thus bank term deposit rates, have fallen.

But investors from the rest of the world, particularly in the US and Japan, had been the most influential driving force behind Australia’s yield rally, given  as good as zero interest rates at home. The sharpness of the subsequent pullback lends itself not only to increases in both US and Japanese government bond yields, but also to concurrent weakness in the Aussie dollar, threatening a double-whammy of losses for offshore investors.

Australia’s banks are very popular offshore, having come through the GFC relatively unscathed, being backed by deposit guarantees from a AAA-rated government, and providing world-leading dividend payout ratios at a time major global banks are still paying back government bail-out funds. But the allure dissipates when yields start to rise at home.

May saw the big sell-off in banks, while June provided volatile consolidation as the resources sector copped the brunt on China fears. The banks out-peaked the index in May, fell similarly but pulled up faster on yield support. Domestic investors remain attracted to fully-franked bank dividends at the right level even if offshore investors are happy to get out. The major banks rose an average 2.8% in June to the ASX 200’s 2.5% fall.

For the year ended June, the ASX 200 rose 17.1%, significantly outperformed by the major banks over the period. Westpac ((WBC)) recorded a 37.1% rise, Commonwealth Bank ((CBA)) 30.3%, ANZ Bank ((ANZ)) 29.7% and National Bank ((NAB)) 26.1%. We do not see such numbers very often. And they include the pullback in May. Below is a chart of the ASX financials ex-REITs index (XXJ).
 

Strength in bank shares prices over the year was all about dividends and had little to do with actual earnings. Australia’s subdued credit market has ensured minimal earnings growth from traditional banking, rather growth has been provided from the return of bad debt provisions, as GFC tail risk rolls off, and from beneficial mortgage repricing (not cutting SVRs by as much as RBA cuts).

Subdued demand has nevertheless led brokers back to competitive mortgage pricing but on the flipside deposit bases are now stronger and offshore funding costs fell over the period. Capital ratios are now the envy of the world and provision returns have allowed the banks to pander to a yield-hungry market with increased payout ratios and special dividends. The market pullback has returned share prices to a level at which yields are once again attractive. But whereto from here?
 

The above table suggests that across the eight leading brokers in the FNArena database, the Big Four banks attract a total of 13 Buy or equivalent ratings, 14 Hold and 5 Sell. The only notable change from the last FNArena bank update in May is that ANZ has gained two more Buys, from previous Holds. Despite brokers almost universally agreeing that peak price levels overvalued the banks, analysts were reluctant to stand in front of the locomotive of yield demand. It took Fed speculation to deflate the bubble, and at lower price levels analysts can now feel a little more comfort about their recommendations.

That comfort is reflected in the fact share prices exceeded consensus target prices at the peak but now targets exceed prices, with the exception of CBA. The level of upside to targets largely determines the consensus order of preference with the exception of Westpac, which exhibits both the lowest FY14 earnings growth forecast and the lowest dividend growth forecast, having delivered its dividend goodies in FY13.

Note that only CBA reports on a June-end financial year, with the other three reporting on a September-end financial year.

Yields have also now improved to an average of around 6% before franking. Given the banks pay dividends based on a ratio of earnings, the actual quantum of dividend paid will still be determined by earnings achieved unlike, say, Telstra, which offers fixed quantum dividends. Thus the earnings growth outlook remains important for bank investors.

APRA's latest credit data, for May, provide some clues as to earnings growth potential going forward. System credit grew 0.3% in May for 3.0% annualised growth, the weakest point in almost two years, BA-Merrill Lynch notes. Macquarie was at least prepared to suggest “some green shoots sprouted in May”.

Lending for housing, which represents around 60% of system credit, was up 0.4% for the month and 4.5% year on year, with CIMB noting the same 0.4% and 4.5% combination was recorded in April. Business lending, at 34% of system, rose 0.1% in the month and 0.9% year on year, compared to 0.2% and 1.4% in April. Personal lending, at 6% of system, maintained its weak performance by falling 0.1% in May and 0.2% year on year. The numbers might suggest that while personal lending, which includes credit cards, remains firmly in the doldrums, and business lending is still struggling to grow, housing lending looks okay. But CIMB notes the annual housing growth rate is the lowest since the RBA started keeping track in 1976.

This despite the RBA’s cash rate having fallen from 3.50% in June 2012 to 2.75% in June 2013.

Merrills believes that while RBA cuts have not managed to spark lending growth, they have at least stabilised otherwise weak credit demand. The outlook remains clouded, nevertheless, as households continue to deleverage and business confidence continues to wallow. CIMB suggests business lending continues to slow on a cyclical basis, suggesting a cycle-up is still ahead, some time. Mortgage lending, on the other hand is structurally weak, reflecting an end to the big house, big mortgage frenzy of pre-GFC years.

Breaking down mortgage lending – the banks’ largest loan book percentage – sees NAB achieving 7.9% housing loan growth in the June quarter, ahead of ANZ (7.1%), CBA (6.7%) and Westpac (3.8%). Westpac’s low growth reflects the bank’s base SVR rate which remains materially above peers, JP Morgan notes. Having soaked up a lot of mortgages immediately after the GFC, Westpac appears to be continuing on a path of rebalancing its lending book break-down – one reason it is least preferred in the group by analysts.

On the other side of the ledger, Westpac nonetheless showed the greatest deposit growth in the June quarter at 7.4%, ahead of CBA (5.5%), ANZ (4.5%) and NAB (4.2%). Note that the deposit growth numbers are the diametric opposite of mortgage numbers in bank order. JP Morgan notes that while the banks recently chose to pass on at least the full RBA rate cut, falls in deposit rates were not commensurate. This implies bank net interest margins, a bank’s underlying life blood, have tightened.

Macquarie suggests that in such a low growth environment, improvements in bank product penetration and profitability are vital. The analysts find that Westpac dominates institutional product profitability at 40% above average, while ANZ and NAB dominate SME/corporate profitability, at 20% above average. Macquarie thus suggests ANZ and NAB have the greatest upside from increasing product penetration, and are the broker’s top two picks.

Another issue of concern in banking at present is the life insurance sector, a business banks also indulge in. AMP’s recent profit warning highlights, notes UBS, that the banks are also vulnerable to the elevated claims and policy lapses which have undermined AMP’s life earnings.

Banks also perform better in periods of central bank easing than they do as central banks tighten. This makes sense, given the intention of rate cuts is to encourage credit growth and the intention of rate hikes is to curb credit growth. While at least one more rate cut is expected from the RBA in the near future (Macquarie has predicted as many as three 25bps cuts yet to come), the reality is the bottom of the cycle is approaching at some stage. The RBA cash rate is already at an all-time low.

Deutsche Bank notes the banks have outperformed the broad market by an average 25% in the past five RBA rate cutting cycles. When the bottom of the cycle is established, banks outperform only mildly for three more months before giving way to underperformance over the next 12-18 months as rates rise again. Note that underperformance does not imply lower share prices or indeed, poor performance. It is merely a comparison to market, and in Australia’s case the big resources companies tend to shine in rate hike cycles (given rate hikes imply a strong economy), relegating the banks to underperformance in comparison.

Deutsche does note that there is no apparent correlation between Australian bank performance and US bond yields. Hence the Fed-related bounce in US Treasuries recently should not impact on Australia’s typical bank performance trends.

UBS continues to view Australia’s banks as “strong, well-managed, high quality companies”. The analysts remain concerned about some sectors of the economy but believe the weaker Aussie, RBA rate cuts, strong corporate balance sheets and a firming housing market provide a level of protection. The performance of banks is closely tied to the performance of the overall economy, and UBS suggests “unemployment remains key”.

Merrills has proven itself a little more pessimistic in recent forecasting, suggesting the Australian economy will struggle through its transition from mining-dependent to not. The analysts expect very low GDP growth numbers for FY14-15 and have suggested a 25% chance of actual recession (as measured by two quarters of negative growth). Under such a scenario, the risk of bad debts, and thus bank bad debt provisions growing again, provides an additional earnings risk for banks.

As for current bank valuations, Deutsche finds that at an absolute level and compared to the All Industrials index ex-banks, bank price/earnings ratios are broadly in line with historical averages coming out of rate cuts. On a comparison to the All Ordinaries, bank PEs are still higher than previous periods, but this is largely due to the more severe de-rating of the resources sector.

UBS suggests that at an average PE of 12.2x, 2.0x book value and offering 6.4% yield, the banks are “still not cheap”. But much of the “extreme valuation stretch” has been removed.

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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-Potential upside to savings
-Transition to Manila going smoothly
-Premium rate increases to taper off
 

By Eva Brocklehurst

QBE Insurance ((QBE)) has added detail to the transformation strategy currently underway. Brokers are upbeat on the company's progress and encouraged by the strengthening balance sheet as well as optimistic about further upside to savings. Catastrophes have been relatively benign so far this year and reserves appear roomy.

QBE was affected by three material catastrophes in the first half including Cyclone Oswald, the Oklahoma tornadoes and the European floods (which were worse than 2002). Individual risk losses included a landslip at a copper mine in Utah and the collapse of a railway line in the UK.

The company has conservatively forecast that initiatives should deliver expense savings of at least $250 million by the end of 2015. The company advised of some added benefits to the claims line of around $90m. Most brokers had incorporated the savings already into forecasts but were keen to get any additional information. The transformation plan is on track and forecast implementation costs have fallen by $20m to $310m.

Key to the update was the transition to the Global Shared Services Centre (GSSC) in Manila. Australian operations are on track for completion by the first quarter of 2014. North America will follow, running from the fourth quarter this year to the second quarter 2015 and Europe will run from the second quarter 2014 to the second quarter 2015. Savings are expected to be split one third to Australia, one half to North America and the remainder to Europe. Morgan Stanley notes Australia seems to be running ahead of plan, North America is commencing execution earlier than expected and targeted savings in Europe appear conservative.

Manila was selected as the location because of a highly educated workforce, cost competitiveness and reliable infrastructure. The company assured brokers the process was being staged carefully and larger, more complex claims would continue to be managed locally. High volume operations are being sent to Manila while in-depth operations will stay in Australia, so senior underwriters can spend more time on value-adding work. Complex claims over US$100,000 will remain in Australia.

Some of the company's global competitors have already moved to access low-cost labour via offshore operations. QBE has the advantage in the Philipppines, in Deutsche Bank's observation, because of employee preferences for Australian companies, shift hours being more favourable. This suggests the company could leverage offshore operations more so than peers, providing some structural operational advantages which position QBE more favourably on the cost curve.

Premium rates have been relatively strong in the first half, outside of the UK and Europe, but the company expects this to taper off in the second half, which makes the top line a little more challenging. Capacity is placing pressure on premiums but, as these were up more than 5% in the first half, QBE is confident on delivering on guidance. Morgan Stanley highlights the preference for margin over top line growth as a positive factor. Credit Suisse does warn that comparing QBE to some peers is dangerous, particularly locals. The business mix is different to most listed players. The broker avoids the temptation to benchmark QBE's expenses against some of the larger peers and believes insurance margin and return on equity are the best indicators of success.

In terms of the first half, investment yield is expected to be in line with guidance of around 2.25% and the sustained Australian dollar weakness is considered positive for the Australian earnings although adversely affecting US$ reported premium and earnings. It has been a relatively quiet period for catastrophe incidents but the bigger risk resides in the second half. US hurricanes are the main risk for QBE, while US crop exposure is also skewed to the second half. Other features of the update were within expectations. The dividend is expected to be weighted 40% to the interim and 60% to the final payment.

Reinsurance rates have softened. Morgan Stanley notes these rates are down around 10% globally and as much as 15-20% for Texas wind events and Florida catastrophes, but then QBE does not write much business in these areas. As a net acquirer of reinsurance this is viewed positively as the January 1 renewal approaches. QBE writes a US$1.4 billion inwards reinsurance book against buying US$2.5bn in reinsurance cover.

QBE will look at selling non-core assets by the end of the year and there are potential proceeds around $80 million. So far it has confirmed the sale of Australian broker agencies (NCIB) and Invivo to Steadfast, provided the IPO is successful, and plans to offload a majority stake in QBE Macedonia.

Overall, brokers are firm but conservative on the ratings front. On the FNArena database there are six Hold and two Buy ratings. There are no Sell ratings. The consensus target price is $16.06, suggesting 2.1% upside to the last share price. The target price has risen from $14.82 a week ago. Target prices range from $13.55 (JP Morgan) to $17.80 (Deutsche Bank).

Deutsche Bank rates the stock a Buy. This is supported by earnings and savings being on track and an improving macro backdrop, as well as the confirmation the turnaround is progressing well. The key upside risk is the additional cost savings. The broker notes consensus factors in only 50% of the implied 220 basis points of ITR margin benefit. In addition, the potential for claims procurement savings has now been quantified ($90m) which could lift profits a further 4% if not reinvested. This should benefit underlying margins by up to 1.9% by FY16, in the broker's view.

Macquarie has hailed the rapid progress being made and expects the cost cutting program will result in consensus earnings upgrades, retaining an Outperform rating. The broker also expects upside to the savings potential with scope to remove costs from Europe as well as North America and Australia. Macquarie notes no IT benefits have been factored into the savings as yet but they were identified, such as labour cost reductions and processing efficiencies. QBE is Credit Suisse's preferred pick in the sector, having addressed debt issues and with management lining the business up for future growth.

For UBS the overhaul has been long overdue and there is an element of catch-up to other global insurers in this respect. Nevertheless, the company is considered to be executing well. Along the same lines, CIMB considers the insurer is on track, but cautions that the recent rally, based largely on external factors, means the share price now looks to be incorporating much of the potential upside.
 

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- AMP profit 12% below forecasts
- Wealth protection big loser
- Structural trends underlie
- Analysts remain cautious

By Greg Peel

Wealth manager and insurer AMP’s ((AMP)) share price had been rising steadily since mid-last year before peaking in May. The peak coincided with the sharp Fed/China-related plunge in the Australian stock market, highlighting the market’s perception that if the stock market is rising, AMP’s funds under management performance must also be rising, offering growth on a solid yield.

The share price pullback in June confirms this perception, with AMP punished along with just about every other Australian stock. Yet as investors continued to buy AMP shares in May, they didn’t know what was going on behind the scenes in AMP’s other sizeable business, life insurance, and specifically wealth protection (WP). There was no need for investors to be concerned given an upbeat assessment from management on the WP division at the company’s AGM on May 9.

Yesterday management downgraded its FY13 profit forecast by what amounted to a 12% reduction from consensus forecasts. The downgrade was mostly driven by $32m of life “experience” losses in WP over the five months to May, with the business now expected to provide a $54m first half 2013 profit when analyst consensus was sitting around $100m. The downgrade came as a shock, and unsurprisingly analysts have rushed to cut their earnings forecasts for both 2013 and 2014 and slash share price targets.

The shock element related mostly to the seemingly sudden deterioration in May in WP, given management was upbeat at the beginning of May, and less to the problems actually driving the losses. Has management really got a handle on what’s going on? The $32m loss breaks down into, adjusting for costs, $26m in claims and $8m in lapses, with half the claims stemming from income protection and the other half from deaths.

The first thing every broker noticed immediately was that a surprisingly large number of policy holders died in May. Anyone would think there’d been an epidemic. Analysts are at a loss to explain this spike, but all assume it’s just that – a statistical spike – and that the numbers will normalise ahead. But it is income protection claims and policy lapses causing concern. Recent commentary from National Australia Bank noted a heavy rise in disability claims over the past quarter, CIMB points out, and further anecdotal evidence suggests rising disability claims and lapses have become and industry-wide issue.

FNArena has observed ubiquitous funeral insurance ads on television now seem to have given way to a proliferation of income protection insurance ads, from everyone from AAMI to Virgin. The market appears to have become very competitive. Why else let a particular life insurance policy lapse?

“The underlying causes of [experience losses] are structural, industry wide and not easily fixed,” suggests Macquarie. The structural issues in the Life sector the industry is trying to address include product design, especially around mental health in income protection, lapse rates, particularly with regard to upfront commission structures for insurance planners, claims management and the increased propensity of policy holders to claim, and pricing structures which see some premiums increase as policyholders age. Goldman Sachs suggests the market has already been well aware of the lapse and disability claim issues facing the industry, and Deutsche Bank is not alone in assuming higher disability claims and rising lapse rates will potentially be recurring.

Cyclical pressures are likely to remain a headwind near-term, says Deutsche, given unemployment is expected to drift higher by year-end. The broker estimates every 1% increase in unemployment increases disability claims by $45m.

That seems strange. Why does unemployment lift disability claims? Perhaps the answer lies in AMP’s intentions to lift claims management, including fraud capabilities. AMP also plans to restore profitability through early intervention strategies and return-to-work initiatives, but Deutsche notes progress will be slow. Perhaps the most fundamental issue to address is summed up by UBS, with the broker noting “an industry approach to advisor remuneration structures is back on the cards again”. UBS suggests ACCC approval could take well over a year, nevertheless, and in the meantime economic pressures aren’t easing.

Have we seen this movie before? I seem to recall it was a decade ago when a backlash against fees and planner kick-backs led to a great migration away from the traditional wealth managers, of which AMP is one. What next, self-managed life insurance?

AMP’s other plan of attack to restore profitability is simple – just raise premiums. Analysts agree there is scope to do so given the problem of rising claims is industry wide and not specific to one insurer. Yet analysts also warn that to raise premiums at a time of economic weakness is to tread a very fine line, with a risk of increasing lapse rates beyond their current levels. Can the industry raise premiums in unison?

“We’d feel more comfortable with AMP at current levels,” says UBS, “if the roadmap to a restructured life industry was clearer to understand”.

Outside of the FNArena database, Morgan Stanley retains an Overweight rating on AMP, believing patience is merely required as the company turns the ship around. MS suggests there will be no recession in Australia and that we are at the early stages of an equity market recovery. The market has overreacted to the life insurance risks and adverse “experience” has likely peaked, the analysts suggest, while AMP can happily operate on a lower cost model.

Morgan Stanley engenders little support from its FNArena database peers. JP Morgan is arguably leaning to the positive side, but retains Neutral nevertheless, joining all but one other broker on an equivalent rating. Both Deutsche Bank and BA-Merrill Lynch have downgraded to Hold or equivalent ratings post the profit warning, with Merrills fearing a worsening economic backdrop and Deutsche believing uncertainty over industry pressures will likely keep investors on the sidelines. Macquarie agrees the negative experience from the WP business will continue, but on yesterday’s 13% share price fall has actually upgraded to Hold from Sell (Neutral from Underperform), while UBS wants to wait to hear more at the first half result and is sticking with its Sell rating at this time.

Following substantial forecast adjustments, the consensus target in the database drops to $4.75 from $5.37. Given AMP works on a payout ratio of 70-80% of underlying profit, Citi is among those cutting dividend expectations. Consensus yield forecasts show 5.4% for 2013, rising to 6.0% in 2014, but earnings growth is expected to fall next year.

Many Australians hold AMP shares given many Australians were policyholders at the time of demutualisation. Listed wealth manager/insurers always have a fundamental issue to deal with, being a conflict of interest between who should benefit most from the business, the policyholders or the shareholders? One offsets the other.
 

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