- CommBank widely expected to announce additional capital management in August
- Big Four Bank shares widely seen as fully valued, but brokers reluctant to take a negative stance
- Thirst for yield might still push up share prices higher
- Questions whether Big Four Banks are currently in a sweet spot

By Greg Peel

Last week Commonwealth Bank ((CBA)) provided a brief update of its position post the March quarter. The update provides bank analysts with a chance to contrast/compare all four major banks following the interim reports offered earlier by each of ANZ Bank ((ANZ)), Westpac ((WBC)) and National Bank ((NAB)). CBA is the odd bank out in accounting on a June year-end while the other three account on a September year-end.

This reporting mismatch has arguably never been as significant as this time around given CBA announced its interim dividend in February while the others have announced their interims this month. Never before has a market been so obsessively focused on yield, and such a focus has come to a head in 2013. To that end, ANZ and Westpac have played to the crowd and announced an increased payout ratio (ANZ) and a special dividend (WBC). No doubt NAB would have liked to have followed suit, but for the capital impact of bad debts in NAB’s UK business. CBA’s earlier interim dividend was nothing out of the ordinary, so the pressure is now on for the bank’s final dividend, to be announced in August, to deliver.

Unlike the other three’s interim profit reports, CBA’s quarterly update was scant on detail, yet there was enough for analysts to suggest the bank’s quarterly profit largely matched the “run rate” of second half forecasts, and to suggest its breakdown was similar to peers. UBS echoed other brokers in summing up the highlights as soft revenue, given low growth across the Australian banking system, improved net interest margin, given loan repricing (not passing on RBA rate cuts in full), reasonable trading income, well managed cost control, and lower bad debt charges. CBA’s asset quality remains benign, UBS suggests, and organic capital generation is strong.

The simplest split to make between the Big Big Banks (CBA, WBC) and the Small Big Banks (ANZ, NAB) is that the former lean more towards retail banking and the latter towards business banking. We recall that CBA and Westpac went somewhat berserk snatching up mortgages in 2009-10, both by acquiring smaller banks and non-bank loan books and by attracting the bulk of government-subsidised first home buyer stimulus. Once loaded to the gunwales, both then backed off by actively being less competitive on mortgage rates. JP Morgan notes that after three years in the wilderness, CBA is back to growing its mortgage book. This has helped to offset a lack of growth in the business book.

That’s all well and good, but of course for investors the question is: what about yield? Will CBA match peers, come August, in announcing an increase in capital return?

The Australian credit market is very subdued, with the long process of post-GFC deleveraging still continuing from both households and businesses. Earnings growth is therefore hard to come by from traditional operating income. BA-Merrill Lynch acknowledges that we might at least be seeing the beginnings of a more sustained recovery in housing finance, but the response to date has been less than typical of what one might expect from 200 basis points of RBA cash rate cuts. While credit demand has not yet rebounded from the GFC, offshore funding costs have fallen considerably from GFC panic rates and GFC-inspired bad debts are rolling off.

The banks have also been on a concerted drive to attract deposits over the last few years, and term deposit investments have proven very popular. Cost cutting has also been prevalent, outside of IT upgrades which ultimately provide greater efficiency. The bottom line is that if we take increased deposits, cheaper funding, fewer bad debts and lower costs on the one hand, and subdued credit demand despite low base interest rates on the other, Australia’s banks effectively all dressed up with no place to go. They have the capital security to invest in the “normal” business of offering loans, but customers are few and the outlook does not yet suggest a rebound in demand. What, then, to do with the excess money?

Return capital, of course. What we have witnessed in this six-monthly bank reporting season is a demand for yield from the market and the capacity to provide such yield from the banks. NAB is the exception, albeit brokers assume that NAB will also be able to join in the hand-outs shortly as its UK bad debts run off. CBA is yet to deliver its capital gift, if it is to do so, because the bank reports on a different cycle.

At its quarterly update, CBA management noted that “shareholders want the payout ratio optimised”. The bank’s current dividend policy, dating back to the February interim report, is to deliver a payout ratio of 70 to 80%. The interim dividend announced in February represented a ratio closer to 70%. Analysts are now assuming CBA will either lift its payout ratio come its full-year report, al la ANZ, or offer a special dividend, a la Westpac.

For shareholders, an increased payout ratio is more attractive than a special dividend, and for the banks the opposite is true. “Special” means what it says, and implies “this is a bonus only and don’t think there’s necessarily more down the track”. A lift in payout ratio, on the other hand, sets a precedent. Banks are heroes when they lift their payout, but villains when they reduce them, as they did in 2009. Right now, in a yield hungry market, the banks are being taunted into lifting their payouts and were they to reduce their payouts later, they would be crucified by the angry mob. Westpac’s payout ratio was already peer-leading, so a special made sense rather than a further lift. ANZ’s payout was bottom-of-peer, given the bank was using capital to develop its Asian business, so it made sense for ANZ to lift its ratio.

CBA lies in between. Hence analyst opinion lies in between. Morgan Stanley, for example, believes CBA will lift its payout to 78% for the final dividend. JP Morgan is also now assuming 78%. Citi, on the other hand, suggests “the bank may be in a sufficiently strong capital and franking credit position at FY13 to be able to add a small special dividend to shareholders,” while Macquarie suggests that while a special final dividend is possible, it depends whether CBA would then be comfortable with a lower capital ratio than peers and whether the bank is happy to use its franking credit surplus.

The franking credit issue is not an insignificant one. Australian investors have grown used to Australian banks not only offering attractive nominal yields, but offering fully franked yields. Yet each of the four Big Banks has at least some level of offshore operation; in New Zealand for example, and in NAB’s case the UK and in ANZ’s case Asia. It is only because the banks have been accumulating large levels of franking credits in the post-GFC years that full franking has been maintained. With higher payout ratios and special dividends, those credits are being consumed. The day is not far off when bank dividends will only be partially franked, particularly if domestic lending remains subdued for some time.

And the subdued domestic credit market also offers up an interesting conundrum. As Macquarie puts it, “there is a risk of return to higher growth”.

As noted above, the banks are currently in a position to return capital and thus appease shareholders because they cannot use the capital to provide “normal” lending while credit demand remains subdued. The yield feast could thus prove short-lived if – heaven forbid – the Australian economy picks up and credit demand begins to grow again. This is why bank analysts are not jumping in to simply assume increased payouts or specials or any other form of capital management. They were mildly surprised by ANZ’s extensive lift in payout and by Westpac’s special. They were not completely surprised, because they suspect an element of “pandering” to shareholders and their yield demands at this time.

On the other side of the coin, there’s also an element of “pandering” to the great unwashed and ranting politicians in reversing earlier mortgage repricing policy (that is, keeping some of the RBA rate cut back to offset high offshore funding costs), to a new competitive policy (cutting SVRs by even more than the RBA rate cut). All up, the banks are trying to avoid the usual negative attention they really do not wish to draw.

This is important when we return to the subject of yield. An increased payout ratio implies a higher percentage of earnings paid out, not a higher absolute cash payment. Were bank earnings to be lower in FY14, absolute dividend payouts would also be lower. Yields may still look hefty, but only if share prices fall to account for reduced earnings.

Which is not to suggest the banks are all about to lose money. Earnings growth is subdued at present, not negative. But if there is one point bank analysts largely agree on, it’s that the first half of FY13 (or the six months to March) may prove a sweet spot for the banks. Credit Suisse sums up the view:

“For the sector the result suggests the optimisation of bank earnings is now reaching its limit: bad debt charges are as feasibly low as they can get for a couple of the major banks, margin expansion and the pace of productivity improvements is fading, and capital management initiatives have now been announced”.

NAB still has scope to increase its dividend, assuming UK bad debts continue to run off quickly. CBA is expected to announce some form of improved capital return when the time comes. Thereafter, we can assume further improvement in capital return initiatives are less likely. We can also assume the franking credit pool will begin to run down. Over the past six months, the banks have made very little money out of “normal” banking. They have made money from reduced bad debt costs, from improved trading profits in a more risk tolerant financial marketplace, from reduced funding costs, and from operational cost cutting. For everything outside of “normal” banking, things cannot get much better, as far as analysts are concerned.

Which brings us to the obvious question: are the banks overvalued? Here, broker opinion is divided. Let us first peruse the following table:

The first thing we notice is that the eight FNArena database brokers are collectively ascribing a total of eleven Buy (or equivalent) ratings on the Big Four, thirteen Hold ratings and eight Sell ratings. On a simple Buy-to-Sell basis the conclusion should be that the brokers remain slightly bullish. Among post-season reports are comments such as these:

“We see bank stocks as fully valued on a PE [price/earnings] basis, slightly above fair value on a book multiple basis, and approaching full value on a dividend yield basis. The key risk to our view here is that share price momentum could see valuations become even more stretched.” – Credit Suisse.

“The major banks are currently trading on 2.3x NTA [net tangible assets] which is a 4% premium to our sustainable target price/NTA multiple of 2.2x. We therefore see valuations as full. However, we are hesitant to be too negative on the sector given low relative earnings risk, potential for further capital management, and the relatively stable outlook for long bond yields” – Goldman Sachs.

“[The] banks may be seen as ‘expensive’ but not out of kilter with historical ranges. The move to a lower 10% cost of capital [reduced funding costs] has increased our price targets by ~15% and now sees them approximating fair value” – JP Morgan.

JP Morgan has raised the subject of target prices, and if we return to the table we see that, based on yesterday’s closing prices, only ANZ is offering upside to target. CBA is well over target, NAB is a bit over, and Westpac is about right. Yet there are more Buy ratings than Sell ratings.

The problem for bank analysts is that by any traditional metric, be it price/earnings, price/book value, premium/discount to peers or whatever else, the banks are overvalued. But on a comparative yield basis, the picture is not so clear. Yields do not now exceed 6% even out to FY14, but that’s still a solid premium over the bond rate, and a hefty premium over offshore bond rates. Australian banks are looking at low growth but they are, on a comparative basis, solid as rocks in the ocean of global banking. The conclusion from analysts therefore might be put as: “Everything I’ve ever learned or experienced to date tells me the banks are overvalued, but I am reluctant to stand between bank stocks and the market’s thirst for yield”.

As to preferences within the sector, among the Big Four, the picture is even cloudier. For example, UBS states clearly: “Our concerns with CBA relate purely to value” and is far from alone in that opinion. On the other hand, JP Morgan upgraded its call on CBA to Overweight post update. Macquarie believes the business banks (ANZ, NAB) are offering more potential ahead than the retail banks (CBA, WBC). Most believe CBA and NAB still have the capacity to surprise on capital management. Quite simply, different brokers have different views on different banks, as they always do.

As the Australian economy moves through cycles over time, fund managers typically respond to those cycles by being defensive in weak times and pro-risk in strong times. Given the Australian share market is heavily weighted towards a limited number of sectors, a typical trend over time is to buy banks in weakness and resources in strength, switching between the two. While the resource sector currently has its own issues regarding the peak in the mining boom, we have still witnessed the stuttering beginnings of a switch into cyclicals this past month. It’s been very stop-start, and quite volatile at times, but with bank valuations now looking stretched, and resource sector companies now concentrating harder on offering yield, such activity is on the rise.

It could all reverse again tomorrow of course, with some bad news out of China/Europe/the US, but right now the outlook for the bank sector appears to be one of “how much further can this really go?”
 

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- NAB disappoints on dividend
- Domestic business okay, UK the drag
- UK improvement appearing
- Capital management soon?

By Greg Peel

National Australia’s Bank’s ((NAB)) interim profit beat consensus estimates by about 0.5%. The announced 93c interim dividend is 3c ahead of last year’s interim and 1c ahead of consensus forecasts. Under normal circumstances, such a result would be well received. In the current environment, however, NAB has proven the poor cousin among rivals ANZ Bank ((ANZ)) and Westpac ((WBC)).

Both ANZ and Westpac posted profit “beats” of a greater magnitude than NAB. ANZ increased its dividend significantly and declared an ongoing target payout ratio of 80%, up from a previous 65% target. Westpac’s dividend was in line with expectations and no change was made to the bank’s already peer-leading payout ratio, but Westpac offered up a 10c special dividend instead.

In a yield-hungry market, NAB has thus proved a disappointment. NAB’s share price has run up 33% this year and outperformed the bank index by 8%, having started from behind. Having assumed ANZ to have set a precedent on capital management two weeks ago, the market bought up the other banks in anticipation. Westpac delivered, NAB did not.

While the market may have been disappointed, analysts were not surprised. It comes down to NAB’s legacy UK business, which has proven no less than a disaster since the GFC. NAB has tried in the interim to offload its albatross, but no one has been silly enough to stump up. Management has simply had to grin and bear it, and ride out a lengthy and costly recovery process.

Take the UK out of the equation, and NAB’s interim performance was much the same as peers. Domestically the bank saw a reduction in bad debt charges, particularly in business banking, and booked some impressive market trading income. Like peers, NAB felt a 3 basis point squeeze on net interest margin and its wealth business struggled. Capital generation was strong, with an 8.22% tier one capital ratio well ahead of the bank’s 7.5% target. NAB is not as exposed to New Zealand and Institutional banking as peers, and thus is avoiding additional pressure on margins. On the other hand, business banking’s growth outlook remains subdued, so bad debt reductions will continue to be needed to drive profits.

The level of impairments in NAB’s UK business continue to worsen. UK property prices outside of London are still falling, and the UK economy remains weak. Citi believes NAB is yet to see the peak in UK bad debts. The good news, nevertheless, is that the rate of new impairments has slowed and provisioning is solid, in line with UK peers. As the loan book starts to run off, Deutsche Bank believes NAB’s UK bad debt charge “should reduce materially from here”.

Macquarie is also enthusiastic about NAB’s UK impairment charges having apparently turned the corner. There is a real possibility, suggests Macquarie, the new Bank of England governor will eschew the policies of his predecessor and “go for growth”. If so, the next twelve months could see further impairment charge declines in NAB’s exposures.

NAB’s Australian business is in no better or worse shape than peers, and all banks are facing a low earnings growth outlook, reduced margins on lower base interest rates and struggling wealth management businesses. All have enjoyed renewed risk appetite in the market and subsequent trading profits, although analysts suggest the first half 2013 will probably prove a stand-out. All are enjoying reductions in lingering bad debts, which should continue to provide an earnings offset to low credit demand. All are in strong capital positions vis a vis new international requirements.

Only NAB has the UK, and the UK has crimped the bank’s group profit result and constricted any ability to improve capital management for the benefit of shareholders. But capital management remains a possibility in the short term if the UK run-off continues favourably. NAB may yet still buy back its dividend reinvestment plan (DRP) shares in the second half, management has indicated, thus reducing resultant earnings dilution. Analysts were expecting DRP buybacks from both ANZ and Westpac, but both banks opted for cash in hand to shareholders instead, no doubt playing to the current mood. A payout increase from NAB might yet be a 2014 story, or maybe even a second half 2013 story.

So on all of the above, is NAB cheap or expensive, particularly given its solid 2013 run? Here analyst views diverge.

Of course, a more general argument is one of whether or not all the banks are expensive right now. Here bank analysts have been forced to throw away the old rule book and simply assess whether bank yields in a low global interest rate environment are enough to support prices. Almost begrudgingly the answer seems to be yes, but as to whether the banks can run further still is another matter.

On a relative basis, Macquarie (Outperform) believes NAB is delivering on its turnaround story. Deutsche Bank (Buy) believes NAB is well placed to deliver above-peer growth over the next two years and that this is not reflected in the share price. Goldman Sachs argues NAB’s sustainable return on total equity (ROTE), which post-result is up to 18.0% from 16.9%, suggests NAB’s discount to peers is excessive. JP Morgan suggests gradual improvement in the UK book matched with around a 21% ROTE domestically provides cause to Overweight NAB within the sector, but against the market JPM can’t see momentum continuing in the near term after the solid run.

NAB is CIMB’s preferred pick among the Big Four, offering the capacity for above-peer growth in return on equity out to FY16. CIMB sees NAB as relatively cheap at a 10% discount to peers, but on a market basis maintains a Neutral rating. UBS (Neutral) believes NAB is no longer cheap on a 5.8% yield. Citi (Neutral) cites poorer funding, lower margin and weaker asset quality than peers. Credit Suisse (Neutral) wants to see more improvement in the UK and Morgan Stanley (Equal-weight) is not yet convinced loan losses have turned.

BA-Merrill Lynch simply needs “more comfort that further negative surprises do not await”, and is sticking with Underperform.

Of the Big Four, NAB is the most open to risk, being not only one of the two smaller banks but the only bank exposed to the UK. With increased risk comes more price volatility, but also the opportunity for greater reward. Perhaps this is evident in a 3/4/1 Buy/Hold/Sell split among brokers in the FNArena database. A consensus $31.15 price target suggests 4.1% downside from Friday’s closing price.

Commonwealth Bank ((CBA)) runs on June year-end (December interim), but will provide a quarterly update on Wednesday. Investors will need to wait until August to learn of any new capital management initiatives.

Previous stories:

Westpac And Macquarie: More Yield
Australian Banks: For And Against
ANZ Result: Stock And Sector Implications
 

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- WBC offers a special while MQG lifts its payout
- earnings growth low for WBC and volatile for MQG
- share prices lofty for both

By Greg Peel

Last week ANZ Bank ((ANZ)) announced an interim profit result which beat consensus due to better than expected cost reductions and lower than expected bad debt impairments. Significantly, ANZ announced a higher than expected interim dividend and lifted its dividend payout ratio guidance, playing right into the hands of a market hungry for yield.

The market then wondered whether ANZ, as first cab off the reporting season rank, had set the scene for similar capital management initiatives from Westpac ((WBC)) and National Bank ((NAB)). Morgan Stanley, for one, suggested Westpac would not raise its already peer-leading payout ratio but did have the scope, and the franking credits, to either pay a special dividend or buy back its dividend reinvestment plan (DRP) shares. The analysts favoured a DRP buyback.

Westpac went the other way. On Friday the bank announced a profit result which also beat consensus, rising 10% on last year’s first half, and an interim dividend of 83c. The dividend was in line with expectations and no payout ratio increase was forthcoming, but the bank did announce a 10c special dividend.

Once again, yield is king.

While the profit result might have been a “beat”, analysts were not all that enthusiastic about the factors behind the beat. Westpac has managed to reduce its cost ratio to a level below peers, but 4% growth in costs from last year was more than analysts had expected. Bad and doubtful debt charges fell 26% due to one-off write-backs for the institutional bank, and a bad debt expense of 17 basis points was the lowest since 2006. Beyond these two significant factors, underlying operational growth was not so flash. Underlying revenue only grew 1% for the half, and that included contributions from trading and wealth management which reflect the recent solid run in the market.

With a tier one capital ratio of 8.7%, Westpac has the strongest capital position of the Big Four. The other three are sitting on ratios just above 8%. It is this strong capital position, which Westpac has been focusing on and quietly improving since the GFC shock, as well as a surplus of franking credits, which has allowed the bank to pay the special dividend and maintain its sector-leading payout ratio. Capital has been able to grow due to falling offshore funding costs and a rising deposit base, over which all of the banks have fought. Capital growth does not reflect earnings growth, which is modest.

At the moment, the earnings growth outlook for all banks remains modest.

Westpac’s lending growth rates, notes JP Morgan, remain below-system and the bank’s net interest margin has stalled at 2.19% rather than climb to provide at least some revenue growth in a time of low volumes. Unless the deposit spreads can improve, management suggested on Friday, downside margin risk remains. Many a broker suggests that while Westpac has been ahead of the pack in cost reduction, there’s little more room for improvement now while others catch up. Bad debt levels are low, which is great, but as low as they are likely to get. Last year’s RBA rate cuts provided scope for advantageous loan repricing but the cash rate is unlikely to see as many cuts this year. And now that interest rates are generally lower, earnings are more difficult to come by.

The first half FY13 may well be “as good as it gets” for Westpac, suggests Morgan Stanley.

The other problem, of course, is Westpac’s share price. Different brokers arrive at different valuations but picking one example, Goldman Sachs suggests a sustainable return on total equity of 21% implies the stock should trade on 1.9x net tangible assets, or 2.4x NTA taking franking credits into account, but it is trading at 2.8x and is thus 15% expensive. Furthermore, Westpac’s superior return suggests a 9% premium to peers but the current premium is 17%.

The BA-Merrill Lynch analysts cite a PE multiple of 14.8x in suggesting they “can’t get too excited” about buying the stock. UBS is not even all that fussed with a 5.1% (before franking yield) at this price. All brokers nevertheless agree there remains more room for capital management, irrespective of a low earnings outlook, given strong capital generation and franking credits.

Citi believes there’s scope for as much as 40cps in further special dividend capacity, and is expecting another 10c special in the second half. That’s before franking credits run out. Macquarie suggests 20-30c capacity over the next 12 months. UBS is backing two 10c dividends in the next two halves before Westpac then moves to buy back its DRPs. All brokers point out franking credit limitations.

Westpac’s yield may have been a lot more attractive a few months ago, but yield is king in this market. That’s why Morgan Stanley is sticking with its Equal-weight rating. Goldman Sachs joins CIMB on Sell, while JP Morgan maintains a sector-relative Underweight rating.

No database brokers have changed their ratings in the wake of the interim result. Macquarie, Merrills, UBS, Credit Suisse and Deutsche Bank all remain on Hold. Citi is the only broker with a Buy rating, believing Westpac is well positioned in the low growth, low rate environment. On a net basis, earnings forecasts have been ticked up to reflect those lower than expected bad debts charges. The consensus price target has risen to $30.54 from $29.40 to suggest 8% downside.

Westpac and its peers are considered “commercial banks” due to an emphasis on loans and relatively minor focus on broking and proprietary trading. In contrast, Macquarie Group ((MQG)) is an “investment bank” with a strong focus on broking, trading and corporate finance. An investment bank is typically a “risk” proposition, while commercial banks are supposedly defensive. On that basis, commercial banks are bought for yield and investment banks for growth.

Well there’s no doubting the Big Four are still yield stocks, but Macquarie has now joined the fray. The Group surprised on Friday with a better than expected full-year profit but somewhat shocked with an announced final dividend of 125cps, some 67% above the first half, way ahead of analyst expectation, and representing a payout ratio of 86%. Management has guided to future payouts of 60-80%, with a leaning to the upside, when payouts of less than 70% have always been the norm.

That puts the FY13 payout ratio ahead of the Big Banks. But Macquarie is not meant to be a capital-returning business but a business that invests in growth. Could it be that Macquarie has found itself in the same dilemma as Woodside? That is, no prospects for growth in the near term so best just to give out the money? Or is Macquarie also just pampering to the current yield-hungry investor environment?

The latter may well be true, but brokers also suspect that having run around the world snapping up broking and trading units post-GFC, and more recently invested in some more typical banking businesses, Macquarie is done with acquisitions for now as attractive targets are more difficult to come by. A $250m share buyback was also meant to be underway in the second half but has gone nowhere, so given a share price rally in excess of 40% over the period it is likely a capital return is the alternative.

Driving Macquarie’s better than expected profit were further gains in the annuity-based businesses that have now become a fundamental contributor to the Group. Improved market conditions also allowed for the sort of rebound in financial market broking/trading revenues management has been waiting for, nay praying for, since 2009, but the improvements are only modest at this point, not all areas have returned to profit, and earnings in these markets are always potentially volatile. Advisory fees (such as M&A) remain subdued.

Could the 80% payout ratio guidance signal that Macquarie has decided to move toward a more “capital light” model, in which higher payouts are more justifiable? asks UBS. Another point to note is that a solid profit was also as a result of reduced costs, and this includes a reduction in the staff compensation ratio. Macquarie’s payout model has always involved paying out staff bonuses first, often handsomely (remember the Millionaire’s Factory?), and then looking after shareholders. Macquarie executives were once both admired and envied. This is not so much the case anymore, following post-GFC staff consolidation and a shift away from peer-leading compensation.

Which is another reason why there is now more in the kitty to give to shareholders, even after a hefty increase in the Group’s tax rate due to a greater global spread. As CIMB puts it, Macquarie has shifted “from star to cash cow”.

So should investors now consider Macquarie in the same light as the Big Four? No, is the general answer. Macquarie’s new payout might look commercial bank-like but the Group does not run loan books of note. The annuity-style businesses are growing but earnings still rely heavily on the financial market backdrop, which even management admits is still subdued and analysts are yet to feel particularly confident in. An 80% earnings payout ratio still means lower dividends if earnings fall.

Underpinning share price support is yield, which has now jumped to 6%. But caution is needed, say Deutsche Bank, given Macquarie is still an investment bank. UBS suggests a shift to “capital light”, with more emphasis on asset management and advisory fees, may be the best chance of increasing return on equity back to above the cost of capital. CIMB thinks a lift in returns and earnings is “still several years off” given it hinges on market-linked revenues.

As is the case with the Big Four, Macquarie’s value as an investment has to be judged in the context of a solid share price rally to date. Only two FNArena database brokers, UBS and Credit Suisse, are comfortable enough with further upside potential to maintain Buy ratings. Everyone else is on Hold, as is Goldman Sachs.

The earnings surprise and increased dividend nevertheless force earnings forecast upgrades among brokers and increased target prices. The consensus target in the database has risen to $41.44 from $36.88 but, in keeping with the more volatile nature of investment banking versus commercial banking, the spread of targets is substantial. CIMB is the low marker at $36 and Credit Suisse the high marker at $48. The consensus of $41.44 suggests 6% downside.

Watching on warily has been National Bank ((NAB)) which will report on Thursday.

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- Banks in a bubble, says UBS
- No they're not, says Citi
- Bank dividends are not annuities, warns UBS
- They're not being priced as annuities, argues Citi
 

By Greg Peel

In a report this morning, the UBS bank analysts quoted Citigroup former CEO Chuck Prince: “As long as the music is playing, you’ve got to get up and dance”. Across town in the Citi office, the bank analysts entreated in their own, separate report: “Come join the ‘dance’”. Both were making reference to what many fear might be an Australian bank share price “bubble”.

Yet UBS and Citi have diametrically opposed views on whether there is a bank bubble at play.

Yesterday’s FNArena report ANZ Result: Stock And Sector Implications highlighted UBS’ outspoken view on bank share prices in the wake of the ANZ Bank ((ANZ)) interim result and subsequent share price surge. The surge, all brokers agree, was nothing to do with the fact ANZ posted a profit result which slightly beat consensus forecasts and all to do with an announced dividend increase and increase to future payout ratio target. It was all to do with yield.

The yield argument is far from lost on UBS. The analysts are conscious of the “bull case” for Australian yield stocks based on increasing global quantitative easing (QE), RBA rate cuts, falling bank term deposit rates and increasing fund manager allocation into equities in general, not to mention (in the case of banks in particular) added domestic attraction from franking credits. They also acknowledge that Australia’s banks are “very good companies”, being profitable, resilient, well-managed and shareholder-focused within a strong industry and regulatory structure. What they struggle with however, in terms of bank share valuation, is the risk side.

Whereas once banks conducted conservative businesses which offered defensive earnings streams, today banks are far more competitive and exposed to economic cycles. Over the past thirty years households in Australia and New Zealand have become significantly more leveraged than in earlier generations, but have eased off on the leverage hunger post GFC. Hence at this point banks are “low growth” while remaining heavily exposed, notes UBS, to offshore funding markets and domestic house prices and unemployment levels.

Citi, on the other hand, sees the banks in a slightly different light. The Citi analysts believe Australian banks are amongst the lowest risk, highest returning in the world. Underpinning this risk/reward is “favourable” sovereign balance sheet, sound management, improved competitive dynamics and market structure, the analysts argue, along with better funded individual balance sheets, and higher capital ratios and lower credit risk mix than at any time in the past ten years (of boom and crisis).

The last time Australian banks were trading at record price/earnings ratios (PE) was in the pre-GFC lending frenzy – a time when it seemed as if the party would never end. UBS argues the banks are now looking at legacy high leverage in their customer base coupled with cyclical risk, meaning lower growth on higher risk than the traditional bank model. Yet the Big Four banks today have reached a new record high average PE of 14.9x, with Commonwealth Bank ((CBA)) the stand-out at 16x.

“To argue that a stock is expensive relative to historic levels,” says Citi (and remember these guys are not arguing face to face; they are writing independent reports), “is somewhat akin to saying ‘don’t buy a loaf of bread today because it was cheaper ten years ago’”. Looking to historic precedent of absolute levels of valuation is only appropriate if all else, such as inflation, economic policy, risk tolerance and so forth, is equal, the analysts argue, and nothing is ever equal.

“Relative, not absolute, is important,” Citi declares.

UBS strongly believes the market is looking at bank dividends as if they are annuities (known income streams such as fixed-rate term deposits), but they are not annuities, the analysts insist, given the risk of not being fixed. Citi agrees wholeheartedly that bank dividends are not annuities, but does not believe the market is valuing them as such.

Bank dividend yields are trading with an implied risk premium of around 200 basis points over ten-year government bonds and around 170 basis points over the same bank’s (government guaranteed) term deposit rate, and those premiums remain “well above” historical averages, Citi points out. Add in franking credits for domestic investors and dividends are even more attractively priced.

Coming back to whether bank PEs are unrealistically high or not, UBS notes some argue that because banks can source cheaper funding for their businesses, because they are banks, than your average corporate, this lower cost of capital should translate into a higher PE multiple. But if the banks were to subscribe to this argument, say the analysts, and think of themselves as low cost of capital corporates, then they will be more inclined to bid more aggressively for business and accept lower net interest margins will eventually produce lower returns on equity and lower dividends. They will lower growth while increasing the volatility of bad debts and become even more cyclical, rather than defensive. It’s a negative feedback loop. “This has already been seen overseas,” they warn.

Australian banking is a highly concentrated industry, Citi fires back, with high barriers to entry and thus a higher degree of pricing power.

There is one thing UBS is forced to admit, with respect to the nature of all asset bubbles. “They can go higher and higher and for longer than many expect”. As long as the banks’ near-term earnings outlook is solid, there is nothing stopping the market buying bank shares all the way to their previous historic low dividend yield of around 4.5%, which implies another 10% share price upside, the analysts point out. It is at this point UBS draws upon Chuck Prince’s suggestion, “As long as the music is playing, you’ve got to get up and dance”.

“Come join the dance,” says Citi. “High dividend yields will continue to attract investors while alternative investments provide significantly lower returns and the earnings and dividend outlook for the sector remains solid near term”.

“All we can say is buyer beware,” concludes UBS.

“All we can say is Buy ANZ, CBA and Westpac ((WBC)) today!” concludes Citi.

Yes, Citi does use an exclamation mark and yes, I think there might be one bank missing as well. And yes, it’s uncanny: you’d swear one report was written in direct response to the other.
 

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- ANZ lifts lagging dividend payout
- Revenue growth questioned by some
- Will the other banks now be forced to lift payouts?

By Greg Peel

“We believe focusing purely on short term dividend yield as a valuation methodology is fundamentally flawed for all banks,” insists UBS.

Tell that to the market, which yesterday sent ANZ Bank ((ANZ)) shares surging 5.8% despite a quite remarkable sector rally since June. Obviously that’s what the UBS analysts are at pains to do. But if Gordon Gekko were operating today, his mantra would likely be Yield is Good.

Last night US tech giant Apple successfully issued US$17bn in corporate bonds, an issue oversubscribed from an initial US$15bn intention, to mark the biggest corporate bond issue in US history. It is of little surprise the issue proved popular in a market thirsty for investment grade paper to deliver returns simply not available from traditional Treasuries. It is notable that Apple plans to use the funds raised to underpin an intention to become the largest dividend payer in the world, as well as to buy back shares.

Dividends from debt. Many a company/fund has come unstuck in the past funnelling borrowings to shareholders (recall Telstra’s dark days). By contrast, Woodside Petroleum’s decision last week to become a yield play rather than a growth play (better yield than any of the banks or Telstra) was all about drawing on substantial cash flows. Woodside may not grow in the near term but its distributions are unquestionable. Banks, on the other hand, by their very nature are paying dividends from debt. Banks cannot be equated to Apple, because debt is a bank’s fundamental business. But…

“While yield is important, especially in a QE world, dividends are a function of ROE [return on equity] and growth opportunities,” rails UBS. “Bank dividends are also a result of significant leverage, they are not annuities”. [UBS emphasis]

Investors will nevertheless be pleased to learn that not all brokers are as outspoken as UBS in the wake of ANZ’s result and increased dividend. Indeed, some are quite positive.

Yesterday ANZ announced a $3.2bn interim profit which represented 8.5% growth on the second half of FY12 and 9.9% growth year on year. The result beat market consensus by 2%, although largely matched or even fell short of many of the major brokers in the FNArena database. The “beat” came down mostly to better than expected cost cutting and lower than expected bad debt charges. But it was not the result itself which caused all the fuss, nor caused the big jump in share price. ANZ’s announced 73c interim dividend beat just about every forecast, for which consensus sat at around 67c after brokers factored in their own dividend increase expectations. It was not the increase which surprised, it was the quantum.

More significantly, ANZ announced a target dividend payout ratio of 65-70% of earnings, with a bias towards the upside of the range. This lofty interim is hence no “special”, but represents a shift towards a higher ongoing yield for shareholders. ANZ’s previous target was simply 65%, and this interim represents 67%.

ANZ’s payout ratio has for some time lagged that of Big Four peers. At 70%, ANZ will still sit behind National Bank ((NAB)) on 75%, Commonwealth Bank ((CBA)) on 76% and Westpac ((WBC)) on 79%. The shortfall is not implicit of any inferiority on the part of ANZ’s business, rather ANZ is unique among peers post GFC in investing in growth outside the domestic market, establishing a presence in Asia. The bank has thus sacrificed distribution for growth, and will continue to do so. By contrast, NAB would dearly love to exit its ill-fated UK business and CBA and Westpac remain firmly rooted downunder.

That said, ANZ’s performance since last year’s full-year profit result release in October has been “plagued”, as JP Morgan puts it, by margin deterioration, stemming from above-peer exposure to institutional banking and to New Zealand. The good news is that JP Morgan sees margin pressure headwinds now easing in those sectors. It is also a positive that the bank has reduced costs by moving to a single brand in New Zealand, and more importantly by having reached a point of critical mass in Asia, JPM, notes, such that incremental revenue is now exceeding incremental cost.

ANZ has unwound recent underperformance and closed the yield gap, and JP Morgan suggests the bank can meet its payout guidance while still allowing capacity for further investment. JPM’s sector-relative rating for ANZ remains at Neutral but the analysts see yield as providing ongoing support now that RBA rate cut expectations are back in vogue.

Goldman Sachs calculates ANZ to be trading at 2x its net tangible asset valuation, which would make the shares 5-10% expensive. But a sustainable return on total equity (ROTE) of around 17.5% implies ANZ should trade at a discount of 12% to peers, and the stock is trading at 15% (even taking yesterday’s jump into account). This conundrum leaves Goldman on Neutral.

While cost and bad debt reductions are positives, CIMB points out that market share gains and a bounce in trading income in the half masked the fact ANZ’s revenues were weak. Net interest margin – a bank’s fundamental measure – fell three basis points. The increased payout ratio is welcomed but CIMB suggests bank capital requirements will restrain ANZ from any further capital management before FY16. ANZ elected to increase its ratio rather than buy back, or “neutralise”, its dividend reinvestment plan (DRP) discounted shares.

CIMB is sticking to Neutral, suggesting the environment remains “hostile” for ANZ compared to peers. The analysts do not concur with JP Morgan that margin pressure is now over in institutional and Asian lending, and while peers have enjoyed repricing gains on mortgages (that is, by not cutting rates by as much as the RBA), ANZ is relatively underweight mortgages.

UBS, unsurprisingly, on the strength of the above quotes, is maintaining a Sell rating. The analysts also point out ANZ is now trading at no less than a 32% premium to leading Asian banking franchises such as Standard Chartered. Morgan Stanley (Underweight) believes FY13 will be as good as it gets for ANZ. Revenue growth will be limited, the analysts suggest, and the Asian expansion will continue to impact on return on equity.

BA-Merrill Lynch, on the other hand, has retained a Buy rating. Credit Suisse (Outperform) suggests ANZ offers best in sector productivity, growth via Asia, a catch-up on capital management and below peer valuation. Deutsche Bank (Buy) believes, unlike CIMB, that ANZ could indeed buy back its DRP in due course while still maintaining the new payout ratio and organically generating capital.

Macquarie is arguably the most outspoken database broker on the positive side. Yesterday’s jump in share price was clearly all about the dividend, Macquarie acknowledges, but the analysts believe “a bigger re-rate” is in store once the market comes to realise the optionality ANZ enjoys in earnings potential in Asia and more focus on mortgages and SMEs domestically.

This superior earnings performance along with a commitment to pay out more,” suggests Macquarie, “should see better than peer dividend and stock price growth”.

Broker opinions, therefore, are not offering much solace for the uncertain investor. UBS is screaming “don’t buy banks just for dividends” on the one hand and Macquarie is lauding ANZ’s above peer dividend growth on other. Such division only serves to highlight the conundrum that is bank share investment in the post-GFC world. If you had told brokers in June last year that the banks were all going to rally around 70% in under a year they all would have fallen about laughing. Where on earth would earnings growth come from?

And that’s the point. Yesterday’s monthly private sector credit growth data from the RBA highlighted the fact banks have little source of earnings growth at present, at least not enough to justify such sterling market outperformance. But they are offering strong yields, making them domestically sought after and globally a must-have. When will the music stop?

The next question is as to whether an increased payout ratio from ANZ provides any suggestion that the other banks will follow suit.

The starting point for this argument is that an increase to a target 70% payout still leaves ANZ short of all three peers in the payout ratio stakes. On first glance one might thus assume that ANZ’s catch-up of sorts puts no pressure on the others to further widen the gap. But Morgan Stanley does see some scope.

Not for NAB though. In FY12 NAB maintained the quantum of its dividend despite a decline in earnings which by default lifted the bank’s payout ratio to 75%. Morgan Stanley believes NAB could actually lift to 76% for FY13 but that would represent a peak, with the analysts citing relatively low returns as cause for that ratio to fall back towards 70% over the next few years.

CBA has the scope to lift its ratio from an expected 76% in FY13 given the bank revised its payout ratio at the FY12 result to a range of 70-80% and has a requisite mix of high returns and franking generation, Morgan Stanley notes. The problem is CBA’s guidance at that point was for a dividend that would “likely be slightly lower” in FY13 from FY12 so management would have to suddenly change guidance after nine months. Note that CBA runs on a June-end year rather than the September-end year of the other three and will only provide a quarterly update this round, not an interim result.

Westpac also has the scope for a lift, the analysts point out. Yet the bank has gradually increased its ratio from FY10 to a forecast peer-beating 79% consistent with guidance to “maintain a payout ratio that is sustainable in the long term”. Long term sustainability would not include a sudden “anything you can do” response to ANZ, one would assume. Yet given an excess of franking credits, Morgan Stanley would not rule out a special dividend from Westpac, albeit the analysts believe the most likely capital management outcome, if any, would be a DRP buyback.

Meanwhile, the FNArena database shows five Buy or equivalent ratings for ANZ, two Holds and one Sell, with no changes stemming from the result announcement. The consensus price target has been lifted to $29.70 from $28.55 previously, but this still suggests 7% downside from the current share price.

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-Banks attractive despite full valuations
-Solid earnings expected
-Focus for ANZ is on Asian strategy
-Question for Westpac is over dividend
-NAB could still be hamstrung by UK
 

By Eva Brocklehurst

Three of the major banks will publish earnings reports over the next few weeks. In general, brokers believe things are pretty good. Sure, there's no runaway growth but asset quality is improving. Banks may be fully valued on several measures, but attractive yields and few large cap alternatives make the majors, at least, a safe bet. So, what are brokers zooming in on? Impairments, capital and margins.

UBS is expecting a solid season. Earnings growth is expected to be the strongest in some time and industry trends such as mortgage repricing and an easing in deposit competition should support the retail net interest margin. Improved credit spreads should help trading income. The sector is expected to deliver cash earnings growth around 4.9%. Goldman Sachs finds the sector near fully valued but is hesitant about being too negative, given the low relative earnings risk, potential for capital management and stable outlook for long bond yields. 

Delving into ANZ Banking Group ((ANZ)), Morgan Stanley thinks the downside risk to institutional bank margins will be mitigated by retail margins and higher trading income. The second half will be more challenging and the broker is hoping for an update on the Asian strategy. Macquarie is looking for clarity on the Asian businesses too, particularly regarding relative capital allocation between Asia and ANZ's other businesses, including the Asian minority stakes. This is where the broker sees the problem for ANZ. It's the fact these regional segments are not generating a return on equity equivalent to the rest of the business. The broker continues to see stress in parts of the economy and believes it prudent to expect a slight increase in the bank's provisioning, perhaps around 10%. Citi flags the organic capital generation, which appeared in the first quarter, and thinks the bank is a compelling Buy at present levels.

UBS is focused on net interest margins. UBS is the most negative on the FNArena database and has the stock rated a Sell. In contrast to Morgan Stanley, UBS thinks margins will contract, as positive trends from the Australian retail segment are likely to be offset by re-basing and competitive pressures in commercial, New Zealand and international and institutional banking businesses. Deutsche Bank has decided to fine tune a view on the bank ahead of the results, reflecting on the fact that, with the market chasing yield, ANZ could be being penalised for its lower than peer payout ratio. The bank could increase the ratio to 70% from the current 65% and still fully frank the dividend. Based on the FY13 and FY14 forecasts this would increase the dividend yield to 5.6% and 6.0% respectively, which would place it at the top end of peers from a yield perspective.

ANZ has five Buy, two Hold and one Sell rating (UBS) on the FNArena database. The dividend yield on FY13 consensus earnings estimates is 5.0% and for FY14 5.3%. The consensus target price is $28.45, suggesting 4.8% downside to the last share price.

Westpac Banking Corp ((WBC)) may disappoint on institutional bank margins and loan growth in Morgan Stanley's view. The main feature for Westpac is the speculation about dividends and buyback. Morgan Stanley expects a buyback will be announced for dividend reinvestment plan (DRP) shares. According to Citi, Westpac is in the best shape to do this and the bank may at least start neutralising the DRP issuance. No capital returns are anticipated at this stage but a 2c lift in dividend is seen as possible. UBS expects the DRP neutralisation in the first half with a special dividend likely in the second half. Westpac's capital position will be an attention getter for all the right reasons, in this broker's view. This is based on a forecast 16% return on equity, good organic capital generation in the first half and a Basel III harmonised core Tier 1 ratio just under 11%.

For Macquarie, margins will expand from asset re-pricing for all banks and Westpac should benefit the most. Trading income is likely to remain robust and a a source of potential upside from Macquarie's forecasts. The broker also canvases the prospect of a higher than expected dividend but believes it prudent not to pay out capital, given the ongoing global debate on appropriate risk weightings and methodology. Maybe, instead, a special dividend will be forthcoming in the second half. CIMB does not see capital management on the cards, although accepts the bank might neutralise the DRP. The reason is capital ratios look like heading higher. Westpac is now overvalued, in the broker's opinion, given recent share price gains, and has been downgraded to Sell.

Westpac has one Buy, five Hold and two Sell ratings. The dividend yield on consensus earnings estimates is 5.4% for FY13 and 5.5% for FY14. The consensus target price is $29.33, signalling 9.7% downside to the latest share price.

National Australia Bank ((NAB)) may have potential upside for markets and treasury income but margins could be disappointing and UK loan losses could still be higher than forecast, in Morgan Stanley's view. Provisioning is the focus for Citi as well, despite the improving domestic credit quality. More specific to NAB of the three under scrutiny is the significant core banking system replacement that is underway, which carries execution risk. Citi is also mindful of the non-core presence in the UK, which may be divested or scaled up and is, therefore, subject to price/execution risk. Adverse or favourable movements in either of these risk factors may cause NAB's share price to deviate substantially from the target.

Macquarie expects NAB to continue to generate strong capital given the non-core asset run-off. Further progress on the UK book and and further resolution of the exposure to the UK would be welcomed by Macquarie. No spectacular result is expected, just a steady improvement in UBS' view. Again, the UK is cited as the top risk. NAB has been the most aggressive of the majors in the re-pricing of business loans. This may potentially lead to upside for the net interest margin. UBS is forecasting an improvement in bad debts in the half to 48 basis points from the elevated second half FY12 level of 60 bps which included a $250m increase to the collective provision overlay. Nevertheless, legacy UK issues remain a headwind for material improvements in asset quality.

CIMB prefers NAB because the bank is better positioned for structurally lower mortgage credit growth and a cyclical improvement in business credit growth. Goldman Sachs finds UK cumulative provisioning is now more closely aligned with peers in that market and prefers NAB too, expecting the bank to deliver the strongest growth of the three. 

NAB has three Buy, four Hold and one Sell (BA-Merrill Lynch) rating on the database. The dividend yield on consensus earnings estimates for FY13 is 5.7% and for FY14 is 5.9%. The consensus target is $29.95, suggesting 8.6% downside to the last share price.

Commonwealth Bank ((CBA)) will only provide a third quarter trading update on May 15 and Morgan Stanley notes there is some upside risk to forecasts. The broker believes margins and credit quality trends should compensate for ongoing market share loss. CBA has one Buy, three Hold and four Sell ratings. The dividend yield on consensus earnings estimates for FY13 is 5.0% and for FY14 is 5.1%. The consensus target price is $63.28, implying 11.3% downside to the last share price.

No broker finds much to unsettle the banks, provided there are no more global shocks. Nevertheless, UBS is a bit concerned that prices have disconnected from fundamentals, fearing over-extrapolation of the current asset allocation flows, and QE-driven speculative bubbles, may overshadow underlying risks and leverage. Goldman believes the banks do have capacity to start paying special dividends in FY14 but has opted not to include this in forecasts. The broker stresses the need to see capital targets finalised and Level 3 capital requirements from APRA, before doing so. 

ANZ will kick off the season on April 30 with first half results followed by Westpac on May 3. National Australia will report first half results on May 9 and Commonwealth Bank's update is on May 15.

Macquarie Group ((MQG)) will file its FY13 report on May 3. Citi has previewed the results and rates the stock a Sell. While the capital surplus provides some support, the broker believe that ongoing weakness in market business will delay material return on equity improvement, and accordingly, the stock is viewed as trading above fair value. Citi is 5% below consensus for FY13 earnings estimates, primarily due to lower merger & acquisition, and commodities trading expectations. Citi also sees risk of further equity investment impairments, given weakness in small resources over the period.

Citi is the one with a Sell rating on the FNArena database. There are four Hold and two Buy. The consensus dividend yield on FY13 estimates is 4.1% and on FY14 is 5.3%. The consensus earnings forecast is $35.96, suggesting 4.9% downside to the latest share price.

Goldman Sachs expects Macquarie to maintain its strong surplus capital position. What's of interest to the broker is guidance on what management plans to do with excess capital, given the lack of traction the bank has had in this area in FY13.
 

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