- Suncorp's investor day highlights cost saving potential
 - Underlying margin guidance better than had been expected
 - Brokers speculate about the potential for the upcoming special dividend(s)
 - Buy ratings dominate on valuation grounds

By Chris Shaw

Suncorp Group's ((SUN)) investor day yesterday showed management is attempting to control what can be controlled through simplification, an approach UBS suggests is appropriate in the current low growth and risk averse environment.

One element of the business that can be controlled to some extent is costs, and here Suncorp is looking to make significant progress in coming years. Simplification benefits could amount to as much as $200 million by FY16, notes UBS, on implementation costs of around $275 million.

While the savings are a positive Credit Suisse notes detail has to date been scant, particularly with respect to how much overlap there is between the Simplification and Building Blocks programs in place.

The other issue noted by JP Morgan is while the initiatives seem sensible, management are yet to decide whether savings achieved will be given to shareholders in the form of profits or reinvested in the business to drive growth in later years. 

Assuming the savings are returned to shareholders by way of higher earnings, Deutsche Bank estimates there could be a boost of 10% to net profit after tax by FY16. This full benefit appears unlikely as Deutsche expects some of the savings will be reinvested in growth.

From an earnings perspective, the investor day highlighted management now expects to achieve underlying margins of 12% for FY12. This comes just a few months after management attempted to hose down such an expectation, though UBS for one is somewhat cynical given it comes just two weeks after Suncorp announced $714 million of escalating natural perils claims.

Assuming the underlying margin of 12% can be achieved it bodes well for FY13 as well, Deutsche Bank noting a higher run rate and incremental Building Block program benefits can deliver margins for next year of 12.5%. This compares to the broker's previous forecast of 12.0%.

On the back of the update to margin guidance, brokers across the market have made minor changes to earnings estimates. UBS has lifted its earnings per share (EPS) forecasts by 1c each in both FY12 and FY13, while Goldman Sachs has changed its forecasts by 1% in both years. Consensus EPS forecasts for Suncorp according to the FNArena database now stand at 64.4c in FY12 and 81.7c in FY13.

The market remains positive on capital management potential from Suncorp, JP Morgan noting the company at present has around $1.2 billion in surplus capital. Short-term a special dividend is seen as most likely, J Morgan expecting a 10c special at the upcoming result and Citi factoring in a 25c special.

With only minor changes to earnings estimates post the update there has been only one change to broker ratings. That was by Macquarie, who upgrades to a Neutral recommendation given recent share price weakness means the current price better reflects the balance of risks in relation to under provisioning in the non-core bank business.

All other brokers in the database continue to rate Suncorp as a Buy, as does Goldman Sachs.

Morgan Stanley is not in the FNArena database but rates Suncorp as Equal-weight within an In-Line view on the sector. The reasons for the rating are there remain some question marks with respect to margin quality, falling yields, higher reinsurance in FY13 and recurring non-core bank provision top-ups. As well, Morgan Stanley suggests the amount of capital available for distribution by Suncorp is uncertain at present, which offers some scope for disappointment relative to market expectations.

The Buy argument is primarily a valuation call and reflects both the potential for earnings to improve as Suncorp delivers on efficiency programs and the positives of likely capital management initiatives in coming years.

On Deutsche's numbers Suncorp's core business is trading on a FY13 multiple of just 7.6 times, which implies compelling upside from current levels. Credit Suisse agrees, in part given the expectation of $200 million of special dividends in each half of next year. This would boost the yield on Suncorp to 11% for FY13.

Suncorp's upside potential is reflected in the consensus price target as calculated by  FNArena with the target of $9.28 suggesting upside of around 19% relative to the current share price. Price targets range from Macquarie at $8.62 to JP Morgan at $10.40.

Shares in Suncorp today are weaker in a lower overall market and as at 11.05am the stock was down 5c at $7.76. This compare to a trading range over the past year of $6.03 to $8.85. 

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By Greg Peel

Alphinity is a boutique fund manager established 18 months ago after the four founders left a well known institution together to do their own thing. Prior to leaving, the team had racked up eight years of equity fund management returning an average 2% above the ASX 300 index. Today Alphinity has $1.5bn under management for both retail and high quality institutional clients.

Alphinity's sole focus is on investing in quality undervalued companies undergoing an earnings upgrade cycle. The managers' valuations are deeply rooted in assessments derived from talking at length to those “on the ground” in the various industries which make up the sectors of the Australian stock market. Aphinity's portfolio currently consists of 14 stocks (only one change has been made in 18 months) representing, at present, the sectors related to resources (and resource servicers), the consumer, the US housing market and insurance.

Today's article will deal specifically with the insurance sector.

Someone once suggested “bad luck comes in threes” and someone else once noted “it never rains but it pours”. An insurance company executive would nod knowingly at the latter but as for the former, would probably argue “whaddya mean only threes?” It is the nature of things that for some reason major catastrophes – or “cats” as the cats in the insurance game like to call them – never seem to spread themselves out evenly over time but rather occur in concentrations and then go quiet for long stretches.

It must drive actuarial types nuts.

Take a look at the following graph:

Here we can see a cycle of significantly higher than average cat costs occurring on a rough decade frequency. Very notable is that a bad year is often followed by a particularly quiet year. The latter end of the graph – the five years through 2011 – stands out as a particularly catastrophic period with potentially a final blow-off.

The year 2011 was by this measure the second most costly for insurance companies in four decades. It featured the culmination of a cyclical La Nina period and the less cyclical impact of the larger Christchurch earthquake. Meteorologists are now seeing evidence this La Nina cycle is fading and devastating earthquakes are not a common occurrence.

Alphinity notes Australia's insurance losses accounted for 17% of the global total in 2011 compared to a long-run average of 5% in what was also a stand-out year for losses globally. Alphinity's feedback from insurers, and importantly insurance brokers, is that prices are rising in both personal lines and commercial property.

The insurance cycle is a simple concept. When insurance companies are struck by a run of cats they are forced to run down contingency pools and tap into reinsurance cover. Thereafter, contingency pools need to be topped up again and next year's reinsurance premiums are likely to be higher. Both imply insurance companies have little choice but to increase their own premiums. It is one price rise the general public can mostly understand.

On the assumption the run of cats then subsides, insurance companies are now collecting higher premiums while making fewer payouts. Their net margins thus expand. A period of few catastrophes will then allow insurance companies in a competitive mood to start easing off on premium increases or even cutting premiums. Margins then begin to contract. Along comes another bad cat year or years and bang – margins are crunched.

The performance of insurance companies is also very closely related to global interest rate cycles. This works in two ways. The most obvious is that insurers must invest the funds they collect as premiums in order to cover payouts, such that invested premium income net of payouts is what really provides the day to day margin in “normal” years. Insurers cannot afford to make risky investments lest they find themselves unable to meet payout obligations. Low risk investments such as sovereign and other government-supported bonds thus form the bulk of an insurance company's portfolio. If interest rates on bond investments are in a low cycle, insurers' margins are squeezed, and vice versa.

Interest rate curves are also fundamental to the actuarial alchemy that underpins insurance price setting. Using historical data insurers attempt to predict a level of future payouts and hold contingency pools accordingly. If interest rates are high across the curve the value of future payouts is discounted steeply and thus today's value of an insurance company is enhanced. Vice versa if rates are low. What an insurer really doesn't want is a bad run of cats coinciding with a low interest rate environment.

Oh dear.

Have another look at the chart above. Note the most consistent run of high costs on the graph is in the period 2007-11. This happens to be the period in which global central banks began madly cutting rates as first credit markets froze and then collapsed. Subsequent excessive quantitative easing has ensured an historically low interest rate environment.

Alphinity's recent research trip to the US highlighted that a combination of significant catastrophe losses, persistent low interest rates and declining reserve releases and profitability, added to increased capital scrutiny, is finally leading to a turn in reinsurance and commercial property rates in the the major insurance markets globally. Reinsurance and the upper end of the commercial property markets tend to be more global in nature and directly affect the Australian market, leading to rate (premium) rises here. Australia seems to be ahead of other markets, Alphinity notes.

The last positive price cycle for insurers was 2000-04, or ten years ago, albeit margin benefits tend to linger longer than a cycle. While cycles are never consistent and are often driven by major cat events (9/11, Katrina for example), ten years is a rough average and we've just had one of the biggest loss years on record. In other words, suggests Alphinity, “the conditions are right”.

The reality is the long down-cycle experienced from 2004, followed by persistent low interest rates and a rise in cats ahead of last year, meant the premium price cycle had already begun to turn upward before the rolling disasters of 2011 played out. Last year has simply provide greater price rise impetus. With price increases in both personal and commercial lines now coming through in 2012, Alphinity expects an improved cycle for insurance to begin to be reflected in margins and share prices.

It is the trend in underlying margins – that which had begun to turn before 2011 – which best reflects longer term value in insurance company investment, Alphinity points out. However near term share prices are highly influenced by immediate “reported” margins which are impacted heavily by cat levels. With price rises coming through, and if we can look ahead to somewhat steadier investment markets, a more “normal” year of losses ahead would imply “materially” improved insurance margin performance, which should drive share prices.

Australian business is the biggest driver of earnings over time for Insurance Australia Group ((IAG)). Alphinity holds the stock in its portfolio.
 

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By Greg Peel

At the end of the day, a bank's profits reflect the margin between its lending and borrowing rates, with mortgages, business and other loans on one side and deposits and wholesale funding on the other. Proprietary trading and wealth management businesses offer additional revenue, but banks are not going to outperform when margins are under pressure.

Which is the situation they finds themselves in now.

Over the past month, ANZ Bank ((ANZ)), National Bank ((NAB)) and Westpac ((WBC)) have all provided earnings results for the six months to March while Commonwealth Bank ((CBA)) has completed the picture with a March quarter update. And over the past month, the world has slipped back into Europe-related “risk off” mode yet again. In wrapping their reporting season views, bank analysts have had to contemplate both events.

The books closed on a buoyant global marketplace at the end of March, albeit Australia's performance was tempered by the two-speed economy factor. The RBA has since provided a 50 basis point cash rate cut as a result, which impacts on the banks' margin picture going forward.

The buoyant market nevertheless provided the banks with a more positive trading environment, which helped offset weak ex-market revenues. The picture would have been pretty bleak without trading profits, Citi suggests, but all in all the banks' results were largely as expected. 

It was no surprise that margins were lower. Ignore what the idiot, vote-seeking politicians have said, bank wholesale funding costs are higher now than they have been in recent times albeit lower than they were at the depth of the GFC crisis. To settle on “higher” or “lower” one must first set the terms of reference. In the meantime, the banks continue to pay up for deposits, particularly popular term deposits, given stiff competition for this cheaper form of funding. With the wider Australian economy subdued to say the least, loan growth has been anaemic. Hence the margin crunch.

The good news is that bad debt provisions are reasonable, overall sector loan quality continues on an improving trend and the Big Four are very well capitalised in the context of the new Basel III requirements coming into force in January. The bad news is there appears further pressure on margins ahead.

As to how the six months to March and the relative price movements of bank shares has impacted on analysts' sector preferences, it is interesting to first take note of the following table. It indicates how the FNArena broker database perceived the Big Four following the previous half results posted in November.

Six months ago, NAB was number one pick amongst the sector. NAB is seen as the riskiest of the quartet but thus offering, at the time, greater upside from earlier weakness. NAB had seen the benefits of its “Your dumped” ad campaign which attracted new loans, and the feeling was all the bank had to do was exit its dragging UK operations and the world would be a happy place. CBA was, is, and pretty much always has been considered the least risky of the four, but also the most-overvalued on this basis. Hence it was, six months ago, firmly planted in last place. Now let's fast forward to the latest table, based on yesterday's closing prices.

A number of changes immediately stand out, but let's start with stock prices. Bearing in mind we've just had another savage euro-based sell-off, each bank's stock price is not much changed from six months ago. If we compare prices to consensus targets using the up/downside measure, we also note not a lot of difference in the readings for all of CBA, NAB and Westpac. NAB, on the other hand, has seen its upside to target halved.

It was suggested by at least one broker six months ago that NAB's competitive loan rates might just come back to bite the bank on the backside, and with wholesale funding costs having drifted higher, and competition for deposits remaining elevated, they have. Perhaps NAB's biggest problem, however, is an even steeper deterioration in the banks' UK business under government austerity measures and the realisation NAB may simply not be able to exit for some time.

It is thus no surprise NAB has now crashed to the bottom of the table (rankings based on Buy/Hold/Sell ratios). Perhaps more surprising is that CBA's share price has risen 4% over the six months yet suddenly analyst consensus has the lumbering giant in equal first. CBA's premium to the bunch has seen some easing, but where the bank stands out is on its investment to date on new technology, offering a lower cost structure ahead than its slower moving rivals. And at the end of the day, not all analysts suggest CBA's premium is unjustified.

Costs are considered one of the more significant headwinds for Westpac, while in the deteriorating local economy ANZ's Asian exposure provides it with sufficiently positive point of difference to bump it into equal first with CBA.

We should also take heed that analyst forecast adjustments to date have been confined to a result season response, with any further forecast changes pending on the escalation of euro-fear. The exception is Macquarie which has this week moved to trim bank target prices, but I'll address Macquarie's reasoning shortly. Target trimming may also be ahead for the other brokers but in the meantime there has been much discussion about what the whole “Greek exit” story may imply. Europe adds an additional element into domestic-based expectations for bank margins over the second half.

Let's just hold wholesale funding costs steady for the moment. Led by ANZ, the banks have been attempting to shift the average Australian's focus away from the RBA overnight cash rate and toward the cost of overall funds when it comes to mortgages, primarily, and business loans thereafter. Banks quite simply do not borrow overnight cash in order to provide 20-year loans. A cut in the overnight rate helps to shift rates down across the yield curve, but one needs to go out to 90 days to find the banking sector's short-term borrowing cost, known as the bank bill swap rate (BBSW) and one needs to reflect on why the banks have been recently, and always have been, issuing five year paper in various forms. The reason is because that's where a bank's loan exposure is concentrated.

ANZ has thus been bold enough to make “out-of-cycle” increases to its mortgage rate, meaning unrelated to any RBA rate change, to reflect the bank's true borrowing cost. The 50bps RBA cut also provided scope for the banks to reprice their loans and pick up some margin relief. On the other side of the equation however, we are yet to see the banks reduce their deposit rates.

While an RBA rate cut provides the banks with every excuse to drop term deposit rates, such cuts usually follow a couple of months later once the loan book impact has played out. The problem is that demand for term deposits remains strong but so does the competition amongst the banks for this cheaper form of funding. It might be difficult for average Joe to switch mortgage providers mid-stream but it is very easy to switch term deposits at every rollover. Cut the TD rate too far and a bank will suddenly find it is isolated in the deposit funding market.

Were it not for TD market tightness, bank analysts suggest net margins could improve over the second half even as credit demand sags as room is provided for loan repricing at more favourable levels. But ongoing tightness rather nips this possibility in the bud. 

Now consider how things will look if offshore funding costs really do shoot up again as another global credit freeze descends.

Just to add to the gloom, offshore funding risk was not the primary reason for Macquarie's target price cuts this week, albeit “tight funding conditions” are a factor. The Macquarie analysts have drawn on analysis from East & Partners to paint a weak picture of net margin expectations ahead. Let's divide the Australian economy into its two dominant sectors. We'll call them Mining and Not Mining (with energy part of mining for the sake). Due to the geographical luck of the draw, we thus have two Mining states while everyone else is in a Non Mining state.

East & Partners' analysis show weak borrowing intentions from Not Mining in the next year, particularly from SME and micro business cohort. Macquarie suggests “the outlook for business margins is bleak”. In the meantime, bank exposure to Mining states has doubled over the past three and a half years, with WA and Queensland now representing some 40% of net interest income. Mining is now conceding more subdued conditions, and Macquarie sees risk to the downside. At best, the analysts suggest, margins could be weak as Mining stalls. At worst, the banks may find their Mining state exposures now providing risk.

The news is, however, not all bad. Analysts agree there is no reason the banks would need to decrease their dividends. Not only are capital positions comfortably within the new Basel III requirements, they are significantly higher on a ratio basis than most developed world banks, particularly those deemed “too big to fail”. Asset quality is also improving and bad debts are under control, so while the outlook for earnings growth appears very subdued, very attractive yields will remain the order of the day.

This is comforting when confronted with yet another possible period of serious global “risk off”. Yet while Australian banks to date have not tended to materially underperform in such times, BA Merrill Lynch is concerned the Big Four may just be a little more vulnerable this time around. This time around the underlying domestic growth backdrop is weaker, margins are not set to recover and may even be squeezed further on RBA rate cuts if there is no room to lower TD rates. Deutsche Bank sees scope for reduced TD rates but upside risk to wholesale funding cost would provide a counter, as would continued competition for deposits. Merrills also notes bank valuations have come off sharply again across the globe but not so for Australia's Big Four, making elevated price to book values on a peer comparison an easy target.

Citi notes that on their own, the Big Four are currently trading on undemanding multiples. Yet Citi can't get too excited given valuations reflect the anaemic credit growth outlook ahead and further volatility in markets is likely.

So just how bad could it get? 

Following last week's CBA quarterly update, bank CEO Ian Narev addressed the implications of a Greek exit. He believes they would be “material”, but notes there has been a degree of forward planning. Narev was speaking only for CBA, but one assumes the others haven't ignored the possibility either. Narev is confident of CBA's settings with respect to counterparty risk.

He is also “confident the Australian economy is in pretty good shape” but is also wary of the further overflow of negativity into consumer sentiment, impacting on credit demand. In particular, Narev suggested CBA is carrying sufficient funding to carry it through any potentially deepening crisis in Europe.

This is true for all banks, which have pretty much secured their funding requirements for FY12 (year ending September). They will soon have to think about FY13, however, and the risk is we'll see another bout of sustained credit spread elevation, pushing up wholesale funding costs.

So to summarise:

The outlook for Australian bank margins, and thus earnings, is weak, based on ongoing subdued credit demand, rising offshore funding costs, ongoing deposit rate competition and the risk of a more significant blow-out on a Greece-led crisis. Were sentiment to turn sour again Australia's banks are likely to be hit. However capital positions are strong, dividend payments are not under threat, asset quality has improved and bad debt levels are not overly concerning.

It is interesting to note at this point that last week's unsecured note offer from NAB (supposedly the weakest of the four) was so well subscribed the bank doubled the size of its intended borrowing. (See: Yield On Offer From NAB Note Issue). NAB is offering at least 2.75% over BBSW which puts the note's initial floating coupon at over 6.5%. On yesterday's closing price and analyst forecasting NAB is offering a 7.8% equity yield, but also equity risk. You would only lose your capital on the note if NAB went bust.

Citi suggests waiting for a further market correction before buying Australian bank shares. The public is saying bonds are a safer bet than equities.
 

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 - Citi goes against consensus on Computershare
 - Suggests none of the company's US businesses are in growth markets
 - This earnings pressure is likely to limit share price upside
 - Neutral rating retained by Citi

By Chris Shaw

When BA Merrill Lynch reinstated coverage on Computershare ((CPU)) earlier this week it was with a Buy rating and above market consensus earnings estimates, the positive view on the stock being matched by a majority of the brokers in the FNArena database (See: Computershare's FY14 Upside).

One of those to hold off on a positive rating is Citi. The broker rates Computershare as Neutral, based on the view the company remains in an earnings downgrade cycle as none of the group's US businesses are positioned in growth markets.

As evidence of this, Citi notes the US registry maintenance market shrank by 5% in 2011, meaning the Transfer Agency (TA) account base is now 15% lower than was the case five years ago. The news was worse for Computershare specifically, as Citi points out the company's TA account base declined by 8% last year, while registry maintenance revenues fell by 6%.

A reversal in the market trend appears unlikely as the TA market in the US is becoming more competitive. Citi notes another manager, Broadridge, is attempting to transfer TA accounts across the broker nominee style accounts as a means of lowering registry maintenance fees for listed companies.

At the same time, the rapid growth of ETFs (Exchange Traded Funds), low IPO activity following the Global Financial Crisis and a general shift away form equities as households deleverage is likely to drive further declines in the TA market in the view of Citi.

While the recent Shareowner Services acquisition has positioned Computershare for some short and medium-term growth in the TA market, the longer-term outlook of a market in decline leads Citi to suggest US growth options for Computershare are more likely to be focused on mortgage servicing.

To reflect this potential shift Citi has trimmed its registry revenue forecasts, though overall earnings are broadly unchanged as allowance has been made for two new accounts in Computershare's Business Services division.

Both of the acquisitions – SLS and ServiceWorks - offer expansion possibilities in the view of Citi, more so than the vertical acquisitions made by the company in both 2009 and 2010. 

A review of its model leaves Citi forecasting earnings per share (EPS) for Computershare of US48.7c this year and US59.1c in FY13. These estimates compare to consensus forecasts according to the FNArena database of US48.3c and US60c respectively.

The expected structural decline in US shareholder numbers and the fact equity market turnover in all of Computershare's key markets means little scope for share price outperformance in Citi's view, which underpins the broker's Neutral rating.

Only UBS agrees and similarly rates Computershare as Neutral, while six of the eight brokers in the FNArena database rate Computershare as a Buy. The consensus price target for the stock is $9.07, while Citi's target stands at $8.50.

Computershare today is trading slightly lower in a weaker overall market and as at 11.00am was down 3c at $8.31. The trading range for Computershare over the past year has been $6.55 to $9.58, with the current share price implying upside of just under 10% relative to the consensus price target in the FNArena database.

 
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