- APRA imposed rules will only have minor impact on banks' profits
- Subdued outlook forces banks into cost control
- Overall reliance on offshore funding declining further
- Question marks about CBA's natural market premium

By Greg Peel

Australia's banks breathed a sigh of relief last week when the Australian Prudential Regulation Authority unveiled its new liquidity requirements in light of the Basel III international regulatory amendments made as a result of the GFC. Basel III included strict new rules providing not just capital requirements for banks but also liquidity requirements which force banks to hold a level of quality liquid assets on their balance sheets, such as sovereign bonds.

(A lot of good sovereign bonds have done the European banks prior to the new rules even being in place, one might say.)

The issuance of sovereign bonds nevertheless requires a government to need to borrow, which in turn implies a budget in deficit. Problems thus arise for countries in which the budget is in surplus or heading back to surplus, such as Australia, suggesting limited bond issuance and thus difficulty for banks to comply with liquidity rules. Anticipating this issue, Basel III makes provision for other assets to be deemed eligible by local authorities, which APRA has addressed. What banks have been more concerned about, however, is just what penalty cost APRA would impose on banks for assets outside Basel's guidelines given the Authority had flagged its own stringent approach that would be potentially even stricter than that of Basel's.

The good news is that while the banks and bank analysts had feared a charge of anything up to 50 basis points, the 15 basis point charge announced by APRA falls well short of even the low end of expectations. Residential mortgage-backed securities (RMBS) have been included as eligible and APRA's rules have diverged very little from Basel III. Bank analysts are in agreement that the cost to the Big Four banks will be minimal, in the order of 1% of earnings.

Over the past few weeks ANZ Bank ((ANZ)), National Bank ((NAB)) and Westpac ((WBC)) have reported full-year results on their September year-end cycles and Commonwealth Bank ((CBA)) has provided a first quarter update on its June year-end cycle. All up the results came in a little below analyst expectations but not to the extent of being a major concern. The main source of earnings miss was weaker than expected investment bank trading profits which is hardly a great surprise with market activity currently very depressed on low volumes. This is a swing factor which clearly can rebound at the first sign of a rebound in market confidence. It is also the primary source of income for Macquarie Bank ((MQG)) which has been duly suffering as a result.

As far as commercial banking operations are concerned, the word “subdued” is popular among analysts and bank managements. Demand is subdued and outlooks are subdued with a widespread lack of consumer and business confidence clearly the driver. This means profit growth has stalled providing flat quarter on quarter results and pressure on margins. On the positive side, the banks are pushing to control costs and bad and doubtful debt charges are back to manageable mid-cycle levels after the great scare of the GFC.

The one bank that bucked the trend to some extent was NAB, which sequentially grew profit and expanded returns and margins. NAB's result reflected its aggressive competitive stance taken earlier in the year. That stance has further been rewarded by the RBA's November rate cut given three of the Big Four have passed on all of the 25 basis points to variable rate mortgage customers, while NAB only handed back 20 basis points, providing a nice little 5bps buffer.

NAB's 5bps buffer will also help the bank ride through the next financial year, suggests Credit Suisse, when history suggests the aggressive loan growth of FY11 will become a drag on margins in FY12. In FY09 it was Westpac and CBA who went in hard on the back of the government's first home buyer stimulus which came back in their faces with greater than peer margin declines in FY10. Of the Big Four, NAB is also the bank which will be worst impacted by increasing funding costs, but in that instance the new covered bond initiative will help to reduce reliance on offshore funding.

Indeed, this shall be the case for all banks. While RMBS in the US in the form of CDOs were largely to blame for the GFC, there is no reason a “prime” RMBS, featuring quality mortgages, low loan-to-value, full documentation etc cannot be a viable AAA-rated security issued by a AA-rated Australian bank. It's just that all mortgage securities have now been tainted. However, another problem with the US market was that of beneficial ownership, such that even today the US courts are still trying to sort out who actually ended up with the risk on mortgages within defaulted CDOs.

Covered bonds are an alternative in which the bank does not package up mortgages and on-sell them, thus relieving themselves of the risk, but instead keeps the mortgages and the risk and simply on-sells the interest payment income stream to yield-thirsty investors. Covered bonds have long been popular in Europe and are now allowed to be issued in Australia, thus offering Aussie banks with another means of reducing their reliance on offshore funding (note also that covered bonds can be issued on assets other than mortgages, such as car loans etc).

This reduction of reliance on offshore funding was another major theme of the recent bank reporting season, and the main offset to otherwise dreary outlooks. Australian banks were caught in the GFC holding little in the way of deposits (Australians were borrowing, not saving) and a lot in the way of RMBS and dirt cheap offshore funding. The GFC sent offshore funding costs through the roof and shut down the RMBS market, forcing Australian banks to cut dividends and raise dilutionary capital as they put aside large chunks of funds for the bad debt explosion they feared was about to hit.

Today Australian banks boast much higher tier one capital ratios and significantly higher levels of deposits which they've achieved through aggressive competition for Australia's now historically high rate of savings. Covered bonds will provide another source of domestic capital to help insulate Australian banks from an onerous need to source offshore funding at a time those rates are rising again due to the European debt crisis. Were we to see “another Lehman” in Europe, this time around the Big Four are in a much safer position.

In actual fact, the more subdued Australia's credit demand growth is, the less offshore funding the banks will need. It's not exactly the sort of trade-off you want but right at the moment it's probably better to bungle along in a “subdued” environment on lower risk than to increase funding risk in the face of what might dangerously transpire.

On that basis Macquarie notes European concerns have meant Big Four credit default swap (CDS) prices are now back where they were a couple of months ago when markets went into a tailspin over Greece and the US credit rating downgrade. What Macquarie points out, however, is that CDS prices are an unreliable indicator for Australian bank funding costs which are typically 30-40bps cheaper than CDS prices imply. Macquarie also notes the benefit of covered bond issuance is worth around a 50-70bps buffer over unsecured wholesale funds as well.

The implication is that were the Big Four to come up against much elevated offshore funding costs again when they come to roll their 2012 maturities, they would suffer only a minor and manageable few basis points of margin decline. More of a concern would be any related drop in Australia's terms of trade (global recession, lower Chinese exports, lower Chinese imports from Australia) which would see the RBA cutting more aggressively and bank deposits losing their appeal for Australian investors.

As we stand now, Australian banks share prices have rebounded quite sharply out of the European-led depths of earlier months which saw yields at must-have levels. As far as JP Morgan is concerned, for one, we can no longer argue that the Big Four are “cheap”. On the other hand, Deutsche Bank is happy to boldly take an above-consensus stance.

Deutsche's bank analysts believe Big Four bank valuations are still “compelling” as they expect double-digit returns over the next 12 months. They are looking for 9% earnings growth in FY12 and 7% in FY13 on better than expected margin performance, cost controls and ongoing bad debt reductions and the prospect of increased dividend payouts. Deutsche's earnings forecasts are sitting 5% above consensus.

A consistent theme to come out of the earnings season was nevertheless agreement that CBA's performance was the least inspiring. While analysts have been suggesting for a couple of years now that CBA's traditional premium for size over the others, which translates into a higher afforded PE ratio, means CBA shares offer the least value, now there is a general view that premium is no longer justifiable and should erode.

The flipside to CBA is NAB, and here brokers remain positive with the caveat that NAB remains the most risky given its UK exposures. ANZ's story is still one of what it might be able to derive from its Asian expansion (with deposits important here) while Westpac is all about spending to improve systems while cutting costs on the other side.

FNArena last updated the banking sector in late September when global markets were in a particularly volatile state. At that time our stock analysis table looked like this:

It's now late in November and in the interim we've seen quite a sharp bounce, only to see that bounce again under threat as European and US debt issues continue to weigh. Today our table looks like this:

There have been only slight changes to consensus target prices and from a rating perspective, NAB has lost one Buy rating and CBA has gained one Sell since September. These moves have not changed the overall consensus order of preference and it's not hard to see why, with analysts setting a target for NAB 20% above yesterday's closing price compared to only 6% for CBA.

The stand-out column remains those fully-franked yields on the right hand side which have proven very tempting for many investors. The problem is, of course, that no matter how many times it is pointed out that Australian banks are in a much safer position than many elsewhere it will not stop the market, and particularly foreign investors, selling down Australian bank shares in times of macro panic.
 

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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- Computershare granted approval for BNY Mellon shareholder registry acquisition
- Acquisition a positive as it boosts earnings growth during a downturn
- Brokers lift forecasts and price targets, one rating upgraded

By Chris Shaw

Having announced the proposed acquisition of the shareholder registry operations of BNY Mellon in April of this year it has been a long wait to finally receive regulatory approval for Computershare ((CPU)). Yesterday the US$550 million deal was approved and should now close early in January of next year.

Acquiring the BNY Mellon assets is something of a game-changer for Computershare, as UBS notes the deal will give the company around 70% of the US transfer agency market. It also offers a scale platform from which further unit cost reductions can be achieved as around 950 transfer agency clients and about 900 staff are being added.

The big plus of the deal, comments JP Morgan, is it provides Computershare with earnings per share (EPS) growth over the next two or so years, even allowing for a still subdued corporate activity and interest rate environment.

As JP Morgan points out, this will help offset what was expected to have been a subdued earnings outlook offered at Computershare's annual general meeting later this week. Now, with the acquisition being approved, securities brokers across the market have lifted earnings expectations.

As examples, JP Morgan has increased its EPS estimates by 5.6% in FY12 and by 9.9% in FY13, while Citi increases its numbers by 1% and 6% respectively. Deutsche Bank has actually trimmed its FY12 forecast by 4% but increased its FY13 forecast by 11%. Consensus EPS forecasts for Computershare according to the FNArena database now stand at US57.4c for FY12 and US68.5c for FY13.

Risk to these forecasts appears to be to the upside, in part because Computershare may be able to achieve synergies above the level currently expected as the BNY Mellon operations are fully integrated in coming years.

As well, Computershare has also recently acquired SLS and Serviceworks and these are expected to add to EPS by as much as 8% from FY13. RBS Australia suggests these deals have been positive moves by management, as Computershare has added growth during a downturn in its markets.

UBS has been a little more cautious on the BNY Mellon purchase in the sense that the market appears to have over-reacted to some extent. The share price yesterday rose by more than $1.00 per share on news the deal had been approved, whereas UBS suggests an increase of 70-75c may have been more appropriate.

Having said so, UBS does accept the BNY Mellon deal improves the earnings growth trajectory for Computershare, especially given management's solid track record with respect to synergies and integration of acquisitions.

The increases to earnings estimates across the market means increases to price targets. The FNArena database now shows a consensus price target for Computershare of $9.58, up from $8.42 prior to the BNY Mellon purchase being approved. Targets range from UBS at $8.75 to JP Morgan at $10.20.

Macquarie has made the only change in rating among brokers in the database, upgrading Computershare to Outperform from Underperform. This reflects the view Computershare now should be priced as a growth stock in the Australian market, given the combination of earnings stability and operational leverage to the upside is rare in the current trading environment.

Overall the database shows Computershare is rated as Buy four times and Hold three times, Credit Suisse similarly arguing there is value in Computershare at current levels that justifies an Outperform rating. 

The Hold argument is well stated by Citi, which suggests the market backdrop for Computershare remains difficult. This is evident in the broker's move to cut expectations for corporate actions revenue. When this tough outlook is added to the strong share price gains seen yesterday, valuation appears appropriate at current levels in Citi's view.

Computershare today is trading lower and as at 11.30am the stock was down 14c at $8.30. This compares to a range over the past year of $6.55 to $11.37. The current share price implies upside of around 14% to the consensus price target in the FNArena database.

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- Macquarie's result weak but no shock
- Costs, staff and divs cut but is it enough?
- Stock well leveraged to market improvement
- Inexpensive but is it time to buy?

By Greg Peel

“Following the release of the European financial package,” declares Goldman Sachs' equity strategy team, “we believe there is potential for the macro risks, which have been dominating investor sentiment and driving equity risk premiums higher, to diminish as we head into the end of the year”.

Goldmans has backed up that belief by increasing the cyclical exposure of the strategists' model portfolio and reducing the defensive stance it has maintained up to now. Out goes the defensive toll collector Transurban ((TCL)) and in comes the cyclically exposed building products manufacturer James Hardie ((JHX)). And along with James Hardie comes Australia's battered and war-torn investment bank, Macquarie Group ((MQG)).

The “upgrade” for Macquarie from the GS top-down analysis team is at odds with the broker's own bottom-up stock analysts. They retain a Hold rating following the release of MQG's first half FY12 earnings result on Friday. While acknowledging that stock analysts limit their views mostly to a 12-month horizon, while strategists are more inclined to change views on an open-ended time scale, the disparity of opinion amongst representatives of the same broking house accurately reflects a more general market view on the company which no longer carries the tag of “The Millionaires Factory”.

I last reviewed analyst opinions on MQG following the release of its full-year FY11 result in a report entitled Macquarie A Matter Of Faith. Ever since the GFC destroyed MQG's previously successful infrastructure fund model, the Group has been forced to revert to being basically a common or garden investment bank once more. Such businesses rely on market sentiment and turnover, on demand for advice, broking services and investment opportunities, and on trading profitability potential. In short, it's difficult for an investment bank to make money when markets are weak and volumes are low. Unfortunately such conditions have been the state of play ever since 2008.

It was never going to be easy to predict just when global market sentiment would “normalise” in the wake of the historically rare event that was the GFC. No one was ready for Greece to become an issue in early 2010 and again in early 2011, leading the whole European debacle to dominate the last two years of activity. All Macquarie management has been able to offer at successive six-monthly earnings updates in the interim is guidance based on the caveat of “if market activity improves”. It hasn't, so management has been forced to successively downgrade earnings expectations. As Goldman Sachs stock analysts suggest, “[Friday's] result has seen a continuation of the downgrade cycle which has further delayed MQG's recovery to mid-cycle returns”.

The longer market sentiment remains subdued, the longer MQG must endure weakening earnings results, and thus the longer the path back to an improved return on equity (ROE). Macquarie could boast ROEs of 20% pre-GFC but at the moment it's lucky to reach 10%. Analysts see 20% as possible again one day but are looking to at least 15% in the shorter term if markets can improve. The longer that improvement takes, the more MQG bleeds and the more it is forced to cut costs and reduce staff. The risk is that such cost-cuts are held up by management on fear the bounce will come immediately after and upside recovery potential will be crimped. It was a matter of faith, analysts then suggested, that MQG was not doing much about cost cutting at end-FY11.

Since then, the European situation has come to a head, and we've suffered two of the most difficult trading months on record in August and September. No one was expecting MQG to post anything other than another weak trading result. It would simply come down to a matter of degree. As it was, the result mostly fell short of analyst expectations which had already been trimmed in the past quarter. As Credit Suisse points out, the “miss” was related to exactly the area one would expect – the Capital Markets division.

On the other hand, analysts note fees from funds management and other “annuity-style” activities (those which provide more predictable earnings flow largely immune to specific market movements) were solid and better than expected. BA-Merrill Lynch values that “annuity” business at $28.86. The analysts suggest that even if one were to assume zero income from Capital Markets activities, another $7-14 of value could be released for the Group. Macquarie shares closed on Friday at $25.15.

Citi is following a similar trajectory in suggesting MQG's current share price implies an ROE of only 7% by FY14. If the Capital Markets businesses can reach at least an ROE of 10% by that time, Citi believes the stock should be trading 20% higher.

Aside from missing expectations and once again watering down guidance, management made two important announcements on Friday. The first was on the subject of cost cuts and the second related to an intended share buyback. MQG may well be struggling but it is not about to go out the back door. A Basel III update at the result release was welcomed by analysts and we can't forget the big dividend due the Group shortly from the MAp Group ((MAP)) restructure.

Analysts welcome an announced dividend cut. Shareholders may not welcome this news but announced cost-cutting initiatives including a reduction of 485 staff should provide a sufficient trade-off going forward. Dividends can only be paid to MQG shareholders after bonuses have been paid to MQG staff. However, on the matter of cost cuts more than one broker questions whether they go far enough.

Citi suggests “there remains scope to go even harder on costs” and UBS believes MQG needs to “right size” the investment bank to deliver more appropriate returns across the cycle. A headcount of 15,000 is down 3% but “still appears too high for MQG's revenue potential,” says UBS.

On the matter of a proposed share buyback, analysts were universally supportive as this will go some way to assisting that much needed ROE improvement. However, only an intention to buy back was announced rather than an actual buyback being confirmed. While analysts believe management will be determinedly true to its word, there is a lot to be done before a buyback can proceed. MQG needs to optimise its capital structure, exit legacy businesses, raise hybrid capital, grow retained earnings and receive APRA approval. “This may take a while,” says UBS. At least 12 months by JP Morgan's reckoning.

Yet as noted, the true bottom line for MQG is quite simply whether or not market conditions can improve. Brokers were expecting a better result on profit, dividends and outlook on Friday “but these are extraordinary market conditions,” notes Citi, “and the stock may continue to rally if investors are relaxing their extreme aversion to risk”.

In other words, investors stand to do very well out of MQG if market conditions can just start heading back towards “normal”. This would imply positive market direction and a bit more certainty than has been the case in 2011. Or 2010. If markets can't do so then MQG is in for further downgrades and an even longer path back to the ROEs it once boasted. It then comes down to whether the market has now sufficiently priced down MQG. On that, analysts remain divided.

RBS (Buy) is happy to acquire MQG stock at current levels which it calculates to be 0.9x net tangible asset valuation. Merrills (Buy) agrees, and also points out an attractive 0.7x book value. Credit Suisse (Outperform) likes the book value too as well as an implied 7.7x forward PE. Citi (Buy) is forecasting less risk aversion from markets ahead and it, too, makes note of MQG's 10% discount to net tangible assets.

Deutsche Bank (Hold) suggests it's too difficult to know just when markets will return to “normal”. JP Morgan (Neutral) believes management has laid out a clear path towards ROE improvement but “it is too early to 'pay ahead' for these prospects”. Goldman Sachs (Hold) suggests a ROE greater than cost of equity looks an achievable goal over the next 2-3 years, but “the risk to earnings remains high”.

All brokers have trimmed their FY12 earnings forecasts. Of the seven brokers covering MQG in the FNArena database, four have a Buy or equivalent rating and three a Hold or equivalent (Goldmans is not in the database and Macquarie is not allowed to rate itself). There are no Sell ratings. The consensus price target was impacted by moves both up and down post-result, and is today at $31.00 compared to $30.61 prior to Friday. The uncertainty of whether or not markets can “normalise” from here is nevertheless reflected in the wide target range, from $27 (UBS) to $40 (Credit Suisse).
 

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