- Macquarie's FY11 result was roughly in line
- Quality was arguable
- Faith plays a large part in forecasts
- Valuation undemanding for the long term
 

By Greg Peel

“Management appear to be waiting for 'operating leverage' to arrive with no specific plans to reallocate capital or costs among underperforming divisions,” suggests BA-Merrill Lynch, “We still view the path to a materially higher ROE [return on equity] too uncertain and too far into the future”.

The path of the merchant bank Hill Samuel Australia to become Macquarie Bank, to obtain a commercial banking licence and then to be listed on the stock exchange was predicated on investment banking activities reliant upon solid financial market demand and turnover. The 1990s recession brought with it a swift slowdown in activity in equity, capital and advisory markets, but the investment bank morphed into a unique structure dominated by the infrastructure fund model. That model carried what became the Macquarie Group ((MQG)) into the new century, before it “broke” in 2008.

For Macquarie, the last three years have been all about a return of focus to that which set the original merchant bank on a path to greatness in the first place – financial market fees, commissions and trading profits. But the group has not returned such focus because that's now where the riches once more lay. It has done so because of the amount of capital the remaining business has invested in such activities. Unfortunately it is the markets themselves which have not been playing along. 

For the past three years since the GFC, Macquarie's return on equity (ROE) has been at or below 10%, notes UBS. Both management and the market would like to see a return to ROE's of 15-20%. If everything falls into place, that may be possible in the longer term. But right now a strong element of hope is involved.

The group's FY11 profit of $956m was roughly in line with analysts forecasts and recently downgraded guidance. The result was a lot “cleaner” than FY10's because it contained less one-off adjustments and was not supported by a low tax burden affected by excessive bad debt write-offs. In this case, paying more tax is seen as a good thing in the wider scheme. However, in terms of actual result “quality”, analysts are split. While, for example, RBS has called the result quality “reasonable”, JP Morgan, for example, begs to differ.

JPM's analysts note a miss in expectation in the group's higher PE-generating fee and commission result. The balance is made up from higher than expected but lower PE-generating asset realisation gains, meaning booked from on ditching unwanted assets. MQG is now an operation for which fee and commission income is paramount, yet the accounts show management is withholding a reserve of around $400m in equity representing assets “Available For Sale”. This substantial figure cannot be ignored, so the JPM analysts have been forced to include potential asset realisations in its forecast earnings when normally they wouldn't given inherent uncertainty. Hence even their own forecasts now imply a “lower quality”.

The other problem with FY11 earnings was one of currency. By financial year-end, 64% of Macquarie's profits were being sourced offshore. While the ongoing internationalisation of the business has growth and diversification merit, the strong Aussie dollar has decimated profits on conversion back into the local currency, and a similar drag is expected in FY12 with little end to currency strength in sight.

Management has guided for an FY12 result ahead of FY11, but subject to improving market conditions in the Securities and Capital divisions. These divisions have borne the brunt of the loss of investor interest since the GFC. Low volumes and demand still dominate this space, but analysts, and clearly management, are assuming that activity must “normalise” eventually. It's just a matter of how long an investor in MQG shares is prepared to wait.

Indeed, if one takes a five-year average of profits earned across each division, FY07-11, management's guidance looks quite conservative, more than one analyst notes. The question must be, however, one of whether five-year averages are an accurate guide when this particular period is one in which a once-in-a-lifetime event dominates. Management has also guided to 16% profit growth in FY12 by simply doubling the result of the second half of FY11. In this case, analysts believe guidance is really quite conservative indeed, given consensus growth of some 35% was expected in FY12 prior to the result release.

On that basis, Citi has stuck its neck out and suggested that it is consensus forecasts which are ambitious rather than management's. Not only would market conditions have to pick up, but Macquarie's growth rate would have to be “notably faster” than consensus forecasts are suggesting for international peers. And as Merrills notes, “given current market share trends we are not confident past levels can be easily recaptured”.

All analysts note that at 1.0x book value, MQG does offer more upside than downside. Merrills nevertheless fears the “franchise may be slipping” and Citi can't see any signs of a reduction in headcount or expenses flagged in order to boost returns. At least the deal pipeline is in better shape than it was 12 months ago.

Aside from these naysayers, the general response to the MQG result from analysts was one of gradual signs of recovery. Amongst the broker reports were headlines of “small steps”, “turnaround evident”, “getting ready for the good times”, and “encouraging signs...keeping the faith”.

It seems faith is playing an important part, particularly given the extent of crossed fingers with respect to a pick-up in trading activity. For the most part nevertheless, the story is one of a long road back and at an undemanding valuation it becomes a matter of investor patience.

There were no ratings changes in the FNArena broker database emanating from the result, meaning the Buy/Hold/Sell ratio remains at 3/4/0 (note Macquarie can't rate itself). Goldman Sachs is also on Hold and Morgan Stanley on Equal-weight. The consensus target has fallen only slightly, to $40.98 from $41.35, suggesting 13.4% upside at current levels.

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By Greg Peel

The heavens began opening over the Sunshine State in late 2010 and by early 2011 the state was awash. Cyclone Yasi was the icing on an tragic cake. The reality is Queensland's economy began to slump in 2008.

The GFC was obviously a catalyst, but when we consider Queensland's partner state in commodities boom benefit – Western Australia – has seen its economy surge along, it makes Queensland's poor performance seem that much poorer. The biggest problem has been the savage hit to Queensland's other major industry of tourism and leisure from the constantly rising Aussie dollar. Commercial property has borne the brunt, with the populous South East corner a standout. Before La Nina came to spoil the party, the party was already struggling.

With the rains came flooded mines, lost commodity production and sales and a virtual wipeout of the state's attraction as a tourist destination. It is thus no surprise local lender Bank of Queensland ((BOQ)) posted a rather disappointing first half earnings result on Friday. A 161% increase in bad and doubtful debts (BDD) still took analysts by surprise. Of the further $134m provisioned, $45m was weather related but another $35m came from four large commercial property exposures.

The reality, however, is that bad debts aside the bank posted strong underlying growth of 16%, assisted by a much lauded 5% reduction in costs. Growth was cut back to 4% net of BDD provisions, but that figure fits nicely into the range of Commonwealth ((CBA)) with 7% down to ANZ ((ANZ)) with 2%, Macquarie notes. The majors are nevertheless seeing a reduction in their own BDDs as the business cycle turns. A healthy rise in BOQ's net interest margin was also a pleasant surprise, but this was ascribed to BOQ's recent acquisitions of St Andrews Insurance and CT Asset Finance, such that further increases may yet be reliant of further acquisitions.

Not that BOQ is in a luxurious position to throw money around. Many analysts were surprised the bank went the full 100% payout with a 26c dividend when 24c was expected. Looking ahead, capital is a problematic issue.

The bottom line is that management is confident the bank has seen the worse and that the rebuilding of Queensland will assist in a swift reduction in BDDs over the next 18 months. It's been two months since the floods and already many businesses are back to normal trading. Management retained its FY11 recently updated guidance range but shifted expectation to the low end. In terms of return on equity (ROE), management is still touting a recovery to 15% but has pushed the timing out beyond FY12.

BOQ's first half result represented an ROE of only 5.3%, notes RBS. Assuming bad debts do normalise as hoped, RBS believes a 12% ROE might be possible but that 15% is a stretch. BA-Merrill Lynch suggests a 15% ROE would be quite compelling but believes even reaching double digits is going to be a challenge. JP Morgan had assumed 13% but notes current pricing implies a figure more like 10.5%. JPM has been maintaining a theme that it believes the market is not yet prepared to “pay ahead” for ROE recovery of any Australian bank.

While analysts agree BDDs are not likely to blow out further from here, they are not quite as optimistic as management when it comes to the expected pace of reduction. UBS suggests management's 18 month target “may be unrealistic”. Flood recovery is one thing, but the bank's troublesome commercial property exposures are not weather-related and Queensland's economy remains subdued. BOQ's provisioning was already below that of the majors on a relative basis (albeit in line with regional colleague Bendigo & Adelaide ((BEN))), and while provisions have been increased, provision coverage levels have fallen from 106% to 50%, Macquarie notes. This leaves Merrills “concerned” and Citi suggests its forecasts for BDD recovery are “a little more conservative”.

The BDD issue leads to further concerns regarding the bank's balance sheet. JP Morgan notes that asset growth in the first half was in line with expectations, but the balance sheet was skewed towards lower margin housing loans (+6.5%) and away from higher margin business loans (-9.4%). Analysts expect Queensland property prices, particularly in flood-impacted areas, to come under pressure. Ongoing asset growth has also now shifted into slightly riskier territory post-acquisitions, with higher-yielding leasing, for example, “almost inevitably” leading to a rise in typical bad debts over time, UBS suggests.

With BOQ's credit rating a constraint on the bank's capacity to access mortgage security markets, and the government's deposit guarantee soon to roll off, BOQ is going to have to rely heavily on higher priced deposit funding, UBS suggests. At 7.7%, BOQ's tier one capital ratio is “healthy”, suggests Macquarie, but with the new Basel III regulations soon to come in under as yet unknown APRA interpretation, BOQ's balance sheet will be questionable in a weak Queensland macroeconomic environment still being battered by the ever rising Aussie.

And to top it all off, the bank's driving force over the past ten years, CEO David Liddy, has announced his pending retirement.

It all sounds rather much like a tale of woe. However, of the eight brokers in the FNArena database only one has a Sell (Underperform) rating. Merrills justifies its pessimism on the bases of ongoing asset quality risks, loan volumes remaining subdued in the state and only limited net interest margin upside.

By contrast, RBS (Buy) acknowledges that BOQ has been doing it tough but the analysts are prepared to suggest the bottom in the bank's earnings was marked in the half just gone. Credit Suisse (Outperform) notes BOQ's share price represents a 14% valuation discount to the majors and 6% discount to Bendelaide Bank. Citi (Hold) thinks this discount can narrow while Deutsche Bank (Hold) can't see this happening in the short term.

The remaining brokers all have Hold ratings based mostly on capital and macroeconomic concerns, as does Goldman Sachs which suggests the market will need to see tangible evidence of falling BDDs as the water recedes before investor commitment is revived.

Post the result, BOQ's consensus price target fell to $10.91 from $11.00 which compares to a current share price of around $9.77.

- BOQ is in and not too bad
- Mac Bank will probably meet guidance
- For ANZ, NAB and Westpac it'll all be about margins and disaster debts
- Valuations are not stretched

By Greg Peel

It was always going to be a poor first half result for Bank of Queensland ((BOQ)) given the regional impact of the Queensland floods and cyclone. Bank analysts were well prepared after a couple of profit warnings, and sure enough profit fell 41%. But at $57.6m, BOQ still managed to beat consensus profit expectation of $55m. So in that sense it was a “good” result.

BOQ had already been struggling with bad debts on Queensland commercial property before the heavens opened, and the impact to business from the weather has meant a 161% increase in bad debt provisions over the first half last year. This comes at a time when the majors have been quietly bringing excess provisions back into earnings. But the good news is that management is seeing a swift recovery – business has returned to relatively normal after only a couple of months – and no further provision increases are foreseen.

Adding to the positives were a solid increase in deposits, delivered by canoe presumably, and a rise in net interest margin – the holy grail of banking. As I write BOQ shares are up around 1.5% on the day.

The majors will not have fully escaped an impact from natural disasters either, including the Christchurch earthquake, but in the wider scheme of things they will not see anything like the specific impact felt by Queensland regionals.

For Macquarie Group ((MQG)), which reports on April 29, the story will be all about a move back to more normal trading revenues from investment banking activity. RBS Australia is expecting Mac Bank to deliver a full-year result in line with most recent guidance, meaning a 9% drop in profit from its FY10 result.

Credit Suisse will be interested to see if the Group has managed to find greater cost efficiencies, and the analysts highlight the age-old Macquarie dilemma: what split in payout does management make between staff bonuses, which are crucial in retaining talent, and dividend payments, for which a 50-60% payout ratio has been targeted?

Attention then turns to the major commercial banks, with three of the Big Four reporting half-years. Commonwealth ((CBA)) reported three months ago on its July-December cycle. The others account on an October-March basis. ANZ ((ANZ)) will report on May 3, Westpac ((WBC)) on May 4 and National ((NAB)) on May 5. RBS suggests there are several themes to keep an eye on.

Volumes on both sides of the ledger will be important given the battle that has been raging amongst all four. NAB has been pushing up its lending numbers across both homes and business and on the other side, ANZ has been winning with deposits given its Asian exposure. Both sides of the ledger combine to impact on net interest margins, which have been under pressure from rising offshore funding costs. But the out-of-cycle mortgage price increases occurred in November, and previously very competitive term deposit rates have been pulled in a bit recently.

Trading income, meaning more investment bank-like activity, has become an important swing factor for all the commercial majors over the years. As Macquarie will tell you, times have been tough of late as volumes remain low in a volatile period.

Credit growth has remained subdued ever since the GFC in business lending, and remains so still. There have been positive signs in terms of lending pipelines, but these actually have to be converted for banks to be able to grow earnings. On the home lending front, the housing market has now stalled between affordability, lack of supply and on-hold RBA rates. Improvements in net interest margins, if achieved, will point to better earnings growth ahead, but the banks still have to grow their lending books to cash in.

Bad debts have been quietly cycling down post-GFC, allowing the majors to bring large chunks of provisions back into earnings. Initial substantial provision reductions are now behind us and bad debt conditions are normalising, so the majors can't count on too much of a boost from that side from here. It will interesting to see, however, just what impact natural disasters across the country have had on bad debt growth.

Finally, the banks have being in the process of attempting to reduce costs and improve productivity. For Westpac (and CBA) this has meant expensive outlays on IT upgrades which will no doubt take time to filter through. But the banks need to reduce costs to offset the current weak lending environment.

BA-Merrill Lynch notes that net interest margin pressures have eased somewhat from both aforementioned repricing on loans and deposits, and also from cost controls. Underpinned by still significant provisions along with solid capital, margin stability sets up a solid base for earnings growth. The problem is Merrills again expects the banks to reveal disappointing follow-through on those lending pipelines, but the strategists are upbeat and feel the market is not appreciating the positives.

ANZ shares have underperformed the sector in the period on market concerns over lower profitability from lower revenues and higher costs, notes RBS. So for ANZ to reverse that trend, it has to show its margin advantage, derived from its Asian exposure, is sustainable.

Can NAB show progress in the long-term task of turning around its weak UK business? That will be a crucial factor for the bank which has seen a good earnings recovery in personal banking. Also of particular interest will be valuations on NAB's long-held “toxic assets”. In the GFC these were worth nothing on a mark to market basis, but three years later it is apparent NAB might just collect after all.

The lumbering Westpac has had a good share price run, and its focus will be on bad debt growth from exposure to disasters but also the lingering problems in the St George lending books. The bank has nevertheless shown margin improvement and Merrills is confident result expectations can either be met or exceeded.

Credit Suisse is confident the banks as a group can show improved margins, which should more than offset disaster-related bad debt growth. Merrills remains upbeat on the sector, and RBS is sticking with a sector overweight at present. But the proof of the pudding, as they say, will be in the eating.

Soon after the earnings updates provided by the banks three months ago, share prices for the Big Four were trading very close to consensus target prices (CBA was actually just over). Then came MENA, Japan and Portugal, and before we knew it gaps had opened up of 10% (15% for ANZ). Bank analysts did not change their targets as a result of global issues, so several ratings upgrades followed. Now that global problems have eased (for now), Westpac is within about 3% of its consensus target, NAB 5%, CBA 6% and ANZ 8%. Banks have underperformed resource stocks in the run back. There have been no ratings changes for the banks in the interim.

The result season will thus provide investors with possible cause to further close those gaps, or not. By the same token, bank analysts will always reassess their earnings forecasts target prices with the half-year actuals now there as concrete evidence. Moreover, we will, as always, have this lumpy business of “rolling forward” forecasts, such that the half falling off is replaced by a future half in net present valuations. Given all bank analysts are looking for margin improvement in 2011, based on funding costs peaking, business lending finally recovering and even the consumer becoming more confident, the likelihood is that targets might rise.

That is, of course, unless it is a season of disappointment.

- NAB's retail banking operations are improving, notes DJ Carmichael
- NAB is gaining retail market share and the stockbroker believes NAB is attractive relative to peers
- NAB and WBC outperformed CBA and ANZ, which throws up a question mark about relative valuations

By Chris Shaw and Rudi Filapek-Vandyck

The FNArena database shows a Sentiment Indicator reading for National Australia Bank ((NAB)) of 0.3, which is in-line with that of Westpac ((WBC)) but it trails ANZ Banking Group ((ANZ)) with a 0.6 reading.

DJ Carmichael suggests this reflects a history of strong potential but difficulties in delivering on potential. NAB equal second in terms of Sentiment Indicator reading comes despite the third worst relative share price performance among the major banks since March of 2009 (Westpac has been the prime laggard).

While this likely reflects some caution from investors with respect to business strategy and NAB's long-term prospects, DJ Carmichael takes the view the stock looks attractive at current levels. 

The dividend yield of a forecast 6.6% in FY11 stacks up well relative to peers, while DJ Carmichael notes the bank's forward earnings multiple is also relatively low. So too is the price-to-book value at current levels.

What also attracts DJ Carmichael to NAB is banking business volumes continue to grow strongly, which implies solid top-line revenue growth. This supports forecasts for underlying earnings growth before bad debts and tax of 14% in FY11 and 10% in FY12.

DJ Carmichael is forecasting earnings per share (EPS) of 239.9c in FY11 and 269.1c in FY12. This compares with consensus forecasts according to the FNArena database of 240.7c and 264.7c respectively.

NAB's market leading position in business banking is also a positive for group strategy, according to DJ Carmichael. The broker points out CEO Cameron Clyne has shifted management focus to turning around the underperforming retail operations as a complement to the business banking position. 

As performance is improving in the retail sector, NAB is enjoying some improved momentum and market share gains, a trend DJ Carmichael expects will continue. Aside from the retail business, other priorities for management include a resolution to NAB's exposure to the UK banking market and an expansion of wealth management operations. 

Adding all this up, DJ Carmichael sees enough upside in NAB to rate the stock as a Buy. The FNArena database shows NAB is rated as Buy three times, Hold four times and Sell once. The consensus price target for NAB is $27.10, which implies upside of around 4% from current levels.

Over the past year the stock has traded in a range of $22.23 to $29.03.

FNArena observes both NAB and Westpac shares have outperformed their peers in recent trading sessions. This now leads to the observation that both shares have moved closer to consensus price targets than CBA and ANZ, suggesting the internal dynamic in between the leading banks in Australia has changed. This also suggests relatively more upside potential now resides with CBA and ANZ Bank.

(For more details about banks' share prices and their consensus price targets: see Stock Analysis on the FNArena website).

By Greg Peel

The words “collateralised debt obligation” are enough to send a shiver down the spine of anyone impacted by, or able to simply appreciate, the recent Global Financial Crisis and its origins. The butterfly which caused the storm was the trickle of defaults in the US of subprime CDOs, a form of mortgage security.

That storm finally resulted in the fall of Lehman Bros and the near collapse of the global financial system, were it not for massive central bank and government intervention. And it was all about the packaging up of humble mortgages.

Understandably, mortgage securitisation all but shut down offshore and in this country in the wake of the GFC. Lack of securitisation funding saw the collapse, closure or sale of many smaller institutions that relied on this cheaper source of funding given their credit ratings made offshore funding simply too expensive, the latter camp including St George and BankWest. There have since been a handful of mortgage securities issued, but realistically no one expects or wants that business to become fundamental again.

One might be surprised to learn, therefore, that last week the Australian Treasury outlined a draft bill proposing exactly that – the return of mortgage securitisation. What the Treasury is proposing, however, is a very different form of mortgage security – the “covered bond”.

Australia did not really see any level of subprime mortgages or related CDOs sold locally -- most of the damage was done offshore. Not that they were totally absent, and the preponderance of “no doc” and high loan-to-value ratio mortgages meant that there was still securitised mortgages of questionable quality. CDOs were highly complex instruments. In simple terms the nature of CDOs meant packaging up and on-selling mortgages from brokers to banks to hedge funds and other investors – a maze which rendered the actual end-holder of a mortgage unclear in many cases.

Covered bonds are different in that rather than on-selling the mortgages themselves, banks keep the mortgages and only on-sell the interest payment stream. A package of prime mortgages is still considered by ratings agencies to be AAA (“safe as houses”), albeit requiring of a higher risk spread (interest rate) than government debt. Mortgages that continue to reside in bank loan books are also a lot “safer” than those for which ultimate responsibility is questionable.

Covered bonds in reality are little different than good old finance company debentures, which allows investors to buy units in the interest payment stream from a collection of car loans, for example. Income from the sale of the debentures allows finance companies to offer more loans, leading to more debentures. The finance company profits from taking a cut in the middle of the loan rate to the borrower and the coupon rate to the debenture holder.

And that's exactly how covered bonds would work for banks. They will write mortgages at a certain interest rate, and then sell units (the bonds) to investors at a slightly lower coupon rate, with the spread representing a profit margin. Income from the sale of the bonds can then be used to finance further loans.

When banks go offshore for funding, they do so by typically issuing debt in the form of bonds maturing in 4-5 years which are purchased by mutual funds and so forth. These bonds are on the bank itself, not on some collection of loans. Thus one must take into account the bank's exposure to bad debts among other things, and in Australia's case the big banks are rated around AA, not AAA. Collections of prime mortgages – those with low loan-to-value ratios and plenty of accompanying paperwork – can be rated AAA, as noted, meaning the coupon needed to attract investors is less than that which the bank itself has to offer when issuing typical funding bonds.

In other words, covered bonds are a cheaper form of finance for Australian banks than offshore funding.

Since the collapse of the mortgage securitisation market in Australia, bank funding costs have been on a steady rise as bank bonds issued in the pre-GFC days of cheap money roll off to be replaced by bonds issued in the very expensive money days of the GFC and its wake. Given maturities are typically around five years, there are still expensive lumps of funding sitting on bank balance sheets which are still to roll off into the now cheaper funding environment. Westpac, for example, has stated its offshore funding costs will not begin to reduce until late 2012.

In the interim, banks have competed heavily for the cheapest form of funding – deposits – such that margins have been squeezed from both sides. Mortgage securitisation provided a funding source that sat in between offshore-issued bank bonds and local deposits in cost, and covered bonds are ostensibly the same, with a much reduced risk. Deutsche Bank, for example, estimates the cost of issuing covered bonds will be 60-100 basis points lower than offshore funding, adding around 2% to Australian bank earnings. The Treasury will limit total covered bond financing to 8% of total assets.

As JP Morgan notes, the timing and size of the covered bond issuance allowed closely matches that which the banks will lose once the government's deposit guarantees – put in place after the fall of Lehman – expire. The ability to issue covered bonds will also assist Australian banks in satisfying the various aspects of the Basel III rules on bank capital and liquidity ratios.

So everyone's a winner. The banks can raise cheaper funding. This will directly and indirectly offer a reduction in mortgage rates for Australian homeowners. And those looking to maintain a portion of their investment portfolio in fixed interest have a higher return option on offer than just government paper.

Covered bonds, incidentally, are not specific to mortgages and can be issued over any from of qualifying loan. Nor are they a new phenomenon. Indeed, covered bonds have long been popular in Europe given a history going back several hundred years.

- Analyst bank target prices unchanged despite global disruptions
- Several ratings upgrades in the past week
- ANZ's Asia strategy sets it aside from the pack

By Greg Peel

I lasted updated the Australian banking sector a month ago just after all the interim and quarterly results were in. At that point analysts felt the results had been reasonable without being spectacular, and market prices were now at or near fair value. Eventually the bounce in business credit demand will come, the analysts suggested, as will a return to somewhat better retail spending. But in the meantime things will remain fairly subdued, they said, given a stalled housing market and ever increasing funding costs.

I note that Westpac ((WBC)) CEO Gail Kelly has been deliberately getting her face on television a lot lately, with one intention being to suggest mortgage rate premiums will definitely come down as soon as funding costs peak out in late 2012. That suggests, of course, about another 18 months of pain and subdued bank earnings growth.

Just before unrest developed in Libya, the shares of each of ANZ Bank ((ANZ)), National Bank ((NAB)) and Westpac were trading near consensus analyst 12-month price targets and Commonwealth Bank ((CBA)) had just exceeded its consensus target. FNArena has oft pointed out that such convergence either means analysts need to raise those targets or a sell-off is due. Analysts had just updated their targets post results, so the latter seemed inevitable.

As it was, the sell-off was sharp and severe. Usually, all things being equal, a sell-off might be sparked by foreign investors deciding to cash in on now fully valued bank stocks and switch back into resources instead, for example. This time it was MENA, and then Japan, which is not usual. But a sell-off is a sell-off.

As of yesterday's closing prices, NAB, CBA and Westpac shares are all 10-11% below consensus target prices and ANZ shares are 15% below. Bank analysts have not changed their targets from a month ago, which suggests they see no specific effect which will change earnings forecasts for the local banking sector based on what has transpired globally. Even the impact of the Christchurch earthquake is containable.

So something else thus has to give, and hence there have been a slew of broker upgrades to bank stock recommendations over the past week.

Post the result season, a fully priced CBA could draw only a 0/7/1 Buy/Hold/Sell ratio from the eight major brokers in the FNArena database. Following an upgrade to Buy from Hold, CBA has moved to 1/6/1.

Westpac has seen two upgrades to Buy from Hold to take it from 1/6/1 to 3/4/1 while NAB, with its greater exposure to the UK, remains stuck on 3/4/1. ANZ has seen two upgrades – one to Buy from Hold and one to Hold from Sell – to take it from 4/3/1 to 5/3/0.

ANZ's latest rating upgrade came this morning in the wake of the bank's strategy update held yesterday, and saw Citi moving to Buy from Hold. ANZ, claims Citi, is simply the “best growth story within the sector”.

Which begs the question as to why ANZ shares have been the most beaten down in the recent market sell-off, particularly given ANZ boasted the highest B/H/S ratio after the results season as well as now. The market is perhaps focusing on ANZ's smaller size, its comparative lack of exposure to the burgeoning Wealth Management sector, the current fierce competition between the banks for business on both sides of the ledger (loans and deposits), the investment being made by CBA and Westpac in particular in new IT systems, and ANZ's acquisitional aspirations in Asia at a time when bank capital ratios are under more pressure since the Basel III accord. And you can probably throw in the Christchurch earthquake, given the NZ in ANZ.

In short, whenever things go a bit pear-shaped in the world it seems ANZ is always the one to be sold off hardest.

But it is ANZ's Asian aspirations which most excite bank analysts, and establish that which differentiates ANZ from its other Big Four peers. Aside from NAB's disastrous foray into the UK which it now wishes would just disappear, the other banks have otherwise remained firmly rooted in Australasia. So one might suggest that it is ANZ Asia, or more correctly its APEA (Asia, Pacific, Europe and Americas) division that has polarised investors on one side and bank analysts on the other.

The biggest problem facing the Big Four at home, to put it in a nutshell, is to reestablish the double digit and even better than 20% return on equity (ROE) levels they once enjoyed. When we began to bounce swiftly out of the GFC, analysts assumed that ROEs could be quickly improved from shattered levels (which required large bad debt provisions and capital raisings) as credit demand swiftly returned. But demand has not returned, funding costs have remained a crush on margins and over time analysts have been quietly pulling back in their ROE growth assumptions.

(Ex-JP Morgan bank analyst agitator Brian Johnson, now with CLSA, has stated emphatically post-GFC that Australian banks will simply never return to the sort of extraordinary growth they enjoyed in the heady free money days of the pre-GFC boom.)

It is ROE growth potential that differentiates ANZ, as far as analysts are concerned.

UBS suggests that yesterday's strategy update was actually “uneventful”, in that ANZ's strategy did not actually change at all, but this the analysts declared to be “a good thing”. What did change, nevertheless, was the bank's outlook horizon. Prior to yesterday, ANZ had set a target of 20% of profit growth to be emanating from the APEA division by 2012. Yesterday ANZ CEO Mike Smith extended that figure to 25-30% by 2017.

Now a year is a long time in banking, so six years is an eternity. On that basis, analysts have been quick to point out that such long-dated aspirations (and Smith acknowledged that we're talking aspirations, not hard and fast forecasts) are all well and good but not brimming with realistic substance. Obviously anything can happen between now and 2017 and probably will. But that does not detract from the fact that in APEA, ANZ has growth engine with upside potential.

If one assumes the current compound annual growth rate (CAGR) of the rest of the business of 6%, says Deutsche Bank, that implies an 18-22% CAGR for APEA over the period. ANZ has indicated it hopes to achieve the great bulk of this aspiration through organic growth, but that is not to say further M&A opportunities will be ignored if the price is right. (ANZ recently missed out on one bid, suggesting prices are normalising in Asia post-GFC.)

Crystal ball gazing aside, bank analysts largely agree with ANZ that its APEA strategy is that which makes the difference. Deutsche, for one, believes ANZ could indeed lift its ROE from around a current 14% to 18-20% in the medium term. But this will still require careful management at home.

At home, analysts are still impressed with ANZ's strategy. Smith has indicated he does not want to go diving in to the current battle between peers for limited retail banking opportunities (unlike NAB, for example, with its painful “you're dumped” campaign). Little ANZ was never going to be a big winner in that cat fight. Instead, he sees solid scope to improve Wealth Management market share and to keep the focus on commercial banking. In so doing, note analysts, ANZ is improving its opportunity to grow “non interest income” – that which is not so beholden to funding costs, the RBA, moronic politicians and media pressure.

It's not all beer and skittles, and ANZ still has challenges ahead. But at least it is doing something different to the other three rather than just sacrificing margins by fighting them. Analysts thus see ANZ as unique within the sector, and with Asia providing the major opportunity analysts are positive on the stock, particularly since the recent sell-off.

By Greg Peel

Is the world about to end? Fans of the Book of Revelation may be somewhat inclined to believe so, but seismologists recently interviewed by the media have played down the implications of the seemingly endless stream of seismological events the world has suffered over the past couple of years, noting that such activity usually occurs in clusters. Eventually the earth will settle down again, they say.

For Australian insurance companies, the end just never seems to come. If the pre-Christmas floods in Queensland weren't enough then came Brisbane, followed by Cyclone Yasi, and while insurers at that point were still comfortably within annual catastrophe provisions the warning bells were sounding that there wasn't a lot left in the kitty. Earnings forecasts would not be largely impacted, analysts noted, as long as the catastrophes stopped.

Then came Christchurch, and provisions were again stretched. Then came the big one. (Let's hope it still proves to be “the big one”.)

Yesterday QBE Insurance ((QBE)) announced it was estimating US$125m of insurance losses stemming from the Japanese earthquake. QBE has reinsurance exposure through its Lloyds stake as well as some marine and energy insurance cover. JP Morgan was surprised at just how quickly QBE was able to arrive at this figure given past delays, and as such is assuming it to be a worst case scenario.

Analysts note the figure is only around 0.9% of QBE's net earned premiums (NEP). QBE operates on a calendar financial year, so unlike peers operating on June financial years QBE still has plenty left in the kitty of annual catastrophe provisions. After all that has occurred in 2011, the company's claims now total US$550m against the full-year provision of US$1.65bn incorporating aggregate reinsurance protection. About a third of the provision has thus been accounted for already in the first quarter of the year.

Again we say, if it all now stops...

The bottom line is that analysts have not deemed it necessary to make any meaningful adjustments to earnings forecasts based on QBE's assessment. JP Morgan queries whether QBE can reach even the bottom end of its 15-18% profit growth guidance, but it, too, left forecasts unchanged this morning.

But the Japanese quake throws open a wider question for discussion.

The global insurance business is a competitive game, and as such margins need to be carefully managed. One cannot just put up premium prices willy-nilly given (a) the level of competition and (b) the destruction of insurance demand high premiums will spark. We recall that many Brisbanites had decided not to buy flood insurance on their houses given the high cost. The cost of flood insurance is understandably high for houses built in a flood plain.

An industry body has estimated the cost of the Japanese quake to reinsurers could be as high as US$35bn, which moves to US$50bn or so if you then add in the actual tsunami. After a shocking couple of years, when is enough enough? The question is as to whether global reinsurers will now simply have to raise their catastrophe premiums and damn the demand destruction given the extent of mounting claims. Were this to happen, QBE would be a beneficiary of higher prices.

“The key question for the stock,” notes JP Morgan, “is whether the losses for the global industry could lead to a turn in the insurance cycle. In this there could be a strong silver lining for QBE”.

Macquarie's take is, “whilst this tragic event will almost undoubtedly give rise to a massive economic loss, it is still too early to determine whether the insured loss will be of sufficient scale to turn the global reinsurance pricing cycle”.

Deutsche Bank thinks not. The bottom line is that building a house on the Ring of Fire is not dissimilar to building a house in a flood plain. Insurers either don't want to know you, or price their premiums so high as to make insurance untenable. Hence the number of householder and small business claims in Japan will not be nearly as extensive as one might expect. The real cost will be on infrastructure claims, and for that the Japanese government pays the premiums.

Macquarie notes that following the 1995 Kobe earthquake, losses totalled some US$100bn for infrastructure and property and another $50bn for economic disruption, yet the insured loss totalled only US$3bn.

Following Kobe, the Japanese government instituted the Japanese Earthquake Reinsurance fund which covers residential policies. BA-Merrill Lynch notes there is low insurance penetration outside Tokyo. It is the Japanese government which will cop the brunt of the cost, and not the global insurance industry. And as Merrills notes:

“With insurance losses estimated at 1-3% of the global reinsurer capital base and large amounts of surplus capital even today, the jury is out as to whether this loss will be enough to tip broader global commercial insurance pricing more positive”.

RBS makes note of competition in suggesting, “abundant global insurance capacity may limit more broad based price increases”.

On that summation, it would seem analysts are leaning away from the notion of industry-wide price increases and thus benefits for QBE. Without, that is, fully dismissing the possibility.

In the meantime, for QBE the wait continues for the day global interest rates start to rise again, to which the company's fortunes are highly levered.