- Earnings results disappoint
- Regulatory concerns ongoing
- Dividends at risk
- Yield hard to ignore

By Greg Peel

Earnings

In the wake of recent FY15 earnings results from ANZ Bank ((ANZ)), National Bank ((NAB)) and Westpac ((WBC)), and a first quarter FY16 update from Commonwealth Bank ((CBA)), one word has been bandied around extensively – “disappointing”. Such disappointment follows the impact recent regulation-driven capital raisings have had on bank share prices.

Sector average earnings per share for the second half fell 1.6%, UBS calculates, to mark the second consecutive half of decline.  Sector revenue growth was 1.9%, but cost growth averaged 3.6%. All bank trading desks suffered through the tough period that was August but ANZ was particularly hard hit.

Net interest margins expanded for retail banking but business banking margins came under pressure, mostly impacting on NAB.

Analysts have long expected bad and doubtful debt levels to begin to rise again around now, following the long period of decline from the GFC peak. This is yet to prove the case however, as BDDs have largely “banged along the bottom,” UBS notes, of post-GFC lows. The exception is ANZ, where the bank’s Asian exposure comes into play. New impaired loans are on the rise, particularly in Indonesia.

Up until recently the biggest factor within the banks’ requisite costs was IT upgrading – bringing systems kicking and screaming into the 2010s. But most recently the big issue has been ever tighter global and domestic regulatory controls and the costs associated with compliance. Unfortunately that story has yet to run its course.

UBS does nevertheless conclude that recent capital raisings, driven by regulatory requirements, have had only a partial impact on valuations.

For at least a couple of years, bank analysts wailed that bank share prices were too high and price/earnings ratios were overblown for the sector. Analysts then came to acknowledge that in a world made hungry for yield due to low interest rates both at home and abroad, traditional PE comparisons were not necessarily helpful. A premium was required in valuation models to account for this post-GFC trend.

But back in April, when the ASX200 took a look at 6000, analysts wailed that bank PEs were now overblown even if one does take such a premium into account. Earnings growth would be minimal ahead, they said. Dividends would have to stop growing and special dividends were no longer an option. Moreover, the growing tide of global capital consideration, and the implications of the Financial System Inquiry released late last year, suggested capital raisings were quite possibly on the cards.

Well, they were right. Bank shares have since corrected, to extent as part of the China-led market correction but further still on sector-specific and Australia-specific issues. The banks are now trading around a 12.3x PE which is in line with the 20-year average, and thus they are no longer “expensive”.

But are they “value” at this level?

Regulatory issues are yet to reach a conclusion, so the risks of higher costs and lower returns on equity persist on this front. Bad debt levels will eventually have to rise. But the recent round of tit-for-tat mortgage repricing indicates a “strong industry structure’” UBS suggests, given the banks have been able to pass on risk management costs to customers.

And there is scope for more of the same. While the jury is still out on timing, most bank economists expect the RBA will eventually be forced to make at least one more cash rate cut, if not two, in the year ahead. Analysts have little doubt the banks will use such a cut(s) as another opportunity for mortgage repricing, by not cutting new rates by as much as the 25 basis point increments the RBA adopts.

On this basis, and the fact retail banking net interest margins are growing rather than falling in the face of repricing, UBS prefers the two big retail banks – Westpac and CBA – over the two smaller banks, despite their sector premiums. ANZ looks cheap on 10.7x but Asia is the issue. For NAB, competition in business banking is unlikely to abate.

Credit Suisse agrees that retail banking appears to be “in rude health” while corporate banking is “struggling somewhat”.

Regulation

It’s hard to believe Lehman Bros fell seven years ago but only now are banks being forced to address the concept of “too big to fail”. TBFT falls into two categories – global and domestic.

Global risks give us the G-SIB – globally systemically important bank – which are your US, European and UK Big Bank multinationals for example, such as a Citigroup, or a Deutsche Bank, or a Lloyds. Domestic risks give us the D-SIB, or domestically systemically important bank, the failure of which may not bring down the world but may bring a country to its knees. Locally we call these the Big Four.

The Big Four are big in Australia but nowhere near as big as the multinationals, yet Australia does tend to fight above its weight in global financial markets as well as sport. Thus the aforementioned FSI suggested the Big Four needs to not only carry sufficient capital to cover against another GFC event, but more than other global banks given Australia’s relative size.

The FSI suggested Australia’s banks needed to be “unquestionably strong”. Problem is, it didn’t outline the questions, so no one is exactly sure just what tier one capital ratio heads off all doubts. The Inquiry also suggested Australia’s banks should be in the “top quartile” globally, but no one’s quite sure just how one measures the quartiles across all of the world’s banks.

Recently the US Federal Reserve proposed not only a tier one capital ratio requirement against loan books, but a “total loss-absorbing capital” requirement (TLAC) which then extends to tier two capital, which is upper level debt. This brings up the issue of “bail-in” bonds.

In the GFC, bank bondholders (ie lenders to banks) were at risk of losing their money when TBFT banks threatened to F. They did not in the end fail, because they were bailed out, across the globe, by taxpayer funds. This meant bonds could be repaid in full but governments put it to bondholders that were it not for government bail-outs, they would have lost their investments. It would only be fair, therefore, that they take a “haircut” (some amount cents in the dollar).

The bondholders pointed to their original prospectuses and highlighted the sanctity of “the contract”, being the foundation of all capitalism. They were then paid in full. But this experience has given rise to the possibility of the creation of the “bail-in” bond. At the time of another major financial market disaster, some trigger would turn bail-in bonds into equity, forcing bondholders to shoulder the burden.

Tier one capital is, in simple terms, ordinary shares. Tier two capital would include bail-in bonds were the likes of Bank of England governor Mark Carney to have his way. Tiers one and two would make up TLAC.

The global Financial Stability Board has decided upon TLAC targets of 16% and 18% by 2019 and 2022 respectively. It is not yet clear just what the Australian Prudential Regulation Authority (APRA) will individually require, but either way APRA has assured the banks they’ll be given plenty of time to comply.

This provides some scope, suggests Credit Suisse, for the required residual capital to be generated organically in the interim. But just how it all fits into “unquestionably strong” and “top quartile” remains an unknown. Thus Ord Minnett suggests “we expect earnings growth to remain pressured with banks continuing to be reliant on repricing to maintain their return on equity”.

The banks may have successfully passed on new capital requirements costs through mortgage repricing for now, but for how much longer?

Dividends

At the end of the day bank valuations are all about dividends, given earnings growth outlooks are weak. Morgan Stanley notes that Australian bank dividend payout ratios (dividends/earnings) are “elevated”.

Indeed, the latest round of earnings results and subsequent dividend declarations reveal that despite increased capital requirements and recent declines in bank returns on equity, payout ratios have continued to increase since 2011. Morgan Stanley is forecasting a period of flat payouts from here but warns “the probability of dividend cuts is rising”.

The recent round of results suggests ANZ and NAB have less margin for error than Westpac and CBA. ANZ’s ratio has already risen above the bank’s 65-70% payout target range, and the new CEO might just take the opportunity to respond. NAB’s payout is only near the top of its 70-75% payout range but Morgan Stanley does not believe the range is sustainable.

Were bad debts to begin rising once more, as every bank analyst expects they will, against a backdrop of ever increasing capital requirements, then Morgan Stanley suggests all four banks would have to review their dividends.

Different Story

The last FNArena banking sector update was published in June, and entitled The (Negative) Implications Of Forthcoming Regulatory Changes. At that point the ASX200 had retreated from its May high of 6000 into a 5500-5800 band, with concern over bank capital requirements a factor within that move.

Analysts were not, at that point, screaming overvaluation but they were highlighting the possible risk of necessary capital raisings which the market in general seemed to ignore. In June, our bank analysis table looked like this:
 

August’s China-related sell-off was a market-wide de-rating which brought the banks back to levels which looked pretty attractive on a yield basis, compared to where they came from. Buy ratings on the FNArena database outweighed Sells by 11:7. But then came the capital raisings, and then came the disappointing earnings results. Based on yesterday’s closing prices, our table now looks like this:
 

The tone of all of the issues discussed above would tend to imply analysts are not that keen on the banks at present, given weak earnings growth forecasts, ongoing capital issues, the risk of dividend cuts and so on. Yet those same analysts now have a Buy to Sell ratio of 14:2.

Two elements stand out: the now yawning gap between trading prices and target prices and the very attractive yields (which do not reflect full franking). The suggestion here is that for all the issues confronting the sector at present, a skittish market has panicked too much on the downside.

Also notable is a changing of the guard, with Westpac now number one (can’t remember when this was last the case) and NAB relegated to least favoured. While CBA remains analysts’ preferred bank on paper, its ever present premium to peers (note the difference in target price upside) keeps it in third spot.
 

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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-Bad debt charges may rise
-Low earnings per share growth
-Margin stability in focus
 

By Eva Brocklehurst

What is expected from Australia's major banks in their upcoming earnings reports? Brokers expect the news will be mixed, although recent mortgage re-pricing reveals the market power of the big four players and their ability to insulate returns. The medium term outlook, in the view of analysts, will not be without its challenges given ongoing changes to regulatory requirements.

UBS suspects, while earnings may be stronger overall, bad debt charges will also be higher as the benefits of improved asset quality and the run-down in provisions come to an end. Dilution from recent capital raisings provides an obstacle to earnings per share and on that metric brokers expect little or no growth across the major banks. Goldman Sachs expected diluted cash earnings growth around of 11%, generally, and ordinary dividend growth of 1.0%.

The sector should be well supported over the remainder of 2015, the brokers maintain. Near-term capital requirements have now been met and asset quality is benign, while earnings momentum is underpinned by mortgage re-pricing. Even with higher mortgage risk weights, pro forma returns are healthy, in Citi's view, with retail banking still offering the best returns in the sector.

Goldman Sachs still believes the sector needs an additional $14bn in capital to become "unquestionably strong" over the next 2-3 years but should be able to raise this organically or via dividend reinvestment plans.

JP Morgan expects margins to remain stable, while expenses will likely to grow as the banks invest in technology to meet industry requirements. The broker expects a non-recurrence of write-backs will underpin asset quality, as low interest rates continue to support values and reduce losses. The prospect of official cash rate reductions have likely been brought forward by the mortgage re-pricing and this presents downside risk to sector margins, in Goldman's view.

The main upside risk, Deutsche Bank maintains, is from market trading and treasury income, should the better-than-expected result that was pre-announced at Westpac ((WBC)) be replicated across the other banks. Given the recent capital raisings the broker also expects to hear more on the optimisation of returns.

Surprises are unlikely after ANZ Bank ((ANZ)) delivered a warning with its institutional placement back in August. UBS expects the market will focus on its bad debt provisions. The broker is looking for more detail on credit risk grade migration, noting that ANZ is the only one of the four that has acknowledged this factor. Deutsche Bank also questions its worse-than-peer bad debt trajectory.

Global market revenue is another area of focus for ANZ and UBS wonders whether it will be forced to impair its investment in Malaysia. In a similar vein, JP Morgan will also focus on the performance of the offshore franchises, given volume growth has been slowing and margin pressure continues.

Goldman is more upbeat on the Asian franchises and ANZ Bank remains its top pick among the majors. The broker notes there is strong momentum in the domestic franchise, as well as an attractive valuation.

National Australia Bank ((NAB)) is expected to provide an update on the de-merger of Clydesdale Bank, progress on which Deutsche Bank will be observing closely. It will take conduct charges of GBP350-500m above the line, funded from its indemnity, and the broker will also be looking for further clarity on its liabilities. Aside from Clydesdale, accounts will also be re-stated to exclude Great Western Bank.

UBS expects NAB's underlying result will be reasonable and reveal an ongoing improvement in asset quality. The bank's rate of growth in housing has been in decline recently, given its intention for investor volumes to fall below the APRA threshold of 10%. JP Morgan will home in on this detail. Also, the broker will note whether volume recovery and the hiring of bankers to chase market share in business credit has come at the expense of margins.

Westpac has guided to FY15 cash earnings of $7.82bn and a final dividend of 94c a share. JP Morgan will assess the performance of the underlying margins and the drivers of elevated cost growth. The key issues for Deutsche Bank will be further detail on the net interest margin and management's strategy to maintain returns.

Commonwealth Bank ((CBA)) is expected to reveal a strong first quarter update. JP Morgan expects cash earnings of $2.4bn and will look for any sign of asset quality weakness, given the rise in personal lending arrears in the second half of FY15 and the exposure to Western Australia through Bankwest.

The first half results for Macquarie Group ((MQG)) are due on Friday. The bank has guided to earnings being up 55% on the prior corresponding half. JP Morgan forecasts an interim dividend of $1.60 a share, taking the pay-out ratio to 50%.

Further clarity will be sought on the prospects of a continued benefit to Macquarie from a weakening Australian dollar and whether this is offset by a reduction in market volatility - and hence a more subdued result for the securities business. The broker raises FY16 earnings estimates but suspects if volatility continues in Hong Kong and China then there may be further upside. JP Morgan forecasts a further $400m in performance fees in the first half.

NAB will report tomorrow, ANZ on Thursday and Westpac next Monday.
 

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-Support for retirement income products
-Higher growth potential for annuities
-Challenger well positioned for opportunity
 

By Eva Brocklehurst

The Commonwealth government has endorsed nearly all the recommendations from the Murray financial systems inquiry, which suggests superannuation fees will continue to be scrutinised and the Productivity Commission will develop criteria to assess the competitiveness of the superannuation system.

Superannuation trustees will be allowed to pre-select opt-in comprehensive retirement income products while impediments to product development will be removed.

How do the recommendations stack up for Challenger ((CGF))? The government's response supports growth in Australia's annuity market, brokers agree. The most relevant recommendation for Challenger is the support for development of comprehensive income products for retirees.

The government's proposals are in line with Deutsche Bank's expectations and the implementation timeline for Challenger, including the government's upcoming retirement income review, is now clearer.

Credit Suisse also believes Challenger is well placed to capitalise on the opportunities presented, with a strong brand and focus on increasing its distribution agreements. There is high growth potential in this market. If the share of flows from annuities into retirement income increases the total market could increase.

The broker calculates an example over a three-year period whereby, if the flow share into retirement income increases to 5-30% and Challenger can capture 25-65% of this additional flow, its annuity book could experience growth of 40-150%.

There is probably a 2-3 year window in which Challenger will operate with limited competition, Credit Suisse contends. This will close, so the company needs to continue securing distribution agreements to embed its leading position. The government intends to legislate on its retirement income review by 2017.

The recommendations reveal broad support for income products over account-based pensions. Credit Suisse believes the recommendations demonstrate that the recent decision by the Department of Social Security in regards to Challenger's Care annuity product is just the impediment the government wants to prevent in future.

The recommendations do not include any mandatory requirement for retirement income products, which would lead to a more definite growth outcome for annuities. This would be less favourable for Challenger, the broker argues. Significant growth in lifetime annuities could create a rush to market by local and global players and put profit margins, potentially, under pressure.

There remains a risk that competition increases from alternative products as the market grows. Challenger could also be at a disadvantage if life insurance providers were able to offset the mortality risk in life insurance operatoins wth lifetime annuity products.

Challenger's penetration of retail and industry fund platforms stands it in good stead for organic growth, UBS asserts. The government's support of a requirement for trustees to develop and pre-select retirement income products was largely expected.

What was, perhaps, not as well anticipated is the proposed use of legislation to introduce a principles-based framework to guide design of these products, the broker notes. The guidance will be developed in consideration with the government's white paper on tax and the retirement income review.

UBS expects a number of market participants will likely develop compliant framework for comprehensive retirement income products. There is some evidence this is occurring already, with annuities forming part of a solution currently being offered by VicSuper's in-house advisers.

As Challenger is progressively increasing its penetration of platforms UBS believes the company is well positioned to facilitate early adoption of this retirement product structure.

The brokers reviewed above retain steady ratings and targets. FNArena's database has five Buy ratings and three Hold for Challenger. The consensus target is $7.71, suggesting 1.8% downside to the last share price. Targets range from $7.10 (Morgan Stanley, Deutsche Bank) to $8.30 (Credit Suisse).
 

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-Is there a near-term opportunity?
-Global equities fund a positive
-More consistency in flows needed
 

By Eva Brocklehurst

Perpetual ((PPT)) reported funds under management (FUM) ended the September quarter at $28.4bn, revealing outflows of $1bn in Australian equities from the institutional channel and $400m in inflows from the intermediary channel. The company also confirmed it has obtained a new $1bn institutional client mandate to manage Australian equities which is expected to fund the second quarter.

Bell Potter believes the current share price does not reflect where the business is at and this provides a near-term opportunity. Despite the net outflows of $700m in the September quarter, the company's new mandate is a positive and the broker expects more synergies will still ensue from the Trust Co acquisition.

Perpetual is currently trading at less than 15 times FY16 price/earnings, below its long-term average, and this does not reflect the growth profile, in Bell Potter's view. The broker, not one of the eight monitored daily on the FNArena database, upgrades its price target to $49.50 from $47.30 and reiterates a Buy rating.

Credit Suisse is more cautious. While the company has obtained benefits from cost cutting and cost synergies in FY15, no such benefits are likely in FY16. The broker believes the softer fund flows and markets are becoming a headwind, although the stock does offer a leveraged play on a run in Australian equities.

The broker acknowledges a positive case exists at current valuation levels, based on the assumption that the last of the major outflows occurred in the September quarter, but its performance has softened over the past 12 months and this may affect inflows in the short term.

The quarter disappointed JP Morgan, with the stock lagging its listed competitors over the past 12 months and now trading at a discount based on consensus forward estimates.

The broker acknowledges some of the discount may be justified, given a more diverse operating business and lower leverage to markets, which is accentuated through its ownership of Trust Co. The focus is on organic growth and JP Morgan believes the establishment of Perpetual's global equities fund is a positive move.

The net outflows actually had a positive impact on revenue in the quarter, in Macquarie's observation, because of the mix of institutional outflows versus intermediary inflows. Moreover, the new institutional client mandate to manage Australian equities is of similar size to the outflow expected to be funded in the December quarter.

UBS is also upbeat. The broker upgraded to Buy at the FY15 result on the basis that the share price reflected a lack of confidence that he company could successfully execute the next phase of its strategy. The institutional outflows were modestly disappointing but the intermediary inflows were encouraging to the broker, given a tough quarter for equities.

UBS continues to believe the company can jump a relatively low hurdle on organic growth expectations in FY16-17. The update has no major revenue implications for UBS. Earnings risk is manageable and the broker is prepared to give the company the benefit of the doubt on delivery of positive flows in retail an intermediary channels as there are some early positive signs emerging.

Deutsche Bank sticks with a Hold rating and cannot go past the fact that this has been a second consecutive quarter of net outflows, which have offset all positive net flows since December 2013. Funds under management are back at a two-year low and, the new mandate aside, the broker requires a more consistent record on flows to become more positive on the valuation upside, although the current price is considered undemanding.

The new equity mandate provides some encouragement for Citi, partly alleviating concerns about further fund outflows stemming from recent changes in personnel. The broker considers the stock has growth options which are more medium term, despite being strongly leveraged to a potential rebound in the Australian equity market.

The market backdrop has been difficult, although Citi acknowledges the softness in the stock stems from the large outflow of $1bn from Australian equities. The broker notes Perpetual is still only attracting minimal net flows to its global share fund and needs to achieve an average of $100m in quarterly net flows for the next two years to meet its targets.

Morgan Stanley believes the global share fund, with its strong brand and distribution, should deliver a solid performance. The fund remains well placed to benefit from asset re-allocation in a lower-for-longer interest rate/inflation environment. Revenues are also expected to benefit from stronger flows into higher margin products.

Winning further share in the domestic market is difficult and the broker envisages better growth opportunities elsewhere in  the sector. That said, Morgan Stanley is encouraged by not only the global share fund but the diversity across private clients and the trust business.

FNArena's database shows three Buy and five Hold ratings with a consensus price target of $46.35, which signals 9.6% upside to the last share price. The dividend yield on FY16 and FY17 forecasts is 5.7% and 6.2% respectively.
 

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-Market relief on change of tack
-Other Asian investments continue
-Several special dividends possible?
 

By Eva Brocklehurst

Insurance Australia Group ((IAG)) has had a change of heart on China. Following its $500m equity raising from Berkshire Hathaway in June the company intended to pursue a pan-national insurance offering in that country but, after assessing the opportunities, has determined it will not proceed.

The announcement instigated a sigh of relief from many investors, as to make meaningful inroads into China would require a significant commitment and several stockbrokers had doubts about the idea. Now, the prospect for a capital return is looking more likely.

The market was worried about a large expansion so soon after the company took a $60m write-down on its Bohai acquisition at the FY15 result, given an initial $100m investment. A dilutive equity raising had ensued that IAG chose not to participate in. This resulted in its ownership stake falling to 14% from 24.9%. JP Morgan notes there is no indication whether this remaining stake will be divested.

Nevertheless, the decision to abandon expansion in China is not convincingly the right one, JP Morgan contends, although whether the long-term bears this out will not be known. IAG has been in China for more than 15 years, through its Roadside Assist venture. It also helped the regulator there set up a Compulsory Third Party (CTP) scheme.

As scarce insurance stakes were up for sale, the timing for investment may have been favourable, JP Morgan asserts. China is a high-growth market and the broker suspects there may not be another chance to get in on the ground floor.

That said, JP Morgan acknowledges the decision reveals the company and its new CEO Peter Harmer are willing to listen to investors and not just pursue deals from a top-down perspective. The extent of the share price reaction was a surprise but the broker suspects Peter Harmer may be unravelling what could have been an unpopular move by the former CEO.

One item brokers all agree on is that this decision ratchets up the potential for a capital return. JP Morgan highlights the deal with Berkshire Hathaway meant an improvement to the core capital position of $1.2bn. The company's common equity tier one (CET1) ratio improved modestly in the first half and JP Morgan expects it will continue to do so as the surplus capital is released from the Berkshire Hathaway quota share.

Macquarie estimated the company could have invested $500-750m in China with risk to the upside but accepts this decision will ease uncertainty. The broker forecasts the company will increase its target pay-out ratio to 60-80%. For FY16 Macquarie increases this to 90%, which implies a special dividend of 10c a share.

The broker will review the potential for special dividends annually, recognising future investment in Asia, uncertainty on reserving in New Zealand and ongoing rate softening.

Of note, IAG is maintaining other parts of its Asian strategy, increasing the stake in SBI General Insurance in India to 49%, increasing stakes in Malaysia's AM Assurance and participating in consolidation in Thailand. With the focus on other Asian countries, Macquarie expects the company will invest a further $450-700m over the next 2-3 years.

Deutsche Bank believes it would have been difficult for IAG to achieve targeted returns in China and its concerns were confirmed by the Bohai write-down. This broker also envisages scope for $400-600m in capital returns by the end of FY16.

UBS accepts special dividends should logically follow this decision but points out there are many variables to consider, none the least being the challenging margin outlook in the domestic market. In addition to timing considerations, the company could require $150m for the Indian joint venture and has an open-ended liability for NZ earthquake claims to consider.

While it is unlikely Insurance Australia Group will find the acquisition opportunities to absorb its growing surplus, the broker believes it would be unusual for a CEO in his first year at the helm to part with too much capital. Hence, UBS puts its money on a large special dividend in FY17.

Credit Suisse wholeheartedly welcomes the decision and upgrades its rating on the stock to Outperform from Neutral. The broker remains confident in the delivery of core earnings expectations in FY16 and now includes three years of special dividends in forecasts.

The company was already in a strong capital position, with minimal requirements for capital from organic growth. The broker expects IAG to benefit from 24c per share in excess of CET1 requirements at the end of FY16. Additional capital should be released in the subsequent years as the quota share takes full effect and NZ tax losses are recognised, adding a further 10c per share.

The broker remains concerned about commercial lines but believes this is offset by expected reinsurance benefits. Post the bounce in its share price the stock is seen trading at a 13% discount to the market versus its historical 9.0% discount. With further upside potential Credit Suisse believes it offers a relatively safe holding in the current environment.

FNArena's database contains one Buy (Credit Suisse) rating and seven Hold. The consensus target is $5.55, suggesting 1.9% upside to the last share price. The dividend yield on FY16 and FY17 forecasts is 5.7% and 5.2% respectively.

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