-Asset quality, outlook stable
-Equities affected by funding costs
-NZ banks cite higher funding costs
 

By Eva Brocklehurst

The negativity suddenly surrounding Australian banking stocks is not new, but is it justified?

Bell Potter believes not. The sector is performing well on the back of strong domestic GDP growth and tight cost management, while asset quality is considered stable. Recent raising of capital has ensured the banks are now comfortably funded and organic capital generation remains strong.

Bell Potter observes bank sector dividends went backwards on just three occasions in the last 37 years and the economic climate which prevailed in those instances is not the case today. Dividends are expected to be maintained going forward, at the very least.

The broker's top picks are Macquarie Group ((MQG)), Westpac ((WBC)), National Australia Bank ((NAB)) and Suncorp ((SUN)). Citi also finds bank valuations more attractive and has become positive on the sector following reporting season.

The stress that has been evident in debt markets has meant the Australian major banks have underperformed the Australian market, but a counter rally has meat some improvement in this regard although many valuations are still at or near crisis levels, in the broker's view.

Citi maintains that the drivers of recent earnings revisions for global banks are not featuring locally. Market estimates are being revised down for global bank earnings in the context of negative interest rates, oil & gas loan impairments and large restructuring of balance sheets. In contrast, the Australian banks are increasingly looking to asset repricing to grow revenue.

Despite their leverage to the economy, Australian banks are relatively underweight oil & gas exposures and it would require stress in the property sector to drive a major credit event, in the broker's opinion. Moreover, higher funding costs can be better managed now too.

Citi believes the time is right to re-visit the sector and retains Buy ratings for ANZ Bank ((ANZ)) and National Australia Bank and Neutral ratings for Westpac and Commonwealth Bank ((CBA)). Buy ratings are also maintained on the regionals, Bendigo & Adelaide ((BEN)) and Bank of Queensland ((BOQ)).

Macquarie has reviewed is medium-term bad debt expectations for the banks. Bank exposures to the energy and mining sectors have attracted significant attention and while parts of this book appear riskier, the aggregate weighted probability of default appears to the broker to be relatively low. The majority of rated exposures are investment grade.

However, looking at share price changes as a forward indicator of credit quality movements suggest the overall quality profile has deteriorated in the past 12 months. In Macquarie's opinion this justifies increasing the level of provisioning.

Among the majors, the broker believes Westpac and NAB have better quality institutional lending books compared with ANZ and Commonwealth Bank, in part due to their relatively underweight position in energy and and mining and lower exposures to offshore companies. In sum, the broker’s analysis highlights the average credit rating is sound across the rated portfolio.

The pricing of credit default swaps is often taken as a proxy for wholesale pricing by the equity market and, coupled with assumptions that pricing will not improve again, Ord Minnett suspects that equity prices have been disproportionately affected by the implied cost of funding. The broker suggests that as more debt issuance comes to market, and the headwinds to margins are observed as not all that bad, this may rally bank share prices.

Ord Minnett explains that while the spot cost of funding is now higher than the average of the portfolio, term debt maturities partially comprise relatively expensive debt that was issued during the European sovereign debt crisis.

In essence, with expensive new debt replacing expensive old debt the overall headwind to margins will actually be modest in FY16 and the broker believes the challenges will become greater in FY17, when major bank funding portfolios experience maturities of the relatively cheap issuance of 2013 and 2014.

Meanwhile, across the Tasman, New Zealand banks have repriced mortgage portfolios in recent days, following the reduction in official cash rates by the Reserve Bank of New Zealand, by not passing on the full reduction. They cite market volatility which is leading to higher offshore funding costs.

Deutsche Bank believes the changes also reflect the need to recover the impact from customers increasingly moving to fixed rate lending from floating rates. The broker acknowledges the changes are immaterial for the Australian banks but suggests that similar moves could occur in Australia if wholesale funding costs continue to rise.

Of note, one of the proposed changes from the Basel Committee on Banking Supervision - withdrawing the ability of banks to use their internal models for operational risk, such as Australian banks do - is probably a negative, in Deutsche Bank's view.

Yet the broker believes the inclusion of historical loss experience in the committee's preferred standardised measurement calculation is a positive, given Australian banks have a below-industry average loss experience. While there is limited disclosure on historical operational losses from the Australian banks Deutsche Bank still, on balance, believes any impact should be manageable.
 

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-Youi outperforms on profitability
-Mixed views on IAG vs Suncorp
-NSW CTP changes canvassed
 

By Eva Brocklehurst

Challenger brands are gaining ground on Australia's established insurers, winning a substantial slice of premium such that market share losses among the top three traditional carriers in Australia are now larger than market growth.

Macquarie's analysis of growth and claims data for one of the upstarts,Youi, which recently published its 2015 results, suggests that not only is the upstart gaining share it is also gaining a share of the more profitable segments.

Youi has materially outperformed the industry on profitability, Macquarie notes. Moreover, on the broker's calculations, challenger brands', which includes the banks, gross loss ratios have outperformed weighted industry gross loss ratios by 1,670 basis points over the last nine years.

One offset to be considered is that both challenger insurers and the banks have expense ratios which are not as low as the major insurers, because they do not as yet have the scale advantages.

Macquarie estimates the competition will step up in the next three years, with banks attaining a market share for addressable products of around 10% (from 8.2% in FY15) and challenger brands attaining 13% (from 9.0% in FY15).

The broker's data suggest the banks have captured risks that have performed better than the system in low catastrophe environment while matching system in periods of high catastrophes. Macquarie suspects that the bank home insurance product distribution, sitting as it does alongside residential mortgages, may provide them with a positive selection bias.

Meanwhile, challenger brands typically have a higher portion of motor risks but as they grow they are underwriting an increasing proportion of home risks, which are more exposed to natural catastrophe than motor insurance.

Youi has now captured 2.6% of its addressable market in home and personal motor insurance and Macquarie observes the company is showing signs of approaching scale, with 22.9% gross written premium (GWP) growth in the first half. While Youi may be the leading example of challenger brands the broker highlights that its performance reflects the broader experience as well.

Macquarie suggests that despite a perceived acceleration in Australian GWP growth, the margin decline at traditional insurers is not stabilising. Average premium spending continues to be in a downward trend and is continuing in negative territory in home and motor insurance.

The broker remains concerned about the 12-month outlook, as all traditional insurers are struggling to grow and hold market share. As a result, Macquarie reduces its FY16 GWP growth forecasts for Insurance Australia Group ((IAG)) to a negative 1.1% and Suncorp ((SUN)) to growth of 1.1%. QBE Insurance ((QBE)) is expected to do relatively better, supported by a weaker Australian dollar and a shift higher in US/global interest rate expectations.

Citi has juggled its order of preference for the insurers, placing QBE, AMP ((AMP)) and Medibank Private ((MPL)) in its Buy camp. The broker expects QBE's margins will improve in FY16 and, allowing for 1.2% of reserve releases, expects a margin of 10.3%. AMP is considered attractively valued and offers leverage to a market rebound, while more claims cost savings are expected at Medibank. Citi also believes the regulatory risk is overplayed.

Suncorp, IAG and nib Holdings ((NHF)) are rated Neutral. The broker suspects the speed of improvement at Suncorp could prove disappointing, while IAG and nib appear fully priced.

Morgan Stanley believes IAG's solid franchise, upside earnings risk and capital options make the stock attractive in contrast to the weak momentum overhanging Suncorp. The broker’s adjusted FY16 margin expectations, excluding reserve releases, is 13.1% for IAG and 8.8% for Suncorp. Restoring underlying margins appears challenging for Suncorp in the near term, in the broker's view, as the market competition heats up.

Meanwhile, on the subject of compulsory third party (CTP) motor insurance, the NSW regulatory authority has published an options paper to canvass possible changes to the structure of compensation in the state. The paper recommends moving to free rating of major risks, rather than a capped, gross subsidised system, and reducing the gap between filed profit margins and actual margins achieved by insurers.

Overall, Ord Minnett envisages risks to insurer profitability in this class going forward, although the reforms in the near term could actually boost margins from their current low levels. The most exposed to changes is IAG, in the broker's opinion, given it has 7.0% of its premiums coming from NSW CTP, versus 6.0% for Suncorp and 2.0% for QBE.

UBS suspects the proposed changes may limit the current high claims frequency, reduce volatility and generate surplus capital, but premiums and return will be lower for insurers. Over the longer term this is considered a net negative, given the substantial support reserve releases have provided for IAG and Suncorp profits over the past decade.

Still, the broker envisages IAG's exposure as the number one insurer could be mitigated by an effective 50% quota share. Suncorp has 23% share across its AAMI and GIO brands.

The government last reviewed the scheme in 2013 but made no changes, Credit Suisse notes. This time the options are similar but the government has adopted a softer approach and the broker believes, at a time when insurer profits from NSW CTP are falling, the review should be a small positive. In conjunction, a new task force to address CTP fraud has been set up which should also assist in repairing insurer profitability.

In commercial lines, Macquarie also notes that Australian Prudential Regulatory Authority (APRA) has begun looking at the pricing of upper commercial property risks. Should APRA find that certain carriers are incorrectly pricing these risks the broker believe they will push them to hold more capital. Yet, given the cost and abundance of capital at present Macquarie does not believe this will be a material deterrent.
 

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-Policy downgrades, lapses continue
-Honeymoon period for margins
-Struggle to suppress claims inflation
 

By Eva Brocklehurst

Health insurers have received government approval for an annual round of premium increases that were lower than historically the case, but also greater than many brokers had feared. Is this a good outcome? It depends.

Lower premium increases mean lower revenue growth for health insurers, although there may be some offset in a stemming of the current rate of downgrades or lapses in cover. Morgan Stanley observes industry revenue growth fell below 7.0% in 2015, with this trend likely to continue as policy holder growth slows.

Yet, brokers also consider the government was generous with its increases, given the current strong profitability of the sector, albeit mindful that regulatory risks remain elevated. The minister approved a 2016 premium rate increase of 5.6% (versus 6.2% in 2014, 2015), well ahead of the inflation rate in claims of 1.4% in the past six month, Credit Suisse notes.

Medibank Private ((MPL)) achieved a rate increase of 5.64% while nib Holdings ((NHF)) has achieved 5.55%. The largest health fund in terms of premium value, non-listed insurer BUPA, achieved 5.69%.

The government has flagged reforms across the industry to save on the cost of claims. The first of these has been the change in prostheses claims, with nib noting the potential for $800m in annual savings. Credit Suisse observes these reforms will reduce claims costs but won't be factored into premiums until after the savings are achieved, providing a honeymoon period of inflated margins for insurers.

Moreover, consumers have shown a lack of willingness to absorb premium rate increases, with downgrades to cover at record levels. Credit Suisse observes the rate of increase achieved in 2016 effectively allows the insurers to recoup this lost premium but suspects lapse rates could accelerate.

Following the government's announcement, UBS believes the health funds have achieved a very good outcome, considering the minister's commentary in the months leading up to final submissions. UBS believes the government's “affordability” reform agenda is questionable over the short term with the major health funds likely to significantly “over-earn” well into 2017, and relative to its measure of a long-term sustainable margin.

The broker expects the 9.0% margins in the first half will be a high watermark, although 7.0% appears achievable in the medium term. UBS is yet to factor in any impact from the change to prostheses costs but notes some potential timing benefit should pricing reforms be implemented. Regulatory risks should persist and the affordability and channel constraints which have reduced policy numbers in the last two years are well entrenched in the broker's opinion.

Considering the increased political scrutiny, low 2015 claims inflation and calls for insurers to subsidise rates with capital, the approved increase was better than Deutsche Bank expected. The broker suspects the government was intent on not being too heavy handed in its efforts to improve affordability.

Still, despite the minister's call to utilise surplus capital, the broker notes only HBF's increase was below the industry average at 4.94%, with HCF at 5.42%. Moreover, despite a lower 2016 premium rise, lower rebates (indexed to CPI) for those on full rebates means they will still encounter an effective rise of 7.1%. Thus, combined with slowing wage inflation, this will exacerbate affordability issues and heighten the need for reforms.

Without significant savings in terms of prostheses the industry is likely to struggle to keep claims inflation below 3.9% and Deutsche Bank suspects this should lead to gross margin contraction in 2016. Further out, prosthesis reform could temper 2017 premium rate increases by 1-2%.

The backdrop is the most advantageous for Medibank, which is in the position to enjoy margin tailwinds from hospital contract renegotiations and savings from its claims integrity program. Deutsche Bank believes, over time, better margin trends should allow the company to seek below-industry premium rises and thereby boost its efforts to rejuvenate its brand and stem market share attrition. In comparison, nib appears to have few claims offsets.

BUPA, in releasing its 2015 results, was careful, given the margin performance of its listed peers and the trends in claims. The company has stated it is witnessing more downgrades and a discontinuing of health insurance as affordability pressures continue. Deutsche Bank suspects the advantages outlined earlier for Medibank could mean it displaces BUPA as the industry's most profitable operator.

As a corollary, with the sort of funding system in operation, the earnings trajectory of private hospitals cannot be maintained, in Morgan Stanley's opinion. The most rational outcome, the broker asserts, is for better-negotiated outcomes from the private hospitals on the proviso the insurers hand the benefits back to policy holders.

Morgan Stanley believes that rising demand elasticity from health insurers must translate to poorer outcomes for private hospital operators, Ramsay Health Care ((RHC)) and Healthscope ((HSO)). The broker envisages risks from FY17 onwards to rates paid by insurers to hospitals.

Two key health insurers in FNArena's database are Medibank Private and nib Holdings. There is one Buy rating, five Hold and one Sell for Medibank. The consensus target is $2.60, suggesting 7.2% downside to the last share price. For nib there are two Buy ratings and five Hold. The consensus target is $3.77, suggesting 4.6% downside to the last share price.
 

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-Pressure from volatile credit markets
-Funding costs offsetting mortgage re-pricing
-Will out-of-cycle rate hikes occur?
 

By Eva Brocklehurst

Bank of Queensland ((BOQ)) has set off a nervous murmur in the market, for the second time in several months pointing to continued pressure on margins. Deutsche Bank was not surprised by the cautious statement but does wonder whether the bank is particularly vulnerable to such pressure compared with the other banks.

Bank of Queensland does have a shorter tenor on its wholesale funding book, and the broker observes it is less adept at garnering low-cost deposits that its peers. Hence, it is likely that there is greater risk to its margin in the current environment. As a further re-rating is unlikely in the short term Deutsche Bank downgrades to Hold from Buy.

Morgan Stanley lowers forecasts to reflect the higher funding costs and the bank's up-front investment to implement organisational efficiencies, including mortgage distribution and specialist areas. The broker looks for a further four basis points in margin contraction in FY17, having lowered its FY16 forecast to 1.98%. This is due to competition for home loans, lower interest rates as well as funding costs.

The additional investment of $15m implies a 2.5% downgrade to cash profit estimates although the broker acknowledges management expects a full pay-back within 12 months. The bank did not update on credit quality, which Morgan Stanley assumes to mean management is comfortable with consensus estimates on loan losses.

The broker retains an Overweight rating, given the benefits of a relatively strong capital position and the potential for further standard variable rate re-pricing benefits. Morgan Stanley still expects low single-digit earnings and dividend growth in FY16.

Macquarie lowers FY16 earnings expectations by 3.0% to account for increased costs and reduced margin expectations. but forecasts for FY17 and beyond are largely unchanged, as reduced margin forecasts are offset by future cost savings. 

For the first time since the European sovereign debt crisis in 2012, the spot cost of term funding for Australian banks is higher than the average of the portfolio, Ord Minnett observes. The broker wonders whether the current conditions will translate into a new round of out-of-cycle hikes in interest rates, led by the major banks and followed by regionals. On this subject, the broker notes the majors may choose to tackle the disruption in the near term via alternative tools, such as their less costly covered bonds issuance, and leave regional lenders squeezed on margins.

The bank's cost to income (CTI) ratio target has now been reiterated in the low 40% range. Ord Minnett notes, while in line with expectations, this will put Bank of Queensland below the current run rates of Suncorp ((SUN)) and Bendigo & Adelaide ((BEN)).

Specifically, Bank of Queensland's skew towards housing, which is 70% of its balance sheet, caters for a lower CTI profile, the broker asserts, compared with a stronger business lending profile for others. In comparison, the retail arms of the major banks operate CTIs at less than 40%. The key issue now, the broker believes, is how movements in credit markets will translate to deposit pricing, given the larger proportionate exposure for smaller lenders.

The margin squeeze is a negative development, in Credit Suisse's view, as wholesale funding costs will likely take a large chunk out of any mortgage re-pricing. The broker, at an industry level, will be looking for funding cost pressures to spill over into deposit markets.

UBS also assumes funding costs and competition will offset the mortgage re-pricing the bank implemented in 2015. The broker believes the stock offers upside potential from stronger volume growth as it expands broker relationships and optimises its owner-managed branch network.

Recovery in parts of the Queensland economy on a lower Australian dollar should also help. For now, the broker asserts, most of the upside from re-pricing has been obtained and the bank remains a price taker.

Citi was not flustered by the announcement, having suspected pressure on margins was building. While competition, funding volatility and higher costs in the short-term markets are now back in focus, and estimates are reduced based on the update, the broker retains a Buy rating.

FNArena's database shows two Buy ratings and five Hold. The consensus target is $13.11, signalling 17.4% in upside to the last share price. Targets range from $11.95 (UBS) to $15.40 (Citi). The dividend yield on FY16 and FY17 estimates is 6.9% and 7.3% respectively.
 

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-Commodities and markets income downgraded
-Stock retracement in line with global peers
-Positive outlook for Corporate & Asset Finance
 

By Eva Brocklehurst

Macquarie Group ((MQG)) is coming to the end of a three-year period of consistently upgrading its forecasts and the latest update suggests softer aspects to the outlook are emerging.

The company described trading conditions as satisfactory, with annuity business contributing more but capital markets weaker versus the prior comparable period. The investment bank's equity tier 1 ratio was stable at 9.9%. FY16 forecasts were maintained. The main change was the downgrade to estimates for the commodities and financial markets division, where the profit contribution is expected to be lower than FY15.

Credit Suisse downgrades FY16 estimates by 2.0%, noting the recent sell-off in the US credit market is the likely driver of the financial group's first easing in its estimates since early 2013. The company has also highlighted the demands of comparable earnings.

The stock's retracement is in keeping with the downturn in global investment banks, but at 6.0% below the broker's valuation highlights a degree of valuation support. Hence, Credit Suisse maintains an Outperform rating.

Market conditions may remain challenging for some time so UBS reduces earnings forecast by 3.0% for FY16 and 4.0% for FY17. Over recent years Macquarie Group has made improvements in its operating efficiency, with its cost-to-income ratio falling to 70% from 85%. In the broker's view this remains unacceptably high, given the business mix. UBS is encouraged by management's renewed focus on its cost base, believing this offers the largest point of potential upside.

The company has benefited over recent years from a falling Australian dollar, easing central bank rates and rallying equities markets, as well as price inflation in hard assets and commodity price volatility.

UBS suspects all these features have peaked in the first half and, while there are a number of strong businesses in the portfolio, conditions are likely to challenging and performance fees lower. The broker expects the stock to remain volatile, but envisages upside over the medium term as operating leverage offsets revenue headwinds.

Deutsche Bank considers Macquarie Group's performance is admirable compared to other investment banks but accepts the cautious outlook may weigh on the share price for some time. A tilting towards annuity-style revenue should shield the company from the worst of markets, the broker maintains.

Still, the price/earnings ratio over history suggests to Deutsche Bank a de-rating tendency in tough times even as forward estimates fall. Hence, the broker considers it too early to rule in a re-rating.

Deutsche Bank remains impressed with the diversification and balance sheet of both the Macquarie Asset Management and Corporate & Asset Finance segments. Still, the disclosure did signal that the geographic and product emphasis in Macquarie Investment Management will result in net flows and market performance remaining below Australian listed fund managers.

Ord Minnett claims it is easy to blame a lack of growth prospects in the next year for the recent share price decline but the main driver is more likely to be the sharp retreat in global investment banking peer multiples. The broker forecasts limited earnings growth in FY17 but expects the result will be compositionally superior to FY16, with significantly lower performance fees and trading revenues replaced by more highly valued lease income from the AWAS aircraft and Esanda businesses.

Morgan Stanley estimates that AWAS and Esanda will add around 40% to corporate and asset finance division earnings and is positive about the segments trajectory, forecasting 31% profit growth in FY17.

Yet, the broker believes the overall earnings upgrade cycle is definitely at an end and the briefing raised questions about the pace of profit growth in asset management and asset finance, and the outlook for commodities related revenue in FY17. Moreover, the briefing revealed that FX and market movements delivered around 75% of the traditional assets-under-management growth over the past five years.

Morgan Stanley envisages emerging headwinds in four of the operating divisions and retains an Equal-weight rating. Citi, too, was unsurprised that the volatility in financial markets was affecting profitability. The broker assumed FY16 would provide a peak in profits and continues to believe the environment is turning less accommodative for asset values and Macquarie Group's profits.

In summary FNArena's database shows three Buy ratings and three Hold. The consensus target is $75.90, signalling 18.7% upside to the last share price. This compares with $86.00 ahead of the update. Targets range from $65.50 to $85.00. The dividend yield on FY16 and FY17 forecasts is 5.7% and 6.1% respectively.
 

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