Thursday, June 8th, 2017
ANZ has derated by 15% since its 1 May high of $32.95, mainly due to disappointing revenue growth in the interim result and uncertainty about whether the bank will be able to pass on the Budget’s bank levy. These added to some investors’ existing concerns about increasing regulation, political scrutiny and criticism, capital requirements and price competition in key banking categories – as well as medium-term uncertainty about house prices and mortgage bad debts.
StocksInValue subscribers would however note the share price discount to our intrinsic valuations and wonder if this is an opportunity.
To build to the valuation, first let’s review ANZ’s financial performance over the last five years using the Financial Summary table in the Key Stats section of the Dashboard tab. The obvious feature is the sharp fall in profitability, as measured by NROE, in FY16 after the $3.2bn equity raising in 2015. ANZ and other banks were forced to suddenly raise large amounts of equity after the prudential regulator APRA gave a short deadline to increase capital adequacy for the greater risks it saw in mortgage loan books.
In the Value table below from the Dashboard, our analysts have adopted a 10.8% required return for ANZ. This percentage summary of the risk to NROE balances ANZ’s conservative management and funding, its large size and ease of access to funding markets, its currently low earnings volatility, its prudential regulation by an independent regulator, its financial and economic leverage and its exposure to Asian business.
Figure 2. ANZ Value
NROE comprises distributed earnings (dividends) and reinvested earnings. The black box includes reported historical data from FY13 through 1H17. The blue box shows value metrics implied by the average forecasts of stockbroking analysts who cover ANZ, and the green box contains our adopted value metrics. Note we see profitability continuing at the same 15.5% rate consensus has for FY18 but our Reinvested rate of 3.0% is slower than consensus and indeed only in line with real GDP growth. This captures our view the growth outlook for Australian banks is constrained by soft business investment, price competition in loans and deposits, and a developing slowdown in investor lending.
One of ANZ’s priorities is to increase ROE by becoming more capital efficient. The chart below shows progress at reducing the proportion of capital allocated to the volatile, capital-intensive institutional (large corporate) loan book, accompanied by rising RORWA (Return on Risk-Weighted Assets). Divestments of low-returning Asian banking interests will also boost ROE. Both are reasons we think NROE can sustain at 15.5% after FY18 despite the headwinds to revenue. The main near-term risk to NROE is a more aggressive statement on bank capital by APRA in June. Currently we forecast $4bn of buybacks by ANZ over FY18 and FY19, reflecting the bank’s surplus capital after the divestments. In case the regulator demands more capital than the market expects, the model portfolio has not yet bought more ANZ shares despite the share price fall. Another reason is the large existing weighting to the stock (~5%).
Meanwhile, ANZ’s losses on bad loans remain historically low, reflecting low interest rates and economic growth in Australia, Asia and New Zealand. This is a crucial support to profitability when revenue growth is very slow.
Figure 5. ANZ Observed Loss Rate
Source: ANZ 2017 Half Yearly Results
A decline in 1H17 net interest margins (NIMs) disappointed the market and weighed on the result. NIM captures the difference between interest revenue from borrowers and interest paid to depositors. NIM shrank 6bp against expectations for flat or wider margins due to mortgage book repricing (the “Assets” column in the graph), and the result was revenue was flat against consensus for +3%. The reason was a drive to gather more Australian deposits, which are expensive because they have to be attracted by higher deposit rates, to replace deposits about to be lost with the divestment of the Asian retail bank. Seemingly no one saw this coming, which goes to the difficulty the market is having understanding the mix shifts due to restructuring. Higher wholesale funding costs also detracted, only partly offset by mortgage book repricing (the out-of-cycle interest rate increases of late). The market saw the disappointment as a reason to sell the stock. It shouldn’t recur in the 2H.
Figure 6. Net Interest Margin
Source: ANZ 2017 Half Yearly Results