Thursday, May 10th, 2018
Investors often say the four major ASX banks all move together and you might as well own one as much as any other. But while of course the banks operate in the same industry and face the same fundamentals, strategy and corporate decisions are starting to differentiate them and as we near the end of the May 2018 banks reporting season we can now nominate ANZ as our top pick of the four majors for the year ahead.
ANZ’s interim surprised on the upside as cash earnings grew by four per cent compared with the two per cent forecast by the consensus of sell-side analysts who cover the stock. The surprise was in loan impairment (bad debts) expense, which fell to just 14 basis points (0.14 per cent) of gross loans, down from 16bp in the second half of 2017 and 24bp a year ago as ANZ wrote back provisions for previous bad debts. The other driver was ANZ’s fourth successive half-yearly reduction in absolute dollar operating costs.
ANZ has the fewest problems likely to drag on earnings, return on equity and share prices over the year ahead. Despite buying back $1.1 billion of its own shares in the half, ANZ has the strongest capital position of the majors, with a common equity tier one capital ratio of 11 per cent when the others range as low as 10.1 per cent in the case of CBA. This ratio will increase after ANZ sells its Australian wealth business, so further buybacks are likely.
Return on equity improved 30bp to 11.9% in the first half – still ordinary but there is further upside as ANZ reallocates capital from institutional banking, which is low-margin and earns low returns on equity, to owner-occupied mortgages, which still earn returns on equity invested of over 20 per cent. So far ANZ is the least scandalised bank at the Royal Commission, admittedly with hearings into business banking yet to start. ANZ is mainly a business bank.
ANZ’s key vulnerability is its institutional (large corporate) banking business, which still accounts for 42 per cent of risk-weighted loans. This is a tough category, with strong competition from foreign banks and lumpy loan impairment expense given the smaller number of loans. ANZ needs to prove it can earn a double-digit return on equity in an institutional bank focused on trade and capital flows into and around the Asia-Pacific. Its successful New Zealand institutional bank is a model for how the broader division could evolve.
We are encouraged by the currently low incidence of impaired loans in ANZ’s institutional bank, which means the derisking of the loan book is working. Risk-adjusted interest margins are also improving as ANZ tilts its book towards higher-paying large corporates.
ANZ was the only major bank to cut its dividend payout ratio in 2016, when the others should have done the same. This derisked the bank and the stock rallied that day. Now ANZ finds itself with the strongest capital position in the sector, no need for topup capital from its dividend reinvestment plan, the ability to support the share price by buying back shares on-market and the ability to resume dividend growth in 2019.
National Australia Bank declared a flat 99-cent dividend. The payout ratio of over 80 per cent would be unsustainable if not for NAB’s organic capital generation due to slow lending growth. NAB’s dividend is unlikely to grow until 2020, when the major cost reduction program delivers $1 billion of recurring annual cost savings. However execution risk for this huge project is significant and while simplifying the bank is intuitively appealing, and we appreciate the drag on NAB’s agility of its complexity, management has not yet quantified the revenue upside from being a “simpler” bank. The exit from MLC should boost return on equity after a period of elevated separation costs, writedowns on sale/demerger, and stranded corporate costs.
The prudential regulator APRA punished Commonwealth Bank by adding $1 billion to its operational risk capital requirement. CBA may apply for removal of the adjustment when it can demonstrate compliance with an enforceable undertaking (EU). We expect CBA will eventually comply but the extra capital will weigh on return on equity until then and there is now little prospect of a special dividend or buyback in 2018. Shareholders are paying a high price for electing directors who allowed the scandals to happen and new CEO Matt Comyn has an enormous task managing this large organisation organisation while complying with the EU. At this stage we expect a flat final dividend of $2.30 per share. A negotiated settlement with Austrac would derisk the stock sooner than letting the case go to court and making a judge decide on the fine.
Westpac’s pleasing result benefited from its service-led strategy and benign credit conditions in its home states of NSW and Victoria. Westpac has been the sector’s quiet achiever and should continue to deliver mid-single digit earnings growth with some downside risk to interest margins as the bank’s large interest-only mortgage book transitions to principal and interest. Regulatory model changes are weighing on capital, so investors should lower their expectations for dividend growth in coming halves. To support capital WBC also will continue to issue shares under its dividend reinvestment plan, which is dilutive. ANZ’s superior capital strength enables it to neutralise its own DRP by buying back the same number of shares on-market, preventing dilution. Westpac’s concentration in the Sydney property market exposes it to the slowdown there.
All banks benefited from the absence of corporate collapses in their first halves and generally excellent credit quality in the Australian economy, especially in the eastern states. This should continue while the economy and employment continue to grow and interest rates remain at historic lows. A random spate of corporate collapses unrelated to general economic conditions is possible at any time; the last was in the first half of 2016.
The bad news for all banks was management guidance for mortgage lending growth to slow, price competition to increase and wholesale funding costs to rise. The Royal Commission won’t change the demand for mortgages but it will make getting a loan harder as banks tighten their serviceability criteria. This will weigh on net interest income and further dampen sector earnings per share growth over 2018-19 to only two per cent.
Banks are trading moderately below average price-earnings ratios and at larger than average discounts to industrial stocks. A relative value rally in banks should occur once earnings downgrades cease.
The lack of growth means the purpose of banks in portfolios is steady fully franked yields. These are now around six per cent, which tends to hold bank share prices. The share price downside is limited from here so the main question facing investors is the total weight to banks in the portfolio. Twelve per cent of our model portfolio is invested in three bank stocks (ANZ, CBA, NAB), which for us balances the attractive dividend yields with the lack of growth.
Originally published in The Australian, Tuesday 8th May 2018.
Clime Group owns shares in NAB, CBA, WBC and ANZ.