Thursday, May 17th, 2018
ANZ’s interim dividend was steady at 80.0 cents fully franked, payable on 2 July, with cash earnings growing 4% on pcp compared with expectations of +2%.
The upside surprise was loan impairment expense, which fell to a remarkably low 14bp (0.0014%) of gross loans, down from 16bp in 2H17 and from 24bp a year ago. We thought 2018 would look like this as the economy continues to grow, unemployment is steady at a moderate rate and interest rates remain at historic lows. ANZ sees nothing on the horizon to damage credit quality and we tend to agree though are monitoring the situation closely given the household sector’s record leverage.
With a common equity tier 1 ratio of 11.0%, ANZ has the sector’s strongest capital position. And today, over a month since the 31 March interim balance date, ANZ announced its reinsurance arrangements with Zurich and the receipt of around $1bn of reinsurance proceeds. This will increase the CET1 ratio by ~25bps.
At the half year ANZ had completed $1.1bn of a $1.5bn on-market buyback program. Today’s announcement foreshadowed a possible additional program of $1.0-1.5bn, which in our view is more likely than a special dividend given ANZ’s tight franking position. ANZ also reiterated it would neutralise the interim dividend reinvestment plan through the on-market purchase of shares.
The accounts are complicated due to multiple large divestments (life insurance, Asian retail banking, Australian wealth management) but disclosure of the underlying trends is clear. There is consistent execution of a turnaround strategy that is gradually working. ROE rose 32bp to 11.9% as capital was reallocated from institutional banking to more profitable owner-occupied mortgages, boosting risk-adjusted interest margins.
Before bad debts expense, ANZ barely grew with pre-provision earnings down 2% on a year ago and just 1% higher half on half. Loans on the balance sheet grew 2% and underlying interest margins were broadly flat. Headline margins fell 5bp with the government’s bank levy detracting 2bp and markets and treasury the other three.
Near term the revenue outlook is worsening as housing credit growth slows and price competition in the high-ROE owner-occupied lending (OOL) segment increases. This is also the category where ANZ wants to grow because it is underweight NSW and VIC and thinks a lifetime relationship with an OOL borrower is more valuable than with an investor borrower, where the relationship is more transactional.
Rising offshore wholesale funding costs, if sustained, will drag on 2H interest margins by 2-3bp. Repricing mortgages to recover these costs is probably politically impossible while the Royal Commission keeps creating embarrassing headlines. Business lending is up next at the Royal Commission and ANZ is exposed. Given the intensifying price competition in mortgages, consensus earnings downgrades are likely for banks.
There are some straws in the wind suggesting banking system business lending could accelerate from currently slow growth rates of 3-4%. Realistic expectations are required given the modern Australian economy is centred on services, which are not capital-intensive and don’t require as much bank funding as the manufacturing sector of times past.
ANZ’s response to this environment of slow growth for banks is to cut costs to support earnings. Absolute dollar costs fell for the fourth consecutive half.
ANZ should hold its rating in the market from here while continuing to trade at a discount to value given the lack of growth in the sector, intensifying competition in the attractive owner-occupied mortgage category and negative newsflow from the Royal Commission. ANZ has the highest required return of the four majors due to its exposure to the less profitable and more volatile institutional banking category. Our strategy on the stock is to hold for the attractive dividend yield and incremental value growth. We would lighten into a rally towards value (ANZ is currently in quarantine) or to fund investments in alternative large-cap stocks with more risk-adjusted upside.
Figure 1. Ongoing reallocation of capital from institutional banking to retail and SME
Figure 2. Highlights of ANZ’s 1H18 result
Figure 3. The nuanced outlook for banks
NAB held its interim dividend steady at 99 cents fully franked, payable on 5 July. Due to the slowdown in housing credit, 1H18 revenue growth missed market expectations and the stock is only marginally higher since the result.
Given NAB’s expense profile is largely locked in for FY18, pre-provision profit growth this year will be difficult. NAB appears committed to its agenda of investment in technology upgrades, digital capacity, automation and removal of manual handling. The rate of technology spend is highly elevated due to historic underinvestment and management’s desire to better position the bank for the future. In the short term, earnings could decline as a result. However, in FY20 earnings growth should improve if NAB can deliver flat costs growth. Ultimately, NAB’s success should become evident beyond 2020 if cost performance can be maintained or improved in subsequent years and management positions the bank to capture revenue opportunities.
Credit growth disappointed but the result was underpinned by a 1bp gain in interest margins, historically low bad debts expense and lower operating expenses for the half. NAB’s guidance for 5-8% expense growth for FY18 suggests that expense growth is likely to pick up in 2H. Rising wholesale funding costs, if sustained at current levels, will detract 2-3bp from 2H interest margins.
The program to transform the bank by taking out $1bn of annual costs comes with elevated execution risk but we continue to see longer-term value in NAB and expect the dividend will be held steady at 99 cents per half until the end of FY20. The dividend is flat because the payout ratio is excessive after generous increases in earlier years. As a result NAB does not generate organic capital (earnings less dividends) as quickly as banks with lower payout ratios, and will need to hold back from raising the dividend to meet APRA’s target for a 10.5% CET1 ratio by January 2020. Slow loan growth makes this easier, as less regulatory capital is needed to back new loans.
Our strategy on NAB is the same as for ANZ: to hold for the attractive dividend yield and incremental value growth. We would lighten into a rally towards value (NAB is currently in quarantine) or to fund investments in alternative large-cap stocks with more risk-adjusted upside.
Figure 4. NAB’s own summary of its result
Figure 5. Credit quality in Australia is at 20-year highs
Figure 6. Rising funding costs will weigh on margins
Figure 7. Long-term downtrend in bank interest margins
Figure 8. Flat/falling house prices to weigh on credit growth; business lending needs to compensate
Clime Group owns shares in NAB and ANZ for and on behalf of various mandates for which it acts as investment manager.