Monday, May 20th, 2019
Once again ANZ held its interim dividend steady at 80 cents, supplying another instalment in the franked income stream on which hundreds of thousands of SMSF investors rely. ANZ’s dividend has now been 80 cents for seven consecutive halves, admittedly cut from 95 cents in the 2H14 half. It’s useful to understand why ANZ’s dividend was resilient to the earnings and capital pressures facing banks over the last four years, why it should remain so, and why the stock continues to earn its place in the Clime Direct Model Portfolio.
The resilience is explained by how solid capital generation, earnings diversification, operating cost reductions, derisking and a largely benign credit environment offset higher regulatory capital requirements, slowing growth and margin pressure in Australian mortgages, the consequences of earlier lending policies, and elevated remediation, legal, compliance and regulatory costs.
ANZ entered the post-2015 era of greater regulatory capital and tighter mortgage underwriting requirements with an excessive dividend payout ratio and a risky institutional (large corporate) loan book with too much exposure to Asian and sub-investment grade companies. The 1H15 dividend cut was crucial to the dividend’s subsequent stability – and the share price, as ANZ would probably have otherwise traded at a discount for an excessive dividend payout ratio. NAB did this for several years until its recent dividend cut. For example, ANZ’s organic capital generation (earnings less risk adjustments, capital deductions and net dividends) averaged 57 basis points over the four first halves to 1H15 but 88bp over the four subsequent first halves to 1H19. Assisted by divestments of risky non-core businesses and reductions in excessively risky institutional loans and the large amounts of prudential capital they required, this uplift increased the amount of surplus capital for paying dividends.
On 31 March ANZ had the highest reported common equity tier 1 capital ratio of the four major banks, 11.5 per cent (12.1 per cent proforma after divestments), well above APRA’s 10.5 per cent unquestionably strong ratio, and this was after $3 billion of outlays on share buybacks and five halves of neutralising the dividend reinvestment plan. The buffer positions the bank well for further potential increases in regulatory capital to be held against investor and interest-only loans, and the Reserve Bank of New Zealand’s new capital imposts currently being negotiated. We expect ANZ to defer further buybacks until there is more certainty here.
Today ANZ is diversified across Australia, New Zealand and a pan-regional institutional banking business which has gone from a source of earnings volatility to a source of earnings growth. In 1H19 Australian earnings fell 12 per cent and New Zealand was flat but institutional earnings jumped by a third, supporting the dividend.
ANZ started early in 1H17 at remediating its advice customers who paid fees for no or no documented service and $928 million of charges have been booked since then. This includes the bulk of remediation for salaried and aligned financial planners, which means only remediation costs for retail banking, which should be much smaller, remains. The passage of the worst of remediation costs further supports the dividend.
Assisted by the largely benign credit quality environment, loan impairment expense remained near historic lows at 13 basis points in the recent first half and long-run loss rates have fallen 27 per cent over the last four halves. Derisking the institutional loan book has permanently lowered this expense. Mortgage arrears have increased but the worst vintage is pre-2015 when lending standards were tightened. With the passage of time, this vintage should contribute a declining proportion of arrears.
In 1H19 ANZ cut operating costs for the eighth consecutive, and boosted earnings, by continuing to simplify the bank and reduce manual handling. In our view, this simplification and digitisation of banking has years to run and is a valuable support to dividends while revenue growth is negligible and mortgage margins contract due to price competition.
ANZ is not flawless. It is overweight Western Australia in mortgages, the product of earlier dubious decisions to chase market share in this state, and these loans have the highest rate of arrears of all jurisdictions. Switching from higher-margin interest-only loans to lower-margin principal & interest loans is weighing on interest margins and this detraction has another four halves to run before it abates. However, these effects are unlikely to be strong enough to justify cutting the dividend given the above reasons why it can continue at 80 cents per half. WA contributes 13 per cent of the home loan book but this percentage is declining due to a more careful lending policy, so the translation of arrears to loan losses should also diminish in proportion.
All that said, shareholders should not expect an increase in the dividend until the second half of 2021 at the earliest, as we expect ANZ will continue its conservative approach to capital management. External macro risks like the health of the Australian and New Zealand economies are the main source of any downside to the dividend. We value ANZ at $28.00.
Originally published Tuesday 14th May 2019.