Australia | Oct 24 2016
This story features NATIONAL AUSTRALIA BANK LIMITED, and other companies. For more info SHARE ANALYSIS: NAB
Earnings declines, rising bad debts, potential dividend cuts, potential capital raisings – it’s not shaping up as a great reporting season for the Big Banks.
– Margins under pressure
– Weak earnings expected
– Dividends at risk
– Capital raisings possibly ahead
By Greg Peel
In the wake of each CEO having faced a parliamentary grilling, the pressure is off Australia’s Big Four banks, for now. Calls for a Royal Commission have subsided as politicians’ limited attention spans move on to other matters. RBA monetary policy is presently on hold, although we await this week’s inflation data. So the banks will not be drawing further ire by not passing on full rate cuts.
We may nevertheless see the usual round of shock-horror when three of the Big Four release their full-year earnings results, as the billions are revealed. The reality is bank earnings have likely gone backwards this year. It’s no great surprise – corporate earnings do ebb and flow – but if bank earnings growth is indeed net negative, it would be the first time since the GFC.
National Bank ((NAB)) will report FY16 earnings on October 27, ANZ Bank ((ANZ)) on November 3 and Westpac ((WBC)) on November 7. Commonwealth Bank ((CBA)) will provide a first quarter FY17 update on November 9.
The key risk for this reporting season, Citi suggests, is a continued failure to meet consensus revenue estimates. CBA, which reported FY16 earnings in August, was expected to generate second half revenue growth of 6% but reported 4%, the broker notes. Bank of Queensland ((BOQ)), which reported earlier this month, reported 0.5% against 3% expectation. Citi expects this trend to continue.
Morgan Stanley agrees revenue growth prospects have moderated further as loan growth slows and margin pressures increase. Net interest margins have fallen due to pressures on both sides of the ledger. Despite all the brouhaha over the banks not passing on all of the last RBA cut, discounting wars for mortgages have ensured that in reality, it has indeed been passed on to those who shop around. Despite no one ever paying attention to depositors, competition amongst the banks for deposits has also been stiff.
At the same time, levels of bad and doubtful debts (BDD) have been growing after finally hitting a post GFC trough. At the banks’ first half reporting season in May, the market was shocked with the level of “single name” exposures to the likes of failed electronics retailers, foundering law firms and cash burning miners. The good news is a repeat performance is not expected in the second half.
But the bad news is the “pockets of weakness” also apparent among BDDs in the first half, such as New Zealand dairy and Australian mining state exposures, will likely remain an issue. More worryingly, analysts expect BDDs to have risen across the broader Australian economy – not alarmingly so, but risen nonetheless.
In the meantime, the banks have been spending capital on systems upgrades to try to catch up to the modern world.
So if we add up weaker revenue growth, lower net interest margins, increased BDD provisions and increased capex, we get lower earnings. Goldman Sachs is forecasting a 6% net earnings decline in FY16 among the three banks reporting.
Dividends and Capital
Lower earnings should translate into lower dividends. And in terms of quantum of dividend, this will be true. But banks pay dividends based on a payout ratio of earnings, unlike, say Telstra, which pays a fixed quantum. Thus the real risk is a cut to payout ratios.
Dividends paid in cash reduce capital. The banks currently need to increase capital. By how much is as yet uncertain.
The new Basel 4 capital requirements for large international banks – those deemed domestically systemically important banks (D-SIB) or “too big to fail” – are expected to be announced by year-end. APRA then intends to add an additional capital requirement to Australia’s big banks to account for the smaller economy and population Australia’s banks service compared to, say, the US and Europe. All we know to date is that APRA requires Australian bank capital positions to be “unquestionably strong”.
APRA will quantify “unquestionably strong” once the Basel 4 requirements are known. This will not likely happen until at least early next year. At that point it will become more clear whether or not the Big Four need to raise more capital. In the meantime, analysts do expect the banks to address the drain on capital through dividend payouts at the upcoming reporting season.
The banks' current payout ratios are historically high. They were able to creep up and up as the fallout from the GFC subsided and the damage in Australia proved not to be nearly as extensive as feared. Having taken on board enormous provisions against BDDs and also against general macro-economic risk, the banks were able to feed these unused provisions back into earnings and reward (and attract) shareholders with dividend increases.
Those days are over. The GFC provisions are gone and BDDs are rising again, earnings are under pressure and capital requirements are increasing. Something has to give.
ANZ already took the hit. Most analysts assumed the banks would not cut their dividend payouts but if anyone did it would be the smaller two, ANZ and NAB. ANZ did, NAB didn’t, and neither did Westpac, nor CBA at its full-year result.
Six months on consensus is for more dividend cut announcements.
The Citi analysts, who were half right six months ago in predicting the ANZ cut, believe NAB and Westpac will both cut this time around. Goldman Sachs expects NAB to cut by 10% and suggests Westpac’s payout ratio “does look high”. Credit Suisse notes consensus is for NAB to cut by 4 cents. Deutsche Bank acknowledges “elevated” ratios. UBS would not be surprised in a NAB cut, although suggests the bank may wait until after the new capital requirements are known next year. Morgan Stanley believes the risk of dividend cuts remain for all the majors bar ANZ.
Macquarie believes the banks can sustain and should maintain their dividends in the current low growth environment, other than NAB.
Macquarie believes the banks can continue to partially rely on dividend reinvestment plans (DRP) to support their capital positions, maintain dividends and distribute franking credits to optimise value for their shareholders. DRPs represent an incremental, back-door capital raising given new shares are issued in lieu of cash. The Macquarie analysts acknowledge not all agree with their view.
“We continue to see value in the banks sector,” they say, “and believe concerns around the sector’s dividend sustainability are overstated”. However there is a caveat. Macquarie believes dividends are “largely” sustainable “putting the potential for additional capital accumulation aside”. The analysts’ view is therefore dependent on as yet unknown Basel 4 and APRA quantification.
And this is The Great Unknown. It is a bit hard for bank analysts to make predictions and subsequent forecasts. However, Morgan Stanley has long assumed the banks will indeed be forced to raise more capital. The broker is forecasting a net required capital build for CBA, NAB and Westpac of around $16bn by FY18.
Morgan Stanley believes investors are largely dismissing the potential for a bear case outcome on capital requirements.
UBS is on the same page. The analysts believe the requirement for new capital is “likely to be substantial”, potentially exceeding the capital raisings undertaken by the banks last year. The regulators will give the banks a period of time to reach new capital benchmarks but the market, UBS suggests, “is unlikely to be as generous”.
With capital the focus, UBS suggests it is hard to build a compelling overweight case for the banks.
While assuming a weak FY16 overall, Goldman Sachs expects things to get better for the banks in FY17-18. Goldman is forecasting no further RBA rate cuts, which should lead to relief from margin pressure. The broker also expects increasing BDDs to be a mild rather than severe headwind, and thus expects earnings will stabilise.
On an average twelve month forward yield of around 6%, Goldman believes bank valuations are currently attractive. For the same reason, Macquarie also finds the banks attractive and remains Overweight the sector.
There are eight major brokers in the FNArena database covering the four Big Banks. As the table below indicates, collectively the brokers have twelve Buy ratings, eighteen Hold and only two Sell.
As for preference amongst the Four, the table is rather interesting. Westpac has held top preference for a while now, which is understandable given a leading 6% upside to consensus target price. Aside from a little bit of a blip last year, CBA is in the very familiar position of least preferred.
Typically CBA is least preferred due to investors perennially affording Australia’s biggest bank a premium over the other three, which is typically apparent in CBA showing either the least upside to target or even a target below the last treaded price. At present, CBA is second only to Westpac on upside.
CBA will provide its own update after the other three have all reported.
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For more info SHARE ANALYSIS: ANZ - AUSTRALIA AND NEW ZEALAND BANKING GROUP LIMITED
For more info SHARE ANALYSIS: BOQ - BANK OF QUEENSLAND LIMITED
For more info SHARE ANALYSIS: CBA - COMMONWEALTH BANK OF AUSTRALIA
For more info SHARE ANALYSIS: NAB - NATIONAL AUSTRALIA BANK LIMITED
For more info SHARE ANALYSIS: WBC - WESTPAC BANKING CORPORATION