Feature Stories | Jun 06 2018
This article was first published fro subscribers on May 22 and is now open for general readership.
In the shadow of the Royal Commission, the Big Four banks have delivered results that point to a subdued outlook, while risks and uncertainties remain.
-Revenues slowing, costs rising
-RC fallout uncertain
-Capital position strong
-Downside risk remains
By Greg Peel
“The big uncertainty is of course, what will the Commission find? And having so found, what will be the cost to the banks in related fines or other penalties, compensation and possible class actions stemming from such findings, and possible constraints on the way banks can operate going forward? These questions cannot be answered ahead of time.”
This excerpt comes from FNArena’s last update on the Australian major banks, back in December last year following the announcement of the Royal Commission. The article was optimistically entitled Australian Banks: Could Have Been Worse, reflecting the view of bank analysts at the time that proposed terms of reference of the Commission were not as imposing as they might have been.
In regard to “The big uncertainty”, it was a fair assumption to make that surely there could be no more skeletons in the cupboard than had already been revealed – Austrac accusations, interest rate fixing, insurance indiscretions and so forth – particularly considering there had already been no less than 51 substantial reviews, investigations and inquires launched into the banks since the GFC and 12 were still ongoing.
Little did we know.
Subsequent revelations have been no less than staggering, and the Royal Commission remains ongoing. With regard the second uncertainty – the ultimate cost to the banks – that remains an uncertainty and that will likely be the case until the year-long inquiry is over, recommendations are made, and government and regulatory action is decided upon.
Until then, a black cloud will continue to hover over the majors on the cost side of their ledgers. For bank analysts, earnings forecasts are difficult given ultimate costs from fines and compensations can only be guessed at, as is also the case with what regulatory responses there may be to further constrain earnings capacity.
It was with that backdrop that ANZ Bank ((ANZ)), National Bank ((NAB)) and Westpac ((WBC)) all released first half earnings results this month and Commonwealth Bank ((CBA)) provided a March quarter update.
Citi believes the results largely met reduced expectations. UBS found them disappointing. Macquarie highlighted a soft outlook and Credit Suisse has since factored in lower growth assumptions.
The banks are facing the double-whammy impact of revenue growth falling as costs rise. Moreover, each side of the ledger is facing double-trouble issues.
Revenue growth is more difficult due to tighter regulatory restrictions and, whether as a result of those tighter restrictions or simply as a result of the inevitable end of the cycle, Australia’s housing market is now slowing.
The Royal Commission will lead to higher one-off (fines, compensation) and ongoing (compliance) costs at the same time as the banks are being forced to invest in new and updated systems to keep pace with the digital age.
Net earnings for the Big Four fell -3.7% in the first half 2018 from the second half 2018, UBS calculates. Revenue growth was weak at 1.7% compared to a cost increase of 6.6%, exacerbated by the cost of NAB’s restructure and the provisions CBA has already put aside for fines and compliance costs, remembering that CBA was already in the spotlight before the Royal Commission even began.
Net interest margins expanded by 2 basis points thanks to mortgage repricing, which we could call the silver lining of the earnings cloud of tighter APRA restrictions on investor and interest-only loans. Even tighter restrictions may result from the RC, but can the banks continue to reprice mortgages as the housing market turns?
The good news on that front is that the one highlight of the results was persistently low bad & doubtful debts (BDD) numbers. Corporate losses continue to fall. However, UBS does note an increase in “watchlist” exposures, and the beginnings of an increase in mortgage arrears from very low levels.
The other highlight was that of strong tier one capital positions, removing any doubt there may have been that the majors would easily satisfy APRA’s pending “unquestionable strong” capital requirements. Yet the reality is capital positions have been boosted by lower lending growth, benign BDDs and business divestments.
The common theme emanating from management outlooks was that of even tighter lending standards ahead and further slowing in credit growth at the same time funding costs are rising, by virtue of the widening spread between the Australian band bill swap rate (BBSW) and the international overnight indexed swap rate (OIS) from which bank funding (bond issues) are priced.
Slow growth will likely lead to increased competition among the banks for new loans, which will weigh on net interest margins, as will the need to migrate existing interest only loans to principle & interest loans as required by the regulator.
On the other hand, while mortgage growth slows on tighter lending standards and a cooling housing market, record business confidence is supporting a long awaited rise in business credit demand. Citi suggests business banking will replace retail banking as the main driver of earnings growth.
The banks had begun to increase their tier one capital ratios long before APRA finally quantified its “unquestionably strong” requirement. When quantification was finally determined, the banks uttered a sigh of relief. The new requirement would not be as imposing as feared, and well achievable before the deadline.
Since that time, tighter credit controls and slower growth have curtailed earnings but boosted capital positions. Benign BDD positions have reduced the level of provisions required on balance sheets. And to top it off, the banks have variously sold off their wealth management and/or insurance businesses, further boosting capital positions.
The irony is, capital management may be back on the agenda once more. To date, ANZ is the only bank to have moved on this front, announcing a share buyback during the first half and, post-result, suggesting a potential extension to that buyback on the completion of the sale of its Zurich insurance business.
All banks are facing the potential of costs stemming from the RC, and beforehand, considering CBA’s Austrac issue and all-bank BBSW collusion, among other things. All banks are currently spending to update their systems.
ANZ has now undergone a period of strategic divestments and is focused on reducing absolute costs. Credit Suisse can see the potential of an additional $4.5bn in buybacks. Macquarie agrees ANZ is well placed.
NAB is currently undergoing a restructuring program which is meeting with analyst support. But it will mean medium term gains are predicated by short term cost increases, and this will likely rule out capital management.
CBA is undertaking a “program of action” as a result of all the revelations that have emerged. This, too, will cost money, although brokers suggest the provisions the bank is putting aside to cover the costs emanating from the RC are “conservative”, meaning hopefully larger than will prove necessary.
Analysts never saw the RC revelations coming, and CBA was once again glaring in the spotlight. The RC remains ongoing, so time will tell.
Credit Suisse suggests the distraction that will stem from CBA’s program will play into Westpac’s hands. With all that is going on for the other three majors, the broker declares “if there was ever a case of boring is good, it’s Westpac”. The bank does not have the same cost reduction potential as ANZ, but it does have the ability to “manage the times”.
Credit Suisse believes Westpac will be the next bank to go down the capital management path, with a special dividend, but probably not in 2018.
Capital management potential aside, the major banks have and always will be valued by investors on their fully franked yields. History suggests that yields in excess of 6% tend to represent a natural floor in share prices.
At the time of announcement of the RC, bank valuations had already fallen on emerging scandals. They fell further still when the RC was announced. At that point, analysts were prepared to believe that “the worst was priced in”.
Once again: Little did we know.
The following table shows the state of play as it was back in December:
As we can see, yields had begun to push above 6%, to some extent supporting the call of the worst already being priced in.
Let’s now look at the state of play today:
NAB’s forecast yield has surpassed 7%, while both the larger Westpac and CBA are offering sixes. ANZ’s is under six, but the buyback underpins.
We can also see that back in December, analyst consensus had NAB and Westpac -8% undervalued, ANZ bang on the money, and CBA, as always, boasting premium over peers that bank analysts have perennially questioned.
That premium may have finally been eroded, given CBA has been shown to be arguably the biggest villain among the rat pack. While no bank has come out smelling of roses, one reason CBA carried a seemingly perennial premium is because it is the biggest, with the largest number of “mum & dad” shareholders thanks to the privatisation of what was once the government lender. CBA was trusted over the others.
In the current table, all banks are seen to be undervalued, by a margin, based on consensus targets. Not only is CBA’s target in the rare position of being greater than its current share price, one struggles to remember when it was not offering the least value based on broker views. Yet while offering 7% upside to broker targets to Westpac’s 5%, CBA can still only manage one lone Buy rating. Westpac has three.
Consensus ranking of the banks has not changed since December, but then at 10/18/4, the total Buy/Hold/ Sell ratio is not wildly different to December’s 9/20/3. The biggest differences are yields and the extent to which analysts see the banks as undervalued, by way of consensus targets.
“Despite a subdued earnings outlook,” says Macquarie, “we continue to believe that current valuations capture the challenging operating environment”.
Let us not forget the RC is ongoing.
UBS agrees current bank valuations are “not expensive”, and concedes yields are back at levels that may encourage some investors. But the analysts remain “very cautious”.
UBS believes that the risk of even tighter restrictions to satisfy an interpretation of Responsible Lending are large, and “the risk of a Credit Crunch is material” as funding costs rise.
“How quickly,” UBS asks, “will boards react to the Royal Commission?”
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