Tag Archives: Insurance and Finance

article 3 months old

A New Era For Australian Banks

This story was first published for subscribers on September 27 and is now open for general readership.

Are Australian bank returns on equity really too high? What lies ahead for the banking sector?

- Australian banks face a hostile political environment
- Bank returns on equity are falling
- Household indebtedness scare misleading
- No more RBA rate cuts?


By Greg Peel

Playing Politics

Australian politicians have apparently learned a new financial buzz-phrase – return on equity. Clearly return on equity benefits the holders of that equity, otherwise known as shareholders. The Labor Party now wants to know why the ROEs of Australia’s banks are higher than those of banks in other developed economies. Surely by default a high ROE implies a benefit to shareholders at the expense of borrowers.

There should be a Royal Commission.

Except that Labor has already tried that one, to no avail, and the government has settled for an annual parliamentary grilling of bank bosses instead. Ahead of that grilling, new RBA governor Philip Lowe was asked to look into this ROE travesty.

It is fair to say the banks have done themselves no favours in areas of wealth management and insurance where alleged rip-offs have recently been discovered on a regular basis. For these crimes they deserve to be punished. But do they deserve to be punished for the crime of attempting to optimise returns for their shareholders? They are not public servants, they are public companies operating in a free market (and indeed in the case of banks, a very heavily regulated free market).

It was the Hawke-Keating Labor governments that deregulated the Australian banking industry and privatised the taxpayer-owned Commonwealth Bank. Coalition governments nevertheless are the flag wavers for capitalism and free markets. But it matters not which colour tie today’s politicians are wearing, one by one they will predictably trot out to tell the country the banks are obliged to pass on all of every RBA rate cut into mortgage rates and to suggest the Big Four operate a a cartel.

In the matter of the first point, why? Does the Australian government tell McDonalds how much to charge for a Big Mac? But if the second point is true, the argument is borrowers cannot vote with their feet because there is no competition. The reality, however, is one of the biggest problems facing the banks since the GFC has been competition between them.

One does have to wonder whether politicians even believe what they are saying or is it simply a matter of bank bashing being politically popular and thus mandatory.

There are further questions which flow.

Why were politicians quiet in 2007-08 when the banks were not putting up their mortgage rates by as much as the RBA was raising? Why are mortgage holders the only Australians that matter, do those relying on deposits and retirement investments not count? Why is there no political outcry when bank share prices tumble, considering just about every working Australian is a shareholder via their superannuation fund. And the biggie – why would anyone want Australia’s banks to be in the same predicament as the banks of the US, Europe and Japan?

For it is those banks used as the benchmark to determine that Australian bank returns on equity are criminally too high. As late as last night, the European banking crisis that has been simmering for eight years took another turn for the worse. Japanese banks have been labelled “zombies” for two decades and carry vast stores of non-performing loans. The US banks had to be bailed out by the taxpayer in 2008.

So for the sake of all parties, when is a bank’s return on equity “too high”.

The Fourth Era

A simple equation for a bank to stay afloat is to maintain a return on equity in excess of the cost of capital. The bank analysts at UBS make a bold statement in suggesting “we believe all parties would agree bank ROEs above the cost of capital is desirable”. Presumably they assume politicians to be one of those parties.

Given the question of bank ROEs has been raised, UBS decided to look back into time.

In the post-war period 1946-72, Australian banks were heavily regulated and interest rates were low. Over that period, bank ROEs were broadly equal to the banks’ cost of capital, UBS notes. The analyst are calling this the First Era.

From the 1970s and into the 1980s, interest rates soared as inflation went through the roof. In 1983 the Australian banking system was deregulated and around the same time central banks began to tackle the inflation problem with monetary policy. By 1993 Australia was in recession. In the period 1973-93 bank ROEs averaged 3 percentage points below the cost of capital. We recall that were it not for Kerry Packer at the time, Westpac would have gone bankrupt. This was the Second Era.

In the period 1994-2015 interest rates steadily fell (with the odd blip), reducing the cost of capital for the newly deregulated, consolidated, and increasingly leveraged banks. The period was punctuated by a little thing called the GFC. Australian banks raised capital, put away hefty provisions for the loan losses expected to come, and importantly, survived without having to be bailed out by the taxpayer (notwithstanding the brief period of government deposit guarantee).

This Third Era saw banks enjoying ROEs of 6 percentage points above the cost of capital, UBS calculates.

As the new RBA governor has pointed out, the post-GFC period of higher ROEs has mainly been driven by the fact Australian banks never had to use those hefty provisions, have significantly cut costs, and have significantly deleveraged. Dr Lowe also pointed out that the banks must now hold a lot more capital, which aside from anything else has led to them competing for deposits. They must also limit their lending to investment property, which has left the banks to compete for mortgages by offering discounts on rates they hadn’t dropped by as much as the RBA cuts.

And notably, Dr Lowe pointed out that recent regulatory changes have meant bank ROEs are now coming down.

And we are still yet to find out just what APRA means, quantifiably, by “unquestionably strong”. Brokers are divided on whether Australia’s banks will be forced to go through another round of capital raisings.

“With a very challenging economic outlook, a hostile political environment and APRA’s broad definition of ‘unquestionably strong’,” says UBS, “we believe we are now in a fourth era for banking returns”.

Taking into consideration the pressure on bank net interest margins from low rates, higher capital requirements and competition among the banks, UBS suggest ROEs of 2-4 percentage points above the cost of capital appear more likely over the next decade.

On that basis, UBS suggests “it is difficult to build a compelling case to hold an overweight position in the banks”. Any share price re-rating is unlikely in the near term.

Politicians accuse the banks of favouring bank shareholders over borrowers (no mention is made of depositors). It has never been so cheap to borrow and shareholders are facing low returns. Yet the RBA governor noted that the banks could have accepted lower ROEs in recent times.

“My assessment,” said Dr Lowe, “is that the borrowers have largely borne the cost of [changes in the regulatory environment], not the shareholders of the banks, and it is an interesting question about who ultimately should bear the cost of that: the shareholders or the borrowers”.

Many an Australian has a mortgage and a superannuation fund. How many Australian borrowers and bank shareholders are actually the same people?

The Housing Bubble

In his parting statements on monetary policy over the past few months, former RBA governor Glenn Stevens seemed relieved that tighter regulatory controls were helping to prevent a possible housing bubble and burst in Australia. Analysts do not foresee a bursting bubble either, but they do see a cooling in the housing market ahead.

It is well known that as housing in Australia has become increasingly less affordable, the ratio of monthly mortgage obligation to monthly wage of the average mortgage holder has increasingly risen, as has the net level of Australian household debt. While a “cooling” in the housing market may not cause too much strife, what about another economic crisis?

Australia has just clocked up 25 years of uninterrupted economic growth, and survived the GFC, so an economic crisis seems remote. But when “Deutsche Bank” is being mentioned in the same breath as “Lehman Bros”, one cannot discount any possibility. Were for some reason the unemployment rate to begin rising once more, the risk is cascading mortgage defaults and a subsequent collapse in house prices, wealth, and confidence.

Credit Suisse has investigated the issue.

There is a “fallacy of averages”, Credit Suisse suggests, in merely examining overall household indebtedness. The analysts highlight some more pertinent, and less worrisome, numbers.

Of all Australian households, 31% have no debt at all. Of all Australian home owners, 32% have no mortgage. Of that 32%, 66% have no debt at all.

Of those with mortgages, the two major risk cohorts are those with both an owner-occupier mortgage and an investment property mortgage, ie double-geared, and least wealthy Australians (lowest 20%) with a mortgage. These cohorts number 5% and 1% respectively.

So stop fretting.

The RBA Factor

When Australia’s March quarter CPI data suggested Australia was suffering disinflation, a shocked RBA cut the cash rate, twice, to 1.50%. Economists assumed at the time there would be more to come, and that the cash rate would ultimately hit 1.00%.

More recently they have begun changing their tune. Ongoing GDP growth at levels that are the envy of the developed world are hard to argue with.

Among those changing their tune are the economists at Goldman Sachs. They no longer see any further RBA cuts, and indeed expect the RBA to begin raising rates in 2018, back to 2.25% by year-end. Goldman’s bank analysts had long warned any cash rate cut, and particularly to rates below 2%, represented a risk to bank earnings. But now, for the first time in a while, those analysts have raised their bank earnings forecasts.

Goldman does not believe bank net interest margins will fall as far as previously assumed in FY17 and their earnings growth forecasts have swung to positive from negative for FY16-19 (note that FY16 ends this month for three of the four majors). With the risk of lower rates dissipating and bad debt risk acting as a mild, rather than severe, headwind, the analysts now see the bank sector valuation as looking more attractive.

Goldman’s order of preference amongst the majors is ANZ Bank ((ANZ)), Commonwealth Bank ((CBA)), National Bank ((NAB)), Westpac ((WBC)). The analysts have a Buy rating on ANZ and CBA and Neutral on NAB and Westpac.

Goldman Sachs is not one of the eight leading stockbrokers monitored in the FNArena database. The current ratings and average forecasts of FNArena brokers appear in the table below.

Technical limitations

If you are reading this story through a third party distribution channel and you cannot see charts included, we apologise, but technical limitations are to blame.

Find out why FNArena subscribers like the service so much: "Your Feedback (Thank You)" - Warning this story contains unashamedly positive feedback on the service provided.

article 3 months old

Brokers Lukewarm On Bendigo & Adelaide’s Acquisition

Bendigo & Adelaide Bank will acquire the Keystart home loan portfolio but brokers are lukewarm, given the increased risk this Western Australian book entails.

-Managing arrears and potential losses may be more difficult with this portfolio
-Bolt-on acquisition suggests lack of organic growth prospects
-Portfolio is higher risk but no loans are in arrears and all are owner occupiers


By Eva Brocklehurst

Bendigo & Adelaide Bank ((BEN)) will acquire the $1.35bn residential loan portfolio from Keystart but brokers are less than enthusiastic, given the increased risk this Western Australian book provides. The book is split 67:33 between Perth and regional Western Australia and the bank will undertake a share purchase plan (SPP) to cover the price.

Brokers remain cautious about the stock, having considered the FY16 results were of poor quality. There are increased risks with the additional loan book, as several note there is no lenders mortgage insurance. The bank will undertake the non underwritten SPP in October, providing details in due course.

CLSA asserts unemployment in Western Australia is increasing with both Westpac ((WBC)) and Genworth Mortgage Insurance ((GMA)) highlighting delinquencies are rising. Despite the average loan to valuation ratio (LVR) of the book at 84% being well above the bank's current 58.1%, the broker is not enthused by the exposure to a state in a downturn.

WA house prices have dropped since 2010 and rental vacancies are elevated. CLSA, not one of the eight brokers monitored daily on the FNArena database, maintains its Underperform rating and rolls forward its target to $10.55 from $9.70.

The acquisition should be around 1-2% accretive to earnings per share and provide 12-17 basis points in uplift to return on equity, in Macquarie's calculations, but this portfolio is materially different to the bank's current mortgage portfolio. Managing arrears and potential losses should conditions deteriorate would therefore be more difficult.

Moreover, with no opportunity to grow the portfolio over time, the earnings per share uplift in future years is lower as the portfolio runs off. With the stock trading at a premium to the sector of around 3%, Macquarie retains an Underweight rating and prefers the major banks.

Keystart is owned by the Western Australian government and provides finance to customers who do not have sufficient savings for a deposit. The portfolio's average loan size is $225,000 and is made up of variable rate, owner-occupied loans. The loans are designed to be transitory, with 80-90% of Keystart customers ultimately re-financing to mainstream lenders over time.

Of more concern to Deutsche Bank is the fact another small bolt-on acquisition suggests a lack of organic growth prospects and underscores the stock's stubbornly low return on equity. The broker acknowledges the returns trajectory would look a little better when advanced accreditation is achieved. Nevertheless,  this appears to be fully factored into the price.

The acquisition adds dilution risk, Credit Suisse believes, in the event the SPP application levels are strong and the bank elects not to scale back. The broker considers the acquisition incremental, with the better quality loans from a low-or-no deposit book being cherry picked from Keystart's larger portfolio. The positive aspect is the weighted average loan term is strong at 64 months while, on the negative side, the LVR is relatively high.

The broker also has reservations about the increased exposure to the mining state of WA at this point in time, although notes the bank has an ability to cross-sell the acquired customer base. The bank also needs to contend with a relatively high level of outward re-financing from this portfolio although it has mortgage broker capabilities and reasonable WA presence to address this issue, Credit Suisse acknowledges.

The acquisition is consistent with the bank's partnership and community strategy, Morgan Stanley notes, as well as its intention to consolidate the mortgage books of smaller lenders. The announcement of a non-underwritten SPP, albeit a prudent decision, suggests to the broker there is currently no surplus capital for acquisitions.

It would reduce the bank's pro forma CET1 ratio - the ratio of a bank’s core equity capital versus its risk-weighted assets - to under 8% if there was no SPP. Assuming a $40m SPP implies a pro forma FY16 CET1 ratio of 8.0% and, beyond that, partial accreditation would help lift the FY17 estimated CET1 ratio to around 8.8%. Morgan Stanley believes Bendigo & Adelaide should operate with a CET1 ratio of 8.5-9.0%.

In terms of mortgage quality, while the portfolio is higher risk than the current one, no loans are over one month in arrears and all borrowers are owner occupiers while there are no interest-only loans. Hence, the broker does not believe mortgage credit quality is a key source of downside risk for the bank.

FNArena's database has one Buy rating (Citi), three Hold, and three Sell. The consensus target is $10.34, suggesting 3.0% downside to the last share price. Targets range from $9.25 (Macquarie) to $12.25 (Citi). The dividend yield on both FY17 and FY18 forecasts is 6.4%.

Find out why FNArena subscribers like the service so much: "Your Feedback (Thank You)" - Warning this story contains unashamedly positive feedback on the service provided.

article 3 months old

Weekly Broker Wrap: Strategy, Infrastructure, Wagering And Receivables

Unforgiving market continues; infrastructure sells off; flat outlook for construction; Canaccord Genuity covers receivables; Bell Potter initiates on TPI Enterprises.

-Stocks with valuation appeal and upgraded earnings likely to be the "new" defensive stocks: Macquarie
-Greatest downside risk to expectations in staples, A-REITs and industrials: Ord Minnett
-Infrastructure cash flow up but sector sells off on spectre of rising rates
-Banks can probably achieve strong CET1 ratios organically


By Eva Brocklehurst

Equity Strategy

Macquarie expects commodity, capital expenditure and consumer related stocks will be dominate themes through the next up-cycle but to achieve greater certainty on the trend requires more indication of where rates and the US dollar are going. Until more durable themes emerge, the broker expects the market to remain unforgiving, with much of the market upside in recent years driven by a bull market in defensive stocks.

Macquarie contends that disappointment over earnings is generally the death of high multiple growth stocks such as Aconex ((ACX)), CSL ((CSL)) and TPG Telecom ((TPM)) and bond yields are the death of high multiple dividend yield stocks such as Charter Hall Retail ((CQR)), GPT Group ((GPT)) and Scentre Group ((SCG)).

It will be stocks for which valuation appeal and/or earnings are being upgraded that will act defensively along with higher interest rates. Macquarie is looking for stocks where upgrades are accompanied by a low analyst forecast spread such as BHP Billiton ((BHP)), BlueScope ((BSL)), Downer EDI ((DOW)), Fortescue Metals ((FMG)), JB Hi-Fi ((JBH)) and Harvey Norman ((HVN)).

In the current environment the broker believes a bigger discount is needed for long duration stocks such as Macquarie Atlas ((MQA)), Sydney Airport ((SYD)) and Transurban ((TCL)). Among stocks which have suffered downgrades but greater price declines the broker likes Commonwealth Bank ((CBA)) and Telstra ((TLS)).

Ord Minnett concludes from its analysis that downside risk to consensus earnings per share (EPS) forecasts has increased and capital management prospects are diminished. Market expectations have, nonetheless, picked up thus far in September and the broker notes the materials sector is supporting a large proportion of the upgrade. Staples, A-REITs and industrial sectors are the areas in which Ord Minnett envisages greatest downside risk to consensus expectations.

Following a protracted period of elevated capital management, the broker envisages a deceleration in activity, particularly for consumer discretionary, energy and health care sectors. Ord Minnett retains a positive view across the China/steel/iron ore complex but remains modestly concerned about earnings being flat in energy and the risks of increased supply from Nigeria and Libya.


Lower interest costs have boosted cash flow for infrastructure companies but Deutsche Bank observes the sector has now sold off amid expectations interest rates globally will start edging higher. The broker acknowledges the companies will argue that cash flows will not be affected by rising interest rates until a majority of debt is refinanced but believes some of the terms and conditions may change.

Deutsche Bank calculates that much of the current available cash flow would need to be re-directed to pay back outstanding debt and this ranges from 15-49% of the current cash flow currently going to shareholders. The broker is not yet convinced rates will rise but, once they do, there is likely to be more than one rise to normalise settings. Moreover, the broker is not convinced rising rates will accompany materially improved growth and believes this is a reason the sector has sold off so sharply on just the spectre of rising rates.


UBS expects FY16/17 will be the bottom for total construction and the outlook is near flat. While construction is unlikely to return to the pre-GFC boom years the environment is still considered to be better than witnessed in recent times. The broker expects mining construction will remain in a slump out to FY18/19 and the drag will diminish as the segment becomes smaller. Housing is expected to flatten and turn down sharply in FY18/19.

The gaps may be filled if UBS is underestimating the structural support in the economy from ultra-low rates and foreign demand. Moreover, public construction is expected to provide a solid, if only partial, offset. Hence, the necessary filler will be the long-awaited recovery in non-mining business investment, the broker expects.


Deutsche Bank estimates that the Basel IV reforms will entail a 50 basis points impact on major bank pro-forma CET1 (common equity tier one) ratios and this fits with the capital build-up required to push the majors further into the top quartile of global ratios. The broker expects the impact can be offset by organic capital generation rather than on-market capital raising. This would also address APRA's call for the majors to be unquestionably strong on capital.

Deutsche Bank believes 50 basis points increases from an average second half of FY16 pro-forma CET1 ratio of 9.3% could be achieved organically over FY17-19 with only National Australia Bank ((NAB)) having to rely on discounted dividend reinvestment programs. This would be consistent with forecasts for CET1 ratios of almost 10% by FY19. Such an outcome could lend share price support to the sector.

The broker's top picks remain Westpac ((WBC)) and National Australia Bank.


Wagering revenue growth slowed to 5.7% in the second half of FY16, partly related to luck, with turnover up 16.9%. UBS notes growth continues to be driven by new entrants in the market as well as elevated levels of promotional activity from corporate bookmakers. UBS observes the shift in consumer preferences continues to evolve with digital betting taking a higher market share.

While this is outside of the control of Tabcorp ((TAH)) and Tatts ((TTS)) the broker still expects Tabcorp can deliver 2-3% revenue growth while Tatts is affected by a significant migration of tote to fixed odds betting that is causing structural pressure in terms of yield, ie a company-specific issue. Wagering for Tatts is expected to endure declining EBIT (earnings before interest and tax) over the next two years.


Canaccord Genuity estimates the investable market for debt ledgers in Australia is around $440m and around 80% of this will originate with the four major banks, GE Money and Telstra. As a result, unsecured personal loan and credit card balances represent the overwhelming majority of debt purchased in Australia in FY17.

The broker notes Credit Corp ((CCP)) is the largest purchaser of debt ledgers and has been able to expand its annual purchases consistently while maintaining the quality of its balance sheet. A Buy rating and $19.42 target kicks of the coverage of the stock.

Collection House ((CLH)) is likely to be the third largest purchaser this year. The company downgraded in FY16 and a reduction in purchasing activity was noted for the second year running. Management changes provide the opportunity to re-position the business, Canaccord Genuity believes and may also mean some near-term write downs. The broker initiates with a Sell rating and $1.06 target.

Pioneer Credit ((PNC)) listed on ASX in 2014 and is in the early stages of growth with a significant increase in ledger investments, which the broker observes have only just begun to be outpaced by annual cash collections. Canaccord Genuity initiates with a Hold rating and $1.85 target.

TPI Enterprises

TPI Enterprises ((TPE)) combines long-term growth outlook in healthcare with the volatility inherent in the agricultural sector and Bell Potter initiates coverage with a Speculative Hold rating and valuation of $3.17.

The exposure to agriculture relates to poppy growing in Australia, where local growers producer around 45% of the raw materials for narcotic production globally. Until recently this industry was confined to Tasmania. The company has now relocated to the mainland and the broker expects this move may increase the number of growers and result in a far more competitive environment, boding well for the TPI.

The Melbourne production facility is the first commercial scale, solvent free extraction plant in the world and, relative to other producers, its cost of production should be significantly cheaper at scale, Bell Potter contends, proving a sustainable cost advantage.

Find out why FNArena subscribers like the service so much: "Your Feedback (Thank You)" - Warning this story contains unashamedly positive feedback on the service provided.

article 3 months old

Are Expectations Too High For Macquarie Group?

Macquarie Group has signalled FY17 earnings are likely to be broadly in line with FY16. Brokers are concerned about investors anticipating that guidance will be upgraded.

-Comparison base of FY16 demanding in terms of net revenue items
-Still offers attractive yield and modestly expanding returns on equity
-Gains on sales, better equity and commodity conditions likely boosted first half


By Eva Brocklehurst

Many investors are hoping that Macquarie Group ((MQG)) will upgrade its outlook, having done so with some regularity in the past year or so. Yet, the Group's latest update signalled the first half result is expected to be similar to the second half of FY16, with FY17 guidance for profit to be “broadly in line”.

Citi calculates that with the sale of a stake in Macquarie Atlas ((MQA)) in the first half, Macquarie Group experienced a $150m post-tax gain. This leaves the underlying operating division earnings actually weaker in the half, and means that a lot needs to happen in the second half to meet guidance.

The broker expects earnings to be lower in four of the six divisions in FY17, emphasising that “broadly in line” can also mean “lower” and citing the fact conditions were mixed in the first quarter, with lower performance fees and subdued markets for Macquarie's capital and securities divisions.

Credit Suisse agrees that the business has a job on its hands, noting the comparison base of FY16 is quite demanding in terms of the net revenue items. The broker observes the multi-year earnings upgrade cycle is now quite mature but the stock still offers a reasonably attractive value and yield, with modestly expanding return on equity.

Nevertheless, the stock is cycling demanding comparisons from FY16, when there were commodity trading, operating lease income and principal investment gains to be had. The broker envisages scope still exists for residual positive earnings surprise.

On the positive side, guidance for the first half and FY17 implies a return to the more traditional seasonal skew towards the second half, with the oil & gas business being geared to the northern hemisphere winter and a tendency for principal investment gains to be crystallised in the second half.

This seasonality was not evident in FY16. Another way of viewing the guidance is in the context of the first quarter trading statement at the AGM, at which Macquarie stated that aggregate contribution profit was down on the previous corresponding quarter but up on the sequential quarter.

Guidance is conservative, Deutsche Bank believes. While remarks regarding Macquarie Asset Management were a little softer, and some may have been wishing for an upgrade to be announced, the broker is comfortable in expecting 3% growth in group profit for FY17, given guidance has erred on the side of caution recently. The group no longer provides detailed divisional guidance, providing only qualitative commentary regarding asset management.

While previously higher base fees were expected, Macquarie now expects underlying growth in base fees to offset the impact of divestments. This suggests that base fees are tracking below Morgan Stanley's forecasts, although additional divestments could raise the prospect of higher performance fees.

The broker suspects investors will still be looking for an upgrade to guidance at the first half result in late October. The forecast for profit to be broadly in line in the first half is around 8% ahead of Morgan Stanley's estimates, although not surprising to the broker given the recent decision to sell a stake of around 10% in Macquarie Atlas.

The broker believes gains on sales and better conditions in equity and commodities markets have boosted the first half, and consensus upgrades are required to support the share price. While the broker already assumes that commodity related net gains on sales/write downs improve by $300m this year there is some upside risk still envisaged for trading income.

Upside bias also comes with improving conditions in equity markets. While Morgan Stanley considers the AWAS and Esanda acquisitions add 6-7% to FY17, earnings commentary suggests modest growth.

On FNArena's database there are three Buy, three Hold and one Sell (Citi). The consensus target is $75.95, suggesting 6.6% downside to the last share price. The dividend yield on FY17 and FY18 estimates is 5.0% and 5.3% respectively.

Find out why FNArena subscribers like the service so much: "Your Feedback (Thank You)" - Warning this story contains unashamedly positive feedback on the service provided.

article 3 months old

Brokers Question CYBG’s Refreshed Targets

UK banking enterprise CYBG has tweaked its earnings aspirations, which brokers expect will require double digit revenue growth as well as a lower cost base.

-Targets riding on advanced accreditation and expectations average mortgage risk will decrease
-May be able to return capital in the absence of acquisitions or ramp up of loan growth
-Loss of "passport" rights for London-based banks may result in softer economic conditions


By Eva Brocklehurst

The latest investor briefing from UK banking enterprise CYBG plc ((CYB)) provided refreshed guidance on several targets, which incorporate an assumption of 1-2% growth in the UK economy along with the current setting for zero official interest rates. Brokers ascertain the new aspirations will require double digit cumulative revenue growth as well as a lower cost base. Management now has a target of double digit returns on tangible equity (ROTE) by 2019 rather than 2020.

Macquarie struggles to envisage how this can be achieved without reductions to costs and a capital release. The broker's enthusiasm for the new outlook is also tested by the fact a material GBP200m pre-tax in restructuring charges is forecast for 2016-18, absorbing a not-insignificant amount of projected capital generation.

Macquarie believes the benefits of better medium term earnings are offset by the costs required to achieve the aspirations. The broker acknowledges the bank offers one of the best restructuring opportunities in European banking but considers the shares are well ahead of expectations. In the meantime, there are some risks around areas such as the pension deficit and the sustainability of hedge contributions.

Morgans considers the earnings outlook implied by the company at the time of the IPO earlier this year has now been downgraded. Moreover, cost cutting will not be enough on its own to achieve the targeted ROTE. This is now reliant on accreditation for the mortgage portfolio.

CYBG was planning previously to achieve the target without the assistance of Advanced Internal Ratings Based (AIRB) accreditation. Morgans describes this as a downgrade. The bank is expecting the accreditation before FY19, hence the bringing forward of the target, based on the expectation the average mortgage risk weight will decrease to 20% from 37%.

Another target has been lowered. The bank now aims for a cost-to-income ratio of 55-58% by FY19, having previously set it at less than 60% by FY20. Morgans takes a similar view to Macquarie. Restructuring costs outlined above will be needed to achieve this target. If accreditation is achieved and the average mortgage risk weight reduces to 20% then Morgans calculates that in the absence of an acquisition or significant ramp-up of loan growth, this would probably allow the bank to return capital to shareholders, subject to permission from the prudential regulator.

The broker is allowing for special dividends to be declared over the second half of FY18 and FY19 in its forecasts. Morgans reduces loan growth forecasts for FY17 and FY18 and increases the net interest margin forecast, while also reducing credit impairment charge forecasts. All up cash earnings per share forecasts have been raised by 10% for FY17 and 36% for FY18.

Yet Morgans remains cautious. Risks relating to Britain's exit of the European Union are still on the horizon. If London-based banks lose “passport” rights down the track then it is probably going to result in softening in economic conditions in London and may affect credit quality for CYBG.

Shaw and Partners is not so concerned and considers the story is about cost reductions and better cost management. The broker, not one of the eight monitored daily on the FNArena database, has a Buy rating and $5.30 target and considers the stock a good long-term proposition.

The trading update was overall positive, in Credit Suisse's opinion, with some conservatism in the revenue targets despite the expected earlier delivery of those targets. The broker considers the stock an inexpensive, self-help story and remains optimistic about the medium-term cost restructuring and enhancement of returns. The broker acknowledges, as with any turnaround, building up credentials takes time.

The apparent modest paring back of the retail lending target is sensible, in the broker's view, and growth in retail should be supported by the expectations in unsecured personal loans and improved mortgage retention.

The bank stated there would be no acquisitions in the early period post National Australia Bank's ((NAB)) spinning off of Clydesdale Bank and the IPO, and any acquisition subsequently would have to be highly accretive. Credit Suisse believes this reduces acquisition risk overall and, regardless, the existing multiples are not necessarily providing a particularly strong acquisition currency for any scrip-funded acquisitions.

Ord Minnett suspects the markets will be hesitant to readily accept some of the underlying assumptions made by the bank, in particular double digit revenue growth with flat net interest margin in 2017. The broker believes the stock's valuation already discounts the new ROTE target and risks are to the downside.

Bell Potter considers the outlook conservative. Cost cutting remains the key value lever, in the broker's view, and there is some strategic appeal in the stock. Bell Potter, not one of the eight stockbrokers monitored daily on the database, has a Buy rating and $5.45 target. The database has one Buy rating (Credit Suisse), two Hold and three Sell. The consensus target is $4.34, suggesting 1.3% downside to the last share price. Targets range from $3.62 (Morgan Stanley) to $5.25 (Credit Suisse).

Find out why FNArena subscribers like the service so much: "Your Feedback (Thank You)" - Warning this story contains unashamedly positive feedback on the service provided.

article 3 months old

Has FlexiGroup Reset A Realistic Base?

Finance provider business FlexiGroup has affirmed its growth targets as it undergoes a re-balancing of its business mix.

-Flight Centre contract drives upgrade to transaction volume guidance
-Expansion in Ireland flagged due to lack of POS consumer finance products
-Return to material growth in Certegy not considered likely in the near term


By Eva Brocklehurst

Finance provider FlexiGroup ((FXL)) has affirmed its growth targets as it undergoes a re-balancing of its business mix. Brokers note the outlook for FY17 has been re-based and appears more realistic. Offsetting stronger growth some headwinds remain apparent, including the cost of funds and increased impairments as well as volume growth in Certegy and continued pressure on the profitability of consumer leasing.

Citi observes the bull case for the stock is summed up with two solid credit card businesses, while the bears probably believe the company is too complex and further rationalisation is needed. While in the bull camp the broker acknowledges that the first half of FY17 will be critical.

The contract won with Flight Centre ((FLT)) is the driver of the company's upgrade to its volume guidance and Citi estimates FlexiGroup only needs to capture 0.2% market share of this $7bn in Australian non-corporate transaction value to meet the increase in guidance. The company believes the Flight Centre contract has potential to double cards profitability over the medium term.

Impairments have increased to 3.5% from 3.1% because of higher Certegy and Point Of Sale (POS) leasing losses but this should stabilise in FY17, Citi observes. While there is much the company is expected to deliver in FY17 the broker looks on the positive side and retains a Buy rating.

The affirmation of volume growth targets is encouraging for Deutsche Bank. Despite a lack of detail, the broker believes these targets are achievable and the stock's metrics do not require much growth to be justified. The company has also reiterated a target for 10% growth in FY18 but flagged further unquantified growth investments.

Morgans believes management has set a realistic base for the business and the opportunities in cards, commercial leasing and in Ireland are expected to offset areas of earnings pressure. Costs of $6m are factored in for developing and marketing Oxipay and expanding into Ireland. Management believes the market in Ireland represents a $15m net profit opportunity over the medium to longer term.

The move into Ireland is a recent decision, as the company has been in that market for eight years with Harvey Norman ((HVN)) but FlexiGroup believes there is an opportunity to expand given the lack of POS consumer finance products. Morgans is increasingly confident in the FY17/18 forecasts and upgrades its rating to Add from Hold.

The recovery in the share price suggests to Credit Suisse the business is at a cross-roads where the market prices the stock as "broken" but then the subsequent delivery on expectations or outlook indicates otherwise. This situation was instigated by the winning of a material contract with Flight Centre, in the broker's view, revealing that FlexiGroup's distribution network and track record are enough to drive new business.

The broker concedes the company is not without its challenges but guidance for $99-106m in underlying net profit for FY17 appears realistic and a path to future growth can be envisaged. An additional $9m in costs is estimated for growth-related plans, resulting in cash profit guidance of $90-97m.

Credit Suisse does not expect major downside for Certegy but, based on a deteriorating trajectory and unproven new product, a return to material growth is not considered likely in the near term. On the other hand, the Australian card business is stepping up and, with Flight Centre volumes to come on line, has a strong future, the broker maintains.

Macquarie still needs to be convinced. New business volumes were up 19% and closing receivables of $2.09bn were slightly ahead of Macquarie's estimates. Countering this, net underlying impairment losses have increased, most notably in Certegy and POS leasing. Macquarie notes the intention to return to double digit profit growth in FY18 but questions what is the right base for the business. The broker is not comfortable using the underlying FY17 profit estimates ($99-106m) as a base, as it expects the company to continue to invest in new business to support growth.

While appreciating the stock could appear good value in an increasingly expensive small cap market, and there are some early positive signs of a return to growth in the commercial segment, the broker expects it will take longer to arrive there in the case of Certegy and POS leasing. Hence, Macquarie considers it too early to get excited about the outlook and retains a Neutral rating.

FNArena's database shows four Buy ratings and one Hold (Macquarie). The consensus target is $2.61, suggesting 3.2% upside to the last share price. Targets range from $2.29 (Macquarie) to $2.70 (Deutsche Bank, Credit Suisse, Morgans). The dividend yield on FY17 and FY18 forecasts is 5.8% and 6.3% respectively.

Find out why FNArena subscribers like the service so much: "Your Feedback (Thank You)" - Warning this story contains unashamedly positive feedback on the service provided.

article 3 months old

Weekly Broker Wrap: Thermal Coal, Oil, Gold And Banks

Thermal coal deficit looms; output freeze in oil?; central banks and gold; Moody's puts major banks on negative outlook.

-Australian thermal coal exporters to benefit from market deficit
-Co-ordinated output freeze on oil production considered unlikely
-Central banks likely to remain net purchasers of gold
-Moody's downgrade limited in impact on major banks


By Eva Brocklehurst

Thermal Coal

The cut back to thermal coal supply appears to have been more severe than the decline in import demand, leading to a short term deficit in the market, Commonwealth Bank analysts note. They cite estimates from BP which indicate thermal coal production has contracted 4% in 2016, the largest annual decline since 1981.

China’s transition to a services economy and growing pollution concerns have meant its imports are falling while India plans to be independent of thermal coal imports and has cancelled plans for four proposed coal-fired power plants. These trends are countered by Japanese and Korean plans, in the short term, to boost coal power capacity. Japan and Korea account for 60% of Australia’s thermal coal exports.

Meanwhile, Indonesia, the largest thermal coal exporter, has experienced a contraction in exports, as loss-making supply exits the market and a preference for higher quality coal increases. Australian thermal coal exporters are expected to benefit the most in the absence of Indonesian supply because the coal is higher quality.

The analysts expect the current deficit will sustain higher thermal coal prices over the next year and upgrade forecasts by 9% to US$55/t for 2016 and by 13% to US$52/t for 2017.


Deutsche Bank notes renewed talk of a co-ordinated output freeze by OPEC and non OPEC producers. The broker cannot measure the extent to which this speculation has helped boost oil prices yet suspects the fundamental impact of any co-ordinated outcome will be minimal.

The terms of a deal are unlikely to pose upside constraints on Libya, Iraq or Nigeria and the broker suspects OPEC production could still exceed its 2017 assumptions of 33.5mmb/day in the event of agreement.

Deutsche Bank expects that after the September talks on the sidelines of the International Energy Forum in Algeria fail to provide any meaningful outcome, attention will return to the weak data sets in the US. After two weeks of counter-seasonal build up in inventory, the production side in the US looks less promising to the broker while net imports remain high.


Macquarie observes central banks were buying gold in the first half of 2016, although falling reserves in Venezuela were a drag. The broker notes there is no appetite for sales and, outside of Russia and China, not much buying.

The analysts estimate central banks bought 166 tonnes of gold and sold 22t, making a net purchase of 144t in the half. This is in line with 2013 and 2014 but behind 2015. Importantly, calculations in 2015 and 2016 exclude Venezuela.

The broker does not believe the numbers have any implications for the sector’s attitude to gold and it is unlikely Venezuela wants to get rid of its reserves. In 2016 so far there is an absence of sellers besides Venezuela.

With gross purchases over the last few years entirely down to Russia and China the concentration does pose a risk if either change policy, Macquarie contends. While there is some evidence high prices are deterring China, a radical change of view appears unlikely. Hence, the broker suspects central banks are likely to remain net purchasers of gold but at a slower rate than in the last few years.


Over the last month, Australia’s major banks have delivered a total return of 2.8% on average, outperforming the ASX200 Accumulation Index. On an absolute basis, Deutsche Bank observes the major banks’ return of 2.0% has underperformed US large cap banks, Hong Kong and UK banks.

Moody’s has placed the major bank credit ratings on negative outlook but the broker believes this will have a limited impact. While the coveted Aa2 senior unsecured debt rating may assist in raising funds offshore at tight spreads, Deutsche Bank notes the majors are currently rated one notch lower by both Standard & Poor’s and Fitch anyway.

So, the broker suspects the market has already priced the banks' senior unsecured debt on the latter two's lower rung. Deutsche Bank expects the major banks will not face capacity constraints in the wholesale markets but may face more competition from issuers in the lower rating band.

Find out why FNArena subscribers like the service so much: "Your Feedback (Thank You)" - Warning this story contains unashamedly positive feedback on the service provided.

article 3 months old

Subdued Outlook Persists For Bendigo & Adelaide

The quality of Bendigo & Adelaide Bank's FY16 result was poor, brokers contend. The main positive is the potential for advanced accreditation.

-Organic capital generation disappoints with CET1 ratio little changed
-Partial advanced accreditation should deliver immediate value benefit
-Attractive dividend but is the pay-out ratio difficult to sustain?


By Eva Brocklehurst

Bendigo & Adelaide Bank ((BEN)) delivered FY16 results that were broadly within most broker forecasts but the quality was poorer than many expected, given the numbers were boosted by re-valuations and one-off gains. Net interest margin continues to fall and volume growth was softer than expected.

The main positive emanating from the results was a tight control of costs, while the tone of management’s commentary suggested the probability of securing advanced accreditation is increased.

Deutsche Bank notes the results was boosted by significant trading gains on securities and some Homesafe modelling changes, both low quality items. Organic capital generation disappointed the broker and the bank’s CET1 ratio – the ratio of a bank’s core equity capital versus its risk-weighted assets -  is little changed from levels witnessed in the first half of 2014. For Deutsche Bank this highlights the importance of securing advanced accreditation.

Discussions with the Australian Prudential Regulatory Authority (APRA) continue regarding advanced accreditation and the bank exhibited confidence that partial accreditation will be granted on the mortgage portfolio. A 25% risk weight on the mortgage book may prove optimistic in Deutsche Bank's view, but 50c per share is incorporated into its valuation in terms of the estimated benefit from the move.

The bank needs to strengthen its capital position, UBS asserts. The broker observes management's efforts to reinforce the view that the bank is well capitalised and its CET1 ratio would rise to 9.52% if it receives advanced accreditation and its mortgage risk weights fall to 25%. Yet, UBS also notes APRA has indicated it would be prudent for deposit takers to plan for the likelihood of strengthened capital requirements.

Although this observation is primarily aimed at the major banks, UBS believes the market expects Bendigo & Adelaide to target similar capital ratios to its larger peers. Hence, maintaining the same capital targets under a new regime is not considered prudent in the broker’s view.

Homesafe is an attractive product but UBS does not believe this means it should sit on the balance sheet. Homesafe enables older home owners to tap into the wealth tied up in their homes without the need to sell. The product is profitable in periods of rapidly rising house prices in Sydney and Melbourne but in the event of a fall in house prices, or even a prolonged period of flat prices, the broker has doubts.

UBS believes the stock presents a unique offering to shareholders with a relatively conservative lending book and solid funding but, without the gains from one-offs, the outlook seems subdued.

The broker suspects the market is not factoring in an additional capital raising, nor potential reductions to earnings. With an elevated dividend pay-out ratio the bank does not accumulate organic capital. As a result a capital raising, or a cut to dividends, cannot be ruled out, especially if the economy slows.

For Citi, the results highlight the effect of intense mortgage competition. Despite a re-pricing of investor mortgages by 45 basis points and owner occupied mortgages by 17 basis points during the year, net interest margins declined six basis points to 1.83%. Citi observes the bank was hit by accelerated front book discounting, a preference for fixed rates and a desire to grow above system. FY17 is expected to be tougher.

That said, the broker believes management is doing the right thing in keeping a lid on costs and partial advanced accreditation for the mortgage portfolio should deliver 66 basis points immediately to the CET1 ratio, with a further 77 basis points once full accreditation is completed two years later.

Citi finds the dividend attractive, less threatened compared with other banks given Bendigo & Adelaide’s relative capital position, and a bankable enticement for investors in a low-rate environment.

Credit Suisse was disappointed in the composition of revenue, with softer net interest income offset by Homesafe equity-accounted profits but, overall, considers the outlook is positive. Asset quality appears to be improving, although the broker points out that Bendigo & Adelaide is heavily concentrated in Victoria.

Margins are under pressure but the broker envisages these holding up well, with re-pricing actions largely offsetting the compression from the May and August cash rate reductions.

Underlying operating conditions are challenging and, should trends persist, Macquarie believes it will be difficult for the bank to grow earnings in FY17. Moreover, the $80m contribution from Homesafe will be hard to repeat. Given the flat earnings and dividend trajectory for the next three years, the broker envisages limited scope for relative outperformance.

Macquarie agrees the CET1 of 8.1% appears low but notes the bank should receive an uplift of around 88 basis points once it is approved to use advanced accreditation, assuming average mortgage risk weights move to 30%. While this will reduce the need for additional capital, Macquarie envisages little scope for a capital surplus.

Moreover, this broker also believes the pay-out ratio is difficult to sustain, even under the advanced methodology, and the bank will either need to reduce the dividend by 10-15% or continue to dilute earnings through dividend reinvestment plans.

In Morgan Stanley’s view the revised target on cost growth and a potential capital benefit from partial accreditation will improve the earnings outlook but downside risk remains in terms of revenue and dividend forecasts in FY17.

FNArena’s database has one Buy rating (Citi), four Hold and three Sell for BEN. The consensus target is $10.06, suggesting 2.6% downside to the last share price. This compares with $9.73 ahead of the results. Targets range from $9.25 (Macquarie) to $12.25 (Citi). The dividend yield on FY17 and FY18 estimates is 6.6%.

Find out why FNArena subscribers like the service so much: "Your Feedback (Thank You)" - Warning this story contains unashamedly positive feedback on the service provided.

article 3 months old

Weekly Broker Wrap: Strategies, House Supply and Classifieds

-Tough season ahead for banks amid margin pressure
-Morgan Stanley moves to overweight on resources
-Credit Suisse suggests lower rates should spur more investment
-Record pipeline of work suggests building completions remain elevated
-Likelihood REA and FXJ refer to volume weakness in results


By Eva Brocklehurst


Defensive growth and income stocks are trading well above historical valuation, while the cyclical/risky segments seem cheap, UBS maintains. The broker envisages a risk that the relative valuation argument will carry equities to new highs. Demanding absolute valuations and low levels of risk aversion suggest a degree of caution is warranted.

UBS also notes that while the economy appears benign, specific headwinds in terms of capital and funding for the banks are likely to weigh on sentiment. The broker expects a tough reporting season for the banks amid evidence of margin pressure.

The broker pushes up its weight for mining from slightly underweight to neutral on a risk/return basis by adding Rio Tinto ((RIO)) into the model portfolio. The stock’s valuation is considered reasonable, particularly versus many other areas where the margin for error is low. However, the house view that iron ore will drop back below US$50/t in the second half continues to dampen enthusiasm.

Morgan Stanley expects earnings upgrades rather than downgrades at the August results with positive drivers in play for Australian materials after a five-year bear trade for the miners. There has also been the benefit of the first half stimulus in China, with some trailing effect that provides near-term stability for resource stocks.

The broker changes its industry view for materials to Attractive from In-Line, believing appetite for the sector is returning. There are still risks for seasonal de-stocking in iron ore and moderating growth in the second half for China but the broker expects any weakness to be shallow.

Morgan Stanley envisages an equity rotation opportunity in resources and moves to overweight on the sector in its model portfolio. The broker believes this view is supported by commodities being past their spot lows and a supply outlook that appears more constrained than it was six months ago.

The broker still favours quality rather than leveraged companies, given potential volatility. Both South32 ((S32)) and Fortescue Metals ((FMG)) traded ahead of expectations this year. South32 is upgraded to Overweight from Equal-weight based on continued productivity gains. Fortescue Metals is upgraded to Equal-weight from Underweight as it fully captures the spot price while the broker will watch for a pull back to re-visit its thesis.

The broker increases the weight in its model portfolio for BHP Billiton ((BHP)) and adds in Woodside Petroleum ((WPL)), South32 ((S32)) and Western Areas ((WSA)). Weights in Aconex ((ACX)), Vocus Communications ((VOC)) and Sydney Airport ((SYD)) are reduced.

Emerging markets ex China are now at the stage where growth is weak but stability is improving and the broker expects some of these economies should move to the gradual recovery phase in 2017, driving an acceleration in growth for the first time in four years.

Morgan Stanley is also cautious about the banks, maintaining an underweight view on the sector given the risk relating to capital, credit and margins. Linked to this is a view that housing activity has peaked.

The search for yield has been given a boost by the last reduction in official interest rates from the Reserve Bank of Australia to a record low of 1.5%, Credit Suisse asserts. The dividend yield for Australian equities has compressed to 4.3% from 5% at the start of the year but the spread between cash and dividend yields remains close to record levels at 280 basis points.

The broker believes lower rates are a reason to spur more investment not less, and with the lowest cost of debt in a generation, also believes a buy-back of shares has never been as accretive as it is now.

With the market trading at elevated valuations the test, Morgans maintains, will be whether earnings have held up in a subdued economic climate. The broker is worried that conservatism will ultimately prevail and this will mean further cuts to expectations.

In aggregate, the broker errs on the side of caution but envisages some opportunities across its coverage that may surprise the market. Resources and energy have rebounded strongly and carry positive earnings momentum into reporting season. The broker envisages some potential for upside surprise in August.

Morgans lists Telstra ((TLS)), Coca-Cola Amatil ((CCL)), AusNet Services ((AST)) and Sydney Airport as attractive, with dividend yields over 4%, low volatility and a capacity to maintain distributions over coming years.

House Supply

UBS finds that although dwelling completions have lifted to a record 190,000, the cycle is only two thirds the way through and will likely peak at 210,000 in 2018, which would be up around 50% on 2012. This suggests upside risk to the broker’s GDP-based dwelling investment forecasts. The lift is entirely driven by a super cycle in multi-unit dwellings.

UBS calculates that even if new building approvals slumped from now on, a record pipeline of work to be done implies completions will remain elevated over the next few years.

Real Estate Classifieds

New listings in the national property market fell 11% in July. While Deutsche Bank believes the decline can, to some extent, be attributed to the federal election, it is also being affected by tough comparable periods.

The broker suspects significant growth previously will put pressure on volumes in the remainder of the September quarter and there is a likelihood that both REA Group ((REA)) and Fairfax Media ((FXJ)) refer to volume weakness at their upcoming results.

Find out why FNArena subscribers like the service so much: "Your Feedback (Thank You)" - Warning this story contains unashamedly positive feedback on the service provided.

article 3 months old

Australian Banks: A New World

- Brokers suggest investment in Australian banks requires a new strategy in an unfamiliar environment
- Updated forecasts for Commonwealth Bank, Westpac, ANZ Bank and National Australia Bank
- New bank capital requirements
- bank earnings growth slowing
- bank dividends at risk


By Greg Peel

FNArena’s most recent bank update (What’s Ahead For Australian Banks? June 28) was published three trading days after the Brexit vote, at which point the ASX200, and Australian bank stocks, reached their lowest point before the bounce.

The plunge in bank shares meant that prior to any chance of a response from bank analysts, the gap to consensus target prices from trading prices had blown out to the mid-teens of percent for all bar Commonwealth Bank ((CBA)) which, due to its near perennial premium, showed only an 8% gap. That’s still sizeable for CBA.

At the time I noted that in FNArena’s experience, gaps of such proportion for bank shares invariably means one of two things follow. Either share prices rally or analysts drop their targets. Under the circumstances of what then looked like the sky was falling, I was leaning to a de-rating from analysts based on increased global risk in the sector.

Whether or not analysts were sharpening their pencils at that point we’ll never know, because the post-Brexit bounce that took everyone by as much surprise as the Brexit vote had done in the first place saw bank shares as a major leader. Here we are a month later, and as the following table shows, the price to target gaps are back in familiar territory, with the CBA premium intact.

The closing prices (yesterday’s) in the table above and thus the gaps to target have much reduced since the last table published on June 28. The targets are steady, and as a result so are the earnings and dividend and metrics. Yields, being based on share price, are back to where they were prior.

Well done to those investors who were bold enough to pick up the extra yield on offer when bank shares plunged. Because despite the fact Australia’s banks are only minimally exposed to the UK and EU regions, analysts agree the rally-back for the banks was driven by one thing and one thing only – yield.

Otherwise, Australia’s banks don’t have that much going for them at present.

Margin Pressure

Today’s bank operates in many and varied fields, from commercial banking through wealth management and life insurance, but at the end of the day a bank still lives and dies on its “net interest margin” – in simple terms, the difference between what it costs the bank to borrow money and what it can charge to lend that money.

A bank’s capital base provides the foundation to leverage its earnings potential (within regulations) by borrowing further funds, which it does so by taking deposits, and issuing debt, for example as convertible notes, locally and offshore. The bank then lends out that money into, in simple terms, three areas – retail banking, being mortgages through to personal loans and credit cards, business banking, being loans and facilities for businesses small and large, and institutional banking, being what was once called “corporate finance” – credit facilities, debt management, merger & acquisition management and so forth for large corporations.

Aside from any fees involved, the net interest margin (NIM) achieved from lending will determine the extent of a bank’s earnings. Bank NIMs have been falling since the GFC, and by all accounts are set to fall further.

Global interest rates are historically low and getting historically lower. In Australia, the RBA cut its cash rate in May to a historically low 1.75% and economists are expecting further cuts, perhaps all the way to 1.00%. If we hold the percentage NIM a bank seeks to achieve over its borrowing rate constant, mathematically the lower the prevailing interest rate, the lower the NIM.

Despite Brexit risk being shrugged off by the market, as the rebound in Australian bank shares suggests, the implications for UK and EU banks is that uncertainty, and thus risk, has increased. Australian banks may have little direct exposure to the region in the business they conduct but they do seek funding via debt issues to the region, as well as to the US. Increased risk reverberates globally, pushing up the cost of borrowing for Australia banks.

Far and away the bulk of Australian bank earnings are achieved in the mortgage market. Late last year the regulators clamped down on investment mortgages, fearing a housing bubble. This has limited the amount of mortgages the banks can write.

This limitation has led to fierce competition among the banks, which might seem incredulous to those who believe Australia’s Big Four are an oligopoly operating as a cartel. Steep discounts are being offered on mortgage rates to quality borrowers, further pressuring NIMs.

The same is true on the other side of the equation. Competition is fierce for term deposits.

And to top things of, Australia’s housing cycle is now at best maturing and at worst already cooling. While ever lower cash rates will offer demand support, ever higher house prices and runaway apartment development open up the risk of easing demand and excess supply. Were prices to begin falling, the next risk is increasing mortgage defaults.

It may not, therefore, be a great time for the banks to increase their base mortgage rates. But they have, including last year when the stiffer regulations prompted rate increases without an RBA cut, and in May, when the RBA cut. RBA cuts offer banks a backdoor means of “repricing”, as it’s called, by not passing on a full 25 basis point cut of mortgage rates. Analysts are assuming that any further RBA rate cut from here – which are expected – will lead to further mortgage repricing.

Mortgage repricing offers up three issues. The first is that bank analysts do not believe repricing will be sufficient to overcome all the other pressures on NIMs. The second is as suggested, that mortgage repricing offers some level of danger if the housing market is cooling. The third is that if the banks have dodged a bullet on pre-election calls for a Royal Commission into their activities (basically because Labor didn’t win), mortgage repricing will likely enrage a hostile Senate and possibly leave the slim-majority government with no choice.

Morgan Stanley’s analysts, for one, have trimmed their bank margin expectations and as a result, earnings forecast cuts of 2-3% across the sector follow. Morgan Stanley expects CBA to come under the greatest margin pressure of the Big Four. Deposit competition is a big risk for the regional banks, the broker suggests, but they are bigger beneficiaries from mortgage repricing (and would not be the target of a Royal Commission).

Default Risk

The bank reporting season in May confirmed what many a bank analyst had feared – while a still-growing Australian economy meant credit quality remained relatively strong on a net basis across bank loan books, “single name” borrowers and “pockets of weakness” in the economy led to the biggest leap in bad and doubtful debts (BDD) since the GFC.

And it was around about last year the banks brought the last of the BDD provisions they had hastily taken following the GFC back onto the books as earnings. The additional risk buffer the banks were carrying is gone.

The good news is that the leap in first half BDDs, for all of Westpac ((WBC)), ANZ Bank ((ANZ)) and National Australian Bank ((NAB)) was a bit of an anomaly. It’s not every half we see names like Dick Smith, Slater & Gordon, Arrium and Peabody (Australia) hit the wall at the same time. The bad news is the “pockets of weakness”, such as the mining states and the New Zealand dairy industry still linger, and a new potential “pocket” is looming in residential apartment developers.

But overall, feedback suggests to Morgan Stanley broader Australian credit quality remains resilient as 2016 progresses.

This goes some way to alleviating the risk of earnings losses for the banks, but does not provide for actual earnings growth.

Earnings and the New Paradigm

The greatest concern Australian investors have at present with regard the banks is capital. This is evidenced by the fact forecast yields are still in the order of 6% (plus franking) despite an RBA cash rate of only 1.75%. Investors fear dividend cuts and/or capital raisings, both of which reduce the yield on shares already held.

The expectation of increased capital stems from expected, but as yet unquantified, increases to capital requirements from both international and domestic regulators. Not all bank analysts believe the banks will be forced to raise fresh capital, but then not all believed they would before last year’s round of raisings. All believe, however, there is a clear risk to dividends.

Aforementioned BDD provisions taken by the banks amidst GFC-related capital raisings in 2009 proved, thankfully, not to be needed as time wore on. Thus as time wore on, the banks handed those provisions, taken from earnings, back to investors in the form of ever increasing dividend payout ratios and the odd special dividend. As noted, there are no longer any excess provisions (beyond what a bank would normally hold) left in the coffers.

Those dividend payout ratios remain elevated for all the majors bar ANZ, which bit the bullet in May. There was much relief when NAB and Westpac didn’t follow suit, although analysts suspected those two were only delaying the inevitable, while CBA has its chance to react next month.

A lack of earnings growth, driven by the aforementioned pressure on NIMs, means the banks will have to do something about their capital positions if regulations force their hands.

Morgan Stanley was one broker predicting last year’s capital raising, and again the broker is expecting a further round sooner rather than later. Citi believes the new requirements will be “manageable”, but suggests that to be relaxed about capital is to ignore the risks to core earnings growth.

“Investing in Australian banks is set to change profoundly” said Citi in a recent note.

Since the GFC, the most successful investor strategy was to own the Big Bank with the most direct access to the higher growth, higher return mortgage market, Citi notes. But given assumed increased capital requirements, and “maxed out” dividends, the pressure is on revenues and earnings. With the mortgage market maturing, Citi believes the banks must now “manage their franchises differently”.

In order to counter all the aforementioned pressures on NIMs, the broker believes the banks will have to become more disciplined and rigorous on cost management, must scale back their institutional businesses (where earnings are weakest at present), and “recalibrate” wealth management ownership, which is code for outsource into a joint venture or simply sell out altogether.

Given a more subdued outlook, Citi suggests investors would now be best served by investing in the lowest rated bank, not the bank with the most direct access to the higher growth, higher return mortgage market. The broker suggests that so far, ANZ has adopted best to the new paradigm (being the only bank to date to cut its dividend and begin a restructure) and this is not being recognised by the market.

NAB has also restructured insomuch as it has finally cut Clydesdale Bank loose (and just in the nick of time) but now the bank must focus on cost growth, Citi suggests. The premiums afforded the big mortgage lenders Westpac and, to a greater extent, CBA, may not remain intact.

Before investors get all excited by this new strategy suggestion form Citi, it might be best to consider some recent research by Deutsche Bank.

That research indicates that holding the bank with the lowest PE of the four is a strategy that ultimately has underperformed over the last one, three, five and ten year timeframes. The best strategy has been to hold the highest PE bank.

Deutsche last conducted such research in 2006, at which point the conclusion was the opposite. That makes sense, given there’s little doubt the GFC changed the very nature of bank investment.

Yet if Deutsche extends the timeframe all the way back to 1992, the most successful strategy has been to buy the “worst performing” bank in each quarter, as determined by total shareholder return. The least successful strategy has been to buy the best performing bank.

So to conclude, the best strategy post-GFC has been to buy the highest PE bank. The best strategy over the long term is to buy the worst performing bank. Deutsche’s current top pick among the majors is Westpac.

Deutsche also notes that a successful long-term strategy has been to buy the bank brokers like the least. Deutsche is a broker.

Short Stories

When ANZ stood alone in cutting its dividend back in May, its shares were duly punished. The punishment didn’t last long, because the RBA then cut its cash rate, allowing for another round of mortgage repricing and easing the pressure on those elevated BDDs. All the banks rallied thereafter.

Before the RBA made its move, ANZ’s sell-off was not as drastic as it might have been. Macquarie has correctly flagged this possibility at the time by noting, prior to bank results season, that short positions held in the banks had become unusually high. This would suggest those in the market with shorting capabilities were preparing for dividend cuts.

Since May, retail investors have once again been drawn to the banks, the data shows, which Macquarie puts down to the search for yield. Those short positions have been unwound back to more normal levels. This leaves bank share prices vulnerable to dividend cuts once more, with Macquarie believing NAB is the most likely candidate.

But NAB, ANZ and Westpac won’t report again until November. CBA, however, reports next month. Macquarie notes the net short position in CBA has been drifting up recently.

Technical limitations

If you are reading this story through a third party distribution channel and you cannot see charts included, we apologise, but technical limitations are to blame.

Find out why FNArena subscribers like the service so much: "Your Feedback (Thank You)" - Warning this story contains unashamedly positive feedback on the service provided.