PORTFOLIO POINT: Shareholders of the major banks have had a great dividend ride. But analysts believe lower operating margins and cash flows make their dividend yields unsustainable.
Santa Claus arrived early for investors this year in the form of the slightly less hirsute Glenn Stevens.
Lopping another 25 basis points from the official cash rate to record lows, and levels not seen since the depths of the financial crisis in 2009, the Reserve Bank chief provided another shot of adrenaline to an economy on the slide and a market that has been moribund for three years.
The immediate market response was muted. By Wednesday, however, the yield scavengers were out in force. And just as they have for most of this year, they plunged back into banks.
Almost half the 15% rise on the ASX this year is directly attributable to the “big four” banks. As they’ve slashed their deposit rates, the yield differential between the dividends they pay on their shares and the interest they pay for term rates has widened.
While dividends remain attractive, the enormous rise in market value has enticed the major banks to lift their payout ratios in order to satisfy equity holders who, in turn, have rewarded the financial institutions by buying even more shares.
It has been the financial equivalent of the perpetual motion machine. But gravity and friction at some stage always enter the equation, and questions now are being raised about the sustainability of dividends.
On the raw numbers alone, all our banks are handsomely rewarding shareholders. National Australia Bank leads the pack with a 7.4% yield, followed by Westpac Banking Group with 6.49%, ANZ Banking Group with 5.85%, and the Commonwealth Banking Corporation bringing up the rear with 5.47%. All are fully franked.
Adjusted Operating Cash Flow
Gross Dividend Payout Ratio
Source: Company Data, Macquarie Research November 2012
But the choice is not so simple. Hunting for the best yield is one thing. Ensuring growth and stability is quite another.
Unlike any other business, banks are taxpayer guaranteed. During the financial crisis, short selling of financial institutions was banned while foreign debt was guaranteed along with deposits. But that is not to say you can’t lose.
Right now, the Australian banking sector is priced at five-year highs. That makes our banks among the world’s most expensive. Add a cooling economy into the mix along with the prospect of increased bad debts, continued reluctance of Australians to borrow, and a lower interest rate environment, and you have to wonder about the sustainability of bank yields.
Most investors, and most politicians for that matter, figure the banks have been gouging their customers to reward their shareholders by not passing on the full rate cuts or adding a premium to official rate rises. That is partly true, but the story is a little more complex.
Since 2008, our big four banks have widened the gap between the official cash rate and mortgage rates by an average 157 basis points. Westpac has added most with a 164 basis point premium, and NAB the least, with 151 basis points.
Small business owners have really copped it in the neck with much steeper hikes, but given mortgages account for about 65% of the loan book, they are more important as a source of revenue.
During that period, they have consolidated market share and reported an impressive run of record earnings. That run certainly appears to have at least peaked, if not stopped.
This week’s official rate has created headaches for our bankers. With interest rates now at record lows, the banks are constrained in how far they can cut deposit rates. Bear in mind that our banks pay zero, or not far above that, on a sizeable portion of their deposits. In fact, about 10% of their deposit bases cannot be repriced.
So as official rates decline, and political pressure is placed upon the banks to cut lending rates, the net interest margin shrinks, which strains earnings. That explains their reluctance to pass on this week’s full cut and most will likely pass on even less if there is another cut in the new year.
Several brokers have been crunching the numbers on just how this will affect the banking sector as a whole, and individual enterprises within the sector.
Not surprisingly, they use different methodology and arrive at different conclusions. But their concerns about sustainability are the same.
JP Morgan this week warned that bank share prices right now are not factoring in the probability of increased bad debts as the economy cools. To back their conviction, they are not recommending any of the big four as a buy, merely as a hold.
Among the big four, they prefer NAB and ANZ while calculating that Commonwealth and Westpac are both overvalued, particularly CBA.
Macquarie Private Wealth has employed a less traditional form of valuation, one that is particularly focussed on dividends and whether or not they are sustainable, which is a question that should be uppermost in the minds of investors.
It has examined the cash flows of each of the banks and the impact this was having on earnings.
“The analysis shows that the sector’s ‘cash conversion’ has been declining, driven by stalling cash flows from operations, rising write-offs and capex investment ‘cash burn’. These symptoms are usually dividend sustainability warning signals.”
That’s just the opening line. The study suggests the banks can mask these symptoms in the immediate future by issuing new equity via dividend reinvestment plans and lower capital expenditure. But this comes at a price, particularly in the longer term, in the form of dilution. While all the banks are investing heavily, most seems directed towards maintaining cash flow rather than expanding it.
“Longer-term dividend sustainability can only be assured by growth in operating cash flows, which of course requires a strong economic backdrop and investment,” the report says.
Most traditional studies measure the dividend payout ratio against earnings. Macquarie has constructed a model employing adjusted operating cash flow and whether or not this is enough to cover dividends into the future.
On this basis, it believes Westpac’s dividend is the most sustainable while ANZ is in the weakest position. NAB, in second spot, and third placed CBA are both deemed to have their dividends “stretched to the limit”.
“Overall, we think at the very least, there are risks to the ability of the major banks to further grow dividends, particularly in the face of softer economic conditions. At worst, dividends may already have peaked,” it says.
ANZ’s operating cash flows have taken a hit as a result of higher taxes, other expenses, consistently higher loan write-offs and continued capital expenditure. And its gross dividend payout ratio at 107% is well above the average of the sector at 87%.
CBA’s cash flow too is declining. And with a large investment program dragging on future earnings and its flanks exposed to debt write-offs, its dividend – which has grown for the past three years – appears elevated.
NAB’s cash flows are more volatile but it appears to have greater buffers for bad debts and write-offs while its payout ratio is below the sector average.
Westpac stands out, according to Macquarie, because cash flows rebounded in 2012 through higher cash conversion of fees, lower capex, write-offs and higher trading profits.
And its payout ratio of 73% is well below that of its peers.
On the surface, they still appear attractive from a yield perspective. But our big banks have gone for a big run and there is almost universal agreement that if it hasn’t already peaked, it is close to it.
This article is the latest in our series The Yield Chase. To read other articles in this series, click on the story links below.