Bank results highlight consistent quality

PORTFOLIO POINT: The “big four” bank stocks still have the attraction of strong yields, but NAB is my least-preferred bank.

Watching the television news or reading the newspapers would have you believing it was a terrible year to own shares in a bank. However, a look at the fundamentals behind the recent results at of Australian banks tells another tale.

In the year to June 30, 2011, each major bank reported a record profit attributable to ordinary shareholders. Amazing but true! As a group, the major banks increased their statutory profits by 15.5% in 2010-11 to $24 billion and this followed a jump of 51% in 2009-10 following a tough 2008-09. Market consensus now suggests that combined major bank profits are expected to increase 6.3% in 2011-12 and by 6.5% in 2012-13.

Only CommBank (which reports on a different calendar cycle) and Westpac reported record earnings per share (EPS). ANZ and NAB are about 10% below record EPS levels, with both still recovering from the dilution caused by capital raisings during the GFC.
When we review dividends, we note that CommBank and Westpac paid record dividends per share (DPS) in 2010-11. ANZ and NAB’s current DPS are about 10–15% below record levels, once again resulting from the increased number of shares following capital raisings and underwritten dividend reinvestment programs.

However, profitability as measured by normalised return on equity (NROE) is not at record levels for any of the major banks. All are holding more capital in preparation for the new Basel III regulations, even though APRA implementation is not expected to be enforced until January 2016. As a result, I do not see any change in dividend payout ratios. Tier-1 capital ratios are at levels not seen for at least 15 years and thus all the banks are well capitalised.

All major banks have reported record levels of equity per share and retained earnings. Pleasingly, this year all major banks managed to grow their earnings at faster rates than their equity base. This resulted in ANZ, NAB and Westpac growing their profitability as measured by NROE during 2011. CommBank’s NROE fell marginally this year. Westpac was the most profitable major bank because it received a boost from a favourable tax ruling on their previous St George bank purchase. Current expectation is for Westpac’s NROE to fall back towards 20% in 2011-12, while CommBank’s NROE is expected to increase toward 25% in 2012.

Only Westpac achieved a return on assets (ROA) above a desired benchmark of 1% and this is the second consecutive year it has achieved this (1.04% in 2009-10, and 1.03% in 2010-11). This was followed closely by CommBank with 0.96% and ANZ with 0.90%. NAB lagged with a mediocre 0.69% in 2010-11 due to the underperforming UK and US operations.

Reviewing cost ratios, for the third year running Westpac was the lowest-cost bank with a cost to income ratio of 43.8% in 2010-11. This was followed by CommBank at 46.7%, ANZ at 47.4% and NAB the most expensive bank to operate with a cost to income ratio of 50.8%. NAB and Westpac were the only banks able to reduce their cost to income ratios in 2010-11. Cost reduction is a particular focus of the major banks at present and you can expect progress from each one on this metric over the coming years as recent productivity enhancements deliver results.

The higher the net interest margin (NIM), the more money the bank makes for each dollar lent to borrowers. On this metric ANZ has been a standout for a number of years, recording a NIM of 2.46%, off one basis point (bp) over the year. The other three were fairly close, with NAB achieving a NIM of 2.24%, Westpac 2.22%, and CommBank lagged marginally, recording 2.19%. NIMs have been relatively stable in recent years after being under pressure for a decade as the result of deregulation.

Following the Reserve Bank’s recent 25 basis point interest rate cut, the banks have responded with different interest rate settings to borrowers and depositors. (To read more on this see Rachel Williamson's feature, Cash alert). NAB passed on only 20 basis points to its variable rate mortgage customers, while the other majors passed on the full rate cut. In addition, NAB has cut the pricing on its UBank Saver deposit product by 40 basis points. While NAB still has the lowest standard variable interest rate by around 10 basis points, we see the above decisions as being supportive of NAB’s NIM going forward. The question remains whether this 10 basis point difference will be enough to encourage more customers to “break up” with their bank?

As for asset and loan growth, it has been well documented that consumers are currently reluctant to borrow or spend. This has restricted revenue growth and put pressure on banks to focus on cost saving initiatives to drive profits.

ANZ has led the way with loan growth over the past couple of years, recording growth of 12.6% in 2010-11. This was well ahead of the NAB at 7.8%, which was helped by the marketing campaign slogan “breaking up with the banks”. The two locally focused banks had a tough time this year, with Westpac managing only 4% loan growth. CommBank recorded poor loan growth of 1.3% in 2010-11 as it lost market share to NAB.

The banks’ forward looking statements were subdued, with low expectations for credit growth in 2012. Fortunately, with the significant global concerns encouraging savings, deposit growth is strong and this is funding loan growth across the major banks. Banks are likely to issue covered bonds in the near term, further diversifying their funding base and further reducing their need to tap unsettled international markets.

The major Australian banks have $1.78 trillion of loans outstanding at year end, up 5.8% from 2010. This is a record amount of loans outstanding and a large increase from the $286 billion outstanding at the end of 1995. As can be seen below, on a somewhat crude per capita level Australians have recently been deleveraging, driving real loan growth negative in 2010.

While bank assets and loans have been growing in nominal terms, in real terms (after considering the impact of inflation), loan growth has been very low for Australian banks over the past couple of years. This trend is expected to continue for the next couple of years while consumers deleverage further and global concerns restrict consumer confidence.

One area where the major banks are struggling is the “other income” line – made up of wealth management, insurance, broking and proprietary trading activities. This space is particularly tough in this environment, as evidenced by the recent poor profitability performance of Macquarie Group. The only bank to increase the “other income” line in 2010-11 was ANZ, which achieved a 10% increase. CommBank, NAB and Westpac experienced falls of about 10%. Each bank derives 20–30% of pre-tax income from “other income” and so falls can provide meaningful headwinds to the bottom line.

Bad debt expenses are loans the bank has not been able to collect and this is the biggest risk for a bank. If a bank is unable to collect just 10% of its outstanding loans, then the bank is likely to be insolvent and at real risk of failure. We have seen this recently in the US and Europe.

During the GFC, Australian banks took large provisions for loans they thought might not be recoverable in the event of a deep recession. In 2009 major bank provisions increased between 48% and 180% in the biggest round of provisioning for two decades. This impacted profits and profitability significantly in 2009, driving the need for additional capital. Fortunately Australia avoided a deep recession and the banks have re-assessed their provisions. Indeed provisions have now been written back and bolstered reported profits and profitability.

Bad debt expenses collectively spiked a massive 191% in 2008 followed by another 102% increase in 2009. Since then bad debt expenses have fallen -35% in 2010 and -37% in 2011, providing a tailwind for bank profits and profitability. The recent tendency of consumers to deleverage and the recent interest rate cut is likely to keep downward pressure on bad debt expenses in the near term, thereby supporting bank earnings.

My current preference for purchase is ANZ, Westpac, and CommBank, with NAB my least preferred bank. I prefer to avoid NAB due to its poor relative profitability, ROA and cost to income ratios. NAB’s provisioning is the lowest among the major banks, and while this may be appropriate at this point in the cycle, it does reduce NAB’s relative flexibility should asset quality come under pressure. NAB’s businesses in the US and UK markets are constraining its overall profitability and this puts NAB at a structural disadvantage to the other major banks.

-Big Four valuations
	2011A	2012 expected grossed up dividend yield	2012E	Value growth
ANZ (Sep)	$27.78	9.84%	$29.40	5.80%
CommBank (Jun)	$56.25	9.43%	$59.60	6.00%
NAB (Sep)	$29.81	9.20%	$31.52	5.70%
Westpac (Sep)	$25.61	9.95%	$26.85	4.80%

George Whitehouse is a senior analyst at Clime Group. Clime uses MyClime, its online stock valuation and research service, to identify profitable companies as determined via NROE. For a free two-week trial to MyClime, click here.