Banks feel broker chill

Many a sharemarket expert in Australia has a new credo: Wait for the Commonwealth Bank results on August 13. Australian banks were supposed to be a safe haven from global credit turmoil; despite their direct exposure to poisonous US mortgage-based financial constructions being almost negligible shareholders have seen the value of their bank shares fall dramatically.

And part of the professional investment community is out for redemption. Australian banks have been treated too harshly, they maintain, the banks have fallen victim to indiscriminate selling on the back of unprecedented problems for peers in the US and Europe. But on August 13, when the Commonwealth Bank reports its full-year financials for the year to June 2008, all those who have doubted the unique quality of Australian banks will be proven wrong and investors will again be able to fully embrace the sector as the profitable quality safe haven it has been since the mid-1990s.

Not everyone agrees. Three weeks before the pivotal event, two leading stockbrokers in Australia have taken an axe and slashed their earnings forecasts for all major banks for this year, next year and the one thereafter. This doesn't really bode well for August 13, does it?

Bank analysts at Citi and Macquarie reduced their earnings forecasts for Australian banks suggesting the global credit squeeze is only one problem hurting the sector. There's also a looming global economic slowdown, and that is really going to impact on the financial figures of banks in Australia. This is exactly why Citi and Macquarie are not waiting until CommBank releases its annual report. The economic slowdown is coming and there is nothing chief executive Ralph Norris can say or do to stop it from arriving.

Macquarie says: "The end of any monetary tightening cycle does not afford banks great operating conditions. In Australia, credit growth will slow and the Reserve Bank is likely to wait for further signs of consumer slowdown before the easing process begins."

Citi says: "A vicious cycle of tight capital, slowing lending growth and rising defaults introduces multiple challenges for banks globally, from which the Australian banks will not be immune."

Months ago I suggested that as Australian banks were facing the headwinds of a global credit crisis and of slowing economic growth on both sides of the Tasman Sea, it wouldn't take much imagination to see their earnings per share (EPS) growth fall to zero, or even turn negative. Now, both Citi and Macquarie agree: both either cut EPS growth to nil, almost to nil, or into negative territory for fiscal 2009.

The good news in all this doom and gloom is that those experts who support owning bank shares will be proven partly correct: Australian banks are different from their international peers; they are likely to keep their dividend payouts intact.

Assuming share prices will remain subdued as long as global financial problems persist, and with the prospect of no EPS growth in the year ahead, this should guarantee unusually high dividend returns for shareholders willing to sit through the next phase of the global bear market for equities.

The flipside is, of course, that with no, or almost no, immediate improvement in EPS ahead, any further share price improvements will need to come from higher price/earnings (P/E) multiples than current. Citi analysts have taken the view this is rather unlikely, which is why they downgraded National Australia Bank and ANZ to Sell, while rating Commonwealth Bank, Westpac and St George Bank no higher than Hold.

Macquarie suggests the first six months of calendar 2009 will probably prove to be the most challenging for the banks. After that, things should gradually turn brighter, even though the broker still categorises 2009-10 as likely to be still "difficult" overall for the sector. By then, however, the likes of CommBank and Westpac should be back at reporting high single-digit earnings per share growth (making 2010-11 possibility the first for double-digit EPS growth again for the banks).

A few weeks ago I wrote that at times of economic headwinds bank shares as a group tend to trade at P/Es between 9 and 11. Macquarie's projections for the year ahead seem to have incorporated the same principle, with ANZ shares projected to trade between 9.1 and 10.1, National between 9.3 and 10.1, Westpac between 9.5 and 11.6, CommBank between 10.3 and 12.1 and St George between 11.1 and 13.5.

If we leave out takeover target St George, Macquarie's P/E projections suggest the challenging environment for the sector has separated the outstanding from the less outstanding; in other words CommBank and Westpac are perceived as carrying less risks than National and ANZ. This underlying view is also implicit in Citi's report, in other broker reports, as well as in recent relative share price developments.

However, the recent relative outperformance of CommBank has left the shares with less upside potential than its peers. Investors may want to keep this in mind for when the clouds start disappearing for the sector. The current average price target of $43.43 suggests there's only about 1% in potential share price appreciation left. Mind you, this is before the upcoming results release, but even assuming CommBank's report triggers increased broker targets, compare this with the implied upside for the other banks: 14.1% for Westpac, 12.5% for National and 22.7% for ANZ.

Implied (non-grossed up) consensus dividend yields are currently 7.6% and 8% (2007-08 and 2008-09) for ANZ, 7.1% and 7.5% for National, 6.9% and 7.2% for Westpac and 6.3% and 6.6% for CommBank. So far, only National and ANZ's payout is seen as modestly at risk, with both banks expected to continue underwriting their dividend reinvestment plans, which effectively amounts to minor capital raisings with dilutive consequences for shareholders.

(All calculations in the previous paragraphs as at closing prices and targets on July 22, 2008).

Rudi Filapek-Vandyck is editor of FN Arena, an online news and analysis service.