Is Bendigo Bank looking like a target?

PORTFOLIO POINT: Bendigo and Adelaide Bank has performed poorly. A bigger bank might see efficiencies that could make it a good target.

Two of Australia’s banks have reported their 2009 financial results in the past week. One of those is the Bendigo and Adelaide Bank. In addition, Bendigo has followed the lead of the major banks and has raised further capital. The $300 million capital raising was completed at $6.75, a 17% discount to its last trade. This comes two years after management knocked back an offer from Bank of Queensland, which valued the company at $17 a share.

With this in mind it is a good time to revisit Bendigo from a fundamental standpoint and to hypothesise about what the future might hold.

The numbers as they stand

All of Australia’s banks disclose their operating ratios with their profit releases. This allows us to compare their operating performances. Banks are basically simple businesses; their operations can be described as follows:

1. Raise capital to support business.
2. Borrow funds (liabilities) at a ratio of up to 20 times capital.
3. Lend borrowed funds to borrowers (assets).
4. Interest earned less interest paid creates the interest margin (net interest).
5. Charge fees (non-interest income).
6. Non-interest costs divided by net interest plus non-interest income is expense ratio.
7. Provisions for potential and possible problem loans are charged against the profit.
8. Profit after provisions divided by capital gives return on equity.

Let’s look at some key ratios for banks generally, look at how Bendigo rates and project what we can expect in the next few years. With Commonwealth Bank of Australia having just reported on Wednesday, August 12, we can use it as a benchmark to assess how Bendigo is travelling. CommBank’s scale and market power may give it an unfair advantage but from an investor’s point of view we feel it accurately reflects the opportunity in terms of Australian banking exposure.

1. Return on equity. A bank should achieve a return on tangible equity of about 20%. In a good year this should be exceeded (but not greatly) and in an economic downturn it may fall short.

Bendigo recently reported its 2009 result. Net profit after tax came in at $83.8 million, however the cash earnings were higher, at $182.2 million. This was down on the previous year of $201.9 million and gives a return on equity (ROE) of 5.8%. Obviously, the economic and credit environment has been tough over the past 12 months and Bendigo’s profitability has suffered as a result. If we compare this to CommBank’s result a few days later – a net profit of $4.7 billion or an ROE of 15.7% based on closing equity – Bendigo is clearly not in the same league.

2. Return on assets. Another rule of thumb is that a bank should have a net return on gross assets of about 1%. Given a bank will gear its equity 20 times, a 20% return on equity produces a 1% return on assets.

Bendigo has assets of $47 billion, thus a profit of $182 million is about a 0.39% return. In contrast, CommBank has total assets of $620 billion; its profit of $4.7 billion is about a 0.76% return.

3. Expense ratio. In the 1980s, the major banks had cost to income ratios of about 70%. Progressively over 20 years this has been managed down to 50% and below. CommBank’s recent result came in at 46%. Bendigo, on the other hand, has struggled to keep this down, with the latest result coming in at 65%.

4. Net interest margin. The banks’ interest margins have been under pressure for many years. The major banks have margins that slightly exceed 2%, however this margin is whittled away by higher costs of wholesale and retail funding for the smaller banks with lower credit ratings. Bendigo Bank has a margin of 1.41%. In its result, CommBank disclosed a 2.1% margin (incredibly this was up 8 basis points on the previous year). Clearly, Bendigo Bank is at a competitive disadvantage to the major banks, especially considering their margin declined post merger.

5. Asset growth, impaired loans and provisions. Bendigo’s assets have declined over the past year by 1.2%. This was after minimal growth the previous year. In comparison CommBank’s assets grew 27% during the year, even after stripping out the effect of the BankWest acquisition assets grew by about 14%. Clearly, Bendigo is falling further behind the majors in terms of market share.

Separately, impairments and provisioning have been major issues facing all banks over the past 12 months, and Bendigo has been no exception. Bendigo expensed $80.3 million of bad and doubtful debts for the 2009 financial year and impaired assets currently sit at 0.49% of total assets. This compares favourably to CommBank, which expensed more than $3 billion during the year and currently has impaired assets of 0.8%.

Much has been made in the media about Bendigo’s exposure to Great Southern Limited. Bendigo has stated that it had no direct exposure to Great Southern or any of its subsidiaries. It did, however, lend money to about 8200 of Great Southern’s MIS investors. The average size of these loans is $75,000, meaning the total exposure for Bendigo is $615 million. These loans are full recourse to the individual borrower and the terms and conditions remain the same. These loans are on a case-by-case basis, so we don’t expect a major impairment.

Bendigo, in conjunction with its results, launched a capital raising for $300 million, which takes its tier 1 capital from 7.43% to 8.61%. This should provide a buffer for further impairments.

Outlook for Bendigo Bank

The past two years have been eventful for Bendigo. It survived a takeover bid from the Bank of Queensland (which in hindsight doesn’t look like the best decision for shareholders) and ended up merging with Adelaide Bank. The merged entity performance has been poor, albeit during difficult economic times. The valuation on the stock looks stretched, ROE is likely to remain below long-term averages for the next two to three years, and we have forecast 10%. At a required return of 13.5%, this values the stock at $6.56, well below the current price of $8.65.

Given the high quality of banks in this country, we would struggle to see why long-term investors would consider Bendigo on a standalone basis.

Could it be an acquisition target? Quite possibly – scale is very important in banking. Currently, Bendigo has the traits of a subscale business; a larger competitor may see efficiencies that could improve the ROE and this would make it a good acquisition target.

Given the size of Bendigo post the Adelaide merger, it is unlikely that Bank of Queensland will be back in a hostile fashion, however a merger between the two may be beneficial. Otherwise the Big Four all currently appear to have surplus capital and are looking for potential acquisitions. However, CommBank’s recent purchase of BankWest has set a low bar in terms of acquisition price.

Guy Carson, an analyst with Clime Investment Management, uses StockVal. Exclusively for Eureka Report subscribers, StockVal is offering a free two-week test drive. Click here.