After analysing National Australia Bank last week, we continue our coverage of the big four banks and turn our attention to the ANZ Banking Group.
For the year ended 30 September 2014, ANZ reported a strong 15 per cent increase in statutory profit to $7.3 billion and increased its final dividend to 95c per share, up 14 per cent on the interim dividend.
Profitability improved with return on equity up one percentage point to 15 per cent due to growth in operating income and increased operating cost efficiency, as cost-to-income fell 94 basis points. ANZ is well-positioned in fiscal 2015 to benefit from the full run rate of the 11.2 per cent loan growth in the last financial year.
The result was solid across all divisions but the standout was the international and institutional banking segment, on the back of a 25 per cent jump in cash profit from Asia. Impressively, Asian revenues have grown at an annual rate of 23 per cent over the last five years.
ANZ's strategy is to become a super-regional bank, aiming to source 25-30 per cent of earnings from the Asia-Pacific, Europe and America division by 2017.
Chief executive Mike Smith indicated “the phase of high investment in Asia largely complete” as revenues from the Asian region now account for 24 per cent of revenues.
The future outlook for the Asia division is positive, with higher GDP growth supporting relatively higher credit growth in Asia. The OECD estimates GDP growth for emerging Asian economies to average 6.9 per cent between 2014 and 2018, more than double the projected GDP growth of Australia at 3 per cent.
Despite strong revenue growth, ANZ’s Asian businesses have not so far earned returns above the cost of capital. At the half year result Mike Smith said the goal was “to lift group ROE to 16 per cent or above by 2016 in part by improving returns outside Australia and New Zealand”.
Investors may question the super-regional strategy given low returns from Asia are weighing on group profitability. ANZ’s return on equity is below Commonwealth Bank and Westpac and only marginally higher than NAB, which has been hampered by legacy assets in the UK and US.
Figure 1 - Historical and Forecast Return on Equity (ROE) of the big four banks
Profitability will improve, however, if ANZ can use its increased scale to drive cost efficiencies in the newly established businesses. Cost to income for International and Institutional Banking Asia has improved, decreasing seven percentage points in the last three years. There is plenty of scope for further reductions towards the group’s cost to income.
A further argument for the super-regional strategy is it has strengthened ANZ’s Australian and NZ divisions; 24 per cent of group earnings were from referrals from the Asian (‘APEA’) operations (see Figure 2). ANZ will continue to benefit from these revenue synergies as business engagement between Australia and Asia increases.
Figure 2 - ANZ Group operating income by geography, fiscal 2014
Another benefit of the strategy is ANZ’s exposure to a downturn in a particular economy or section of an economy has been reduced. It is more diversified by geography and by loan type than its peers, which is an attraction.
In the core Australian banking segment, ANZ remains well-positioned and continued to gain market share, growing net customers by 79,000 in retail banking and 27,000 in business banking.
As discussed last week, declining loan impairments and provisioning have contributed substantially to domestic earnings growth over the last five years. Impairments are now at historic lows due to historically low interest rates.
The downside risk is unemployment and business failures rise, especially in Sydney and Melbourne, which account for most of the home loans on major banks’ balance sheets. This could happen in a nationwide recession and banks would incur losses from credit defaults and loan writedowns.
Our adopted return on equity of 19.5 per cent (green box below) is marginally below consensus, reflecting a more conservative view of future earnings growth, due to historically low provisioning and impairments expense. Our Required Return (RR) is 11.5 per cent (red), reflecting financial strength, large market cap and high earnings certainty.
Figure 3 - ANZ Future Valuation
We derive a fiscal 2014 (September 30, 2014) valuation of $35.36, rising to $36.78 next year. At the time of writing, ANZ is trading at an 11 per cent per cent discount to value.
Although we are cautious about historically low provisioning and impairments expense ratios, ANZ is a quality business, with improving profitability in international and institutional banking and room to drive cost efficiencies in coming years.
By Brian Soh and Jonathan Wilson, Equities Analysts, with insights from George Whitehouse and Stephen Wood of Clime Asset Management. StocksInValue provides valuations and quality ratings of 400 ASX-listed companies and equities research, insights and macro strategy. For a no obligation FREE trial, please visit StocksInValue.com.au or call 1300 136 225.
Clime owns shares in ANZ.