Wide Bay, priced for perfection

PORTFOLIO POINT: It has been one of the better performing banks in the past 12 months, but investors are unlikely to see a good entry point any time soon.

The Commonwealth Bank of Australia (CBA) recently provided profit guidance that was about $200 million ahead of market expectations, lifted by improvements in equity market conditions and the failure of bad debts to materialise.

At the same time, second-tier lenders are testing the waters by slowly returning to the marketplace, as evidenced by Liberty Financial’s return to the mortgage market, which has buoyed hopes for the return of non-bank lenders.

While most of the investment flows have focused on the big four banks and pushed their share prices higher, the regionals have lagged behind because of higher funding costs and poorer quality loan books. As a result their return on equity (ROE) and capital positions have weakened over the past 18 months.

One exception to this is Wide Bay Australia (WBB). Its ROE fell to 17.2% in 2008-09 but this was well above the other peer group regionals and actually was better than two of the big four: NAB and ANZ.

The company

Wide Bay Australia is one of Australia's largest building societies. It was formed by mergers of five regional building societies since the 1960s and now has 42 branches, 17 agencies and 230 staff. It offers a variety of products and services including banking, financial planning, margin loans and insurance products to individuals and business. Services are mainly related to residential housing loans in Queensland, home to about 74% of its customers.

Financial metrics

We use five financial metrics to analyse banks:

Return on equity. As a fund manager and long-term value investor, StockVal has a basic rule of thumb: a bank should achieve a return on tangible equity of about 20% for its shareholders. In a good year it should exceed this (but not greatly), and in an economic downturn they will fall short. StockVal’s ROE includes the franking benefit paid to shareholders.

Last year Wide Bay Australia had return on equity of 17.2%. This was an outstanding result given the state of the economy and compares favourably against all banks apart from Westpac and CommBank. Management last week upgraded guidance for 2009-10, saying they expect profit to increase 30% from the previous year.

Assuming Wide Bay Australia maintains its payout ratio of 90%, that will give equity holders a return of 20.3% in 2009-10.

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.

Last year Wide Bay Australia had a return on assets of 75 basis points, well below the 1% mark but still a good result considering the economic environment. Current guidance has this increasing to 89 basis points in 2009-10, toward a level we like to see.

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 last result came in at 46.0%. Wide Bay Australia on the other hand has sitting at about 55.5% for the last two years. The first six months of 2009-10 has seen this come down to 53.2%. This trend is positive and is indicative of a business with greater scale and one is performing at greater efficiency.

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. To its credit, Wide Bay Australia has managed to match the majors in recent years with margins about 2%.

However, it may struggle to maintain this because it is at a competitive disadvantage to the major banks due to its lower credit rating of BBB. The decline of the residential mortgage backed securitisation market may also effect the funding available to Wide Bay Australia and affect interest margins.

Asset growth, impaired loans and provisions. Unlike the other regional banks, Wide Bay Australia actually grew its assets last year, by 9.3%. This is outstanding result and was achieved through having a strong balance sheet at the right time. Tier 1 capital current stands at 9.5%.

Impairments and provisioning has been a major issue facing all banks over the past 18 months, and Wide Bay Australia has been no exception. It expensed $4.9 million of bad and doubtful debts for 2008-09, and impaired assets currently sit at 0.49% of total assets. This compares favourably to the majors.

This is because Wide Bay is essentially a retail and consumer bank. In this last downturn the Australian consumer and mortgagee had not fallen behind on loan repayments. The key economic indicator for Wide Bay going forward is unemployment. If unemployment continues to fall and the Australian consumer manages to avoid hard times, Wide Bay’s provisioning will remain low.

Valuation

StockVal valuation: Wide Bay Australia Limited (WBB)

Source: www.stockval.com.au

In terms of valuation, we have a return on equity based on company guidance of 20%. This gives a valuation of just over $7 given our assessed required return of 14.1%. Our required return for this bank is much higher than the large banks because of its small size. Another factor that we consider is the history of the bank to continually raise equity. This factor does lead to an increase our required return due to the possible dilutionary affects of future capital raisings.

The market price is currently assuming a return on equity of 28.6%. This is close to the peak of the last cycle in 2005-06 when the ROE peaked at 30.6%. The market is effectively pricing the company for perfection. Even if the company were to achieve 28.6% over the next few years we doubt that this would be sustainable and that eventually it would head down towards the long run average for banks of 20%.

While the valuation doesn’t appear attractive there is an attractive yield on offer of 5.8% or 8.2% grossed up. This yield is based on a high payout ratio, which may need to be reviewed as the bank grows.

Conclusion

Wide Bay has been one of the better performing banks over the past 12 months despite its size. The business has performed well and grown significantly in a difficult economic environment. Unfortunately for investors, the market is currently pricing the company for perfection and it is unlikely that we will see a good entry point any time soon.

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