Adelaide Bank upgraded

Not so. As always, we think through changes to our recommendations very carefully. And we're about to explain why this little South Australian bank deserves to shed the dreaded 'sell' tag.

In issue 97/Feb 02 (Sell/Switch to CBA - $7.50) we didn't see much value in the company, but after a better first-half result we felt it was worth subscribers hanging on and changed our view in issue 120/Feb 03  (Hold for the Upside - $7.26).

To explain why, we first need to review the company's first-half profit result. Earnings per share increased an impressive 18% to 24.9 cents a share, with the dividend jumping 14% to 16 cents.

Other financial indicators were also looking up. Return on equity - one of our key measures - excluding goodwill amortisation increased to 15.7% from 14.2% annualised in the previous half-year and the bank's costs as a percentage of total income fell to 61.4% from 63.1%. Not quite a beautiful set of numbers but pleasant enough.

So, even though the bank's share price is only slightly lower, we believe our recommendation is worth upgrading because Adelaide Bank's profitability is increasing and it's paying a higher dividend as a result.

That, of course, does not necessarily make it good value, although a 2003 forecast PER of 13.6 is significantly lower than a year ago. It is, though, still higher than the big banks. The question is: does Adelaide Bank's recent performance justify that premium? Let's have a look.

To some extent, all banks sell a commodity product. For each dollar they lend, the bank expects to make a set return.

Like the other regionals, most of Adelaide Bank's loans are concentrated in the low-risk residential mortgage sector, so the bank would only expect to earn about 7.5 cents a year on each dollar lent to borrowers.

Slowdown

In the first half of fiscal 2003, loans increased 24% from $5.4bn to $6.7bn, yet the margin the bank earns on these loans remained about the same.

This means that, with an inevitable slowdown in the growth in lending, the bank will have to steal market share if it wants to keep increasing its profits.

And that's a lot harder, especially at the end of a property boom. The rising property market of the 1990s perhaps gave Adelaide Bank a false sense of security - so it set aside only a minuscule amount as a provision for bad debts. The bank could really feel the pain if the market plummets.

To counter its reliance on loans the bank has followed in the footsteps of the other banks by diversifying into - yes, you guessed it - wealth management. But, unlike the majors, Adelaide has taken a different route.

Several years ago, it purchased a margin lending business called Leveraged Equities. That operation's pre-tax profit rose $0.7m to $3.7m in the first half.

Now, this is probably less than management expected when they forked out $47m for the business but despite this, it's a better bet than managed funds at the moment, unless you're Chris Cuffe of course.

Premium

Overall, Adelaide Bank should be able to deliver double-digit earnings per share growth this year. In our view it deserves a slight premium to the majors for operating in such a low-risk area.

That said, the current premium still looks a little high, which is why we aren't upgrading to a Buy.

But, with a strong operational performance and a reduced PER since our last major review, we are happy to say goodbye to the 'sell' tag and upgrade to HOLD FOR THE UPSIDE.