ANZ, Asia and accounting shenanigans

Analysing an Australian bank is a bit like a Rorschach inkblot test at the moment: what you see reveals as much about your own world view as about the bank itself.

If you’re upbeat about Australia’s economic outlook and dismiss the possibility of worse times ahead, the big banks look like a screaming buy. You can collect a fully franked dividend yield of 6% or more, which will grow over time. And, in the case of Australia & New Zealand Banking Group, you’ll envisage that pleasant scenario with the addition of a growth strategy in Asia delivering handsome capital gains over the next decade as that region’s fortunes rise.

If your cast of mind is gloomy, you’ll see in ANZ’s numbers the seeds of a catastrophe: a highly-leveraged financial institution making an international expansion play that’s likely to end in tears (and write-offs). You’ll perceive that shareholders are being exposed to a region which might catch the flu if China sneezes, on top of the existing risks faced by banks in an interconnected global financial system, and from the possibility of a downturn in Australian property prices and/or the mining sectors.

There are, of course, thousands of scenarios in between. We don’t concur with the blissful optimists but nor do we think disaster is a foregone conclusion. We’re on the middle-to-pessimistic spectrum of the scale and encourage all investors to at least acknowledge the possibility of catastrophe in this sector: less than three years after Westpac’s record $801m profit in 1989, it was on its knees begging for an injection of capital. Things can go very wrong, very quickly for a bank.

Expenses as investments

In the end, it’s up to all of us as individuals to make calls on the macroeconomic risks involved based on our own judgment and disposition. The banks’ success or failure will be mostly driven by these ‘macro’ factors but an understanding of some of the specific issues behind their reported profits should also help your investment decision.

One of these is the practice of capitalising software costs. Before your eyes glaze over, let’s convert that jargon into plain English.

When we acquire software at Intelligent Investor, or pay programmers to development it for us, we account for the expense when it’s incurred. That’s the conservative (and intuitive) path and, interestingly, one the big banks choose not to tread. So how does their approach work?

The banks see such software expenditures as an asset which will benefit shareholders over the years. These are ‘investments’, they argue, not ‘expenses’.

As if they were for a piece of machinery, payments for software development make their way onto the balance sheet as ‘assets’—increasing shareholders’ equity—rather than the alternative of expensing them and reporting a lower profit.

This asset is then ‘amortised’ (the fancy term for depreciation when it comes to intangible items) over a period of up to seven years; spreading out its eventual impact on the bottom line.

Bankspeak

The banks (and the likes of Telstra) have been playing this game for years. But ANZ recently took it to another level.

On 19 September, it released an announcement with the headline ‘Sale of Visa shares’, disclosing a $224m after-tax profit on the sale of its remaining shares in Visa. The fifth and final paragraph of that same short announcement read:

‘ANZ also advised it is undertaking a review of asset valuations including software. It is expected that the outcome of this review together with certain costs associated with completion of the New Zealand Simplification Program will involve a non-core adjustment as part of ANZ’s 2012 full year results that will offset the gain on Visa shares.’

If you’re less than fluent in Bankspeak, the translation is that ANZ took the opportunity to write down a few assets against the one-off Visa profit. Thank goodness they didn’t make $5bn on the Visa shares, a cynic might say.

‘Below the line’

Stay with us because here’s the impressive part for aficionados of accounting shenanigans. These writedowns become a ‘below the line’ cost which are not counted in the ‘cash earnings’ figures the bank likes us to focus on. But investors should note such aggressive accounting policies and contemplate the possibility that they’re indicative of a broader approach.

More pragmatically, we should ask whether this nine-figure adjustment has now cleared ANZ’s decks of these dubious ‘assets’. The answer is no. Even after the writedown, the bank’s latest accounts show an incredible $1.7bn in capitalised software still on the balance sheet (up from $1.5bn the previous year). That’s $1.7bn of expenses that have been paid for but haven’t seen the profit and loss statement. And if the procedure of writing them off ‘below the line’ is continued, much of it never will.

Some shareholders might be fooled by this profit-boosting accounting move but regulators aren’t. In calculating ANZ’s ‘Tier 1 capital’ figure, the regulator deducts the full amount of capitalised software ‘assets’ from ANZ’s figures.

To give a sense of the issue, when making the same calculation in 2007 (the year current chief executive Michael Smith took over), the regulator deducted $462m in capitalised software expenses from ANZ’s asset base. So the figure has risen by more than 260% during Smith’s five-year tenure.

Inflating profits

A wholesale change to a conservative policy of writing off all of the current software ‘assets’ and accounting for future expenditure as incurred would have involved taking a 20% hit to this year’s net profit and, we estimate, lowered ongoing annual profits by several hundred million dollars.

The general point is that we think ANZ is under-reporting its expenses and inflating its profits by playing these accounting games and shareholders should be aware of it. With that in mind, let’s consider the company’s latest numbers as reported.

Total operating income rose by 4.6% to $17.7bn, operating expenses were up 6.2% to $8.5bn and bad debts (or ‘provisions’) fell a little to $1.2bn. Totting all that up, pre-tax profit rose by 4.2% to $8.2bn. Yet if those software expenses were accounted for our way, expenses would have risen by 10.7% to $8.9bn and pre-tax profit would have fallen slightly to $7.6bn.

Continuing on with the results as ANZ reported them, a lower tax rate meant the 4.2% rise in pre-tax profit translated into a 5.7% rise in net profit (to $5.7bn). Earnings per share grew at less than half that rate, limping up just 2.4% to 213.4 cents. You can see those details in Table 1 and also see graphically in Chart 1 that earnings per share are still 5% below 2007’s level.

Profit isn’t likely to grow much this year, either. Smith predicted that ‘provisions’ would rise by around 10% over the coming year, which is almost certainly a faster clip than revenue will be rising. So profit growth is likely to be modest once again, probably in the low single digits, barring any nasty surprises. Looking beyond 2013, everything rests on economic conditions and the results of ANZ’s Asian expansion strategy. So let’s consider that piece of the puzzle now.

Incremental approach

Even with five years in the CEO’s seat, Smith’s financial results are difficult to judge: with the waters muddied by the global financial crisis and with acquisitions still bedding down. But we can say that Smith hasn’t ‘bet the farm’ in any single transaction.

His goal now is for 25%-30% of group earnings to be sourced from Asia Pacific, Europe and America by the end of 2017. That compares to 21% in 2012 and 8% in 2007.

This is a more incremental approach than we expected five years ago. It provides the board, and perhaps the next chief executive (Smith has flagged that he is likely to step down around 2015), with the opportunity to assess how earlier Asian acquisitions have performed over a reasonable time period (say, five to seven years) and to learn a few lessons from them.

Reversing course from this approach would be less expensive than a soured ‘big bang’ deal might have been. This may show Smith’s restraint or, perhaps, the moderating influence of the board. It’s difficult for outsiders to discern which.

Amid the turmoil in the financial world, Smith made a few deals—which, if they stay on track, may be seen as triumphs. An expansionist CEO running a financially strong bank in a downturn might add significant long-term value if acquisitions are well executed. So in five years time, we might look back on Smith as the right man in charge of ANZ at the right time.

Yet, in the banking game, problems can take a while to show up. So, while we’re sceptical observers of ANZ’s strategy, all up we have to award a first-round victory to Smith on points. But round 2 might be where the fireworks start if the Chinese and/or Australian economies hit the skids.

The share price is up a little since 20 Aug 12 (Hold – $24.78) and, as it is now firmly beyond the relevant trigger in our price guide, we're downgrading to AVOID. Instead we recommend the relative safety of Westpac or Commonwealth Bank.