ANZ: Interim result 2016

For years we've been saying that ANZ is our least preferred among the big four banks and its latest half-year result shows why.

Grabbing the headlines was a cut in the interim dividend from 86 cents to 80 cents – which we've warned about at least since last year's full-year result (see ANZ: Result 2015 on 3 Nov 15 (Hold – $26.79)).

Management announced a new target payout ratio of 60–65% of cash earnings, down from 65–70%. However, given that the ratio is 66% for the interim dividend (before one-off items), there's a fair chance of further cuts unless the bank is able to generate some earnings growth.

Just below the dividend in the headline-grabbing stakes was the 24% fall in cash profit, of which a little more than half was due to 'accelerating amortisation' of capitalised software (not an impairment, according to managment, although we're inclined to call a spade a spade). Excluding all the one-offs, earnings fell 4% to $3,499m.

We criticised ANZ's capitalisation of software expenses in ANZ, Asia and accounting shenanigans on 29 Oct 12 (Avoid – $25.25) and warned of the potential for writedowns, so this is hardly a shock.

Commercial (in)discipline

According to management, the change is because of more rapid technological change and shorter software lifecycles, but what it really means is that the investments were more expensive than expected and/or the money was spent badly.

In the conference call, acting chief financial officer Graham Hodges said the 'commercial discipline' of expensing more software development expenditure immediately 'brings a sharper focus on reducing cost to market and on realisation of benefits', which kind of says it all.

We've also been consistently down on ANZ's 'super regional' Asian strategy (although we're hardly alone in that), so the writedown of ANZ's investment in the Malaysian-based AmBank didn't come as much of a surprise; nor did the 43% rise in the credit impairment charge for the Asia Pacific, Europe and America region compared to the September half. (The overall credit impairment charge of $904m was up 83% and in line with the guidance given in March.)

Australia powers ahead

So that's the bad news. Ironically, though, it's perhaps the good news that most underlines the problem with ANZ's regional strategy, because it's focused around the Australian banking business which ANZ diluted by heading abroad.

In the six months to March, the Australian business was able to increase its net interest margin by 1 basis point (a basis point, or bp, is one hundredth of 1%) to 2.54% and reduce its cost to income ratio by 2 basis points to 35.9%, while increasing revenue by 7%. Home lending was the standout, where revenue rose by 19%. The net result was an impressive 6% increase in cash profit in spite of a 13% rise in the impairment charge.

ANZ has undoubtedly built a strong institutional banking business, it's just that in the hope of extending it, it has taken it into some unprofitable areas. So the plan now is not to abandon it entirely, but to gradually extract itself from the worst parts. As new chief executive Shayne Elliot explained on the conference call:

 'We've … built a network that is, in many ways, a beautiful thing, right? And it has fabulous capability. We have to ensure that the customers that are availing themselves of our capability are paying for it, and we generate a balanced return for our shareholders. And so we're going through customer by customer and making sure that that's the case.'

That can be accomplished fairly quickly for trade finance, which typically has a duration of 30, 60 or 90 days. However, the global loan book has an average duration of more like three years, and ANZ needs to wait for these to expire before it can renegotiate the return on the loan or end the customer relationship.

The steps taken so far have cut more than 10% of institutional customers and reduced their loans and advances by 12%. That's knocked 3% off institutional revenue in the short term, but the quality of the business has improved, with the net interest margin up by 0.1 percentage point, from 2.06% to 2.16% – its first significant increase in six years.

Small change

Further improvements, though, will take time – and even then the effect will be relatively minor. The plan is to get the capital allocated to the institutional business down from over half to a bit above 40% over five years or so, but that is still a sizable chunk.

By letting go of the lower-quality business, the return on assets will no doubt rise in the institutional division, from the 0.3% earned in the latest half and even from the 0.5% achieved in 2015, but it's likely to remain a far cry from the 0.9% reported by Westpac on Monday, for example, and the 1.1% ANZ earned in its Australian banking business in the first half.

So ANZ remains our least preferred bank. However, it is also the least preferred by the market and, with the stock underperforming relative to its peers over the past year, the valuation gap compared to Westpac and Commonwealth Bank is as wide as ever (see Table 2).

The gap looks about right to us at the moment, as reflected by the fact that all four banks are around 10% above our Buy prices. On the whole, though, we don't like nasty surprises, so our inclination is to continue to favour CBA and Westpac – which is why we recently increased our holdings in these two in our Equity Income Portfolio. However, for those that are prepared to back the turnaround story, and who don't already have large weightings to the banks*, ANZ offers reasonable, though not exceptional value, at current prices. HOLD.

*Please note our recommended maximum portfolio weightings of 8% for ANZ individually and 20% for the banking sector as a whole. More conservative investors and those with other exposure to the property market should use lower limits.

Note: The Intelligent Investor Equity Income Portfolio owns shares in Westpac and Commonwealth Bank. You can find out about investing directly in Intelligent Investor and InvestSMART portfolios by clicking here.