ANZ: Result 2015

Imagine the year is 2030. Australia has dipped back into a 'technical' recession, although it's nothing like the sharp contraction experienced in 2019–22 when reserve banks around the world began raising rates to fight off creeping inflation in spite of lacklustre economic growth.

Following that downturn, most of the Asia-Pacific region got quickly back on its feet and the 'Asian century' is now in full swing. Australia, however, is bumping along the bottom, with house prices still below their 2018 peak and unemployment an uncomfortable 8%.

The big banks are doing it tougher than most, due to their large Australian mortgage books, but Australia's largest bank by market capitalisation, ANZ, is weathering the storm thanks to the 'super regional' strategy put in place by chief executive Mike Smith in the early part of the century. Roundly condemned at the time, former chief executive Mike Smith is now hailed as a visionary.

Not only are ANZ's Asian operations performing well in their own right, but business customers in Australia and New Zealand are increasingly turning to ANZ to support their trade in the region.

Is this so hard to believe? Well it probably does seem a little fanciful, but that's because the failure of ANZ's Asian strategy is a Well Known Fact. The trouble is that whenever we see one of these Well Known Facts, we feel an instinctive urge to play devil's advocate. It's something all investors should try to do – because even if a Well Known Fact is probably true, such a strong consensus often leads to mispricings.

Jury still out on Asia

At the moment, ANZ is being priced at a significant discount to its Australian peers, partly on account of its failed Asian strategy, but is this truly deserved? The critics had plenty to feed off in the bank's latest full-year result, with the cash profit of its International and Institutional Banking division, which houses the Asian operations, falling 2%.

The primary culprits were a 40% increase in new impaired assets to $976m (mostly resources-related customers in Indonesia), and a downturn in customer trading volumes due to the 'market dislocation' experienced in the final quarter of the year. All this helped feed suspicions that the Asian operations are risky as well as low returning.

It takes time to build any business, though, and ANZ has always said the strategy is about long-term positioning rather than short-term profits. As the leading institutional bank in Australia and New Zealand, it isn't a crazy idea to want to help its customers as they expand into the world's fastest growing region, particularly when it's right next door. To do that effectively, it makes some sense to have some operations on the ground.

After eight years of development, there is a real business there. Having been outside the top 20 in 2008, ANZ is now the number 4 corporate bank in the region by market penetration, according to Greenwich Associates, behind the three regional giants: HSBC, Standard Chartered and Citi.

The IIB division now contributes around a third of net profit, with about 79% of the division's total income coming from the institutional side, about 13% from Asia Pacific retail operations and about 8% from stakes in other Asian banks.

Included in the latter are two Chinese banks, Bank of Tianjin and Shanghai rural Commercial bank, of which ANZ holds 14% and 20% and which increased their contributions, respectively, by 63% to $155m and 54% to $218m. The other two associates – the Indonesian PT PanIn and the Malaysian AmBank – saw their contributions fall 9% to $78m and 11% to $138, respectively, but we'll soon forget about those if the Chinese businesses keep motoring along.

Just to emphasise the contrast, ANZ's Australian and New Zealand operations had a good year. In Australia (about 40% of overall cash profit), customer numbers rose by 3% and loans by 9% all while the net interest margin remained all but stable at 2.50% (down from 2.52%). New Zealand (about 20% of cash profit) was a similar story, with customers up 5%, loans up 8% and the net interest margin down just one basis point at 2.48%.

Low returns

here's no doubt that the expansion of its Asian operations has made ANZ a risker and lower returning business than its Australian counterparts, but it's not as if ANZ could wave a magic wand and become a CBA and trying to become so might be severely counterproductive. You are what you are and who knows what the future holds.

With or without Asia, though, ANZ is never likely to make the same returns from its assets as CBA and this has implications for valuation. The problem for ANZ is twofold. First of all, its 'through-the-cycle' average rate of loan impairments will be slightly higher than that of the other banks – we'd have CBA and Westpac somewhere around 0.5% of loans outstanding, NAB at 0.6% and ANZ at 0.7% (compared to the figures around 0.2% at the moment). On top of this, though, ANZ makes a lower return on its assets, so the effect of the higher underlying impairment is magnified.

If we apply a 0.7% impairment provision to ANZ's $562bn loan book, we get a provision of $3.9bn, out of a pre-impairment profit of $11.7bn, leaving an underlying pre-tax profit of $7.9bn, an underlying net profit of $5.6bn and underlying earnings per share of about $1.93 compared to the $2.47 just reported (with similar expected for 2016). That takes the price-earnings ratio up from an apparent 10.8 to an underlying 13.7.

Coming at it from a different angle, the stock's market capitalisation of $78bn amounts to 1.5 times its $52bn tangible book value – for a company making an underlying return on tangible equity of about 11% (based on our underlying $5.6bn of earnings).

Dividend danger

The stock also provides (for the time being at least) a fully franked dividend yield of 6.8%, although that's less an indicator of value and more a sign of investors starting to price in a dividend cut. At $1.81, the full year dividend amounts to about 72% of 2016 consensus earnings, which is already above the 65–70% target range and that's in benign conditions.

All in all, the stock is beginning to look attractive – even with a flat earnings outlook for the next few years, and the potential for further capital raisings – but not quite enough to warrant an upgrade.

The stock goes ex its 95 cent final dividend on Friday and, as things stand, that will take it below our $26 Buy price. Given that it will be shorn of such a large dividend, we won't be rushing to upgrade, but we hope for further 'market dislocation' and an opportunity down the track. HOLD.