Big bank results round-up

On a recent visit to China, the discrepancy between major bank valuations there and here was a constant talking point. While the big four Aussie banks are hitting new highs, Chinese banks are trading at huge discounts to book value as investors prepare for an increase in bad debts from China’s unprecedented credit and housing booms.

Given Australia’s dependency on China’s extraordinary economic expansion and high commodity prices, it seems implausible that Australian banks will be left unscathed if China’s growth slows dramatically. Either Chinese banks are a bargain or Australian bank shareholders need to prepare for tougher times. We’re definitely not banking on the former, so before we explain your options let’s take a look at the recent round of major bank results.

Commonwealth Bank

Commonwealth Bank announced a third-quarter cash profit of $2.2bn, up almost 16% from the same time last year, suggesting it's on track to deliver a $9bn annual profit (CBA has a June 30 year end). Competition for loans ‘intensified’, which explains why banks have been accepting lower home loan deposits despite swearing ‘never again’ to drop their lending standards after the GFC.

Bad debt expenses were just $204m, down around 20%, with problem loans and impaired assets falling from $12bn three years ago to $8bn now – less than one year’s profit. Although quarterly updates are light on detail, it looks like another great result from Australia’s best bank. With the stock increasing 6% since CBA: Interim result 2014 on 12 Feb 14 (Hold ­– $76.20) and currently offering a 4.8% fully franked dividend yield, we’re sticking with HOLD.

Westpac

Westpac is our second choice behind Commonwealth Bank, as it generally sticks to its knitting in Australia and tops the industry for capital and cost ratios. In the half-year to 31 March (Westpac, ANZ and NAB all have 30 September year-ends), revenue increased 5% to $9.8bn and underlying cash earnings increased 8% to $3.8bn.

Return on equity is now an impressive 16.5% and, based on a 7% increase in cash earnings per share to $1.21, Westpac currently trades on a forecast price-earnings ratio of 14.2. A fully franked interim dividend of 90 cents was declared (down 6%, ex date already passed), putting the company on a forecast yield of 5.2%.

The most pleasing aspect of this result was the increase in lending volumes and revenue. Unlike recent results, the increase in earnings wasn’t primarily related to cost cutting and lower bad debts, though they still featured.

Westpac has recently been expanding in China, but so far it’s just facilitating transactions rather than making a ton of loans. In contrast to taking trading positions or lending money, it should be a very low risk way to nominally increase profits. In the medium term we wouldn’t bet on management’s assertion that ‘China’s growth will settle comfortably above 7%’, however.

Westpac will also have no problem setting aside the new 1% surcharge as a systemically important bank. While that helps preclude a potential special dividend, we’d rather the banks retained more capital to offset higher bad debts in the future given current provisions are at or near record lows. With the share price barely moving since Westpac: Result 2013 from 4 Nov 13 (Hold – $34.16) we’re sticking with HOLD.

ANZ

ANZ produced another solid interim result, with revenue increasing 6% to $9.5bn and cash earnings increasing 11% to $3.5bn. Cash earnings per share increased 10% to $1.29, putting the company on a forecast PER of 13. A fully franked dividend of 83 cents was declared (up 14%, ex date already passed), for a yield of 5.3%.

The heroes of the result were the non-Australian divisions. The core Australian banking franchise increased profits by 5%, but profit within Australia as a whole actually fell 6%. We may also be reaching a low point for (provisions for) bad debts, as Australian impairment charges increased 4% to a still low $403m. By contrast, profits increased 46% in New Zealand to $809m and 48% across Asia Pacific, Europe and America to $681m.

One view we heard expressed in Hong Kong was that ANZ was growing tired of the Asian expansion strategy. Bank valuations across Asia increased quickly after the GFC, preventing large-scale acquisitions. While the Asian division is ‘firing on all cylinders’ and has compounded earnings at 37% per year since 2008, total profit from Asia is still well short of the company’s target of 30%. We’ve seen no evidence of this contrarian view, but the success or otherwise of the Asian expansion should be determined after a full business cycle. Only during a downturn do you find out what risks a bank has been taking.

If you’re a fan of ANZ’s Asian strategy you should be pleased with the result. But as ANZ’s valuation doesn’t allow for any hiccups at home or abroad, our preferences remain Commonwealth Bank and Westpac. The share price has increased 8% since ANZ: Q1 Result 2014 from 11 Feb 14 (Sell – $30.56) and we’re sticking with SELL.

National Australia Bank

Cameron Clyne recently handed down his final interim result before being replaced by Andrew Thorburn in August. National Australia Bank’s revenue increased 3% to $9.5bn, with cash earnings rising 9% to $3.2bn. Diluted earnings per share increased 7% to $1.31, putting the bank on a forecast PER of 12.5. A fully franked interim dividend of 99 cents was declared (up 6%, ex date already passed), for a yield of 5.8%.

The result wasn’t high quality like Commonwealth’s, as the increase in profit was chiefly due to a halving in bad debts to $528m. This came mainly from the UK division, which should become less of a problem now that the UK economy is improving.   

The cash return on equity of 14.5% is the lowest of the big four, but this would likely increase if the company offloaded its problematic UK divisions. The UK economy is in the best shape it’s been in since the GFC, which makes a sale more likely sooner rather than later. While the hodge podge of assets might limit the number of potential buyers, a sale would probably give the share price a small boost and potentially trigger a small capital return or special dividend.

National Australia Bank’s share price has fallen 5% since NAB: Result 2013 from 31 Oct 13 (Hold – $35.31) and we’re sticking with HOLD.

Asian flu

Overall it was another good set of numbers from the big banks, given that demand for loans remains relatively weak in spite of low interest rates. The results also show how much fat there is in such large organisations, but the cost cutting and falling (provisions for) bad debts can’t go on forever.

The banks are pulling every lever possible to keep increasing profits and dividends, but the contrast between the valuations of Australian banks and Chinese banks in particular cannot be ignored.

Chinese banks are reportedly priced to absorb about 10-15% total losses from their loan books. One of China’s top property developers recently confided that housing markets are oversupplied and big discounts are not tempting buyers. Luxury sales are also stalling after the Government’s crackdown on conspicuous spending. Given the thousands of half-built apartment towers that we saw fly by on the train speeding along at 320km/h between Beijing and Shanghai, the actual losses could easily be higher.

There is no question there will be massive write-offs of bad property investments in China, the question is how much and how deep will the general economic malaise be when investors realise how much money they’ve lost.

The best bank shareholders can hope for is that the credit bubble will deflate over a long period like Japan without impacting employment too much. Either way, the impact of much slower growth will have a direct impact on Australia, likely producing higher unemployment, lower wages and a lower Aussie dollar.

Watch your weight

Current bank valuations in Australia make no allowance for these risks, as they’re high by historical and global standards. While we note Paul Samuelson’s joke that ‘Wall Street indexes predicted nine out of the last five recessions’, the chief action you need to take now concerns your portfolio limits.

If you’re prepared to own the banks for the long term come what may, then you can sit back and enjoy the dividends and franking credits. But if you prefer to have a margin of safety in everything you own, then now’s the time to adjust your portfolio allocation accordingly. Successful investing is about buying low and selling high, but one reason it’s so hard is because you have to sell winning stocks when there are few alternatives and wait for opportunities that could be years away.

There’s a lot to talk about in regards to the banks, so we’ve decided to put together a detailed special report as part of our end of financial year offer, which you'll hear more about shortly. We’ll take the pulse of the Australian banking industry before comparing it with the US banking industry and suggesting ways you can diversify your bank shareholdings and potentially increase your returns.

For those prepared to do their own homework or paying close attention to China, we’ll also publish some stock ideas and insights from our recent trip soon.

Note: Our model Income Portfolio owns shares in Commonwealth Bank and Westpac. Our maximum recommended portfolio limit for the banking sector is 20%, although conservative investors might consider a limit of less than 10% at current valuations, particularly if you have other large exposures to residential property.