Summary
We have just completed a review of Australia’s four major banks — Commonwealth, Westpac, ANZ and NAB — and conclude that they are collectively overpriced by 23.5 percent. Our review is based on APRA’s quarterly reports, where the four banks can be viewed as a collective unit.
The ASX 300 Banks Index ($XBAK) is in a primary down-trend and we expect it to re-test support at 7000.
We estimate forward PE at 17.2. Allowing a 20% margin of safety — for increases in capital and risks associated with under-performing assets — we calculate a combined fair value of $310.7 billion, compared to current market cap of $406.1 bn, based on a 13-year payback period.
Our conclusion is to wait for $XBAK to re-test support at 7000.
Future Growth
Total assets are the base which generates most bank revenue. Heady growth of the last two decades is unlikely to continue. Growth in total assets has lagged GDP since 2015. Private credit growth for Australia slowed to 4.4% in FY18 and 3.3% in FY19.
Private borrowers are near saturation point, with household debt at an eye-watering 190% of disposable income.
David Ellis at Morningstar writes:
Many investors are concerned about a potential sharp downturn or crash in the Australian housing market. While Australian housing is expensive and debt/household income ratios are high, we remain comfortable for several reasons despite recent weakness in house prices. Tight underwriting standards, lender’s mortgage insurance, low average loan/valuation ratios, a high incidence of loan prepayment, full recourse lending, a high proportion of variable rate home loans, and the scope for interest-rate cuts by the Reserve Bank of Australia, or RBA, combine to mitigate potential losses from mortgage lending. Average house prices in Australia are falling, with the national average declining 5% during the 12 months to end December 2018 based on CoreLogic data. But investors who readily compare the Australian residential real estate market to that of the U.S. and other markets are ignoring fundamental differences.
The counter-argument is that loose lending policies exposed by the Royal Commission, vulnerable mortgage insurers with concentrated exposure in a single sector and low bank capital ratios have created a banking sector “more likely to act as an accelerant in a down-turn rather than a shock absorber” in the words of FSI Chair David Murray.
Nominal GDP is growing at an annual rate of 5.0% (March 2019) and we expect this to act as a constraint on book growth. We project long-term book growth of 4.0%.
Margins
Net interest margins declined to 1.73% for Q1 2019 and we expect a long-term average of 1.70%.
Expenses declined to 1.10% of average total assets but non-interest income has fallen a lot faster, to 0.60%. The decline in non-interest income is expected to continue and we project a long-term average of 0.50%.
Fees & Commissions
Fees and commissions — the major component of non-interest income — have suffered the largest falls, with transaction-based fees the worst performer. Lending-based fees are likely to be impacted by declining credit growth.
Expenses
Operating expenses have also fallen but sticky personnel costs are declining at a slower rate.
Non-Performing Assets
Charges for bad and doubtful debts remain low but we expect an up-tick in the next few years and project a long-term average of 0.20%.
Capital
Common equity Tier 1 capital (CET1) remains low, with a CET1 capital ratio of 10.7% in March 2019, based on risk-weighted assets. If we calculate CET1 as a percentage of total assets, the ratio falls to 4.9%. Leverage ratios, which calculate CET1 against total credit exposure, are even lower because of off-balance sheet exposure.
The Reserve Bank of New Zealand has asked the big four Australian banks for “more skin in the game” and to increase their capital holdings in New Zealand subsidiaries by $12 billion:
The RBNZ proposal calls for systemically important banks to hold a minimum of 16% Tier 1 capital against risk-weighted assets, of which 6% would be a regulatory minimum and 10% would act as a counter-cyclical buffer to absorb losses without triggering “resolution or failure options”.
The move by RBNZ has exposed ineffectual supervision of major banks in Australia. A new chairman at APRA could see increased pressure on Australian banks to improve their capital ratios.
Management & Culture
Australian regulator APRA is suffering from regulatory capture. There have been calls in Parliament and the media for APRA chairman, Wayne Byers, to resign after the Royal Commission revealed numerous shortcomings in bank culture and supervision.
A 146-page capability review, stemming from David Murray’s Financial System Inquiry found APRA “slow, opaque, inefficient, and in urgent need of a culture and leadership overhaul.”
Clancy Yeates at SMH weighs in:
A rare public intervention from banking royal commissioner Kenneth Hayne could be aimed at ensuring his recommendations are not watered down by financial sector lobbying, former watchdog Allan Fels says….
“It’s very unusual for a royal commissioner, especially a former High Court judge, to speak after a report, but probably he is concerned about weak implementation of his report due to enormous pressure from the financial institutions, an enormously powerful lobby.”
There have been several recent changes at major banks whose poor conduct was exposed by the Royal Commission. NAB CEO Andrew Thorburn and Chair Ken Henry resigned in the wake of the findings. Earlier, in 2018 Ian Narev resigned as CEO of Commonwealth after an APRA investigation into money-laundering found there was “a complacent culture, dismissive of regulators, [and] an ineffective board that lacked zeal and failed to provide oversight.”
A change at the head of APRA could have even more long-lasting consequences for the banks.
Valuation
We project:
- long-term asset growth at 4.0% p.a.;
- net interest margins at 1.7% of average total assets;
- non-interest operating income of 0.5%;
- operating expenses at 1.1%;
- provisions for bad/doubtful debts averaging 0.2%; and
- a 30% tax rate.
That delivers a forward PE of 17.2. Allowing a 20% margin of safety — for increases in capital and risks associated with under-performing assets — we arrive at a combined fair value of $310.7 billion (current market cap is $406.1 bn) based on a 13-year payback period.
Technical Analysis
The ASX 300 Banks index, dominated by the big four, reflects a primary down-trend. The recent rally is currently testing resistance at the descending trendline. Reversal below 7000 would warn of another decline. The previous false break below 7000 suggests strong support.
Conclusion
Expect another test of support at 7000. Respect of support would provide an entry point at close to fair value.
Valuations are sensitive to assumptions: LT book growth of 5% and a 0.1% increase in net profit (% of average total assets) would increase intrinsic value to $387.4 bn (4.6% below current prices). At present we favor a conservative fair value of $310.7 billion, 23.5% below current market capitalization.
We currently have no exposure to the four major banks in our Australian Growth portfolio.
Disclosure
Staff of The Patient Investor may directly or indirectly own shares in the above companies.
