Is There Value In Holding the Junior Banks?

​This week we look at two junior banks that currently sit within select income-oriented individually managed accounts at TAMIM. That is the Bank of Queensland (BOQ.ASX) and Bendigo and Adelaide Bank (BEN.ASX). This is a timely review given the RBA’s flip-flopping around the potential timing of rate hikes. 

Author: Sid Ruttala

I personally continue to believe that a rate hike will be 2024 at the very earliest given the emphasis on wage growth as a policy metric. If that is the case then the property market is likely set to continue on its trajectory for a good 24-months yet with that being reflected in an expanding mortgage book across the banks. 
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Given the above context, why look at these two particular institutions? For one thing, both have a disproportionate exposure to residential mortgages as a percentage of the balance sheet; BEN the highest at 72% and BOQ close at 66%. The only close peer to this metric in the Big 4 is Westpac (WBC.ASX) at 63%.

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Bank of Queensland (BOQ.ASX)

BOQ is perhaps one of the most unique models in Australian banking, perhaps even globally. Their owner operated franchise bank model is supposed to help the business deliver better customer service as well as build better flexibility. Whether the bank is able to sustain this in an environment characterised by shrinking physical footprints in favour of online business channels is a question for the future. The bank does seem to have a coherent digital strategy however and time will tell how they manage to integrate the existing footprint of ‘owner managers’ into this context. However, for the longstanding shareholder it has been a rather painful experience to date in comparison to her peers (i.e. the opportunity cost of owning BOQ as opposed to holding one of the Big 4). 

Nevertheless, it does seem the business is changing for the better. The most recent indicator of which has been the acquisition of ME Bank at a palatable price tag and which has received approval from the Treasurer. This adds a great compliment to the existing mortgage footprint. It has also maintained strong housing loan growth at 1.6x system. This compares well with its peers with the highest amongst the Big 4 being CBA at 1.2x. Numbers wise, statutory NPAT came in at $154m AUD - up 66% compared to 1H20 - and cash earnings grew at 9% to $165m. Perhaps the most important metric for us however was the fact that the business continued to maintain its NIMs despite the falling cash rate (this was predominantly driven by flexibility in deposit pricing). EPS came in at 35.5c per share (up 3%) and with the addition of ME we should see this number grow 30% by FY22.

On the negative side, some of the positive numbers were made possible entirely as a result of reversing Covid provisioning with the bank releasing $75m AUD from its group provisioning as well as a loan impairment benefit of $20m AUD. Despite this, I remain of the conviction that the bank remains a good buy. 
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Their continued focus on deposit growth and concentration into the residential housing market looks set to continue on par with the broader property market. In addition, despite the significant loan growth, the continued low interest rate environment effectively ensures credit stress will continue to remain benign.

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Red Flags & Risks: This investment is almost entirely predicated upon continued growth in the residential property market. Intense competition in the space also creates an environment ripe for the deterioration of credit quality along with pricing pressure. The additional risk of increased costs following the ME acquisition and integration remains.

My Expectations: There is significant upside in line with the broader property market at least till 2023 when the market should begin to price in the possibility of rate hikes; potentially a share price of $13 AUD by end of 2022. This is effectively exposure to the residential property market without having to go through the process of taking out a mortgage and sustaining a reasonable dividend yield for the hassle of doing so.
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Dividend Yield: 4.2% assuming a share price of $8.99 AUD, expecting this to grow on a nominal basis over the next Financial Year.

Bendigo and Adelaide Bank (BEN.ASX)

BEN is another bank with a markedly different business model to the traditional banking houses. They operate a community branch model alongside the traditional corporate branches. While this has helped them gain greater scale than would otherwise be the case, this has unfortunately not been reflected in total returns or ROE (as long standing shareholders are probably well aware). So the question remains, why do I believe BEN.ASX seems attractive at this point in time? Again, it effectively remains a play on headline cash rates and the continued growth of the Australian housing market. Along with my soft spot for the fact that it has a significant footprint within regional Australia and Agribusiness (but that's neither here nor there). 

Looking at the outlook for the next 24-months, with 75% of the bank’s book in the residential housing space and continued expansion of the economy along with low unemployment figures, the bank is in a good position to show some decent results. During the last announcements for 1H21, the headline earnings increased 156% compared to 2H20 and 2% compared to 1H20. Cash earnings per share continued to normalise, though they still remained down in comparison to 1H20 (-6%).  Similar to BOQ, we should see some decent revisions upwards given that the bank will release somewhere between $30-40m AUD from Covid-related loan impairment provisions and has seen their NIMs stabilize. However, CET1 stands slightly lower than BOQ and the broader banking system at 9.36% but this isn’t a significant cause for concern. 
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The bank does have a strategy to streamline the process of loan approval and bring down the cost/income ratio. The strategy of trying to attract and retail to younger customers is interesting and it will be worth watching how their digital offering and metrics compare with their competitors. This has so far paid off across most of the business and agribusiness divisions while the consumer division (which remains the bread butter) has seen some progress (Opex coming down by 1.6% in 1H21).

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Red Flags & Risks: Like BOQ (and much of the financial services sector in this country) the business has significant concentration risk towards the housing market (more so in this instance as it has the highest percentage of the balance sheet allocated to the space). We are likely to see continued pressure and deterioration of credit quality as players compete for growth. 

My Expectations: Again, this is a valid and more liquid alternative to residential property investment with the advantage of a considerably higher yield and, given that the business currently trades at a PE of 12x earnings, a much better risk-reward. That being said, there is better upside with BOQ.

Dividend Yield: 4.5% assuming a share price of $10.18 AUD.

Final Caveat & Biggest Risk

This is again a play on residential property growth. At this point there is a marked incentive for policy makers to reign in the market, perhaps not through the cash rate mechanism but rather through alternatives (e.g. lending standards).

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Disclaimer: Both BOQ and BEN are held in select individually managed accounts (IMAs) run by TAMIM.