Talking Top Ten | Part 1: The Banks

This week we go through some of the notes and key highlights from the top end of the market. A disclaimer before reading further, this is the first part of my notes on the top ten securities by market capitalisation.

Author: Sid Ruttala

​Please note, this does not necessarily mean that we currently hold any of the top ten, especially given our domestic equities mandates are broadly ASX ex20. Nevertheless, I do believe it pays to keep a track of what is happening in their universe and their balance sheets to get a feel for the overall economy. In addition, given their sheer weightings in a liquidity driven market (we will leave this topic for another week), it is good for investors to keep a track of them whether they own or not. 

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Commonwealth Bank of Australia (CBA.ASX)

Given the headwinds associated with Covid-19 and the mortgage deferrals, CBA has been pleasantly surprising in its results. The commentary by management has been rather conservative (as would be expected). Numbers-wise, statutory NPAT stands at $9.6bn AUD (up 12.4%), though this is a result of divestments related to the wealth business, while cash NPAT stands at $7.3bn AUD. The cash NPAT gives a better indication of the operating environment for the bank going forward and represents an -11.3% decline. Painful yet better than expectations. The growth in cash rate linked deposits has also provided a buffer.  

What is interesting is the maintenance of a dividend at 98c (with no discount on DRP), taking the full-year dividend to 2.98 AUD p/s. This suggests a payout ratio of close to 50%. Despite the payout and provisioning for bad loans, CET1 remains just above 11.3%, significantly better than its counterparts. This is likely to increase to 12.5% after the sale of non-core assets. 

Red Flags & Risks: NIM (Net Interest Margins) continued to fall from 2.09% to 2.07%. This might stabilise, assuming the RBA doesn’t change its policy stance with regards to negative rates. Signs of stress are also appearing with credit card arrears ticking up exponentially from 1.02% to 1.23%. There is also uncertainty around the residential mortgage book since the annual report doesn’t take into consideration any loans deferred as part of the Covid-19 support packages in line with APRA expectations. This might have the caveat of nasty surprises if there are any changes to government and regulatory policy. 

My Expectations: NIM’s should stabilise at 1.8-2.0% over the next 24 month period. Cash NPAT will be around $7bn AUD and unlikely to grow for the foreseeable future. Management also failed to clearly outline the status and process of cost-cutting initiatives apart from fluff around digital transformation. Personally, I am not expecting substantial strides to have been made via these initiatives. Provisions have been made to deal with the fallout from the Royal Commision, but recent class action from Shine is likely to complicate matters.

Dividend Yield:  Current yield of 4.25% (assuming share price at $70 AUD).
Downward pressure likely to take the absolute payout down further. Payout ratio would conservatively be adjusted, contingent upon overall economic outlook and the property market.

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​Westpac Banking Corp (WBC.ASX)

Revenues were broadly flat through Q3, as is the case with the other majors, along with softer margins, including NIM’s (down by 8 bp). Perhaps of more concern has been deposit headwinds, which acted as a substantial buffer for CBA. This scenario was somewhat mitigated by non-interest income (i.e. predominantly less than expected insurance claims). We believe the wealth business remains a key headache for the bank going forward. The interim dividend was also cut. 

WBC is well capitalised with CET1 standing at 10.8% but was an outlier in that this was a slight reduction compared to the other three competitors. Here we were pleasantly surprised on the upside again, with the BDD (Bad & Doubtful Debts) only coming in at around $825m AUD. $30bn AUD in mortgages remain in deferral, this is similar to the bank’s counterparts in my view and was to be expected. 

Red Flags & Risks: NIM’s are under pressure and, when compared to CBA, Westpac is slightly lower at 2.05%. Impairment charges on mortgages have been cushioned somewhat with the help of regulators and, somewhat surprisingly, management expects around half to return to payment. 90+ day delinquencies in unsecured consumer lending are also ticking up steadily, now reaching 2.52%, with the NZ business slightly lower at 2.31%. 

My Expectations: NIM’s should stabilse at 1.6-1.75% over the next 24 months. Cash NPAT will remain flat for the foreseeable future. The big concern is in regards to legacy business streams, including the wealth management arm, and substantial exposure to commercial property. I remain of the view that we will likely see more stress within these assets. Additionally, I did not get clear signs of how management was likely to reduce costs. This is what will be the key driver within the Australian banking system in the absence of changes to the interest rate environment or mortgage book growth.

Dividend Yield: Current yield of 4.7% (assuming a share price of $17 AUD) and taking into consideration the dividend cut.
​Management are likely to be incentivised to play catch up next year assuming an economic recovery. Taking it higher in the year to come, in terms of yield, to 8%. This also assumes no further stress on the balance sheet. However, this would be a one-off and there would likely be downward pressure again given the cash rate and NIM’s. For the more adventurous amongst you, there is a potential short-term play for dividend stripping here. 

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​National Australia Bank (NAB.ASX)

NAB was a genuine surprise, reporting growth in cash earnings from continuing operations by 25% to around $1.55bn (though Q3 earnings were down -7% when compared to 2019). The caveat here is that most of these would have been balance sheet related. To do with reversal of MtM (Mark-to-Market) losses from the previous quarter (related to Markets & Treasury). 

Even NAB surprised with the BDD amounting to $570m AUD, substantially less than my expectation of $850m AUD. Management has indicated a clear pathway to separate the legacy MLC business. This should, one would hope, see some cash coming back to shareholders in the next twelve months. NAB is well capitalised with CET1 standing 11.6%.

Red Flags & Risks: Again NIM’s are under pressure (there appears to be a theme emerging here), we estimate them to be around 1.78% and likely to stay around this level for the foreseeable future. Much depends on management in streamlining the business through the sale of MLC (or spinning off) and placing focus on the SME lending business, a segment in which they have a substantial edge comparatively. There has also been a 2% increase in the costs, to do with remuneration and annual leave accruals, but Covid-19 has meant that the cost-cutting process is now seemingly taking a back seat. Nevertheless, the stock does trade at a significant discount to its peers. 

My Expectations: NIM’s to stabilise at 1.4-1.55% over the next 24 months. Cash NPAT to remain flat for the foreseeable future. The big concern is the backseat the cost reduction initiative has seemingly taken. The fact that NAB has the SME portfolio is also a big plus when compared to the others as, in my opinion, the market is mispricing the amount of collateral that is actually put up for SME lending.

Dividend Yield: Current yield of 7.2% (assuming a share price of $18 AUD). 
Likely to stay stable overall, assuming that we are right on the SME lending arm and given its relative undervaluation. In absolute terms, likely to stay consistent. 

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​Australia and New Zealand Banking Corp (ANZ.ASX)

ANZ also surprised on the upside with BDD’s standing at $500m AUD. The earnings update was solid with an unaudited profit of $1.3bn AUD. Management has also been exceptionally disciplined in its cost reduction, maintaining a 1% decrease while also increasing capex and seemingly going through with their transformation initiatives. Dividends, thankfully for the investors, were 25c per share for H1 2020.

The caveat, and the one thing that stood out, was the substantially lower net interest margins when compared with the other three, standing at around 1.69%. We expect the bank to maintain this going through the next 24 months while the other three catch up on the downside (catch down is perhaps a more appropriate way of putting it?). The flip side is that, comparatively, ANZ has a greater proportion of fixed-rate loans and disproportionately high liquid assets (13bn). Deposit growth of 2.1% in this environment is to be applauded. 

Red Flags & Risks: The NIM’s are by far the biggest concern when it comes to ANZ. The institutional business is stagnant and needs momentum behind it. The commercial business might get rather messy, especially Victoria. Currently, the commercial deferrals stand at approximately 14% of the book. That said, only 6% of this exposure is currently unsecured. 

My Expectations: NIM’s will stay flat over the next 24 months, as will cash NPAT for the foreseeable future. However, the upside is that a quicker than expected recovery would see ANZ benefit given its institutional and commercial business, as well as well-diversified portfolio.

Dividend Yield: Current ​yield of 5.8% (assuming a share price $18.54 AUD).
​Likely to stay stable given that absolute payout has already taken a hit. On the upside, increased momentum in the institutional/commercial business and cost reductions could provide some upside. Payout ratio expected to stay at these levels. 

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​Takeaways

Leanest and meanest of the lot: CBA 
But look at it like buying investment property... but with leverage given the balance sheets exposure to that particular segment.

Cheapest of the lot: NAB 
The market is mispricing the collateral that SME’s put up for the loans.

The laggard of the lot: Westpac
Reading through the reports, I didn’t see any real indication as to how the business was to be taken forward and what the future might hold.

The one I can’t put a finger on: ANZ 
NIM’s are the biggest concern but it remains the only one that has a substantial institutional business and seems to be the quiet performer in terms of its cost-cutting measures and vision.

Which one would I buy? 
Rationally, either NAB (in need of a substantial re-rating) or CBA (safest bet). That said, I’m a little too scared to own any given I spend too much time reading about what happened to the financials in Europe and Japan in a prolonged low interest rate environment. 

Endnote: CSL along with BHP, Wesfarmers and FMG will be next week.

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Disclaimer
CBA, WBC, NAB and ANZ  are all held in a number of TAMIM client's  income-oriented individually managed accounts.