ANZ had a very strong start to FY17, with 1Q17 (December quarter) cash earnings of $2.0bn above analyst forecasts for ~$1.7bn. The update validated and refreshed several aspects of our thesis on the stock:
- Trading income would benefit from the volatile December quarter on financial markets
- Loan impairment expense would revert lower
- Operating cost savings could offset revenue pressures
- Strong organic capital generation and capital release from divestments make buybacks probable.
In response we have upgraded our FY17 valuation to $33.12.
Lower-quality items support result
To help its business and corporate customers manage their exposure to currency and interest rate fluctuations, ANZ offers hedging and trading services. In the 1Q, revenue from this source, known as trading income, was very strong at $706m as the US dollar strengthened and yield curves steepened.
The result also benefited from gains on sale of a Melbourne property. This and the jump in trading income are lower-quality items because they are nonrecurring, for example market volatility which boosts trading income is good luck which might not recur next quarter.
Credit quality improving relative to management’s expectations
After National Australia Bank’s earlier 1Q17 trading update reported loan impairment expense of just 12bp of gross loans, ANZ’s 2H16 impairment expense of 35bp was clearly unsustainably high. In 1Q17, admittedly ANZ’s seasonally best quarter for credit quality, the ratio fell to just 19bp. This excellent outcome beat our own expectations, which assumed some difficulty from the legacy institutional loan book, and means ANZ has derisked this book faster than we expected. ANZ released $42m of collective loan provisions no longer needed. CEO Shayne Elliott said:
The outlook on provisions is a little more positive. It is still too early to be definitive about the year as a whole however the first quarter together with our experience during first six weeks of the second quarter suggests the credit environment is marginally better than we expected at the time of our 2016 Full Year result which was for the provision charge in 2017 to remain broadly the same as a percentage of gross lending assets.
This suggests a FY outcome of, say, 25bp.
Operating cost savings are valuable when revenue growth is slow
All banks face improving, though still subdued, business lending growth and perennially intense price competition in most retail and commercial loans, especially home loans. Interest margins are also under pressure from higher funding costs as cheap post-GFC funding matures, and larger regulatory holdings of low-yielding government securities.
ANZ said the retail bank, especially home lending, contributed strongly in 1Q17 while commercial lending volumes were more subdued. Business and household deposits grew strongly. Across the retail bank, AndroidPay and ANZ’s exclusive access to ApplePay are driving buoyant growth in customer numbers.
After removing the positive surprise from trading income, underlying revenue was probably flat on 2H16. This is satisfactory given the margin headwinds and the ongoing loss of interest revenue from running down the institutional loan book. Tight cost control and successful productivity initiatives supported the cash earnings beat and we expect further progress into FY18.
Buybacks are now in our valuation
At the FY16 result presentation management did not summarily dismiss analyst questions about the potential for buybacks. Nothing has been announced but there is clearly momentum towards capital management given ANZ could, on its current trajectory, have a common equity tier 1 (CET1) capital ratio of ~11.5% by the end of FY18, some two percentage points above what we estimate is the top of the bank’s target range. The reported figure on 31 December was 9.5% after organic capital generation of 48bp, more than double the 1Q 21bp average of recent years. The management commentary was replete with references to capital strength, for example “very, very strong”, “incredibly strong” relative to peers, “ahead of domestic and international regulatory changes” and “Once the regulatory environment is clearer, we will be in a position to consider what capital flexibility this provides us”.
Explanations for the capital strength include slow lending growth, so less regulatory capital has to be held to back the new loans, and planned divestments of the 20% stake in Shanghai Rural Commercial Bank, UDC Finance and the Asian retail and wealth businesses. The divestments will boost CET1 capital by $2.7bn or 70bp.
The Basel Committee on Banking Supervision’s latest update on regulatory capital requirements is now two months late and Australia’s regulator APRA has said it will not wait for Basel before finalising its own requirements for Australian banks. ANZ already ranks well inside the top quartile of banks globally for capital strength, APRA’s accepted definition for the key “unquestionably strong” requirement, and is set to rise towards the top of the list. So we think APRA will approve ~$5bn of share buybacks by ANZ over FY18-19 and we today included $2.5bn of buybacks in each year in our valuation. Regulators do not expect or want banks to raise more capital forever because this encourages excessive risk-taking to restore adequate profitability.
The buybacks justified an upgrade to our adopted NROE from 15.0% to 15.5%, driven by an increase in RI from 3.0% to 3.5%. We lifted RI, not D, because the buybacks will be temporary, not into perpetuity, and the RI was arguably too conservative in an economy whose nominal GDP grows at 4-5%. The graphic below from StocksInValue’s valuation tab shows the new metrics relative to reported history and consensus expectations for FY17-18. Note our 3.5% RI is still conservative relative to the 4.1% consensus figure for FY18.
The FY17 intrinsic valuation thus rises to $33.12, some 8% above today’s close of $30.62. ANZ retains its place in the model portfolio due to its undervaluation and our conviction on the business.
Updated ANZ thesis
- Changed strategy under the new CEO derisks the bank and reduces capital intensity.
- The strong focus on costs reduces earnings risk by offsetting revenue pressures.
- ANZ has surplus capital and will buy back shares in FY18 and FY19.
- The bank’s 65% target dividend payout ratio is sustainable and ensures faster dividend growth than peers.
- NROE has stabilised at 15-16% and the previous gap to peers will narrow.
Key value drivers
- Growth in owner-occupied lending (steady), investor lending (to slow), SME lending (to improve) and institutional lending (to contract)
- Margin trends
- Costcutting and expense growth elsewhere, for example in rolling out digital interfaces for customers
- Execution on derisking the institutional loan book
- Australian, New Zealand and institutional loan losses
- Capital requirements, capital management and dividend growth prospects.
- Stronger balance sheet and changed Asian strategy drive a rerating
- Buybacks and/or upgrades to dividend forecasts
- Outperformance of peers in retail and business banking
- Operating cost savings surprise on the upside
- Further improvement in credit quality drives earnings upgrades.
- Revenues and cost savings disappoint
- Higher loan losses
- Poor execution on institutional derisking leads to earnings downgrades
- Regulatory capital requirements surprise on the upside
- Dilutive divestments.