A deep dive into banks

Stock Watch

by Chris Pedersen

Fund Manager Chris Pedersen discusses the Fitch downgrade, China trade and what he looks for in banks.

Companies discussed include:
The following transcript was automatically generated:

Good afternoon. This is Chris Pedersen with Stock Watch on Wednesday the 9th of August, 2023. Any advice provided is general advice that may not be suitable for you. Always consult your financial advisor before making any investments. All questions from viewers should be sent to stockwatch@fnn.com au. Here's a little chart that I found that was very interesting. This is migrants with higher education. What you see on the far left is Australia. The only country in the world that is better in terms of skilled and educated migrants is Canada Market hit from Fitch downgrade. Well, what we saw last week was a big overreaction when Fitch downgraded debt from AAA down to AA plus. Now, let's take a look at what really happened here. The debt ceiling was negotiated with reasonable outcome much earlier than the usual 11:59 PM Normally, it is a big mess. This time, McCarthy and Biden came up with a very good debt ceiling deal that both sides won on.

Both sides had to give up and it was well before the deadline. What we also know is that when there's stress in the world, everybody will still buy us treasuries as their safe haven. This whole Fitch thing is much ado about nothing. When you take a look at the US debt to G D P ratio the past couple years, it's been improving China and its trade slowdown. This is very significant for Australia. In July, China trade exports, imports declined quite a bit. However, in the United States up through the end of May, imports are down 24%. That is massive. It is estimated that last year it was one in four products were bought from China. This year, it's only one in six imports are coming from China. This is a significant shift. While decoupling from China is good for various countries, for many purposes, it can also herd Australians and our export market to China.

That is, unless of course China G D P continues to grow and it's over 5% now and their domestic market continues to grow, which means that our exports will still be needed for the domestic consumption in China. This week I'm covering Australian banks. So the first thing that you have to know is when do all the banks report C B A reported this morning, 9th of August, and it was a full year result. Bendigo reports on Monday the 14th. It's a full year, and then nab, A n Z and Westpac, their quarterly updates with NAB on Tuesday next week, a N Z on Thursday next week and Westpac the following Monday.

What I look for in banks, there are a lot of different matrix to look at with banks. These are the ones that I focus on first are the obvious ones that I look at every week. Revenue, E P s and dividend growth rates. Are they improving, looking bad, flat? What are the forward estimates? Net interest margin. This tells me sort of how profitable the bank actually is in terms of all the income that they're earning and what the expense of earning that core tier one capital is important and what is the trend? This is for regulatory purposes, dividend payout ratio. Now, let's take a look at C B A today, which I'll go back in more depth a little bit later. C B A raised its dividend payout ratio is 74%. Well, that's higher than consensus and they did that to have a higher than expected dividend.

Because it's an income stock, the market loves higher dividends. So this is cosmetically making C B A look healthier. Cost to income ratio trend, well, I look at two things. One, if a bank has a low cost income ratio, meaning in the low forties, like 42, 43, that means they're pretty well managed. However, if the bank has a high cost income ratio like 45 or 46, and a couple years ago they were over 50%, well that means there's a lot of improvement possible, which means more earnings per share growth. Then I look at deposits over total loans. C B A happens to fund 70% of their loans a little bit more now through their internal deposits. That is amazing for a major bank around the world. Return on equity. Well, this is the efficiency of the equity and what type of return they're earning for shareholders. On this matrix, I also look at shares outstanding. The reason I look at this is are shares outstanding, declining flat are going up. For example, if the shares outstanding or declining, that means the companies buying shares back reducing the denominator, which happens to say that if the profit remains the same but there's fewer shares outstanding now on an earnings per share basis, the company is looking healthier. Converse to that is if shares outstanding is increasing, well now they have to earn more profit in order to have the same earnings per share.

I also look at percent of non-performing loans to total loans. This is credit quality of the loan book. The amount of new provisions for bad loans, is that going up or down? Australian banks have very good credit officers. They don't have many bad loans on their books, so we're talking about is it 40 basis points,

20 basis points, or 13 basis points. The reality is Australian banks are very well managed in terms of credit risk. Then this is important is trend in 90 day past due loans. The reason this is important is if you're behind one month in your mortgage, you can maybe catch up, but once you get 90 days behind or three months behind in your mortgage, that is very difficult to catch up on. Then I look at trend and market share for various loans like mortgages, small business, commercial, corporate, uh, personal loans, what have you. Now this is a chart that I found that is absolutely amazing. It is the profit per employee and on the right I have the cost income ratio. So with a N Z bank that their profit per employee is $192,000. I mean that's taking into account how much that employee is earning and this is what the profit is.
On top of that. C B A earns a little over $200,000 per employee. N A B is a huge $221,000 per employee and Westpac is almost $208,000 per employee. Just think of that. That is a lot of profits that they're earning. Now let's look at the four big banks. First one is Commonwealth Bank. Yesterday was trading at $102 and 27 cents. Today it's over $104 because of the surprise dividend increase. But what you can see is it's C B A on a chart basis. It's been trending sideways for quite some time. It's in a channel and looking for something to break out. The beta on C B A isn't all that high. It's 84, which means it's just a little bit less than the market overall, but its market cap is 171 billion. That is huge 12 months price target I had yesterday, $94. I will revise it some up to probably around 97 or $98 simply 'cause they're now paying out more dividend, which doesn't mean they're more profitable, but what it does mean it has a higher yield and being a yield stock that makes it more attractive.

The revenue growth from 2023 to 2025 is only 1.9% per annum. Now, the earnings per share growth is only 1.2% per annum and the dividend growth 1.3% per annum. These numbers are a little bit stale now, but what you can see is that they're not a stellar performer. The PE on next year's earnings estimate of $5 and 70 cents is a huge 17.9 times the yield on next year's dividend estimate of $4 and 29 cents. Well, I can tell you that $4 cents this year, they'll have it a little bit higher next year flat or higher. So that yield is gonna be a little bit more, but it's still gonna be less than 5%. Net interest margin is 2 0 7 basis points. This is pretty good of the big banks. Now, the headlines this morning was that Commonwealth Bank net interest margin increased by 17 basis points. Well, the reality is that 2 0 7, which is what it came at it, that was what consensus was expecting already. So the stock didn't jump because they hadn't improved. Net interest margin to pay out ratio was consensus around 70. Well, the payout ratio today was 74%. 70% of the loans are funded through their deposit book. This is what makes Commonwealth Bank so strong that that is sticky money. It has always had strong deposits and those depositors don't abandon the bank.

It has slow growth in almost all sectors of the bank. I'm neutral on it. Today's jump doesn't change my view of being neutral. I see no reason to own other than for the franked dividend. This slide shows the expectations for the result this morning in terms of what a lot of the brokers were saying, and on the right I have consensus, which is a more valuable figure. The cash net profit after tax consensus was a little more than 10.1 billion. Well, that's where it came out. It beat consensus by a little bit there, not dramatically, but nonetheless, it was a beat, not a miss. Cash. Earnings per share consensus was about $5 and 66 cents. I'm not sure actually what this e p s was this morning, but by tomorrow, believe me, I'll be on top of all of the results from this morning's numbers. The dividend per share expected around four 20 to four 30 came in for the whole year at $4 50.

It beat consensus by 18 cents on this half year. The fourth quarter net interest margin was estimated to be around 1.99. It was estimated to be lower this last quarter, but for the full year, as I said before, it came in at 2 0 7, which is attractive National Australia Bank. The code is N a b of course, and it was trading last night at 28.02. Here you have a bank that was very attractive and had a new management and the stock soared because of the quality of management. Strong board, but it got up to around 33 and has been fading since then. It's not delivering. Now, looking at some of the core fundamental numbers here, I have a 12 month price target, which is really an average of a lot of brokers of $26 and 33 cents. Most brokers have it as a sell and they have revenue growth for each of the next two years at around flat.
To be specific, it's negative 0.1% per annum, so call it flat. Earnings per share growth during this period is negative, so that's not good, and the dividend growth is estimated to be flat. So earnings are slowing, but they're able to keep the dividend where it is, which means they're gonna have a higher dividend payout ratio. Let me go back a little bit. A few years that during the last decade the banks were continuing to increase their dividend payout ratio to continue pushing their share price up. Well, you just can't keep doing that 'cause eventually the regulators being a p r and asset say to the banks, your payout ratio is too high. You're not generating enough earnings reserve in case of problems. So I'm just concerned that we are now getting back into that cycle where the banks are slowly increasing their payout ratio to make the entire market think they're performing better than they really are.

The PE for NAB on next year's earnings estimate of $2 20 is only 12.7 times. This is around average for banks. Banks average between 11 and 12 and a half to 13 or so, and C B A is maybe 13 to 14. What you saw though is C B A is much higher than normal. Right now. The yield on next year's dividend estimate of dollar 66 is 5.9%. This is very attractive. Net interest margin is 176 basis points with a payout ratio of 70%. I used to like NAB believing it had better management than its peers. However, as I mentioned before, it just hasn't delivered. The only thing attractive about NAB right now is its yield. Next span. Z N Z was trading yesterday $25 34 cents and look at the chart, extremely unimpressive. Also looking at a 12 month price target averaging a lot of the major brokers.

It's around $25 and 25 cents neutral. Some brokers really love a z I just never see them delivering, although they have great spin and great promises. But if you go back to what they were saying they're gonna be doing five years previously and where they are today, not even close revenue growth for each of the next two years is 1.8% per annum. At least it's not negative earnings per share growth. Well, oops, that's a little negative. And the dividend growth also that's flat to slightly negative. The PE on next year's earnings of $2 and 28 cents estimate is only 11.1 times. What this tells you is the market really doesn't trust a N Z anymore. By the way, A n Z is trying to buy Suncorp bank, which is a way of buying growth. The yield on the 2024 dividend estimate of a dollar 61 is 6.35%.

This is extremely high net interest margin like NAB is low at only 171 basis points and the payout is also around 70. At 70, the banks have room to increase, so watch over the next few years in order for management to keep the price up, get their bonuses by having a strong share price. Believe me, they will be increasing that payout ratio. They don't have any growth trying to buy growth with Suncorp. Well, the regulators right now aren't buying it. However, I'm sure they'll restructure and it'll get across the line. Their margins are poor. Cost to income ratio is poor. Why buy it? The only thing attractive like NAB is its dividend yield. The last bank is Westpac. Yesterday is trading at 2177. Also, look at the chart. It's going nowhere and why is it going nowhere? Well, the important thing from this chart is the revenue growth is flat, the earnings growth is flat, and the dividend growth is basically flat.

I mean, why buy a company for your portfolio? If you want something that's not going anywhere, just put it into a term deposit. The PE on next year's earnings estimate of a dollar 87 is 11.6 times. Uh, that's kind of average. If you look at banks over the past 30 years or so, the yield on next year's dividend estimate of a dollar 38 is 6.3%. Now, when you add franking, it's very attractive that interest margin is 196 basis points. So you see the, there's a tale of two cities here. You have the Sydney Banks, c b, A and Westpac have high net interest margin and the Melbourne banks a n Z and N A B have poor net interest margin. Now are these figures are gonna be improving. There's no sign of it. Royal Commission is behind Westpac, still no improvement. Cost income is high, which has room to improve.

If they can fix this bloated overhead, then they can drive more earnings growth. Let me take an aside here and look at the bank's. Overall. They all have low revenue growth rate, low earnings growth rate. The only way to really drive earnings per share growth for shareholders is to reduce expenses or buy shares back. C B A announced they're buying some shares back and they're really working hard to reduce expenses. But C B A, along with the other three are finding it is very difficult to find places to cut costs. Now, as a result, the whole sector I don't see is very attractive unless you really just want a franked dividend. Now, I don't see banks really deteriorating. I just don't see much upside. So take a higher yielding bank and grab that franking credit. You get the tax benefits and it's better than putting money in the bank and earning 4.5% on a term deposit. As always, if you wanna learn anything more on what I covered today and I can give you a lot more information on the banks, really drill into it for you. If you care, send an email request to stockwatch@fnn.com au and direct it to me, Chris Pedersen. I hope you have a wonderful week. Thank you.


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