ANZ: Favorable valuation offsets gathering storm clouds (ANEWF) (ANZBY)
Worries about tight household incomes and a possible recession are beginning to take their toll on Australia’s banking stocks. The Australia and New Zealand Banking Group (OTCPK:ANZBY)(OTCPK:ANEWF), hereinafter referred to as “ANZ”, has had its worst-performing to date Stocks are down a little over 20% year-to-date compared to more modest single-digit declines in the other big bank stocks.
The increasingly pessimistic near-term outlook is not easy to ignore. Rising interest rates will mean higher monthly mortgage repayments – a big problem given the sheer size of Australia’s outstanding mortgage debt – while household incomes will be further depressed by the sharp rise in the cost of living with prices for utilities, groceries, petrol etc all on the way up.
While that may mean rougher times are in store for banks in the coming quarters, there’s still some things to like here. For one thing, the domestic banking landscape is one of the most attractive in the world and as such favors above-average profitability. In addition, of course, the recent price decline is now leading to some degree of slowing growth and deteriorating credit quality, leaving the bank well below my fair value estimate. Obtain.
An attractive domestic banking landscape
With just over A$1,000 billion (~$690 billion) in assets, ANZ is Australia’s second largest bank of this size and fourth largest by market capitalisation. Australian home loans (c. AUD$278 billion) account for over 40% of gross loans, with a further c. $85 billion of New Zealand home loans also in the account. Australian and New Zealand SME and small business lending (about A$100 billion) and institutional lending (about A$185 billion) make up most of the remainder.
The banking landscape in Australia and New Zealand is attractive to investors due to its concentration, with the ‘big four’ (including their New Zealand affiliates) ultimately accounting for around 80% of the loan and deposit share.
This gives the bank a number of advantages. For one, it reduces the likelihood of irrational credit pricing. Second, the bank’s attractive deposit base (~AUD$620 billion, representing 60% of total assets) results in relatively low funding costs. Both help support its net interest margin — which is important here given ANZ’s reliance on interest income (around 80% of revenue). Finally, the big banks can spread their fixed costs across larger revenues, resulting in industry-leading efficiency metrics. ANZ’s cost-to-income ratio has averaged about 50% over the past five years.
All in all, the above translates into an attractive overall level of profitability here, with ANZ averaging a double-digit return on tangible equity over the past decade despite a significant slump during COVID.
Lights are not flashing red yet
The health of Australian households is now firmly in focus after elevated inflation figures, exacerbated by the war in Ukraine, prompted the Reserve Bank of Australia to go into tightening mode. While interest rates remain modest by historical standards – two consecutive 50 basis point hikes bring the cash target rate to 1.35% – they need to be seen in the context of rising household debt, as higher debt puts borrowers in a riskier position brings.
At ANZ, around 65% of the home loan portfolio is adjustable rate, and the cost of borrowing for these mortgage holders will naturally increase along with the cash rate. At the same time, household incomes are being squeezed by higher inflation as both consumers and businesses look towards a potential recession. Obviously, this could impact both asset quality and growth, with tightening lending standards also impacting the latter.
The good news is that credit quality has remained resilient so far, with loans past due more than 90 days declining sequentially in the bank’s third fiscal quarter. I expect ANZ’s Tier 3 ratio to increase in the coming quarters, but with around A$3.8 billion in collective loan loss provisions and over A$8.5 billion in annual PPOP generation, the Bank has significant firepower to absorb potentially higher bad debts.
On the plus side, rising interest rates will help on the revenue side as loans are re-rated while the bank’s sticky deposit base gives it leeway for higher funding costs.
Upside to fair value
As mentioned in the introduction, ANZ has been hit harder by the deteriorating macro environment compared to its peers and at below A$22 per share in domestic trading it is down around 20% year-to-date.
Notwithstanding the increasing near-term uncertainty, the current listing appears to be an attractive entry point as it is only a touch above tangible book value. P/E is about 10 times analyst estimates for fiscal 2022, while the dividend yield is over 6.5%, based on a 12-month payout of A$1.44 per share.
Based on my estimates for provisioning costs “throughout the cycle” (around 20 basis points, broadly in line with the historical average) and factoring in the impact of upcoming higher interest rates, ANZ should be good for a return on tangible equity in the low teens based on a On a P/TBV basis, fair value would be in the range of 1.4x to 1.5x, close to its historical average. As that works out at around $30 per share, the implied upside of ~50% looks attractive. Obtain.