• Funding cost advantage of major banks widens and should protect margins and market share
  • Major banks fair valued but regionals undervalued despite funding cost advantages
  • Seeing unprecedented top-line and pre-provision operating profit (PPOP) growth from banks

Higher cash rates support solid earnings growth for Aussie banks in 2023, according to Morningstar’s Australian Bank Industry Pulse – Fourth Quarter 2022.

Morningstar bank analyst Nathan Zaia said banks have passed on rate increases to existing borrowers in full.

Zaia said with increases to customer deposit rates on average rising less, margins have already begun to rebound from compressed levels.

He expects further upside – likely from future rate increases, low-rate fixed-rate loans maturing, and better returns on the banks deposits and equity.

However, for smaller banks and nonbank lenders having weaker funding positions Zaia expects the major banks to hold market share.

“The major banks can price home loans and term deposits, in the context of all other funding costs, at levels which allow them to make attractive margins and as a result a low-double digit ROE,” he said.

“The big banks on average, price home loans above deposit rates.”

He said if major banks are pricing loans and deposits at levels which generate low-double digit ROE, we think its competitors will struggle to generate decent returns.

“One because they have small scale operations, and two they don’t have the benefit of transaction deposits,” he said.

“Hence it’s harder for these challengers to offer cheaper loans and better deposit rates than the majors and win over new customers and take market share.”

 

Increased loan loss risks

“Low rates underpinned strong credit growth in recent years, with total system loans up 20% in the three years to November 2022,”

“With higher interest rates and inflation reducing borrower capacity, and falling house prices hurting investor confidence, we expect low-single-digit credit growth in the medium term.”

He said falling house prices, and borrowers facing more than double interest repayments there is an increase to loan loss risks.

“We see a return to long-term averages as most likely,” he said.

“The strength of the economy, household equity buffers, and bank provisioning levels provide comfort.

“The banks remain well capitalised and dividend payout ratios look maintainable, with most banks trading on attractive fully franked dividend yields.”

 

Regional banks undervalued

Zaia said the major banks are fairly valued, but regionals are undervalued despite lacking strong funding cost advantages.

According to the Morningstar report the weighted average price/fair value of the major banks was 1 times, up from 0.9 times in Q3 due to positive returns for Commonwealth Bank (ASX:CBA) and Westpac (ASX:WBC).

For non-major banks the improvement is largely driven by Bendigo and Adelaide Bank (ASX:BEN).

“Major banks traded at a premium to our fair value estimates in early 2022, as the market appeared to be overpaying for the earnings benefit from better margins,” Zaia said.

“When the RBA shocked with a larger-than-expected increase in May, attention turned to loan losses.”

 

Source: Morningstar, data as of Jan 6, 2023

 

Westpac and ANZ Remain Top Picks, prefer MyState Over BEN

Australia’s second-largest lender WBC is a top pick of Morningstar, which remains confident the funding cost advantages and wide-moat-rating it enjoys will see a return to strong profits and returns on equity over time.

“Customer remediation, uplifting risk management, digital investment, and divesting nonbank businesses have been costly and distracting,” Zaia said.

“Not only did operating expenses rise at a time when revenue was under pressure, but loan approval times were not competitive.”

He said Loan approval times (and loan growth) have already improved, but a rebasing of costs will take time, while the balance sheet is sound.

“We think Westpac can maintain a dividend payout ratio of 70%, which leaves the bank trading at an attractive fully franked dividend yield,” he said.

Morningstar has a forward value estimate of $29/share on WBC, which has seen its share price rise ~19% in the past six months.

 

Margins forecast to improve for ANZ

Zaia said Australia and New Zealand Banking Group (ASX:ANZ) has lost material home loan market share, and having less funding sourced from low-cost household customer deposits, has incurred material margin pressure across the bank.

“We suspect shares do not factor in that rising cash rates will help the banks margins improve, and added headcount and investments to digitise processes, should make the wide-moat bank competitive again,” he said.

“Granted while this comes with added operating expenses, it should help drive earnings growth and returns on equity.”

He said the potential acquisition of Suncorp Bank should help the bank operate more efficiently, but  the acquisition and integration costs make it unlikely to be materially value accretive.

“Commercial lending is growing solidly as businesses invest to take advantage of strong customer demand and global supply distributions,” he said.

Morningstar has a forward value estimate of $31/share on ANZ, which has seen its share price rise ~13% in the past six months.

 

Tassie-based MyState pick of the non-bank lenders

Tassie-based MyState (ASX:MYS) is Morningstar’s pick of the no-moat-rated non major banks, trading at a material discount to our fair value estimate.

“MyState commands a tiny 0.3% share of the Australian home loan market, but with investment in its digital offerings and expanded sales team, has demonstrated an ability to profitably grow its loan book, “Zaia said.

He said in FY22 the bank grew home loan balances by more than 25%, over three times that of the system.

It reported its home loan book was $7.3 billion at September 30, 2022, up 6.9% over Q1 FY23.

“We expect market share gains to be more difficult in the future, with cost inflation and rising wholesale funding costs affecting smaller banks more than major banks,” he said.

While MyState will not benefit as much as the major banks from higher rates, due to a greater reliance on term deposits, it is still better placed relative to nonbank lenders.

MyState has a focus on lower-risk owner-occupier borrowers with a loan/value ratio below 80%.

Morningstar has a forward value of $5.50/share on MyState, which has seen its share price drop ~6.50% in the past six months.

 

The WBC, ANZ & MYS share price today:

 

Martin Currie says banking sector ‘resilient for now’, picks ANZ

Active equity manager Martin Currie Australia, part of Franklin Templeton, said Australian banks spent much of the first half of 2022 facing concerns about the fallout from rate hikes on consumers, house prices, and credit risk.

However, since then the material tailwind of higher rates for net interest margins (NIMs) has been recognised in share prices, with a reversal in sentiment between NIMs and housing risk.

Martin Currie Australia Portfolio Manager Matthew Davison said banks were one of the standout sectors through the 2022 August reporting season and November AGM period for upgraded revisions and share price performance.

“We are now seeing almost unprecedented top-line and pre-provision operating profit (PPOP) growth from the banks, and at least for now, impaired assets remain incredibly low,” he said.

“Despite looming consumer pressure, we believe that bank earnings will continue to look solid for the near to mid-term, with the NIM tailwinds to be ongoing in 2023.

He said the sheer weight of recent credit creation in the system is also providing support.

“The sector is resilient for now, and ANZ remains our preferred exposure,” he said.

“Our active positioning within the banks sector is most focussed also on Virgin Money (ASX:VUK), Bendigo and Adelaide Bank.

“We see that all these banks have ample exposure to rising rates and other factors that will support a positive P/E re-rating.”

The author held shares in WBC and ANZ at the time of writing this article.

The views, information, or opinions expressed in the interviews in this article are solely those of the interviewees and do not represent the views of Stockhead. Stockhead does not provide, endorse or otherwise assume responsibility for any financial product advice contained in this article. 

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