What does ANZ's franking cut mean going forward?
This week we again revisit the topic of the banks. An issue that has been especially pertinent to us given the cut of ANZ’s franking composition to 70%, though the dividend payout has remained steady. We have previously mentioned our rather grim outlook for the top 30% of the index that is the Big 4, driven by the changes in the composition of their balance sheets and the increased regulatory scrutiny following the revelations made during the Royal Commission. All this is made even more prominent given the likely direction of the RBA’s cash rate for the foreseeable future and the possibility of unconventional monetary tools which, till now, have been left out of the apparatus of the RBA’s toolkit. Suffice it to say that there is very little room for flexibility given 1) the concentration of the existing distribution and portfolio to the residential property market; and 2) the regulatory environment which curtails the amount of actual credit growth in the broader economy.
As we have previously mentioned, given the saturation of the Australian market and its existing structure we do not see much possibility for continued top line growth. Where the banks could play a role is within the system itself. Almost all of the Big 4 banks have established a framework and strategy that focuses increasingly upon organisational transformation. Namely in the form of a reduction of non-essential headcount and an increased focus on technology to assist with the actual loan approval process as well as efficiencies internally to drive costs down. The key to the game will not be top line growth but continued internal efficiencies. Of these, perhaps the best and frontrunners have been CBA and ANZ, though NAB did announce its own strategy when it came to this aspect early last year. Nevertheless this will be a long term play and the near future looks rather bleak. The decreased margins around net interest and the existing loan book as well as the remediation and compliance costs as a result of the fallout from the Royal Commission is perhaps more evident with NAB.
ANZ’s cut to its own payout ratio (though they refuse to call it that so we shall call it a change to their franking structure) is perhaps a sign of what is yet to come. As the first to break with the pack, we are quite sure it has paved the way for others to follow suit and we believe it is the right move in this environment. That being said, the others might still take some time to come to the same conclusion given that they still retain a substantial surplus in franking credits on the balance sheets, it will come in a delayed fashion. To go a little bit more in-depth into ANZ’s results:
- Cash profit remains flat at 6.47 bn
- Total operating income slightly higher at 2%
Believe it or not, it is not the best of times to be a financial firm in the western world. Especially one in which the fortunes are so intrinsically tied to one particular segment of the market (i.e. property). To be fair to ANZ, they still retain a substantial segment in their markets business and are more global than their three counterparts who continue to be a little more inward looking. However, this does come with the caveat that ANZ is more exposed than the other three to the global environment especially where it comes to funding costs. In fact, their main drags were their institutional business which has continued to see its margins compressed and a clear lack of deposit growth. Nevertheless, from a risk mitigation perspective we might still see this as a positive since there is greater diversification in the underlying portfolio. More pleasingly for us, ANZ has invested over a billion dollars annually in its technology and operational aspects. We would like to see this continue, the results might not be evident immediately but will become more so in the future.
Where to next?
The key going forward will be in segmentation. The days when the Big 4 could sustain themselves due to their place in a highly monopolistic market structure are, we believe, going to slowly grind to a halt. They are in a business where the actual product is highly commoditised (as we have previously mentioned) and the added value/customer loyalty is very fleeting. The competition is purely based on price. Given this to be the case, the actual strategy of the management teams will be increasingly important both from a risk and profitability perspective. Our view is that they should perhaps consider a diversification of the portfolio towards commercial and back to basics banking.
However, in their biggest segment (residential and property backed lending), it will be incumbent upon them to be more targeted on their balance sheets and lending capacities which they have started to do. A recent unfortunate example of this particular aspect was clearly apparent in our recent conversations with a client from regional WA. He posited that many of his counterparts in similar historically drought stricken areas were finding it increasingly difficult to get liquidity, often being required to put up to 40% in equity before even getting consideration. This is despite recent weather making it much more amenable to actually get back to green. In an unfortunate turn of events the banks, in their quest for risk management, are increasingly concentrating their resources and targeting to a selective segment (regionally speaking), mostly limiting their risk appetite towards developed areas and the Eastern Seaboard. From a shareholder perspective, this is the right thing to do. However, from a broader stakeholder perspective we will leave that for our readership to judge.
Nevertheless, in terms of a clear upside, we unfortunately do not see a case for it. While they will still (and should) retain a place in a portfolio from a risk management perspective, given their weighting on the index, the headwinds continue to be there. There will be no top line growth for the foreseeable future and they will have to continue to rely on overseas capital markets to meet funding requirements (though, to be fair, they have done their best since the GFC to increase the composition of domestic deposits). In the absence of wage inflation and the increasing propensity of superannuation funds to look overseas for investments, this creates a necessity to issue more short-term debt and increase securitization to keep up with funding requirements. While it has been reduced to around 20% from above 30% on average we see a likely scenario of this actually going up in proportion to banks’s total funding requirements.
Which one to buy?
Management expertise will be the one clear differentiator and investors are going to have to be discerning. The days of buying the Big 4 with expectation of a minimum ROI have, we believe, ended. We will continue to see net interest margins compressed and increased regulatory scrutiny that will put a cap on any further credit growth on the balance sheet. On top of which, financial technology firms (and alternatives with less regulatory requirements) will continue to take bites out their market share in the more profitable segments. But they’ve done well for their investors so far, we just can’t see how they continue to do so unless you have a firm belief that we could potentially have another twenty year bull market in property.