By Guy Carson, Senior StockVal Analyst
Last week Commonwealth Bank of Australia (ASX:CBA) provided profit guidance to the market. CBA expect first half Net Profit after tax to be circa. $2.9bn and this is approximately $200m ahead of market expectations. This result benefitted from improving equity markets which provided strong investment returns. However, CBA also noted in the press release that there was a decline in impairment expenses relative to the prior corresponding period. The better than expected Australian employment statistics reported last week has meant that the Banks have started this calendar year without the threat of a rise in consumer bad debts.
Whilst most of the investment flows have focussed on the big four banks and pushed their share prices higher, the regionals have lagged behind. This is with good reason; the big four have used that balance sheet and access to capital over the last few years to improve their market position. Meanwhile the regionals have struggled with poorer quality loan books, impairments and higher cost ratios. As a result their Return on Equity and capital positions has weakened over the last last 18 months.
One exception to this is Wide Bay Australia Limited ASX:WBB). The Return on Equity for WBB fell to 17.2% in FY09 but this was well above the other peer group regionals and actually was better than two of the big four (NAB and ANZ). Recent results for the first half are healthy and we are forecasting a 20% return for FY2010.
WBB is one of Australia’s largest building societies. Established in Bundaberg in 1966, it is the product of five mergers. WBB offers a variety of products and services. These include banking, financial planning, margin loans and insurance products to individuals and business. Services are mainly related to residential housing loans in Queensland where the majority of the customers are located (74% of customers). New South Wales and Victoria represent the balance. Residential lending and retail deposits therefore make up the vast majority of the business which has 42 branches, 17 agencies and 230 staff. WBB endeavours to make their differentiation point superior customer service. This is in order to uphold their strong brand name and customer loyalty.
There are 5 financial metrics that we use to analyse banks:
1) Return on Equity
As a fund manager and long-term value investor, StockVal has a basic rule of thumb – a bank should achieve a return on tangible equity of about 20% for its shareholders. In a good year this should be exceeded (but not greatly), and in an economic downturn they will fall short. The StockVal calculated return on equity includes the franking benefit paid to shareholders.
Last year WBB had return on equity of 17.2%. This was an outstanding result given the state of the economy and compares favourably against all banks apart from Westpac and CBA. Management last week upgraded their guidance for FY10 saying they expect profit to increase 30% from the previous year.
Assuming that WBB will maintain its payout ratio of 90% this then gives a return to the equity holders of 20% in FY10.
2) Return on Assets
Another rule of thumb is that a bank should have a net return on gross assets of about 1%. Given a bank will gear its equity 20 times a 20% return on equity produces a 1% return on assets.
Last year WBB had a return on assets of 75bp, well below the 1% mark but still a good result considering the economic environment. Current guidance has this increasing to 89bp in FY10, back towards the level we like to see.
3) Expense Ratio
In the 1980s the major banks had “cost to income ratios” of about 70%. Progressively over 20 years this has been managed down to 50% and below. CBA’s last result came in at 46.0%. WBB on the other hand has sitting at around 55.5% for the last 2 years. The first six months of FY10 has seen this come down to 53.2%. This trend is positive and is indicative of a business with greater scale and one is performing at greater efficiency.
4) Net Interest Margin
The banks’ interest margins have been under pressure for many years. The major banks have margins that slightly exceed 2%. However, this margin is whittled away by higher costs of wholesale and retail funding for the smaller banks with lower credit ratings. To its credit WBB has managed to match the majors in recent years with margins around 2%.
However, WBB may struggle to maintain this because it is at a competitive disadvantage to the major banks due to its lower credit rating of BBB. The decline of the Residential Mortgage Backed securitisation market may also effect the funding available to WBB and affect interest margins.
5) Asset Growth, impaired loans and provisions
Unlike the other regional banks Wide Bay actually grew their assets last year. They had asset growth of 9.3%. This is outstanding result and was achieved through having a strong balance sheet at the right time. Tier 1 capital current stands at 9.5%.
Impairments and provisioning has been a major issue facing all banks over the last 18 months, Wide Bay has been no exception. They expensed $4.9m of bad and doubtful debts for the 2009 financial year and impaired assets currently sit at 0.49% of total assets, this compares favourably to the majors. This is because Wide Bay is essentially a retail and consumer bank. In this last downturn the Australian consumer and mortgagee had not fallen behind on loan repayments. The key economic indicator to watch for Wide Bay going forward is unemployment. If unemployment continues to fall and the Australian consumer manages to avoid hard times, then Wide Bay’s provisioning will remain low.
StockVal Valuation – Wide Bay Australia Limited (ASX:WBB)
In terms of valuation we have a return on equity based on company guidance of 20%. This gives a valuation of just over $7.20 given our assessed required return of 14.1%. Our required return for this bank is much higher than the large banks because of its small size. Another factor that we consider is the history of the bank to continually raise equity. This factor does lead to an increase our required return due to the possible dilutionary affects of future capital raisings.
The market price is currently assuming a return on equity of 29.4%. This is close to the peak of the last cycle in FY06 when the ROE peaked at 30.6%. The market is effectively pricing the company for perfection. Even if the company was to achieve 29.4% over the next few years we doubt that this would be sustainable and that eventually it will head down towards the long run average for banks of 20%.
Whilst the valuation doesn’t appear attractive there is an attractive yield on offer of 5.8% or 8.2% grossed up. This yield is based on a high payout ratio which may need to be reviewed as the bank grows.
Wide Bay has been one of the better performing banks over the last 12 months despite its size. The business has performed well and grown significantly in a difficult economic environment. Unfortunately for investors the market is currently pricing the company for perfection and it is unlikely that we will see a good entry point any time soon.
Clime Asset Management and StockVal are part of Clime Investment Management (ASX:CIW).
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