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Morningstar | A Messy FY18 Result for ANZ Bank as Expected. Increasing Challenges Reduce FVE to AUD 29

The operating environment for all major banks is becoming increasingly uncertain, with legal, regulatory, political, and public scrutiny escalating at the same time earnings growth is slowing. The combined effects of a Royal Commission, increasing regulatory oversight, potential government change in 2019, a weakening housing market, slowing credit growth, softer Chinese economic conditions, rising global interest rates, investment market jitters, and the escalating debate around culture, governance, and trust in the banking sector means the major banks' dominant market positions and profitable businesses are under increasing pressure.

Despite increasing uncertainty, we see medium- to longer-term upside for Australia and New Zealand Banking Group and major bank peers. Wide economic moats based on cost advantage and customer switching costs continue to bestow considerable pricing power to the major bank oligopoly, partially protecting profits from the rising funding costs, but not from increasing regulatory and compliance costs. Despite management making good progress to date in simplifying the bank, it will take another year to get a clearer picture of the strength of ANZ Bank’s underlying franchise and we cut our fair value estimate 3% to AUD 29. At current prices, the stock is undervalued trading 11% below our valuation.

The fiscal 2018 result was messy, as expected. The AUD 6.5 billion cash profit from continuing operations declined 5% on fiscal 2017 but beat our forecast by 3%. An unchanged total fully franked dividend of AUD 1.60 per share was in line. The statutory profit of AUD 6.4 billion was in line with fiscal 2017. The dividend payout increased to 80% of cash EPS, well above the bank’s medium-term target of less than 65% and exceeded the 67% payout in fiscal 2017. Tough conditions in retail banking in Australia will limit revenue growth, however, the bank is well-placed to leverage opportunities in institutional banking, in Asia and New Zealand.

Add to the mix increasing uncertainty around the pace, scale and breadth of technological disruption and the threat of a credit crunch and it is not surprising bank share prices are approximately 20% lower than previous 12 month highs. Despite challenges, the bank is moving along steadily, disposing of noncore assets, building capital levels, growing the profitable Australian home loan portfolio, and most importantly, continuing to benefit from improved asset quality. The balance sheet is strong with capital, funding, liquidity well above regulatory minimums. Our fiscal 2019 forecast fully franked total dividend increases modestly to AUD 1.61 per share based on a 67% payout.

Loan quality was a standout with loan losses declining 43% year on year, representing a multidecade-low loss rate of just 0.12% and below our forecast of 0.14%. We expect annual loan losses to steadily revert closer to medium-term trend levels around 0.24%. We reduce our fiscal 2019 loan loss rate to 0.13% from 0.14% previously with loan losses forecast to steadily increase to 0.20% by end fiscal 2023.

Despite challenging operating conditions, business volumes were positive, with loans and customer deposits both growing 4% year on year. But housing growth is slowing and borrowing capacity is reducing placing pressure on future loan growth. We reduce our forecast loan growth from an annual average of 4.5% to 3.5%.

Despite the 5% year-on-year decline in cash profits, second-half profits suffered from a sharper fall in revenue, down 4%, and a step increase in operating costs, up 10% as increased provisions were recognised for customer compensation, remediation costs, compliance costs, regulatory and legal expenses. Business as usual operating expenses were well contained, and we like the progress to a simpler less complicated business structure and reduced staff numbers, which declined a meaningful 11% to 40,000 at Sept. 30, 2018.

ANZ Bank is transforming into a lower-risk Australian and New Zealand focused consumer and commercial bank. We like the focus on lower risk owner-occupier principal and interest loans and tighter restrictions on higher-risk segments including commercial property, unsecured consumer loans and residential investors and interest only borrowers. The rebalancing of the capital position is being achieved via the AUD 3 billion on market share buy-back initiative.

As expected, second-half net interest margins fell sharply to 1.82% from 1.93% in the first half as higher short-term wholesale funding costs, loan mix changes, and discounts for new loans impacted. Variable home loan repricing announced in early September of 0.16% will go a long way to reversing the margin decline starting first-half fiscal 2019. Full-year fiscal 2018 margins of 1.87% declined 0.12% from 1.99% a year ago and were below our forecast of 1.91%.

Disappointments included the increase in the cost/income ratio to 52%, up from 46% a year ago with operating income declining 3% and operating expenses increasing 3%. Management need to reverse this trend and move as quickly as possible to a positive jaws situation where income growth exceeds expense growth. Westpac reported a peer-leading low cost/income ratio of 42% for first-half fiscal 2018, so ANZ Bank has plenty of room for improvement. Excluding management’s definition of “large and notable items,” operating expenses declined 1.5% for the year, a creditable outcome and provides hope for improved operating efficiency going forward.

Return on equity decreased 0.67% to a disappointing 11.0% but remains above our 9.0% cost of equity assumption. ANZ Bank’s return on equity is the lowest of major bank peers, but we forecast modest improvements during our forecast period to an average of 12% per year.

The common equity Tier 1 capital ratio was a peer-leading 11.4% at Sept. 30, 2018 well above the regulator’s benchmark of 10.5% due by January 2020. Recent asset sales, stable risk weighted assets, better capital utilisation and solid profits boosted capital levels. The pro forma common equity Tier 1 ratio of 11.8% includes announced asset sales less the impact of the remaining AUD 1.1 billion share buyback expected to complete in first-half fiscal 2019. On an internationally comparable Basel III harmonised basis, ANZ Bank’s 16.8% common equity Tier 1 ratio is top quartile. The dividend reinvestment plan for the fiscal 2018 final dividend of AUD 80 cents per share fully franked will neutralised via on market buying of shares issued for the reinvestment plan.

Discontinued wealth operations reported a AUD 682 million loss reducing the reported cash profit to AUD 5.8 billion. Previously announced large and notable expense items totaling AUD 473 million aftertax are included in the AUD 6.5 billion cash profit from continuing operations. Notable items included a profit of AUD 191 million on the sale of divested businesses, a AUD 34 million operating profit from divested business, AUD 295 million in customer remediation expenses, AUD 206 million in accelerated amortisation expense, AUD 35 million in Royal Commission legal costs, and AUD 159 million in restructuring expenses. We expect further customer remediation costs to be recognised in fiscal 2019 and possibly fiscal 2020.