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Morningstar | ANZ’s 1H19 Highlights the Benefits of Simplification, But Challenges Persist. FVE AUD 29 Unchanged

Wide-moat Australian and New Zealand Banking Group’s first-half fiscal 2019 result beat our expectations due primarily to lower operating costs. The performance was a good outcome considering tough operating conditions. Management expect near term challenges to persist, particularly in the bank’s Australian business. The first half AUD 3.6 billion cash profit from continuing operations increased 2% on the previous corresponding period, or pcp, and beat our AUD 3.4 billion expectation by a healthy 6%. Tough conditions in retail banking in Australia continue to limit revenue growth, however, the bank is well placed to leverage opportunities in the Institutional Bank and New Zealand.

We increase our forecast fiscal 2019 cash profit to AUD 6.9 billion from AUD 6.7 billion previously, allowing for lower cost growth partially offset by lower net interest margins, or NIMs, and a modest increase in loan impairments. We increase our full-year dividend forecast marginally to AUD 1.62 per share. Going forward we expect modest increases in dividends based on improving EPS, moderate loan growth and benign asset quality. Despite pressure on NIMs and soft home loan growth, we liked the result and maintain our AUD 29 fair value estimate. The stock is currently fairly valued.

The highlight of the result was the surprising 2% decline in operating expenses, more than compensating for the 1% decline in revenue. During the past three years, the bank has absorbed expense inflation of approximately AUD 550 million and reduced absolute costs by over AUD 300 million. The first half fiscal 2019 cost to income ratio improved more than we expected to 44.8% declining 0.53% compared with pcp. ANZ Bank incurred AUD 175 million pre tax in customer compensation costs in first half fiscal 2019 taking the total cost to AUD 928 million since first half fiscal 2017. We think the bulk of the bank’s remediation cost recognition is now behind it as the bank started the process in early fiscal 2017.

Despite our optimism the customer remediation recognition program is not finished as management noted there could be further costs in the pipeline. We don’t think future remediation costs will be material for ANZ Bank. The statutory profit of AUD 3.2 billion was 4% lower than first half fiscal 2018. An unchanged interim fully franked dividend of AUD 80 cents per share was in line with expectations. The dividend payout of 65% was at the top of the bank’s medium term target.

The strength of the bank’s diversified core business model stood out with the 12% decline on pcp in cash profit to AUD 1.8 billion from the Australian business more than offset by the 33% increase on pcp in cash profit to AUD 1.0 billion from the Institutional business and a broadly flat result of AUD 753 million from the New Zealand operations.

Total lending growth of 3% on pcp was sound but Australian housing went backwards, declining 1% in a tough market. Lending growth in New Zealand was strong, up 6% on pcp and 7% on the previous period, or pp. Group customer deposit growth of 4% on pcp is a good outcome with the AUD 20 billion increase modestly above the AUD 18 billion in loan growth.

NIMs are under pressure declining two basis points to 1.80% during the six months to end March 2019 but fell a significant 13 basis points from a year ago. Despite repricing up the bank’s Australian variable home loan portfolio in September, retail loan mix changes and intense competition for new borrowers detracted. The focus on lower margin, higher quality owner occupier principal and interest home loans hurt the margin outcome. We don’t see this changing soon and reduce our forecast NIM to 1.81% for fiscal 2019 and fiscal 2020. The recent sharp decline in short term wholesale funding costs is a positive for margins, but pricing competition remains intense for high quality new home loan customers.

Loan quality continues to support a strong balance sheet, with annualised loan losses a low 13 basis points and new impaired assets declining 8% to AUD 890 million from a year ago. Worryingly, 90 plus day home loan arrears increased but remain low. The increase in home loan arrears is spreading to New South Wales, with Western Australia continuing to struggle. It is important to acknowledge home loan arrears rates are increasing off a low base, with the annualised Australian home loan loss rates very low at 0.04% for the half. We increase our fiscal 2019 loan loss rate to 0.14% from 0.13% previously with loan losses forecast to steadily increase to 0.21% by end fiscal 2023 - closer to medium term trend levels around 0.24%.

The combination of the AUD 3 billion on market share buyback and the better than expected profit boosted the return on equity to 12%, comfortably above our 9% cost of equity. Balance sheet settings remain sound with capital, leverage, funding and liquidity all comfortably exceeding regulatory requirements. The all-important common equity Tier 1 capital ratio of 11.5% significantly exceeds the regulator’s January 2020 benchmark of 10.5%. Organic capital generation was solid at 0.84% of common equity Tier 1 capital and modestly above the historical first half average of 0.71%. The strong capital position enabled the bank to neutralise the interim dividend DRP.

The pro forma common equity Tier 1 ratio was high at 12.1% after allowing for the completion of announced divestments. The sale of the wealth business, known as OnePath pensions and investments, is expected to complete by the end of March 2020. Future capital management decisions will account for the impact and timing of regulatory requirements, ongoing business needs and the outlook for earnings and growth. That said, we expect some type of return of surplus capital to shareholders during fiscal 2020.

The operating environment is increasingly tough with the decline in the housing market, highly indebted households and low wages growth pressuring household spending. Legal, regulatory, political and public scrutiny is escalating at the same time earnings growth is slowing. The combined effects of the Royal Commission, increasing regulatory oversight, potential change of government, a weakening housing market, slowing credit growth, softer global economic conditions, investment market volatility 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 pressure.

Despite the uncertainty, we see medium to longer term upside for ANZ Bank 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 and operating costs. We like the bank’s commitment to tightly manage cost growth with an ambitious annual operating expense target of approximately AUD 8 billion by fiscal 2022. Business as usual operating expenses were well contained, and we like the progress to a simpler less complicated business structure and reduced staff numbers.

The bank is moving along nicely, disposing noncore assets, building capital levels, investing in technology, simplifying the business model, maintaining a high quality loan book and facing up to the thorny customer remediation problems. Despite the positives, we are concerned with the ongoing decline in the bank’s Australian home loan portfolio and we believe this needs to be reversed as soon as possible without risking asset quality.