Australia’s banks may be worth more than Britain’s entire banking sector, but they are not doing enough to satisfy shareholders. At least according to UBS. The broker is arguing for higher dividend payout ratios to justify the current strong share prices presumably. You know, those share prices that make Australian banks worth more than the British banking sector. It looks a bit like a squeeze, especially with the RBA issuing toothless warnings about low quality lending. Yes, the banks may be a bit closer to a more sound capital position, but profits, and therefore dividends, come from operations. And the economy is looking weak, which is leading to the emergence of more questionable lending practices. The higher dividend ratio is also about taking advantage of franking, and that only benefits local investors. It is probably one reason why overseas investors do not like our banks, while local investors do:
“Over the last few weeks many of the banks have indicated that they are now comfortable with their capital ratios as Australia moves towards the accelerated implementation of Basel III.
This was most clearly illustrated with CBA stating a target Basel III Core Tier 1 ratio (Harmonised) of >9% at its FY12 result, while NAB stated that it would like to see its APRA ratio in the range of ~8.0% to 8.25%.
While the debate continues as to which ratio is appropriate and what the minimum level should be, we think the more relevant implication is that banks are now approaching levels where management and boards are comfortable with capital ratios and no longer believe they need to accumulate higher levels. As a result of (1) mid-teen levels of ROE; (2) low credit growth; and (3) relatively benign asset quality, the banks are now strong generators of free cash flow.
Given the franking credit regime in Australia and shareholder’s desire for yield investments, we believe there is a significant incentive for the Boards to return much of this free cash flow to shareholders in the form of higher dividend payout ratios. However, is this approach prudent for the bank’s in the current environment?”
It is a good question to pose about the banks. As the UBS report comments, there are many moving parts. Asset quality is “benign” (is it?). Every 1% increase in bad debts equals a 0.5% fall in earnings per share. It is very much a knife edge. And the clearing of bad debts is going slower than thought, giving some idea of how difficult it will be if property prices go south. And the Australian economy is showing signs of stress and it is over two decades since Australia has experienced a recession. Here is UBS’s analysis of the major’s strategies:
␣ ANZ: Given a lower payout ratio than its peers (~67%) ANZ organically generates substantial amounts of capital. This is partially used to build its capital base as well as fund the faster growth of its Asian operations. However, in the event of a domestic downturn, we estimate ANZ could tolerate BDD charges into the 50bps without needing to provide a larger discount on its DRP or cut the ordinary dividend.
␣ CBA: widened its payout ratio target with the recent result to 70% to 80% from a historical target of around 75%. Given earnings growth we believe that CBA could absorb BDD charges up to around 40bp without putting too much pressure on the ordinary dividend. However, if CBA were to move to the top of its new dividend payout band it would provide less flexibility for dividends in the event of a reduction in asset quality going forward.
␣ NAB: has a higher BDD charge than its peers given both its business mix and UK exposures. We expect a BDD charge of around 43bp in FY12E. Following the recent hybrid conversion and with another likely in coming months, NAB is now approaching target capital levels of 8.00% to 8.25% (APRA ratio) which it sees as appropriate. Once it has reached these levels it is targeting both the elimination of its DRP discount and a steady expansion of its payout ratio into the 70s. We believe that NAB could absorb BDD charges up into the 50bps as a result of deteriorating asset quality before it would need to again look to reapply a DRP discount.
␣ WBC: has a policy of steady growth in dividends over time. This has resulted in an expansion of its payout ratio, which we expect to reach around 79% this year. We believe that WBC would be able to sustain a moderate hit to asset quality, with BDD charges to around 40bp without pushing its payout ratio too far or requiring a discount on its DRP.
Conclusion? UBS calls for special dividends rather than an ongoing change to the dividend payout ratio. Here are the consequences for yields:
The UBS discussion is really a reinforcement of their underlying recommendation. “We see better opportunities elsewhere, especially internationally.”