How the big four fare in the digital race
Investors must know what this means to the bank stocks
Suddenly the banking sector is alive with the buzzwords of the digital age: digitisation, artificial intelligence, robotics, big data, machine learning and, of course, pre-empting disruption from fintechs. No longer staid generators of dusty files of customer loan and deposit papers, banks now employ some of the most prominent technology leaders.
And it makes sense: it’s imperative to enable customers to interface digitally with their bank when they want, on the device they want, and to use technology to reduce the costs of banking processes or to eliminate them. Customers already benefit from the convenience and ease of the new technology, but, despite the current race for the title, it is unlikely any one bank will emerge with a sustainable competitive advantage in digital banking. Most likely banks will settle into a game of variously catching up, leapfrogging and falling behind peers — and all at a substantial cost.
Let’s look first at NAB, which has made headlines with a very ambitious restructuring program. After an 11 per cent rally from a September low of $29.83 National Australia Bank shares have corrected since the fiscal 2017 result — not over concerns with the result, which was solid and impressive, but with the surge in expenses in 2018 as management accelerates its digitisation strategy.
New expense growth guidance of 5 to 8 per cent for 2018 was way above market expectations and is driving consensus earnings downgrades for 2018.
The digitisation costs outweigh the savings from the net 4000 positions NAB plans to remove from the business by September 2020. NAB will make 6000 positions redundant as traditional processes are automated or not needed anymore, but will also hire 2000 people with skills to deliver the new digital age. There will be a one-off restructuring charge of $500 million to $800m to fund the redundancies..
The surge in digital expenses reduces earnings and therefore weighs on regulatory capital strength by elevating NAB’s dividend payout ratio. At around 80 per cent for successive years, this ratio is too high and the consequence is NAB’s decision to discount the dividend reinvestment plan by 1.5 per cent for the final dividend.
Value investors will be asking what all this means bank stocks? Here’s a snapshot:
At NAB the big question is whether the restructuring means the bank is worth less than before. The answer is yes but not by much. The bank’s share price (about $30.50) will converge to an intrinsic valuation of $33.50 because global equity markets will remain benign as world growth accelerates and inflation remains low, the Australian economy will grow marginally next year, banking interest margins will be steady and bad debts low, return on equity will trend higher, and because a premium will enter the share price for reliable delivery of strategy. The 6 per cent fully franked dividend yield increases the stock’s appeal to those seeking income with some growth. Below $31 NAB trades at an adequate discount to value.
The smallest of the big four banks reported its 2017 result two weeks ago. This bank is at an earlier stage in its turnaround, which so far has emphasised derisking, capital release, divestment of non-core businesses and cost reductions. The result disappointed expectations due to a lack of revenue growth. A year from now ANZ’s results should look much like NAB just reported, with improving revenue and earnings growth across the business. ANZ (about $30.30) is worth about $32.80, making the stock interesting below $30.50.
The market expected a solid second-half result from Westpac, but the headline result fell short of expectations due to lower markets/ trading income and higher customer redress costs. Wider interest margins and historically low bad debts were more supportive and Westpac should benefit from improved trading income, further mortgage repricing and lower customer redress costs in the first half of 2018. Further out, mortgage lending growth will slow down further and Westpac is the major bank most exposed to lower interest margins as borrowers switch from interest-only (higher margin) to principal & interest (lower margin), so we downgraded our valuation to $35 after the result. Westpac is interesting below $32. (currently trading at about $33).
In 2017 Commonwealth Bank was the only major bank to increase its dividend. The stock enjoyed substantial rallies ahead of the interim and final dividends. Then CBA’s first-quarter 2018 update this week beat expectations and triggered a bullish rally ahead of likely earnings upgrades. Cash earnings grew 6 per cent, bad debts expense surprised on the downside, revenue grew faster than underlying costs and regulatory capital was very strong. The market will now expect a solid interim result and another increase in the interim dividend, so we expect CBA ($80.90) will rally to $85-$87 ahead of the result in February 2018.