Uncertainty surrounding the ability of Australian banks to pay final dividends in FY20, and perhaps beyond, has been diffused. Diffused but not altogether removed.
The dividend outlook for banks and insurers, that has weighed on valuations, has been addressed in the latest release from the Australian Prudential Regulatory Authority (APRA), which continues to emphasise prudence.
Macquarie suggests the goalposts have been now been shifted towards bank capital management, pointing out there is little attention being paid to the actual capital starting point and other mitigating factors but suspecting, as is customary with APRA, consideration will be given on an individual basis.
APRA states the banking system, overall, is “well-positioned to withstand a severe downturn”. Nevertheless, the sector would be severely impacted if this were to occur. The updated guidance replaces the prior recommendation made in April, that the banks seriously consider deferring deferring or slashing dividends, at least until the next (yesterday’s) update.
APRA believes economic uncertainty has been reduced, so now there is an opportunity to review financial projections and stress testing. Banks are advised to pay dividends in 2020 of up to half their earnings and use dividend reinvestment plans (DRPs) or capital management initiatives to partially offset the adverse impact on capital of their dividend payments.
Bell Potter welcomes the news, particularly the fact that APRA wishes the banks to continue supporting households and businesses. The broker notes ANZ Bank ((ANZ)) has the most conservative pay-out target and thus retains the greatest capital management flexibility.
Furthermore, banks are not expected to go all out to meet the unquestionably strong benchmark of 10.5% of risk-weighted assets (CET1), postponed to January 2023. This will allow for the rebuild of capital buffers in a gradual and orderly manner.
APRA urges banks to continue lending to households and businesses and build this allowance into their regular stress testing. Stress testing is, in turn, expected to inform decisions on dividends while the capital buffers should be available as needed.
This signals to Citi dividend reductions are generally favoured, as opposed to large dilutive capital raisings.
Will they be off the table then?
Macquarie argues that while the measures reduce the risk of capital raisings, if banks are not prepared to largely eliminate dividends for a prolonged period the risk of capital raising continues to exist should economic conditions deteriorate.
UBS asserts this leaves the banks in an awkward position. Should boards declare dividends from retained earnings during a recession then actively raise equity to offset this at a discount to book value? While believing the banks will acknowledge the irrationality of paying dividends and simultaneously raising equity below book value the broker assumes they may do it anyway.
Questions Anyone?
Issues such as how active banks should be in using DRPs and the definition of earnings perplex brokers. Do earnings include the write-off of capitalised software or equity investments already deducted from CET1? What about 2021?
The questions raised by the announcement largely centre on whether the requirement to retain at least half of their earnings relates to the second half or the whole of FY20 and whether it relates to cash profit or reported profit, or gross distributions versus net distributions.
Morgan Stanley settles for FY20, reported profit and net distributions. The broker believes the guidance leaves scope for banks to set pay-out ratios above 50% but use the underwriting of the DRPs to retain at least half their earnings.
UBS assumes all banks pay out 50% of second-half cash net profit in dividends at the upcoming results and use discounted DRPs with a 30% take up. Citi welcomes the boost to the sector but agrees some of the details are open to interpretation, which means dividend forecasts could be varied.
These details include the time period over which the directive is applied (three of the majors have September year ends and report in November), the stress testing directive, and in particular the extent of the need to allow for lending capacity to support a recovering economy.
Global Comparison
Australia’s major banks have much higher dividend yields compared to their UK, US and EU counterparts. Credit Suisse notes the higher dividend yield and the income this provides to shareholders is a reason why Australian banks trade at higher valuation multiples.
Moreover APRA’s updated capital management expectations that allow the banks to pay a dividend makes these stocks attractive in the current environment. This compares to the recent decision by the European Central Bank to freeze European bank dividends until January 2021.
The outlook is now more certain regarding what Australian banks can do and removes the concerns regarding a requirement to rapidly build up capital after the pandemic, Credit Suisse believes.
The broker increases target prices for the major banks and also incorporates higher credit risk weightings to account for the worsening economic outlook. Citi agrees it is a positive development for a sector where a sustainable dividend yield is important for underpinning valuations.
Dividends Dividends
Macquarie estimates Commonwealth Bank ((CBA)) should be able to pay only $0.63 because a large proportion of earnings were paid for the first half in February (June year end). However, given that bank’s healthy pro forma capital it may seek special dispensation to pay a higher second half dividend with additional support from a discounted DRP.
Meanwhile, National Australia Bank ((NAB)), in Macquarie’s view, will need to reduce its second half dividend to around $0.22 per share and Bank of Queensland ((BOQ)) should be able to pay around $0.19c.
Despite the positive reaction to the announcement Macquarie envisages downside risk to current consensus expectations for second half dividends at CBA, NAB and Bendigo and Adelaide Bank ((BEN)). In the latter case the bank, having paid a large dividend in the first half from its limited allowance, is unlikely to pay a second half dividend.
Citi forecasts a CBA second half dividend of $0.50 compared with $2.31 in the prior corresponding half as the bank benefits from the completion of the sale of CFS Global Asset Management.
On the other hand, the broker believes Bank of Queensland, ANZ and Westpac ((WBC)) are likely to experience significant dividend upgrades for the second half by virtue of having fully deferred their first half dividends.
Or will they? Morgan Stanley would be surprised if ANZ, NAB and Westpac provide any guidance on dividends at their third quarter trading updates. Ord Minnett, too, finds it unclear what APRA intends regarding interim dividends which have been deferred but assumes ANZ, Westpac and Bank of Queensland do not pay these deferred dividends.
The broker includes pay-out ratios for the second half above 50% for Commonwealth Bank and Bank of Queensland in its estimates. Meanwhile, Shaw and Partners upgrades FY20 dividend estimates for ANZ and Westpac and downgrades CBA while retaining unchanged forecasts for NAB.
There are no changes to profit forecasts. The broker also suggests the 50% cap on distributions provides more clarity for Macquarie Group ((MQG)) and Suncorp ((SUN)), given modest bank earnings in both companies.
Compelling Yields
Credit Suisse now includes large dividend reinvestment plans for the major banks for each half until the end of FY21 to offset the impact of dividends on capital buffers. The broker reduces second half dividend forecasts for the banks but asserts, to some extent, the second half dividend is irrelevant.
Even with a conservative 50% pay-out continuing in FY21, and growing to 65% in FY22, ANZ, NAB and Westpac are trading on two-year gross yields of around 15%. In a low interest-rate environment this looks compelling.
Goldman Sachs cuts its assumptions for the pay-out ratios for the six retail banks and assumes all will increasingly use their DRPs at the upcoming results. The revised guidelines are considered constructive and should provide banks with more flexibility to resume paying dividends. The broker assesses, on revised forecasts, the sector still offers in excess of 6% 12-month forward yields, grossed up for the value of franking credits.
See also, APRA Delivers Some Welcome Relief To Banks on July 14, 2020.
