Weathering the earnings growth storm

3 December 2018

Weathering the Australian storm

Bank earnings growth may rely on a new frontier of cost efficiency being achieved by the early 2020s.

Australian banks continue to endure many headwinds, some self-inflicted. Yet, the businesses manage to preserve a healthy level of cash flow generation and return on risk-weighted assets. This reflects the strength of industry pricing power and inertia in the customer base. Earnings growth, however, has been elusive for some time. We fear the headwinds are yet to subside and the big four1 banks have some hard yards ahead.

Earnings per share return

Source: Martin Currie Australia; FactSet; company reports; As of 30 September 2018. Shows average data for the big four banks

Investment and regulatory cost a drag on earnings

While there have been a range of reasons for this earnings growth slowdown – such as: slowing loan growth; asset sales; and rising capital levels – one of the key drags has been the need to continue to invest in systems; particularly supporting compliance. This regulatory cost is ongoing, especially given the recommendations expected from the banking royal commission.

Banks are looking for other savings

In order to offset these costs, many banks are now promising that they will deliver more automated decisioning and fulfilment, and a simplified product suite structure. As an example, NAB are promising to take its number of products from around 600 to just 300. This type of simplification should, in turn, allow the banks to operate more efficiently with fewer staff, less branches and, thus, less fixed costs.

But two interesting questions emerge from this trend. Do banks actually have the ability to execute on this plan; and will they be able to replace the lost revenue from legacy products with the simplified product range?

The outlook for bank earnings growth may therefore rely on a new frontier of cost efficiency being achieved by the early 2020s

Efficiency programs haven’t worked in the past, but this time might be different

Looking back at employee numbers and costs through the many different efficiency programs across the sector, it is clear that achieving a step-change in cost structure has been difficult.

The pitch this time around is that the technology and development tools available now are both cheaper and more flexible than ever before.

This should allow banks to adopt a ‘cloud first’ mentality and use application programming interfaces (APIs) to truly create a more streamlined cost base.

But fewer staff doesn’t necessarily mean cheaper operating costs

There seems a good chance banks will be able to operate with fewer staff going forward. However, a consequence of this is they are replaced with either higher-cost staff, or ongoing technology budgets that are hard to shake.

Fewer staff doesn’t mean cheaper

Source: Martin Currie Australia; FactSet; company reports; As of 30 September 2018. Shows average data for the big four banks

Strong execution will be required to weather the storm

Going forward, we continue to see the headwinds of ongoing investment costs impacting earnings growth in the near term. We believe the banking sector will need to demonstrate even stronger execution on its cost base transformation to justify a growth premium in its valuations.

On a positive note, the banks start with a very healthy capital base and are well progressed in this re-design phase. This should allow them to eventually respond, once the distractions from the banking royal commission pass, to more meaningful disruption by non-bank players, and leveraging the new systems they are putting in place.

Please refer to our recent article What next for Australian banks for more of our thoughts on digital disruption.

The information provided should not be considered a recommendation to purchase or sell any particular security. It should not be assumed that any of the security transactions discussed here were, or will prove to be, profitable.
1 ANZ, Westpac. NAB and Commonwealth Bank.

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