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The Inoculated Investor http://inoculatedinvestor.blogspot.com/ 
Analysis of Australian Bank Fundamentals
In their fifth annual international housing affordability surveybased on Q3 2008 data, researchers WendellCox of Demographia.com and Hugh Pavletich of Performance Urban Planning ranked 265 separatemarkets in Australia, New Zealand, Canada, Ireland, the UK and the US in terms of affordability. As has become painfully obvious, some of the largest housing bubbles have proliferated in the English speakingworld. However, the decline in prices has been much more acute in the US than in Australia (AU) and NewZealand (NZ), as evidenced by the index data I presented in my previous pieceon this subject. The risk of this ongoing discrepancy is as follows: if housing prices in AU and NZ are unsustainable then the bankswho lent money people to buy these overvalued houses could be in for some serious losses, similar to whathas happened in the US.So, what did Mr. Cox and Mr. Pavletich find in their survey? Using a scale in which 3.0 or less isaffordable, 4.1-5.0 is seriously unaffordable, and 5.1 and over is severely unaffordable, the researchersdetermined that 24 of the 64 severely unaffordable markets were in Australia. Additionally, 3 out of the 40seriously unaffordable markets were in Australia and no markets were deemed moderately unaffordable or affordable. Going through the list of the top 20 least affordable markets in the survey, 8 are located in AUwith the #1 spot belonging to the Sunshine Coast of Queensland (an amazing 9.8 ranking) and the #3 spotto the Gold Coast of Queensland (8.7 ranking). In fact, the median score for the Australian cities was a 6.0,versus 3.5 for Canada, 5.4 for Ireland, 5.7 for the UK and 3.2 for the US. Commenting on the AU housingmarkets the researchers conclude:“Unlike the other national markets in the
Survey¸
Australia has thus far been able to avoid materialhouse price declines. It seems likely that, sooner or later, the inherent instability andunsustainability that characterizes bubbles will lead to house price declines in Australia. However,were it possible for Australia to retain its highly over-valued house prices, there would still be asignificant cost. Future generations would pay far more for housing than in the past, andAustralia’s relative standard of living would decline.”Furthermore, the results for NZ are not a whole lot better. Out of the 8 total markets surveyed, 7 weredeemed severely unaffordable and 1 was noted as seriously unaffordable. As a result, the median rankingfor NZ was 5.7, just slightly below that of AU, although no markets were able to crack the dubious top 20least affordable markets. In comparison, the cities considered the most expensive in the mainland USalmost look like bargains in relation to some markets in the AU-NZ regions. The most expensive market inthe US was Honolulu (9.1), followed by San Francisco (8.0), San Jose, CA (7.4), San Luis Obispo, CA(7.3) and Los Angeles (7.2). Even notoriously expensive places to live such as New York (7.0) and London(6.9) look cheap compared to AU cities like Sydney (8.3).
Bank Valuation and Fundamentals
 Now, Cox and Pavletich do go on to discuss the reasons why these markets have become so unaffordableand the piece is actually very interesting for people who want to understand how housing bubbles develop.However, I want to turn my focus onto the banks themselves. So far in my two analyses I think I have donea reasonably good job of illustrating the magnitude of housing price increases in the AU-NZ region anddiscussing why some of these prices may not be sustainable. But the most important questions to try toanswer are what will be the ultimate effect on the banks of a fall in real estate prices and do their currentvaluations reflect the potential damage to their balance sheets?
 
The Inoculated Investor http://inoculatedinvestor.blogspot.com/ 
% Housing Loans
Australia & New Zealand Banking Group53.16%Bank of Queensland71.75%Commonwealth Bank of Australia58.76%Suncorp-Metway Ltd50.46% National Bank of Australia51.60%Bendigo-Adelaide Bank76.35%Westpac Banking Corp.57.82%Group Average59.99%Data from company filings and my calculations
I present the above chart (based on the most recent data available) to illustrate how exposed thesecompanies are to the seemingly irrationally exuberant housing markets in AU and NZ. What this data tellsme is that these banks will perform only as well or as poorly as the credit tied to housing loans. Therefore,the first thing I looked was the credit metrics of the banks. In tough times it is especially important to seethat banks have put aside the necessary reserves for potential loan losses and to evaluate the degree towhich credit quality has been deteriorating. At least up until the most recent data released by these seven banks, they appear to score well on both of those metrics.
NPLs5 Year Average NPLsAllowance forLossesAllowance/NPLsNCOs
Australia & New Zealand BankingGroup1.06%0.33%1.17%110.62%0.43%Bank of Queensland0.14%0.07%0.14%98.17%0.18%Commonwealth Bank of Australia0.60%0.17%0.79%131.83%0.11%Suncorp-Metway Ltd1.77%0.52%0.86%48.78%0.04% National Bank of Australia1.01%0.42%1.07%105.60%0.28%Bendigo-Adelaide Bank0.26%0.13%0.41%157.69%0.04%Westpac Banking Corp.0.73%0.30%0.91%125.58%0.12%Group Average0.80%0.28%0.77%111.18%0.17%Data from company filings and my calculations
It is obvious that the global recession and initial slide in housing prices have had some negative effects oncredit. Over the previous five years the average ratio of non-performing loans to total loans was only 28 basis points (bps). As a result of the recent turmoil that average has jumped to 80 bps, but is significantly below that of even some of the more conservative and credit worthy US banks. The only one that stands outis SUN with its 1.77% NPL ratio. This is up from .64% in June 2008 and is well above the average from the previous 5 years. This larger deterioration in credit may be why shares of SUN trade at a larger discount tohistorical multiples (see valuation chart below) than its competitors. On the other hand, Bank of Queensland (BOQ) looks to be the most conservative underwriter of the group as its current and historical NPLs ratios are the lowest. This may also account for why BOQ has the lowest average ROA and secondlowest average ROE over the last five years (see return chart below). Additionally, I am always dubious of a bank that does not have large enough reserves to cover net charge offs and BOQ fits that bill.However, by in large these banks are very conservatively reserved. These days it is rare to find a US bank with $1 of reserves for each $1 of NPL, a sign that the bank is proactively preparing for future losses.However, all the banks other than Suncorp-Metway (SUN) (which has very low net charge offs and has alarge insurance subsidiary that may influence the need for large reserves) are at or near 100% in terms of Allowance/NPLs. These robust allowances allow the banks to weather a storm of new NPLs withoutsuffering outsized effects on net income or the balance sheet (as provisions reduce equity and tangibleequity). When the June data comes out for the banks with fiscal years that end in June we will see theextent to which credit has deteriorated further. But, as of right now, aside from the relatively low allowance
 
The Inoculated Investor http://inoculatedinvestor.blogspot.com/ 
ratio for SUN and the comparatively high net charge off ratio for Australia & New Zealand Banking Corp.(ANZ) nothing about the credit metrics really stands out as problematic.
6/29/2009Price/EarningsPrice/TBVPrice/BVCurrent 5 Yr Average Current 5 Yr Average Current 5 Yr Average
Australia & New ZealandBanking Group12.66x13.24x1.44x2.78x1.28x2.33xBank of Queensland13.89x16.92x1.64x2.34x1.00x2.11xCommonwealth Bank of Australia11.28x14.98x2.64x3.61x1.93x2.45xSuncorp-Metway Ltd14.27x13.40x1.22x3.03x0.53x2.06x National Bank of Australia9.24x13.40x1.52x3.03x1.23x1.96xBendigo-Adelaide Bank13.82x17.37x1.59x2.35x0.72x2.21xWestpac Banking Corp.11.92x14.29x2.44x3.21x1.67x2.68xGroup Average12.44x14.80x1.78x2.91x1.19x2.27xData from Cap IQ and my calculations
This second chart compares the current valuations of the banks to their 5 year averages and to the groupaverages. Just about across the board and on every metric these banks are all trading at multiples belowtheir 5 year averages. Of course, based on what has happened in the global economy and stock markets, thisis not a surprise. Of note, while the banks are still trading well above tangible book value, the multipleshave contracted significantly as compared to the 5 year averages. The question going forward is whether or not these banks will have the loan book growth, EPS growth and returns on equity to justify trading at closeto a 3x TBV multiple (2.91x is the 5 year average for the group). In truth, solely based in relative andcomparative multiples, none of these valuations really stand out as being extremely over or undervalued.Based on these valuations two of the harder hit banks on a TBV basis are SUN and Bendigo-Adelaide(BEN) while it appears that Commonwealth Bank of Australia (CBA) has been spared to some extent. Thiscan also been seen in the chart below:
% Above 52 Week Low% Below 52 Week High
Australia & New Zealand Banking Group37.02%21.50%Bank of Queensland41.11%45.73%Commonwealth Bank of Australia61.96%22.19%Suncorp-Metway Ltd47.25%56.42% National Bank of Australia41.14%27.35%Bendigo-Adelaide Bank16.72%51.61%Westpac Banking Corp.37.36%20.31%Group Average40.37%35.01%Data from Google Finance and my calculations
While SUN has had a nice bounce off of its 52 week low, it still has suffered the largest fall from the high.BEN, on the other hand, experienced the most dramatic decline and has barely bounced off the bottom. Incontrast to the preceding two banks, shares of CBA have rallied substantially off their lows and are nowonly off their 52 week high by about 22%. Still, nothing about this chart is particularly outstanding as mostof the data is centered close to the mean.Accordingly, when valuations by themselves are not especially intriguing on the long or short side the nextstep is to look at the returns of these banks. On the long side investors should look for banks that havehistorically strong ROEs but are trading at reasonable multiples to BV and TBV. Conversely, on the shortside, bank bears should focus on companies with meager ROEs that are trading at growth-like multiples.
TTM ROE5 Year Avg. ROETTM ROA5 Year Avg. ROA1H 2009 NIM
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