Investment Matters

Mundane matters, and a gripe

Investment Matters are sometimes a little mundane in nature.  We do try to discuss the more interesting stories week.  However, this week there are two matters of note – both of which are important in the context of their timing and impact.   And we finish off this week with a short, but nonetheless important, gripe.

1.  Accounting changes

Reporting season – the financial wrap up of the FY-17 year for those companies with financial year end 30-June – is almost upon us.  And there is an accounting change coming that is expected to shake things up a little this time around.

What is the change

It is in relation to leases, for example, when a retailer takes a long term lease commitment for a store, or a company commits to a long term lease of a piece of equipment.

Currently, such leases are really only considered in financial statements as notes at the back of the report. Changes to accounting standards are going to transform this, by adding them as a liability in companies’ balance sheets.

Why?

The motivation for the change lies in firstly making financial statements (in particular balance sheets) more appropriately represent the commitments, or in effect the liabilities, a company has.

Secondly, it allows:

i. for more accurate comparative analysis, e.g. between the liabilities companies in a particular sector have, including all their future commitments, and

ii. better trend analysis, e.g. whether the future commitments of a company are increasing or decreasing.

Ramifications for this reporting season

Technically nothing has changed about the company.  It would be surprising if lenders to companies had not already accounted for lease commitments in the judgement they have made about a company’s ability to borrow.   However, there may be occurrences whereby covenants need to be reset to reflect the fact that leases are now formally included in gearing calculation (depending on the minutiae in debt contracts).

However, the change in accounting standard may make it more apparent to some what the total effective gearing of a company is (including not just debt but also lease commitments).  Thus it may change or even surprise some in regards to the risk that some investments represent.  From this perspective, there might be some ramifications.

Two key metrics monitored by investors will also be impacted: EBITDA (earnings before interest, tax, depreciation and amoritisation) and EBIT (earnings before interest, tax and depreciation).  Lease costs will now flow through as an interest expense, rather than an operating cost.  Thus there will likely be restatement of these figures for FY-16, so that apple-for-apples comparisons can be made.

Most equity analysts are aware of the lease commitments that a company has.  There should not be any significant changes in valuations caused directly by this accounting change.

2.  Making banks unquestionably strong

The announcement

The much anticipated (in financial circles anyway) announcement from Australia’s banking regulator – making banks "unquestionable strong" – was released this week.

This announcement is the next step in the many regulatory reforms globally, and in Australia, in response to the GFC.

The core of APRA’s announcement this week is a requirement that the big 4 banks have "CET1" capital ratio of at least 10.5% by Jan-20.   Capital, which includes shareholder equity, is essentially a buffer that a bank has against loan losses.

The impact

Overall, the impact won’t have as large an impact as some feared.  It is anticipated that the big 4 banks will be able to meet the new requirement through retained earnings, DRPs (dividend reinvestment plans), and asset sales (in the case of ANZ particularly).

Smaller players, including Suncorp, welcomed the announcement because increased capital requirements on the big 4 act to level the competitive field.  The smaller banks aren’t required to meet the new target because they don’t use complex internal models to assess risk.

Not the end of the matter

The announcement this week is just the next step in the regulatory capital requirement escalator.  Later this year, a ruling in relation to risk weightings is expected – specifically targeting the internal risk models the big 4 use.  Therefore no champagne yet, particularly for the CBA (the most exposed to residential lending).

Bigger picture

Since the GFC, the tier one capital requirements of the banks have increased markedly.  The pre GFC Tier 1 levels were CBA  7.14% (30-Jun-07), ANZ 6.7% (31-Mar-07), NAB 7.33% (31-Mar-07), and Westpac 6.5% (31-Mar-07).

Although this is only a small percentage increase, it does translate to a large increase in dollar terms (many billions).

It is interesting to reflect on what this should mean for shareholders, versus what has actually happened.

The increase in capital means lower gearing and lower returns for shareholders, all else being equal.  Lower earnings should mean a lower P/E.  But as been shown by the following graphs, in fact investors are actually paying more for less earnings.

Additionally, lower growth assumptions should be made – as credit growth slows.  This wouldn’t necessarily have a material impact on P/E (as it only looks one year out), but would impact NPV based valuations.

Instead, what we are seeing is what we have been seeing across equity markets, along with other asset classes.  Lower bond rates and cost of debt have flowed through into lower discount rates (see IM last week), which in turn has pushed up valuations.

Risk levels

There is another bank-specific driver which is likely to have contributed to what we are seeing regarding bank valuations.  A reference to ‘all else being equal’ was made above.  Well as we all know all else is never equal.   Technically risks should have decreased as a result of the requirement to hold additional capital. 

However, it could be argued that the additional capital requirements, along with the macro prudential measures in relation to investment loans, have merely acted as a cap on risks blowing out, rather than to bring risk down.  That is, there has not been a significant reduction in the risk of the banks – especially for shareholders.

Firstly, the composition of banks’ lending has been changing.  Therefore, although capital requirements have been increasing, gearing has not been coming down.  See Investment Matters No 35 FY-17

Secondly, property prices have grown at an unsustainable rate (in relation to wages growth) since the GFC, and household debt levels are at an all time high.  This inherently creates risk in the property sector, which form the bulk of the big 4’s loans.

In this era of chasing yield and a world awash with central bank cash, the reward (i.e. return) from taking on board this risk is trumping the risk itself.  For the time being anyway.

Conclusion

The big-4 banks are required by APRA, not unexpectedly, to put away extra capital so that they have tier 1 capital of 10.5% by Jan-20.  Although this is a significant increase compared to levels held at the GFC, risks have continued to build in the residential property sector over that time.  Bank valuations have proven resilient (Teflon coated?) to these changes.  Additional changes to risk weightings, which will likely flow through to capital requirements, are expected later this year.

A gripe

This week a company we have followed for a few years conducted a capital raising.  The raising was to fully fund the move of a (very simple) development project into production. It will become a good looking company with time.

Given that the completion of this raising will essentially de-risk the project, it was remarkable to us that the raising (which was many times oversubscribed) was done at a 10% discount to the last traded share price.

When the stock resumed trading (after the dilutionary raise) it resulted in a share price increase of +20% (and therefore a return of +33% for those lucky enough to be granted part of the placement).

We see this sort of raising regularly, and it has become a bug-bear. 

Why are the existing shareholders (who have borne all the risk up to this point, with no dividends) being diluted by an issue at a discount, when it is clear the risk of the business will be dramatically lower after the raising?

No one can actually answer this question concisely, because it fails the kindergarten test. 

If capital markets want to have good reputations, it is up to those in control to think about these issues, and our experience is they don’t.  We will raise it every opportunity we get - if the Chairman’s club are going to be the ultimate beneficiaries when things finally start to pan out, it takes away the incentive for people to invest in early stage businesses.