It is no surprise that the market gave the thumbs up to ANZ’’s first half profit result on Tuesday. The result was workmanlike, showed ANZ was making solid progress on its key focus areas and comes after a period of relative share market under-performance. ANZ closed yesterday at $27.52, up 2.5% since Tuesday.

But CEO Shayne Elliott was nonetheless quite downbeat when discussing ANZ’s prospects at the investor call. While Shayne is probably a “glass half empty” sort of guy and naturally cautious, he certainly painted a reasonably bearish picture of ANZ’s revenue trajectory. The wash-up from the Royal Commission, including tighter credit standards, a softening property market and high levels of household debt will make it very difficult to grow revenue from ANZ’s core Australian retail and business banking franchise. Add to this some pressure on the net interest margin due to the increase in short term wholesale funding costs, and the ANZ revenue picture looks a bit bleak.

So, with limited prospects for meaningful revenue growth, ANZ remains a business simplification and cost cutting story. The question is – can ANZ continue to cut costs and “shrink to greatness”, and what does this mean for shareholder returns?

Let me attempt to answer these questions by starting with a review of the highlights of their half year report.

Highlights

Cash profit after tax for the half (H118) from continuing operations of $3,493m was 4.1% higher than the corresponding half in FY17 (H117) and 1.1% higher than the last half (H217). Adjusting for a big fall in credit impairment (bad debt) charges, which fell from $720m in H117 to just $408m in H118, cash profit before credit impairment and tax fell by 1.7%.

A fall in group revenue of 3.8% was caused by a material fall in markets trading income in the Institutional Bank and the impact of the Government’s bank levy, and masked a solid performance from the Australian Retail Bank and New Zealand, where revenues grew by 9.3% and 5.7% respectively.

ANZ largely delivered on its commitment for a fall in operating costs on an absolute basis, which includes restructuring charges. Costs in the first half were 0.2% lower than 2H17 costs and 0.2% higher than 1H17 costs. The Bank shed 914 employees from continuing operations in the first half (mostly in the second quarter), taking its workforce at 31 March to 39,540 staff.

Another highlight was that although investment spending rose, the capitalised software balance fell. ANZ is investing more, capitalising less, and doing this while absolute costs fall.

Notwithstanding the costs of the Royal Commission, ANZ CFO Michelle Jablko suggested that further falls in absolute costs could be expected at least into 1H19.

ANZ’s capital position, as measured by its CET1 ratio, sits at a very healthy 11.0%, well above APRA’s new “unquestionably strong” target of 10.5%. It will rise further to around 11.8% (on a proforma basis) when the divestment of its life insurance and other wealth management business is completed.

A dividend increase?

ANZ is currently undertaking an on-market share buyback, with $1.1bn of shares purchased out of an approved plan of $1.5bn. But with its CET1 ratio set to rise well above what is required, further capital management actions are in prospect.

One option would be for ANZ to increase its dividend, currently running at $1.60 pa fully franked (the interim and final are 80c each). However, this is unlikely for two reasons. Firstly, ANZ’s current policy is to target a full year payout ratio of 60 to 65% of cash profit. This half’s dividend of 80c represents a payout ratio of 66%, and with revenue growth flat, ANZ will be stretched to grow earnings per share. The other reason is that ANZ has no excess franking capacity. A special unfranked dividend is a possibility, but an increase to the ordinary franked dividend is unlikely.

A more likely action will be for ANZ to conduct further on-market buybacks later in 2018 and 2019 and then cancel the shares. This will help to increase earnings per share, potentially allowing the company to marginally increase the ordinary dividend in future years.

What do the Brokers’ say?

According to FN Arena, the major brokers expect revenue growth for ANZ to be very subdued. They like the focus on cost reduction and expect further capital management actions.

Following the result, two of the major brokers reduced their targets, with UBS reducing its target price from $29.00 to $28.00 and Credit Suisse from $31.00 to $28.50. On the other side, Citi raised its target from $30.00 to $31.50 and Morgan Stanley from $28.90 to $29.00.

Of the 8 brokers sampled, there are 4 buy recommendations and 4 neutral recommendations. The consensus target price is $29.59, 7.5% higher than yesterday’s closing price of $27.52.   

                                                                Major Broker Recommendations (source: FN Arena)

My view

I like ANZ because it is arguably the most ‘boring’ of the major banks. With its divestments largely complete, it is now an Australasian business and retail bank. Asia is gone or going, the institutional bank has been peeled back, risk weighted asserts have been cut and divestment of its wealth management businesses is nearing completion. Of the major banks, it has the strongest commitment to cutting costs.

But, ANZ is going to be revenue challenged and will not shoot the lights out. In some ways, it looks set to become “boring but safe” – almost an annuity style of investment.

The two obvious risks to this assessment are the Royal Commission and an increase in bad debts. With interest rates staying low and unemployment at manageable levels, I can’t see the latter blowing out too much in the medium term. And remember, the ANZ has done a lot to de-risk the lending book by jettisoning lower quality assets.

In regard to the Royal Commission, this remains the great imponderable. But you have to buy when others want to sell, and while this may not be the bottom for the ANZ, my sense is that these levels will prove to be good buying.