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On Monday this week, Westpac ruled off the 2018 financial year-end profit results for the Australian banks. In the words of Queen Elizabeth, 2018 could only be described as an annus horribilis for Australian banks and their investors. In addition to the CEO of one major bank losing his job, the revelations of the Royal Commission on Financial Services resulted in remediation provisions and a spike in legal fees (which should see new sports cars and beach houses at Palm Beach being left by Santa for sections of the legal community this Christmas). Numerous fines have also been levied on financial institutions, and credit growth has slowed. These factors have combined to create an environment of fear that has weighed on bank share prices.

In this piece, we are going to look at the common themes emerging from the banks in the October 2018 reporting season. We will differentiate between the major trading banks and hand out our reporting season awards to the financial intermediaries that grease the wheels of Australian capitalism.

 

Scaling back the empire

The main theme from 2018 was the banks breaking down the allfinanz model that they have carefully built up over the past 30 years. Allfinanz or bancassurance refers to the business model where one financial organization combines banking, insurance and financial services (such as financial planning) to provide a financial supermarket for their customers. This model is based on the somewhat false assumption that the bank’s employees can efficiently cross-sell different financial products to their existing customers at a lower cost than if this was done by separate financial institutions. Operating in this way obviously creates some of the conflicts of interest that have been on display at the Royal Commission over the past eight months.

Over the past year, we have seen Commonwealth Bank sell their life insurance business to AIA as well as their asset management business a week ago to Mitsubishi UFJ for a very solid price. Similarly, over the past year ANZ have exited both their wealth management and life insurance businesses. NAB also announced plans to sell MLC wealth management by 2019. Additionally, Westpac has continued to reduce its stake in BT Investment Management (now renamed as the Pendal Group). These moves can be seen as acknowledging that the costly exercise of creating vertically integrated financial supermarkets was a mistake. They might also have been motivated by concerns as to what recommendations the Royal Commission is likely to make in 2019.  If adverse rulings are made on vertical integration in the Royal Commission’s Final Report, most of the banks have already made moves to simplify their businesses, so shareholders won’t be exposed to significant “fire sales” of assets by motivated sellers.

Profit growth

Across the sector, profit growth was quite subdued in 2018 as the banks grappled with slowing credit growth, the application of tighter lending standards, customer remediation, and additional legal costs stemming from the Royal Commission. The above Banks Scorecard looks at the growth in cash earnings inclusive of these costs. Whilst many companies encourage investors to look through these charges, ultimately they are real costs that impact the profits available to shareholders. In aggregate the four banks have set aside $1.3 billion to cover customer remediation.

Westpac reported the strongest cash earnings as a result of keeping costs under control, very low bad debts, and a lower level of customer remediation charges. NAB brought up the rear due to both $755 million in restructuring costs and $435 million in customer remediation charges.

 

 

Gold Star

Bad debts

A big feature of the 2018 results for the banks has been the ongoing decline in bad debts. Falling bad debts boost bank profitability, as loans are priced assuming that a certain percentage of borrowers will be unable to repay. Additionally, declining bad debt charges year on year create the impression of profit growth even in a situation where a bank writes the same amount of loans at the same margin. Bad debts fell further in 2018, as some previously stressed or non-performing loans were paid off or returned to making interest payments. The principal factors causing this fall have been the low unemployment rate and a near absence of major corporate collapses over the past 12 months.

Westpac and Commonwealth Bank both get the gold stars with very small impairment charges courtesy of their higher weight to housing loans in their loan book. Historically home loans attract the lowest level of defaults.

 

 

 

Gold Stars

Shareholder Returns

Across the sector dividend growth has essentially stopped, with CBA providing the only increase of two cents over 2017. It would be imprudent for the banks to raise dividends in an environment where loan growth is slowing, provisions are rising, and the management teams of the banks are regularly appearing either in front of the Royal Commission or before our political masters in Canberra.

In 2018 dividends were maintained across the banks, which was a surprise in the case of NAB, as we expected a dividend cut. In 2018 NAB paid $1.98 in dividends on diluted cash earnings per share of only $2.02; a very high payout ratio and not a sustainable situation given that the bank’s capital ratio is below the APRA target of 10.5%.

Looking ahead, dividends growth is likely to be subdued in 2019 as the banks digest the outcome from the Royal Commission. ANZ and CBA shareholders can expect capital returns in the form of share buy-backs to offset the dilution from asset sales. In 2018 ANZ have bought back $1.9 billion of their own stock, with an additional $1.1 billion to be bought back over the next six months. The major Australian banks in aggregate are currently sitting on a grossed-up yield (including franking credits) of 9.4%, quite an attractive alternative to term deposits.

 

                       

Gold Star

Interest Margins

The banks’ net interest margins [(Interest Received – Interest Paid) divided by Average Invested Assets] in aggregate declined in 2018, reflecting higher wholesale funding costs and borrowers switching from interest only (which attracts a higher rate) to principal and interest mortgages. This switching was done in response to regulator concerns about an overheated residential property market and in particular the growth in interest-only loans to property investors. Looking ahead in 2019 margins should recover courtesy of a rate rise of around 0.15% announced in mid-September. In September all the banks put through a similar rate rise with the exception of NAB, and it will be interesting to see whether NAB increases its market share as a result of this or follows suit at a later date.

 

 

 

Gold Star

 

Total Returns

In 2018 all the banks have delivered negative absolute returns, also trailing the ASX 200 which eked out a small gain of 0.24%. The uncertainty around the outcomes from the Royal Commission, rising compliance costs, and slowing credit growth has weighed on their share prices. Westpac has been the worst performing bank, mainly due to concerns raised earlier in the year about the bank’s lending standards in their $400 billion mortgage book, though we are yet to see any evidence in the form of rising bad debts to back up these claims.

No stars given

Our View

Whilst it is hard to be a bank investor at the moment and some fund managers are advocating avoiding them all together, our view is that at current prices investors are being paid an attractive dividend yield to own solid businesses that have a long history of finding ways to grow earnings and navigate political minefields. Looking at the wider Australian market, the banks look relatively cheap, are well capitalised, and – unlike other income stocks such as Telstra – should have little difficulty in maintaining their high fully franked dividends. Additionally, the share prices of ANZ and the Commonwealth Bank will see the benefit from share buybacks, as the proceeds from the sales of non-core assets are received.  The key bank overweight positions in the Maxim Atlas Core Equity Portfolio are Westpac, ANZ and Macquarie Bank.

We are generally pretty sceptical about new IPOs (initial public offerings). Occasionally, however, a great IPO comes along, either for a long-term investment or one with a high probability of making a short-term gain on its opening day, so it is always worthwhile to run the ruler over companies about to list on the ASX.

In this week’s piece we are going to look at the seven key questions we ask when assessing an IPO and apply them to Coronado Global Resources (ASX: CRN). Coronado’s prospectus was one of the largest that I have ever seen – close to 700 pages – perhaps reflecting what is likely to be the biggest IPO in 2018 with an expected market capitalisation of between $3-4 billion.

When analyzing IPOs few have been more eloquent on this subject that Benjamin Graham, the father of Value Investing.

“Our recommendation is that all investors should be wary of new issues – which usually mean, simply, that these should be subjected to careful examination and unusually severe tests before they are purchased. There are two reasons for this double caveat. The first is that new issues have special salesmanship behind them, which calls therefore for a special degree of sales resistance. The second is that most new issues are sold under ‘favorable market conditions’ – which means favorable for the sellers and consequently less favorable for the buyer”  (The Intelligent Investor 1949 edition, p.80)

History

Coronado was founded in 2011 by private equity group EMG and since then they have spent US$1.2 billion acquiring 4 producing coal mines located in Queensland, and in Virginia and West Virginia in the US. This places Coronado as the 5th largest metallurgical coal producer globally with annual coal production of around 20 million tonnes (of which 75% is metallurgical coal and 25% thermal coal). In terms of profit, in 2017 60% came from the Curragh coal mine in Queensland and 34% from the Buchanan mine in Virginia.

Can the business be readily understood?

Yes, as a miner Coronado essentially digs coal out of the ground and sells the coal predominately to steel mills in Northern Asia and the US. The thermal coal produced by Coronado is sold to the Stanwell power station in Queensland under a long-term contract.

Whilst coal is a dirty word globally – mainly in conjunction with power generation – 75% of Coronado production is metallurgical or coking coal, which is used in the smelting of iron ore to make steel. This is high-quality coal (commanding a higher price) that low is in ash, sulphur and phosphorous and will burn at a very high temperature (1,300C in a blast furnace). Metallurgical coal is necessary for the production of steel, both as a source of carbon and as a means of heating the iron ore to around 1,300C. By contrast, thermal coal can’t be used in steel production, due to both its high ash content and because it cannot be coked (a process to concentrate the carbon and reduce impurities by heating or cooking the met coal in an airless environment). Globally metallurgical coal is much scarcer that thermal coal and currently trades at twice the price of thermal coal per tonne.

How does the company make money?

Coronado digs the coal out of the ground at a cash cost of ~US$80/t (after royalties) and then sells it to steel mills in the US and Asia. Current prices per tonne of met coal are a little over US$200/t which makes this a profitable exercise.  However, in Australia, Coronado’s product is priced at a discount between 6-16% to the benchmark price due to higher imperfections. Additionally, Coronado is subject to two separate royalty payments from production out of its two biggest mines which will cap profits in the near future. This results in Coronado having weaker profit margins than competitors such as BHP Coal and Whitehaven.

The biggest factors determining the price for metallurgical coal have been spikes in Chinese demand fueled by the construction of new Chinese mills (2006-2010) and pollution controls in China (2016-2018). During these periods Coronado’s coal mines have been very profitable, however, the below chart showing the metallurgical coal price over the past 10 years demonstrates that prices have been quite volatile. Over the past few years, metallurgical coal has risen from US$80/t in early 2016 to around US$200/t, leading to perceptions that the price is vulnerable to a fall if demand for steel weakens. Arguably current high prices above US$200/t for metallurgical coal encouraged Wesfarmers to sell the Curragh mine to Coronado earlier this year for A$700M (or at a multiple of only 1.5 times current annual profit).

Why is the vendor selling?

The motivation behind the IPO is one of the first things to look at. Historically investors tend to do well where the IPO is a spin-off from a large company exiting a line of business, or when the vendors are using the proceeds to expand their business. Coronado is a little bit different from most IPOs – which typically see the vendors seeking to exit as much of their investment as possible – in that post the IPO 80% of the company will be retained by the vendors. This is an unusually high proportion to hold onto, as prospective investor usually likes to see the private equity owners retain a stake in the business on listing between 20-30%.

Whilst the owners floating a company may want to sell out completely, an effect of the 2009 Myer IPO – which saw the department store’s private equity owners sell their entire holding – is that new investors are unlikely to accept a full exit without a substantially lower price (in terms of profit multiples). However, seeing private equity owners retaining an ownership stake after the float is no guarantee that the IPO will be a sure-fire winner; the vendors of Dick Smith retained a 20% stake on the listing which was sold down 9 months later. Within three years of the float, Dick Smith went into administration.

The issue with an 80% stake being held by EMG is that the market will perceive this to be an overhang that may depress the CRN share price following listing. This 80% stake is subject to voluntary escrow. Coronado’s owners expect to raise around A$774 million. Of this around $600M will be used to repay debt and pay the costs of the IPO with the sellers banking around $110 million.

Is the business profitable?

Yes: rising coal prices in 2017 saw Coronado’s net profit after tax move from -US$9 million loss to US$282 million profit in 2017 with a similar amount expected in 2018, before a big jump to US$400 million in 2019. However, this is very dependent on the coal price; for instance, a 10% change in the coal price would move 2019 EBITDA by either plus or minus US$200 million. The coal price is highly volatile, despite current very high prices, driven by expansion in the Chinese steel-making industry and demands for high-quality Australian coal over lower quality domestic Chinese coal to reduce pollution. During 2011-2016 the coal price fell dramatically, which saw Coronado’s US mines move to break-even at the EBITDA line (Earnings before interest tax depreciation and amortisation) and the glitzy Curragh mine’s EBITDA decline to US$61 million (2018 EBITDA $360 Million).

Financial stability?

Coronado is expected to have net debt of only around 0.5x EBITDA in 2019, which will equate to an interesting cover of around 14x – two very strong debt metrics. This reflects a $500M reduction in debt as part of the IPO. However, we see that this is a business that cannot handle too much debt, due to the volatility in pricing of its product, of which Coronado is a price taker.

How attractive is the price?

A decision to invest in Coronado should be based on your outlook for met coal prices. If current prices are maintained Coronado will trade on an EV/EBITDA multiple of around 4x, and based on the company’s stated pay-out ratio of 100% free cash flow this results in a dividend yield between 10-12%!  Whilst this looks sensational, there are questions about its sustainability. Comparable coal stock Whitehaven Coal is currently trading on 5x EV/EBITDA multiple and a 6% yield with no debt. Globally coal companies are trading on an EV/EBITDA multiple of 4.5x, a very cheap multiple that indicates that the market does not believe that current high prices for coal will be sustained.

Our take

Using a conservative coal price of around US$150/t, our modelling indicates that Coronado’s free cash flow will drop from around $400M today to around $180M, which would place Coronado on a yield of 5%, i.e. solid but unspectacular.

Whilst we are comforted by vendor EMG retaining an 80% holding, we are concerned about buying into a recently put together company trading at peak earnings, especially when the previous owners of major assets that make up Coronado’s portfolio were happy to sell at lower prices.

We will be passing up Coronado due to this concern and our inability to predict the metallurgical coal price in the near future.  Additionally, with the last line of Ben Graham’s quote from above on IPO’s in mind, given the movement in the coal price over the past few years, it is hard not to take the view that October 2018 may represent a very favourable time for Coronado’s owners to be selling shares to Australian investors.