In May 2018 I wrote an article titled The most (and the least) profitable companies on the ASX200. The article was written in response to reading several pieces in the financial press, breathlessly describing the size of profits that the major banks had generated which created the impression that they were very profitable companies to own. Recently, Livewire got in touch and asked me to provide an update on that article.
While the absolute dollar value of profits the banks made in 2017 was large (around $15 billion), when divided by the number of shares outstanding, the earnings per share was not that impressive. Additionally, when compared to other listed companies, the bank’s profit margins and return on capital was not very impressive.

In looking back at the article written twelve months ago, I am going to both update these tables as to the most and least efficient companies on the ASX200 as of May 2019 and see how the picks from 2018 have performed over the past year.

In the 2018 piece on profits, we suggested that growth in earnings per share, Return on Capital Employed (ROCE) and change in profit margins were a better indicator than some absolute profit figure of how efficient a company’s management team is in generating their annual profits. Over the past year all of these profit metrics have turned south for Australia’s banks due to a combination of slowing demand for credit and remediation and compliance costs stemming from the 2018 Royal Commission.

Return on capital employed (ROCE) – what are currently the companies with best ROCE metrics? And what is the worst?

Return on Capital Employed (ROCE) looks at the profit generated both by the capital that the equity holders have contributed to establish the business, as well as the debt taken on to support the business’ activities. Companies with high ROCE typically require little in the way of equity to keep the business running and little need to borrow from their bankers.

The list of the top performers is largely unchanged over the past 12 months, with milk company A2M leading the pack, which includes fund managers Magellan and Perpetual as well as medical device company Cochlear. New additions for 2019 are the miners Iluka and Rio Tinto, courtesy of surging commodity prices. However miners typically appear only occasionally on the list of the top companies on this measure due to the vast amounts of capital required by mining operations.

Similarly, the list of the bottom performers in terms of return on capital employed is similar to that from 2018 comprising businesses that require both large amounts of initial capital to start the business and regular capital expenditure to maintain the quality of their assets and finance their ongoing activities. This subset includes a logistics company (Qube), retailer (Myer), toll road owner (Transurban) and an energy company (Origin). Grain handler GrainCorp and generic drug manufacturer Mayne Pharma make this list due to falling profits, though GrainCorp also has a substantial capital base.

Profit margins – what companies generate the best margins? And which present poor margins?

Profit margin is calculated by dividing after-tax profits by revenues. It measures the percentage of each dollar received by a company that results in profit to shareholders. Typically, low margin businesses operate in highly competitive mature industries or in industries such as retail and construction where the revenues can be large, and the company is only looking to make a small profit on each dollar of revenue.

The list of the top performers is similar to that from 2018, headed by diversified financials Magellan, Perpetual, ASX, Netwealth and Pendal. The dominance of financial companies and in particular, fund managers on the list of companies ranked by profit margin is due to the operating leverage that a fund manager enjoys once a certain amount of funds covers their fixed costs. After a certain level of funds under management, a significant percentage of each additional dollar of revenue from asset-based fees becomes profit for a fund manager.

The emergence of miners such as Rio Tinto on 2019’s list of companies ranked by profit margins is due to the surge in commodity prices, in particular, iron ore. In Rio Tinto’s case, it is very profitable to sell a tonne of iron ore at US$100/tonne when the cash cost to extract this tonne is around US$14.

Low-profit margin companies characteristically receive large revenues but operate in intensely competitive industries such as petrol retailing (Caltex), grocery retailing (Coles), department store (Myer), telecommunications (Vocus) and construction (Lend Lease and Fletcher Building). Companies with low-profit margins have to keep a very close eye on changes to their profit margins as a 1% change to Myer’s profit margin could have a fatal impact on their business, whereas a 5% change in Magellan’s profit margin may see minimal changes at the global fund manager.

How did 2018’s crop fare?

Over the past 12 months, the average return for the top and bottom companies as measured by ROCE in May 2018 was around 15% – close to 3% above the ASX200. The bottom performers were dragged up by a solid performance from Myer (+51%), Santos (26%) and Qube (+25%). In the top-ranked companies in 2018 by ROCE a2M Milk (+50%) and Magellan (+95%) were dragged down by Flight Centre (-27%) and Pendal (-17%).

Over the past 12 months, the average return for the companies with the highest profit margins in May 2018 was stellar +21%, close to double the ASX 200’s return of 12% and ahead of those companies with the lowest profit margins that returned a surprising 11%. In the high-profit margin companies from May 2018 Magellan (+96%), BHP (+25%) and the ASX (+31%) continued to climb. The low-profit margin companies generally recorded pedestrian performance, though the average was dragged up by a successful spin-off from Wesfarmers (+24%) and bettering very low expectations from Myer (51%).

What companies have both great ROCE and profit margins? And which should investors avoid?

Companies with very strong returns on capital also tend to enjoy solid profit margins, indicating that the company has a franchise or a moat that reduces the impact of competition and allows it to charge a premium price for its product. For example, Cochlear’s hearing implants, REA’s dominance in online real estate sales and a2 Milk’s more easily digestible dairy products.

Conversely, a number of the low return on capital companies also have low-profit margins, something that reflects the intense competition and lack of pricing power in areas such as retail (Myer), energy (Origin) and generic pharmaceuticals (Mayne Pharma). However, from the above table on the right, you can see that several infrastructure companies stand out as having a low return on capital companies but high-profit margins. This occurs as a toll road concession or an airport have a very large upfront capital cost, but the ongoing costs to manage these assets and collect revenue is quite low.

This piece originally was published by Livewire Markets: This year’s most (and least) profitable companies

Our Take

When buying a business or indeed a share of a business that is traded ASX, the ideal company to own is one that has high returns on capital, has a sustainable competitive advantage, low to no debt and generates capital internally to grow the business. In constructing our portfolios, we deliberately avoid companies with low returns on capital and low-profit margins. These two factors tend to offer little in the way of a “margin for error” and often result in dilutive equity raisings from shareholders to steady the ship when business conditions change for the worse. Historical companies with these double negative characteristics included Gunns and Arrium, both of which ended up in administration after several painful capital raisings.

On Monday Commonwealth Bank released their quarterly results. This concluded the May banks reporting season in which NAB, ANZ and Westpac revealed their profits for the six months ending March 2019. The revelations of the Royal Commission on Financial Services have resulted in extensive remediation provisions, increased compliance costs and a spike in legal fees, at a time where credit growth has slowed dramatically. This unusual set of circumstances has generated a complicated set of financial results to analyse; a task made harder still by Commonwealth, ANZ and Westpac all divesting divisions.

In this week’s piece, we are going to look at the themes that can be gleaned from the approximately 800 pages of financial results released over the past 14 days by the financial institutions that grease the wheels of the Australian capitalism and award gold stars based on performance over the past six months.

Remediation

Customer remediation was a key theme for the results in 2019, with banks compensating customers or taking provisions related to financial advice, banking, insurance and consumer credit. Australia’s banks have taken remediation provisions over the past 12 months of between $900M (ANZ) and $1.4b (Westpac), with NAB and Commonwealth around the $1.1b mark. ANZ’s lower level of provisioning does not reflect any lack of prudence, but rather its historically low level of exposure to financial advice and funds management. 

No star is given. The fact that the banks have made these provisions is bad for both customers and shareholders. 
 

Profit growth?

Across the banking sector profit growth reflected the anaemic credit growth in the overall Australian economy, with a combined 2% profit growth reported for the four majors. Westpac profits went backwards in a result characterised by remediation and restricting charges. The weakness in overall volumes was attributed to a combination of consumers being reluctant to borrow in a falling market, and tighter lending standards being adopted during the Royal Commission. ANZ Bank grew cash profits by 2% courtesy of a very strong performance by their institutional bank. However earnings per share for ANZ were higher due to a $3 billion on-market share buy-back

 Gold Star

Dividends

Unsurprisingly given the level of remediation provisions and political scrutiny, no bank grew their dividend per share in 2019, though NAB did cut theirs by 16 cents to $0.83. This cut did not spark much of a reaction from the market as NAB had been paying out close to 100% of cash earnings after remediation charges in 2018.  This was unsustainable as a bank needs to retain some earnings to grow their capital base and thus, their ability to lend to customers. Westpac maintained their dividend, but introduced a 1.5% discount on their dividend reinvestment plan, a move designed to raise capital. Interestingly, Westpac also brought forward its interim dividend payment date by nine days to June 24 2019. This move gives Westpac’s investors three dividends in the 2019 financial year, with payments in July 2018 and December 2018 as well as this one in June 2019.  Atlas interpret this as a move to designed to beat Labor’s changes to franking credits.

         Gold Star

Bad debts

One of the biggest drivers of earnings growth over the last few years 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 and that the outstanding loan amount is greater than the collateral eventually recovered. Bad debts remained low in 2019, with the housing banks Westpac and Commonwealth reporting the lowest level of bad debts despite a cooling in the East Coast property market.

Furthermore, at the big end of town, there were no major corporate collapses over the past six months, keeping corporate bad debts low. ANZ, NAB and Commonwealth reported a marginal increase in bad debts, albeit at levels that are around half of the long-term average (excluding 1991) of 0.3% of gross loans and acceptances. Westpac reported unusually low bad debts at a mere 0.09% of loans, though this low bad debt charge was boosted by a release of provisions previously taken on loans made by their business bank.

           Gold Star
 

Keeping it simple

The main new theme to emerge from this reporting season was that banks are looking to reduce their footprint on the Australian financial services landscape by divesting businesses that are deemed to be non-core or are in areas that have the potential to damage the reputation of the bank’s core lending business. Over the last year, Commonwealth Bank has sold their insurance and funds management business, ANZ Bank has sold their wealth business to IOOF – though this may come back due to ongoing issues at IOOF – and in March Westpac announced that they are exiting personal financial advice. NAB also announced plans to sell MLC wealth management by 2019.

These moves can be seen as acknowledging that the costly exercise of creating vertically integrated financial supermarkets was a mistake. While some of the moves to sell these carefully constructed divisions may be attributed to the events of the Royal Commission, some of the sales were consummated well before the titans of Australian finance faced the harsh light of the witness stand.

No Star Given – ultimately a flawed strategy
 

Interest Margins

The banks’ net interest margins [(Interest Received – Interest Paid) divided by Average Invested Assets] in aggregate decreased slightly in 2019. The decrease was attributed to increased competition and customer remediation charges. However, these pressures were offset by pricing mortgages upwards and, as many retirees will be aware, reducing the interest rate being paid on deposits. Looking forward, the bank’s interest margins are likely to be fairly healthy as their funding costs have continued to decline over 2019. Funding cost refers to the overall interest rate paid by the banks to source the funds that are used for short-term and long-term loans to their borrowers. Westpac reported the highest net interest rate margin in May 2019, which reflects both their greater focus on mortgages (which attract a higher margin than business loans) and the impact of higher pricing on those loans.

Gold Star

New Zealand

Late in 2018, the RBNZ released a consultation paper on bank capital requirements, essentially saying that they would like the banks that lend to New Zealanders   maintain a Tier 1 Capital level of 16%, with a decision to be made in September 2019. The Australian Prudential Regulation Authority (APRA)’s standard is 10.5%. New Zealand is a strange market globally as it is both a significant capital importer and also 88% of its lending comes from foreign-domiciled banks (mainly the Big 4 Australian banks). 
The RBNZ consultation paper is based on the naïve assumption that the banks would do nothing in response to this additional capital requirements, and that Australian shareholders would blithely fund New Zealand’s aspirations to be the best-capitalised banking system in the world. Under current NZ mortgage prices and assuming higher capital requirements, the banks would be writing mortgages in New Zealand giving returns below their cost of equity: an untenable position.

If implemented this would require each of the Big 4 Australian banks to move ~ $3B in capital to New Zealand. ANZ, as the biggest bank in NZ, would need the greatest amount, but it is also the bank with the largest excess capital position post asset sales in 2017. ANZ’s management said that if these capital controls were implemented, the bank would likely ration credit going into NZ and reprice NZ loans upwards to account for the higher capital charge.  On Friday afternoon ANZ share price was impacted as the RBNZ hit back questioning the capital models ANZ is using in New Zealand.

Our take

How to approach investing in Australian banks is one of the major questions facing both institutional and retail investors alike. We expect the banks to deliver around 3-5% earnings growth as they face low credit growth, increased regulatory scrutiny, and the sale of some of their insurance and wealth management divisions, though there are significant cost-out opportunities from rationalising their 1,000 branch networks around Australia.

However, if investors examine 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, their share prices are likely to see support over the next 12 months as the issues raised in the Royal Commission are addressed. Additionally, Commonwealth Bank and ANZ are likely to offer share buybacks, as the proceeds from the sales of non-core assets come through. 

• The S&P/ASX 200 A-REIT index had a weak month in April falling by -2.6%, the sector’s first fall since November 2018. Given the Listed Propery sector’s very strong performance in 2019 it is not surprising to see the sector take a step back.
• The Atlas High Income Property Fund declined by -1.2% in April with weakness in domestic retail landlords being offset by gains in Unibal-Rodamco-Westfield. In weak markets such as we saw this month; the Fund’s risk management strategies acted in-line with expectations and reduced volatility.

Go to Monthly Newsletters for a more detailed discussion of the listed property market and the fund’s strategy going into 2019.