One of the more influential business books is Tom Peter’s 1999 classic “The Circle of Innovation: You Can’t Shrink Your Way to Greatness”.  Shrinking is what the ANZ has been doing over the last few years as it abandoned its Asian foray, started to exit wealth management, and culled its institutional bank. It’s now largely an Australasian retail and commercial bank, which in addition provides transaction, markets, payments and trade services to institutional clients.

Last Thursday, the ANZ delivered its full year results for FY17. The headline number, a cash profit of $6.94bn, largely met consensus expectations. However, this came from a very material reduction in bad debt provisions, and the lack of revenue growth, together with questions about the sustainability of the profit, left the market a little underwhelmed.

So, can ANZ “shrink to greatness”?

The ANZ Strategy

The ANZ strategy is outlined in the slide below. Firstly, to be the best bank for people who want to buy a home or run a small business in Australia and New Zealand. Secondly, to be the best bank for businesses who trade and transact in the Asia Pacific.

Source: ANZ

Owning and operating banks in Asia, lending to corporates, mucking around in wealth management and using capital for other low return activities is gone.

This translates to a very clean and simpler looking bank, focused on areas it believes it can win. To drive growth, ANZ is developing a culture that emphasizes core purpose and fairness, and engenders an agile working methodology. It sees digital capability as a key enabler.

Supporting these initiatives is cost discipline to deliver absolute cost reduction and capital efficiency.  

Upsides and downsides

Highlights of the result included ANZ reaching APRA’s new capital target of being “unquestionably strong” more than two years ahead of schedule, continued neutralization of the dividend re-investment plan, a reduction in costs in absolute terms and above system growth in Australian mortgages and deposits.

On the capital side, ANZ’s Common Equity Tier 1 Ratio stood at 10.58% at the end of September. This will rise by another 0.65% in FY18 and 0.15% in FY19 from divestments already in train (Asian Retail, One Path etc). ANZ will be comfortably in excess of APRA’s target of 10.5%, meaning that it will be able to undertake capital management initiatives in FY18 and FY19. As ANZ doesn’t have a surplus of franking credits, these are most likely to take the form of on-market buybacks rather than through the payment of a special dividend or an off-market buyback.

The divestments of course come at a cost to the bottom line cash profit, leaving ANZ with a hole of $310m in FY18 to fill.

In absolute terms, costs fell from $10.44bn in FY16 to $9.49bn in FY17. Adjusting for large items, the fall was a more modest 1.4% or $140m as headcount fell from 46,554 to 44,896 people. Half on half, second half costs in aggregate were only 0.3% below the first half, although ANZ said that the fall in “business as usual” expenses was 2.5% and expenditure relating to change was up by 43.6%.

Revenue for the Group fell from $20.59bn in FY16 to $20.49bn in FY17. Half on half, it also fell,  although the key Australian and New Zealand banking divisions saw second half income 2.8% and 1.1% higher than the first half.

Two areas for potential concern are the rate of Western Australia home loan delinquencies, and the high proportion (57%) of home loans originated by the brokers.

What do the brokers say

The major brokers are in the main largely neutral on ANZ, with 2 buy recommendations and six neutral recommendations. According to FN Arena, the consensus target price is $30.50, a 2% premium to Friday’s closing price of $29.84. Individual recommendations are shown in the table below.

Most brokers see capital management initiatives in the order of $3bn – $5bn in FY18 and FY19 (which would be positive for earnings), while echoing concerns about revenue growth. Two brokers highlight the underperformance of the institutional bank.

In terms of multiples, the brokers have ANZ trading on a forecast multiple of 12.8 times FY18 earnings and 12.4 times FY19 earnings. The dividend is forecast to remain unchanged at 160 cents per share, putting ANZ on a forecast yield of 5.4%.

My view

Like the market, I was a little underwhelmed by the result, having expected ANZ would have made more progress on cutting its cost base. The fall in underlying costs of 1.4% over the full year was encouraging, but not outstanding. Maybe cost cutting just takes time to flow through to the bottom line.

Certainly, ANZ management remain committed to reducing the cost base further, with CEO Shayne Elliott reaffirming that “absolute cost reduction” was a key target.

What is clear about the ANZ Bank is that it is a simpler, better balanced business. Capital is more than adequate, lending is diversified and in reasonably “safe” pursuits, such as mortgages and small business, and the return on equity of 11.9%, although still low compared to its peers, is improving. While bad debts will no doubt move higher at some stage, it is hard to imagine that ANZ is going to get too badly stung.

ANZ is now a greatly de-risked proposition. Arguably, it is Australia’s “least risky” bank. This comes at a cost, however. While it may be able to marginally increase earnings per share, top line revenue growth will be a struggle. It won’t “shrink to greatness”.

ANZ is unlikely to be re-rated for its growth prospects, but may be re-rated by income investors as they start to appreciate its “annuity” style characteristics.

Income investors should put ANZ on their radar. Buy.