Investors could be forgiven for avoiding Australian bank stocks even though they are reasonable value at current prices.
Politicians on both sides seem intent on having another kick at financial services – the political football that keeps on giving.
Labor’s call for a Royal Commission into the banks, rife with political opportunism, has struck a chord in the electorate. And the Australian Securities and Investments Commission’s war on bank culture shows a more aggressive regulatory approach.
Requirements for banks to hold greater capital and be better placed to withstand the next financial shock will further weigh on their return on equity and challenge their capacity to increase, or in the case of ANZ Banking Group (ANZ), maintain the dividend.
Oh, and let’s not forget never-ending hysteria about an imminent property collapse, the coming spike in bad debts, and deterioration in bank balance sheets.
For the angst, credit growth in Australian continues to increase and business sentiment, as measured by NAB’s monthly business survey, in March hit its highest level since 2008.
Two conclusions can be drawn. First, irrational pessimism has created a buying opportunity in Commonwealth Bank (CBA) and National Australia Bank (NAB). The CBA is trading slightly below fair value and NAB is a little better again.
Second, returns from Australian banks in the next three years could slow, amid a more challenging regulatory environment.
Consequently, the case to invest in overseas banks is strengthening, principally because some offshore banking markets have more favourable regulatory and growth settings.
Which brings me to CYBG Plc, the latest inclusion in the Switzer Super Report takeover portfolio. To recap, NAB Bank spun out CYBG through a demerger in February 2016.
NAB had been itching to offload its troubled United Kingdom banking operations, built through the acquisitions of Clydesdale Bank in 1987 and Yorkshire Bank in 1990. The UK business, a serial underperformer, weighed on NAB’s return on equity.
CYBG Plc is one of the more interesting demergers on ASX in recent years. It was a classic example of a potentially strong business struggling within a larger conglomerate, and having better prospects as a standalone listed company.
CYBG has performed well since listing. Its CHESS Depositary Interests on ASX (CYBG’s primary listing is in London) have rallied from $3.69 to $4.28.
I nominated CYBG as a one of six “turnaround” ideas for the Switzer Super Report in March [1] when it was $3.94. As an aside, another demerger in this report’s takeover portfolio, South32, has almost doubled since mid-January after a difficult first six months as a listed entity.
CYBG could appeal to a European bank that wants a foothold in the attractive UK banking sector. It has almost 3 million customers, 175 years of history, and a well-known and respected brand. It ranks in the bottom half of the top 10 banks for most of its products and is strongest in Northern Europe and Scotland.
The UK banking sector has good prospects. UK authorities are intent on fostering greater competition in the UK banking sector, which is not unlike Australia’s with four banking giants dominating the market. More banks are entering the UK market, but CYBG is arguably one of few with the credibility to help lift competition.
Its exposure to about a third of the UK population, through its extensive retail branches and business centres, could be more valuable in the hands of a larger European bank with deeper pockets and the desire to win market share in the UK.
The UK economy is one of Europe’s best performing and it has better medium-term prospects than many advanced economies. A strengthening UK economy, increased banking competition, and more favourable regulatory settings could see UK banks collectively produce stronger returns than Australian banks over the coming decade.
At a micro-level, CYBG has scope for improvement. Good demergers have a knack of motivating staff, as they no longer run the business in the shadow of a conglomerate. A new CEO and expanded management team at CYBG are excellent signs.
Unlike many demergers, CYBG’s investment program is well underway. Parent companies have a habit of badly underinvesting in businesses that are spun out as standalone entities and, as a result, take years to fix. CYBG’s large investment program began last year. It will reduce the cost gap between CYBG and its UK peers and lift its poor return on equity.
CYBG looks a solid investment with or without a takeover. It came to market cheaply, can lift performance through restructuring and investment initiatives, and has consolidation potential as competition in UK banking rises.
Demergers often underperform in the first year as a standalone company, before stronger performance. CYBG’s good start in a difficult market shows the potential for another financial services company to make more of its assets than NAB did during its ownership.
Five of seven broking firms that cover CYBG have a buy recommendation, one has a hold and one has a sell. A consensus target share price of $4.59 suggests CYBG is slightly undervalued at the current price.
Chart 1: CYBG
[2]Source: Yahoo!7 Finance. Refers to ASX listing.
Ardent Leisure’s potential
Regular readers the Switzer Super Report know I avidly follow the boom in middle-class consumption in Asia and its effect on demand for Australian tourism and education.
Growth in Chinese inbound tourism partly explains why I have favoured stocks such as Sydney Airport and casino operator The Star Entertainment Group over the past three years. Both have excellent medium-term prospects as Chinese tourism in Australia grows, are well run, but look fully valued at the current price.
Ardent Leisure Group should be another beneficiary of inbound Asian tourism through its Gold Coast theme parks, which make up just under a fifth of its revenue. Bowling alleys, family entertainment centres and health clubs make up the rest.
Ardent has delivered an 11.8% total return (including dividends) over the past year – better than the market, but arguably too low given its exposure to Chinese tourism and rising demand for health and fitness products.
I like Ardent’s restructuring decision to sell the marinas and redeploy cash to the higher-performing Main Event family entertainment centres in the United States – the largest earnings contributor. Improving performance in the fitness clubs is another good sign and there is plenty of potential to transform some bowling centres into family entertainment centres.
But investors should expect stronger performance from Ardent given the outlook for the tourism, entertainment and fitness industries. Asset sales are probably likelier than a takeover, and market pressure on the company is building.
Nevertheless, six brokers have a buy recommendation and five have a hold. A consensus price target of $2.35 suggests Ardent is a touch undervalued.
It will be worth a lot more if it lifts performance at its theme parks and fitness centres and quickens the rollout of its promising Main Event business.
If it takes too long, watch for a predator, such as a US private equity firm, to find value by carving up its assets and selling them to the highest bidders. The market has speculated on such an event, but it may take further share-price weakness for it to happen.
Chart 2: Ardent Leisure Group
[3]Source: Yahoo!7 Finance
Portfolio update
A better performance from the takeover portfolio this month as several laggards, particularly in the resource sector, enjoyed price boosts. Standouts include Gold Road Resources, NIB Holdings and OrotonGroup. Monash IVF Group is another with improving prospects and Challenger’s gain was pleasing given its potential as demand for annuity investments rises. The portfolio’s 6% loss over 12 months (on a total-return basis) was in line with the S&P/ASX 200.
[4]– Tony Featherstone is a former managing editor of BRW and Shares magazines. This column does not imply any stock recommendations or offer financial advice. Readers should do further research of their own or talk to their adviser before acting on themes in this article. All prices and analysis at April 26, 2016.
Important: This content has been prepared without taking account of the objectives, financial situation or needs of any particular individual. It does not constitute formal advice. Consider the appropriateness of the information in regards to your circumstances.