Emma Rapaport: Hello and welcome to Morningstar. I'm Emma Rapaport. Today joining us is Nathan Zaia. He is our banking analyst here at Morningstar.

Nathan, thank you very much for joining us.

Nathan Zaia: Thanks for having me, Emma.

Rapaport: Nathan, you covered both the major banks and the mid-sized banks, and a lot of the financial services sector. But for today, I'd really like to focus on the reporting season for the major banks. So, can you walk us through what you learned during reporting season? And some highlights and lowlights amongst our major financials?

Zaia: Yeah, okay, sure. I think broadly, things are tracking as we're expecting for three of the majors certainly a quarterly update, don't forget, and for CBA their full year result.

So, I think if we start with credit growth, it's really had a bit of a shot in the arm from low cash rates and government support packages. But it's hard to imagine that just continues on, especially with the strong house prices that we've had. I think at some point, you're going to see first-time buyers, which have been driving a lot of demand being priced out of the market. So, yeah, I think, what we've seen in the last 12 months or so might have a little bit more to run. But I think credit growth probably slows down to that low-single digit level over the next couple of years.

Net interest margins has been a really interesting one. And we've kind of been waiting for the pressure to come through in the results, given how low cash rates are. Ordinarily, you'd see the bank's margins and earnings come under pressure. But, strangely enough, due to COVID, rising customer deposits have made – the banks didn't have to price as aggressively. And they've had the term funding facility. So, that's really helped. But we are starting to see that pressure come through now. And I think commentary from the banks does support what we've been saying that it's probably going to get worse over the next couple of years. We've got a lot of older loans, which for us – would made higher margin being repriced onto newer loans. And we've also got a lot of demand for fixed rate, given how low rates are at the moment. So, those things are going to be headwinds for the banks.

NIM, we're already seeing it and I think it'll probably get a little bit worse. I don't want to disregard the potential for rising bad debts as we come out of lockdowns and government support, which has come through again, is pulled. But the banks, they've really did take conservative – or they look very conservative now provisions last year for loan losses. I think that probably is one of the highlights just how strong the banks loan books are, how they are holding up where arrears are very low. The banks is very well-capitalised, very well provisioned. So, they're in a really good position.

Rapaport: Leading into reporting season you predicted some pretty big dividends and payouts amongst our major banks. Did those payouts eventuate? How did they eventuate? And do you expect more to be coming?

Zaia: Yeah, broadly, yes. I think CBA's payout ratio was a little bit lower than what we had. We kind of figured – when you've got such a large capital buffer, and your earnings are so strong, you're not going to pay out the top end of your payout ratio at that time, then will you ever but that was slightly lower than what we thought but not material.

In terms of the buybacks, yeah, that's pretty much what we expected to Commonwealth Bank. The 6 billion off market buyback (indiscernible) the on-market route. We did think the other two would probably do part of their capital management through off market. But yeah, that hasn't eventuated. But yeah, we don't think the banks have done either. We think they're still holding capital well above regulatory requirements. So there probably will be a little bit more over time. I think it's more of a timing thing like we still think Westpac will make an off-market buyback, we forecast 4.5 billion and probably get announcement released the result in early November. The shareholders probably have to wait a little bit longer for that one.

Rapaport: Shareholders love getting dividends and they love buybacks, because that means more cash in their pockets. But from an equity analyst perspective, do you think this was the best use of their capital? Is there a reason that they decided not to invest in their own businesses and pay the money out?

Zaia: Yeah, that's a good question. That's always the decision that each needs to make. But I think if you look at their opportunities to grow their loan books, so if they had business lending or home loans like they're doing as much as they can on that front, and the banks have just gone through a process of divesting everything that's non-core to those banking operations. So, really, they would be looking for opportunities where they can add things that help those businesses, they're all pretty small things. So, it's hard to find a large investment opportunity that would move the needle and actually support where they have their competitive advantage. So, I think that's why the banks are probably turning to returning at least some of this excess capital to shareholders. I think it is the right thing to do.

Rapaport: This story of the banks having a really good half - is that across the entire banking sector? Are the small and medium-sized banks experiencing that same rebound?

Zaia: Yeah, it's really across the whole industry. And for the smaller and mid-sized banks, I think they're actually benefiting a little bit more than the majors. If you think about their funding costs, they don't typically have as much cheaper wholesale funding, they rely more on securitization markets. And at the moment, they're able to get those cheap customer deposits that the majors rely so heavily on at similar sort of prices as well. So, they don't have that disadvantage. And I also think the majors kind of getting bogged down in refinance applications. Whereas if you're a smaller lender with a smaller loan book, it takes more before your loan approval processes blow out and it becomes slower. And we're seeing it in their loan growth like Bendigo grew its loan book or home loan book 15%, and the market grew 5%. So, I know they've really enjoyed this period as well.

Rapaport: So, I want to focus quickly on the CBA result. The only major bank, as you mentioned before, to have a major result, as opposed to just a quarterly update. We saw a 20% increase in profits, what was driving those profit figures for the half?

Zaia: Yeah, for the full year, the big swing factor was last year the bank was raising loan impairment provisions for the losses that were going to come through or they thought might come through. And they're obviously – not having to do that, but they're also releasing some of those provisions. So, it's really flattering the growth rate that we're seeing in this period.

If you look at the result before those loan, impairment expenses, bank profit was up slightly on last year. And I think the second half was up about 1% on the first half. So, it's really like quite anemic growth at the underlying rate. That's CBA delivering strong loan growth. But as we mentioned earlier, some pressure on net interest margins, and the bank is continuing to invest for the future. And I think you don't get that strong loan growth, and make sure that it continues to come in and hold your market leader position without that ongoing investment. So, there is a couple of moving parts, both behind the underlying, but it's really those loan impairment expenses that have driven a large swing.

Rapaport: As you highlighted, CBA, in particular, have seen a real price increase. They've gone from about $57 during the lows of March 2020 to around $108 today – a really big increase. In your opinion, are shares currently trading under or at an overvalued level?

Zaia: No, we think they are a little bit overvalued at the moment. If you go back to March 2020 everyone was trying to guess what sort of credit stress the banks would see over the next 12, 24 months and they are being priced for, I'd say a pretty dire situation, but then also being priced as if that situation would never end. And then if you look at current levels now and CBA is on a P/E of 19, a dividend yield under 4%. And that yield might sound appealing and I think that's probably what is – you're seeing a lot of retail holders happy to keep buying CBA. But let's not forget, earnings are vulnerable to economic weakness. And it's, I guess, a little bit surprising that, the reminder that 2020 was has pretty much been being brushed off by the market. So, already we're seeing CBA make highs. So, yeah, I think it is overvalued. The other banks trading around fair value or Westpac slightly below fair value I think they are better options at the moment.

Rapaport: In terms of good ideas in the banking and the financial services sector - you spoke a little bit before about how Westpac is undervalued. But are there any names that you would highlight in your coverage to investors– even outside of the banks?

Zaia: Yeah, the biggest fair value change we made have been post reporting season. And that was two smaller companies I cover, so that's Steadfast and Austbrokers. They're both narrow moat rated names. And they really didn't missed a beat during COVID. There was very little impact on their businesses in what was a very volatile and uncertain period. And that kind of got us rethinking about the resiliency of these names. So, for those that don't know, they are insurance brokers, and they make a commission based on the insurance premiums that their brokers derive, so they take no underwriting risk, so they're not on the hook for claims at all.

So, we concluded that, yes, there would be some impact on premiums if businesses fold in really tough economic periods, but it's probably less severe than the majority of businesses we cover. Insurance is typically one of the last expenses that people trim, the consequences of not having adequate cover can be significant. So, taking the view that earnings risk is below average, because these businesses have quite resilient business models, and because they are growing strongly by reducing our discount rate, our fair values went up by around 30%. So, we see both of those names undervalued at the moment.

Just a quick, why do we like these businesses, first of all, we think there is customer switching costs, brokers typically have no incentive to leave their network. And in many cases, the network owns stakes in those brokers anyway. And customers generally don't leave their broker. And we think revenues are prime to continue to grow. We've got insurance premiums rising, they're not making good returns at the moment, they need to keep putting up premiums, brokers are taking more and more share of the market. And businesses and even individuals are finding the benefits of using a broker which has expertise in the space and can shop around across different insurers. It's pretty much like you're going to a mortgage broker. And these are very capital light businesses, they're generating strong free cash flow, and that's supporting both dividends and ongoing growth in their businesses.

Rapaport: Great. Thanks for those ideas. Just to close out, we've been asking all the analysts to spend the month listening through hours and hours of earnings calls and reading through presentations and PDFs and everything that comes with it. If there was anything that they can share with our viewers that they learned during an earnings call, maybe they were listening to a management team that maybe was surprising, or something that you picked up during these sessions that you could share?

Zaia: Yeah, it's probably not that interesting or surprising. But I would say, in general, like the contrast between this year's call and last year is just management did not appear as concerned at all about lockdowns that we're in at the moment. I believe banks were actually releasing reserves and returning capital during these lockdowns. And I think we've seen how effective the vaccine is, how effective government support has been. And while there is still a lot of uncertainty, I think there is a lot more confidence this time around than there was 12 months ago. And I think the one thing that was caught out in a few places was just timing on international borders opening back up, that's one area where there still is a lot of caution.