ANZ Bank. Trimming the fat A$23.06 AUSTRALIA. Focus on returns should yield value. Elevated historical cost growth provides opportunity

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1 AUSTRALIA ANZ AU Price (at 08:39, 07 Jul 2016 GMT) Outperform A$23.06 Valuation A$ Sum of Parts/GG month target A$ month TSR Volatility Index Low GICS sector Banks Market cap A$m 67, day avg turnover A$m Number shares on issue m 2,927 Investment fundamentals Year end 30 Sep 2015A 2016E 2017E 2018E Net interest Inc m 14,616 15,185 15,490 15,732 Non interest Inc m 5,902 5,589 5,782 6,115 Underlying profit m 11,159,663 12,051 12,512 Reported profit m 7,493 6,239 7,199 7,396 Adjusted profit m 7,216 6,283 7,199 7,396 EPS adj EPS adj growth PER adj x PER rel x Total DPS Total div yield Franking ROA ROE Equity to assets P/BV x Source: FactSet, Macquarie Research, July 2016 (all figures in AUD unless noted) Trimming the fat Focus on returns should yield value We welcome ANZ s strategic shift in focus from growth to returns. In light of the challenging revenue environment the sector is currently facing, ANZ s focus on costs and balance sheet optimisation should deliver upside to its longer-term profitability. In our view, ANZ is the only bank that should deliver an improvement in returns over the next three years. As a result, we see sizeable value upside at current levels. Based on our fundamental valuation we believe ANZ offers ~28 upside, even after we apply a 15 execution risk discount. We note that based on the current share price, the market appears to be attributing negative value to the Asian business. Valuing the Asian franchise at zero and the rest of ANZ on peers multiple offers ~ upside. Maintain Outperform. Elevated historical cost growth provides opportunity We estimate that since 2007, ANZ s adjusted cost growth was ~77, which was ~35 above CBA/WBC. Moreover, ANZ s superior revenue growth appears to have been predominantly balance sheet led. Elevated expense growth combined with RWA intensity put pressure on ANZ s returns. In particular, within the institutional business, the loans and markets businesses contribute 8 and 6 towards profits but consume 23 and 13 of capital, respectively. We see opportunity to address this by reducing low yielding RWA and reducing costs. While there are clearly risks of revenue leakages our assumptions incorporate ~$800m or a ~15 reduction in Institutional revenues. Furthermore, we apply a 5 valuation discount to incorporate execution risk. Based on our restructuring assumptions, ANZ largely maintains its earnings profile, but improves its returns by ~11. Asset disposals are not critical but potentially accretive We believe ANZ is well placed to meet tougher capital requirements based on its organic capital generation. However, ANZ s capital position would be further strengthened if they decide to exit some of their non-core assets. Based on our estimates, a sale of two Asian partnerships and the Life Company would release ~$4.3bn of equity and have ~3 dilution on FY17 earnings. While we don t expect ANZ to use the capital for a buy-back until capital rules for the industry are clearly defined, we estimate that ANZ s ROE could improve by ~60bps with an estimated impact on fundamental valuation of ~3 following capital return. Credit quality deterioration is a risk... but is it captured? Deteriorating credit quality has been a major focus for investors in recent periods. While we recognise that material losses could impact both near-term sentiment and our longer-term fundamental valuation, we believe our current forecasts address this. Our FY16-18f credit expense of ~$6.1bn for ANZ is ~50 above peers. Furthermore we apply an additional 5 discount to our fundamental valuation to address this risk, which equates to additional potential losses of ~$3.5bn. 7 July 2016 Macquarie Securities (Australia) Limited Please refer to page 23 for important disclosures and analyst certification, or on our website

2 Inside The price of growth 3 Cost-out opportunity and RWA optimisation 5 Asset disposals to simplify the business Asset Quality 11 Domestic business is performing 15 Dilution from divestments vs. capital surplus 16 Upside of getting it right 17 Valuation and risks 19 Financials summary 20 Macquarie Quant View 22 Executive summary We estimate that since 2007, ANZ s adjusted cost growth was ~77, which was ~35 above CBA/WBC. Moreover, ANZ s superior revenue growth appears to have been predominantly balance sheet led which was dilutive to returns. Fig 1 Growth in expenses Fig 2 Underlying return on RWA Index FY07 FY08 FY09 FY FY11 FY12 FY13 FY14 FY Index FY07 FY08 FY09 FY FY11 FY12 FY13 FY14 FY Source: Company data, Macquarie Research, July 2016 Earnings changes FY16 FY17 FY18 Cash NPAT Old 6,233 7,304 7,456 New 6,239 7,199 7,396 Change Cash EPS Old New Change Dividend Old New Change Source: Macquarie Research, July 2016 As the figure below highlights, while the institutional business contributes ~30 of ANZ s banking related earnings, it also consumes ~56 of ANZ s banking capital. Fig 3 Banking profitability split Fig 4 Banking capital allocation Aus. Business (17) NZ (17) Australia Retail (35) Insto (30) Markets (6) Loans (8) Trans. banking (6) Retail (2) Partnerships (9) Aus. Business (15) NZ (13) Australia Retail (15) Insto (56) Trans. banking (7) Loans (23) Markets (13) Retail (3) Partnerships (11) Source: Company data, Macquarie Research, July 2016 We see opportunity to address this by reducing low yielding RWA and reducing costs. Based on our fundamental valuation we believe ANZ offers ~28 upside, even after we apply a 15 execution risk discount. We note that based on the current share price, the market appears to be attributing negative value to the Asian business. Valuing the Asian franchise at zero and the rest of ANZ on peers multiple offers ~ upside. Fig 5 Fundamental valuation based on RoNTA profile FY19 RoNTA Change in returns Valuation based on current returns Valuation based on future returns Embedded franchise discount Relative upside (based on current returns) Relative upside (based on future returns) Source: Macquarie Research, July July

3 CAGR ( ) The price of growth While ANZ s Asia expansion strategy has been in place for some time, management accelerated its growth aspirations in As the figure below highlights, by 2015 ANZ s offshore revenues were ~19 and earnings were ~17 with the majority of income generated by Institutional business and partnerships. While this strategy has underpinned superior revenue growth for ANZ relative to peers, it is also increasingly evident that returns were diluted. As the figure below on the right highlights, the offshore institutional business generates returns which are ~2x lower than NZ business returns and ~4x below those of Australian Retail. Fig 6 Revenue from offshore relative to peers Fig 7 Earnings CAGR and RoIC by division Offshore Insto NZ AU Commercial AU Retail NZ Insto AU Insto RoIC Note based on statutory revenue As the figure below highlights ANZ s relative RoNTA has declined in recent periods. Based on our current (normalised) 2H16 forecasts ANZ s relative return to peers is ~ below its recent five-year average. While this is partly a reflection of elevated credit charges, in some respect it is also driven by a lower level of underlying returns from its institutional franchise. This in turn resulted in ANZ s relative de-rating, with the stock currently trading at a 5- relative discount to its five-year average. Fig 8 Underlying RoNTA relative to peers Fig 9 P/NTA relative to peers Relative R/NTA (x) Relative P/NTA (x) H 2H11 2H12 2H13 2H14 2H15 2H16 2H 2H11 2H12 2H13 2H14 2H15 Note: Return based on pre-provision profit Source: Company data, Macquarie Research, July 2016 Source: IRESS, Company data, Macquarie Research, July July

4 While ANZ s offshore growth strategy hasn t been positive for current returns and recently attracted considerable criticism from the market it has provided a footprint into the growing Asian region. If ANZ manages its portfolio optimisation strategy well we believe this footprint should be a valuable asset in the longer term. The figures below highlight our economists and our bank analysts growth forecasts for selected countries where ANZ has exposure. GDP growth in China, Thailand, Malaysia and Indonesia is expected to exceed GDP growth in Australia over the next three years by 2x-3x. Similarly, bank sector revenue growth in those countries is also expected to materially exceed our domestic market. Against that backdrop we would see a material scale-back of ANZ s position in the region as potentially value destroying. Fig Macquarie GDP forecasts for Asia region Q16 2Q16 3Q16 4Q16 1Q17 2Q17 3Q17 4Q17 1Q18 2Q18 3Q18 4Q18 Australia China Hong Kong India Indonesia Korea Malaysia Singapore Thailand Fig 11 FY18E banks revenue growth forecast Source: Macquarie Research, July 2016 Source: Macquarie Research, July July

5 Cost-out opportunity and RWA optimisation In the near term, we expect upside for ANZ to come from the cost-out programme and RWA optimisation. Historically cost-out strategies have achieved mixed success. The key risk is generally around the impact of revenue leakages more than offsetting the cost benefits. This risk is particularly acute when other industry players continue to invest in the targeted area of the cost-put programme. In our view two potentially mitigating factors for ANZ are: 1. Other large global banks are scaling back their operations in the region; 2. The cost base that ANZ is looking to address appears elevated relative to peers. As the figures below highlight, ANZ s growth strategy came at a cost. While ANZ grew revenue by ~70 since FY07 (~20 above CBA/WBC) this growth was also accompanied by a substantial increase in the cost base. As the figure below highlights, ANZ s expense growth exceeded its revenue growth over that period and materially exceeded the cost growth of peers. Between 2007 and 2015, ANZ s adjusted cost growth (ex. acquisitions) was ~77, ~35 above CBA/WBC. Fig 12 Historical growth in expenses Fig 13 Historical growth in revenues Index Index FY07 FY08 FY09 FY FY11 FY12 FY13 FY14 FY FY07 FY08 FY09 FY FY11 FY12 FY13 FY14 FY15 Moreover, growth in revenues appears to have been predominantly balance sheet led. As the figure below highlights, RWAs during the period increased by ~80 (exceeding revenue and profit growth). While RWA growth which exceeded revenue growth was a consistent trend across the peer group, efficiency benefits achieved by peers improved their underlying RoRWA by 5- since 2007 while ANZ s RoRWA declined by ~6 over the same period. Fig 14 Growth in RWA Fig 15 Underlying return on RWA Index FY07 FY08 FY09 FY FY11 FY12 FY13 FY14 FY15 Index FY07 FY08 FY09 FY FY11 FY12 FY13 FY14 FY July

6 While cost-to-income across the peer group fell by 4-12 between FY07 and 1H16, ANZ s cost-to-income ratio increased by ~2 over that period. As a result, ANZ went from a sector leading cost-to-income position in FY07 to being the sector laggard in 1H16. However, as the figure below highlights the cost differential is largely explained by ANZ s offshore operations (ie, cost-to-income excluding offshore operations is largely consistent with NAB and WBC). Moreover, when we adjust this analysis for the entire institutional business ANZ s cost to income ratio is again sector leading. Fig 16 Cost-to-income ratios 51 Fig 17 1H16 cost-to-income breakdown FY07 FY08 FY09 FY FY11 FY12 FY13 FY14 FY15 ANZ CBA WBC Group Total banking Total banking (ex Total banking (ex offshore) offshore & Insto) The figure below highlights divisional cost-to-income ratios. While ANZ has a smaller retail/sme franchise relative to peers, its efficiency ratios are broadly in line with CBA s and better than NAB and WBC. This may be a reflection of their business mix (larger exposure to unsecured lending) or potentially a sign of underinvestment in its Australian Banking franchise relative to peers. ANZ s NZ business cost to income ratio is ~38 is marginally below peers, which arguably could be explained by its relative size benefit. However, ANZ s materially higher institutional cost-to-income ratio is difficult to explain. While NAB doesn t disclose its institutional business financials, when comparing to CBA and WBC, ANZ s cost-to-income ratio of 54 is above peers. This difference is particularly stark given ANZ s Institutional business is almost double the size of peers. Fig 18 Divisional cost-to-income analysis (1H16) Retail banking Business banking BankWest 41.5 Australia Banking Institutional Institutional (international) 60.9 Total Institutional NZ Offshore Corporate Total banking Wealth Group Total banking (ex offshore, Insto and WM) Total banking (ex offshore and WM) Source: Macquarie Research, July 2016 The institutional international business which operates at the cost-to-income ratio of ~60 is one of the drivers of the higher ratio. However, after we adjust for that difference ANZ s Australian and New Zealand ratio is still 6-11 above peers. This characteristic is difficult to explain, as historically ANZ s institutional cost-to-income ratio was below WBC (as highlighted in the figure below which summarises banks divisional cost to income ratios in FY07). 7 July

7 Fig 19 Divisional cost-to-income analysis (FY07) Retail banking Business banking Australia Banking Institutional Total Institutional NZ Offshore Corporate Total banking Wealth Group Total banking (ex offshore, Insto and WM) Total banking (ex offshore and WM) Source: Macquarie Research, July 2016 While we recognise it is difficult to benchmark ANZ s offshore institutional business given the lack of comparable franchises, we use Singaporean banks as a reasonable comparison. We acknowledge this is not entirely like-for-like comparison as Singaporean banks arguably operate within their home market, however it does provide an interesting benchmark. We estimate the three large Singaporean banks have a cost-to-income ratio of ~32 vs. ANZ s ratio for its international business of ~61. While this may partially be driven by the relative scale (ANZ s offshore revenue is ~50 of Singaporean banks) and home market advantage, it appears that an efficiently run franchise in Asia can operate at a relatively low cost-toincome ratio. Fig 20 Institutional businesses cost-to-income ratios Fig 21 Full-year revenue contribution $m ANZ DBS OCBC UOB 0 ANZ DBS OCBC UOB Note: Singaporean banks include Treasury/Markets operations Source: Company data, Macquarie Research, July 2016 Note: Singaporean banks include Treasury/Markets operations Source: Company data, Macquarie Research, July 2016 Elevated expense growth combined with RWA intensity puts ongoing pressure on ANZ s returns. As the figure below highlights, while the institutional business contributes ~30 of ANZ s banking related earnings, it also consumes ~56 of ANZ s banking capital. Within the institutional business, the loans and markets businesses are biggest consumers of capital. Each business contributes 8 and 6 towards profits but consumes 23 and 13 of capital, respectively. Conversely, the retail business generated ~35 of earnings and only consumed ~15 of capital. 7 July

8 Fig 22 Banking profitability split Fig 23 Banking capital allocation Retail (2) Aus. Business (17) NZ (17) Insto (30) Markets (6) Loans (8) Partnerships (9) Aus. Business (15) NZ (13) Insto (56) Loans (23) Markets (13) Retail (3) Australia Retail (35) Trans. banking (6) Australia Retail (15) Trans. banking (7) Partnerships (11) Furthermore, underlying profitability of both the Loans and the Markets business have been under significant pressure in recent period as spreads globally contracted and competition intensified. As the figure below highlights, underlying profitability of the Loans and Markets business declined by 27 and 51, respectively, since FY13. We estimate that in 1H16, ANZ delivered pre-provision return of just 13 on its Loans Business and 12 on Markets Business, which drove overall return on invested capital of the Institutional business to ~9. Fig 24 Pre-provision return on capital Fig 25 Return on capital FY13 FY14 FY15 1H16 FY13 FY14 FY15 1H16 With a loan-to-deposit ratio of ~70, deposit funding has been one of the benefits of international institutional franchise. The transaction banking and markets business in particular have low LDRs which to some extent could arguably justify a lower return hurdle. However, in the NSFR environment the value of less stable deposits diminishes materially. Although core transactional deposits remain valuable, less stable deposits in the institutional business are likely to lose their appeal. In this regard we believe ANZ will continue to target its transactional business which generates ~14 returns and incremental benefits towards the NSFR, however business rationale for some of the Loans and Markets business clients is likely to be examined. 7 July

9 Higher ASF Lower ASF Fig 26 Loan-to-deposit ratios Fig 27 ASF funding mix Wholesale >1yr Retail/SME Deposits FY13 FY14 FY15 1H16 Institutional Deposits Wholesale <1yr Value upside While there is an opportunity to reduce costs and RWA as well as improve returns, in practice we recognise execution difficulties. We expect to see material revenue leakages associated with ANZ s cost-out programme. As the figure below highlights our base case scenario assumes that ANZ will shed ~15 of its Institutional banking revenues over the next three years (ie. ~$800m). However we estimate that this will be accompanied by ~$40bn reduction in RWA (ie. ~22.5 of institutional banking RWAs). We furthermore assume that ANZ improves its domestic institutional cost-to-income ratio towards peers and offshore institutional cost-to-income ratio to ~55 (ie. ~15 above its domestic cost-to-income ratio target). This scenario yields cost saves which largely offset the revenue leakage (even after we allocate additional expenses for reinvestment in Australia to lift its cost to income to peers). As a result of this cost-out programme, ANZ largely maintains its earnings profile, but improves its returns by ~11. We note that upside to returns is more material should revenue leakage be smaller or if ANZ is able to achieve better cost-to-income ratio in its offshore institutional business. Fig 28 Income and revenue upside from cost-out opportunity Revenue attrition Revenue attrition Domestic Insto C/I in-line with peers Offshore Insto C/I ~ above peers Offset by additional investment in franchise Total implied cost saves Implied Group cost to income ratio Upside/Downside to pre-provision earnings Reduction in RWA -13,528-31,566-40,584-49,603-58,622 Return on RWA Upside to returns Source: Macquarie Research, July July

10 Asset disposals to simplify the business Under the current capital rules, equity investments in financial institutions are more capital intensive and hence lower returning. ANZ has made it clear that non-strategic equity holdings will be disposed of at the right price. In aggregate equity investments contributed ~$300m of cash profit in 1H16, which accounted for ~9 of group earnings (excluding one-off items). ANZ has ~$5.2b of capital tied up in these investments (~ of group capital). The figure below outlines the dilution impact and capital benefit from disposals at various price points. Assuming ANZ disposes all of its investments at current market prices we estimate ~7.4 EPS dilution and ~0bps uplift to ANZ s capital ratio. We will explore potential merits and valuation impact of divestments later in this report. Fig 29 EPS dilution and CET1 benefit from minority investment sales at various sale prices 1H16 EPS Dilution () CET1 benefit (bps) Book value Annualised Earnings Current (P/BV) 0.6x 0.8x 1.0x Current 0.6x 0.8x 1.0x Current AMMB Holdings 1, PT Bank Pan Indonesia Shanghai Rural* 1, Bank of Tianjin 1, Other associates* Total 5, *Note: Shanghai Rural and Other associates are unlisted investments and therefore we have used RoE as a proxy to estimate their current P/BV Source: Factset, Company data, Macquarie Research, July 2016 ANZ is also reviewing its Wealth Management business which may ultimately lead to divestment of the entire business or the Life Company. The three subdivisions of ANZ wealth are insurance, funds management and private wealth. Given that private wealth is predominantly a banking related business and general insurance is to a large extent LMI business, we expect most of attention to be focused on the Life business and potentially funds management. Using a PE based valuation methodology we estimate that the combined funds management and life insurance business could be worth $ bn, with a midpoint aggregate valuation of ~$4.5bn. Our valuation is based on an AMP/IOOF multiple for the funds management business. For the life business we have looked at the multiple NAB received following their recent sale of MLC (including experience earnings), which is also broadly in line with AMP s current multiple. Based on our base case, if ANZ disposes its Life Insurance business we expect earnings dilution of ~2.5 and capital benefit of ~70bps. Assuming the entire business is sold, we expect earnings dilution of ~4 and capital benefit of ~1bps. While finding a buyer for these businesses is difficult, given ANZ doesn t need additional capital it could look to divest the business using an in specie distribution to shareholders as a way of unlocking value. In that scenario ANZ s earnings would decline by ~4 and shareholders would receive shares in a new company. Fig 30 EPS dilution and CET1 benefit from sale of wealth businesses Current PE EPS Dilution () CET1 benefit (bps) 1H16 ann. multiple (x) Valuation Low Base High Low Base High Funds management , Life Australia , Life New Zealand Total , Source: Factset, Company data, Macquarie Research, July July 2016

11 Asset Quality Deteriorating credit quality has been a major focus for investors in recent periods. While we recognise that material losses could impact both near-term sentiment and our longer term fundamental valuation, in our view, our current forecasts address this. Our FY16-18f credit expense of ~$6.1bn for ANZ is ~50 above peers. Furthermore we apply an additional 5 discount to our fundamental valuation which equates to potential losses of ~$3.5bn. Fig 31 BDD charge to NHL bps Fig 32 Impaired assets to NHL bps H12 2H12 1H13 2H13 1H14 2H14 1H15 2H15 1H16 1H12 2H12 1H13 2H13 1H14 2H14 1H15 2H15 1H16 As the figure below highlights, ANZ s business is generally riskier driven by its overweight position to institutional and unsecured lending. However when offshore institutional exposures are excluded (as the figure below to the right highlights) ANZ s asset mix appears increasingly similar to the average of its peers. While we believe ANZ s offshore exposures arguably have a different risk profile, its domestic business, in our view, is not materially different to peers. As a result, in our analysis we apply the impairment charge expectations for peers (adjusted for potential areas of stress, such as mining and NZ diary). Fig 33 ANZ s exposure mix vs peers Fig 34 New impaired assets by division $m 0 2, ,800 1, ,400 1,200 1, ANZ Group ANZ (ex o/s insto) Majors (ex ANZ) Mortgages Cards Personal Business Insto 0 1H15 2H15 1H16 Aus NZ IIB Wealth Asia Retail Note: We have used business and insto loan balances to obtain the exposure split. Other asset classes are direct from Pillar 3 disclosures. 7 July

12 Institutional Bank ANZ s institutional bank has ~50 of its exposure to the Australian/NZ markets, ~21 to northern hemisphere and ~27 to Asia. We also note that the relative exposure to the northern hemisphere has grown materially over time. We understand that in part this was driven by increasing business to multinationals based in the US and UK with projects in Asia. Our international BDD charge expectations are now based on ANZ s geographical mix and our relevant analyst expectations for that market. Fig 35 EAD Geographical split Institutional division Fig 36 BDDs growth forecasts for offshore markets NZ (9) US, UK & EU (21) Japan (4) Hong Kong (3) 20 - Asia (27) Sing (6) Other (8) Aus (43) China (6) FY16 FY17 FY18 Source: Company data, Macquarie Research, July 2016 Note: FY16 growth in India is off the above scale at ~90 Source: Company data, Macquarie Research, July 2016 We also note that while ANZ reduced its energy/mining exposures by ~$2.5bn in 1H16 (~0.3 of group exposure at default), the remaining portfolio is likely to have a higher loss rate relative to other parts of the book as energy prices remain subdued. As we highlighted in our syndicated lending analysis, ANZ s institutional book appeared to be riskier than NAB and WBC. We have adjusted for the differences in our impairment expectations. Fig 37 Resources/energy exposures by bank Fig 38 Insto BDD charge differences $b bps bps Oil & Gas Iron Ore ANZ Majors (ex ANZ) Mining services Coal Risk adjusted expected loss (Insto book) Other of Group EAD (RHS) Additional BDD charge from Insto (RHS) 7 July

13 NZ Dairy The NZ dairy sector has also been attracting attention in recent months. This has been a result of ongoing weakness in dairy prices amidst a backdrop of dairy farmers increasing their leverage. It should also be noted that while ANZ has the largest exposure to NZ dairy its growth rate has generally lagged peers in recent years, with their market share in NZ agricultural lending now at 30.9, down from ~34.5 in FY12. While this doesn t make ANZ immune to issues in the sector and absolute losses would likely be towards the top end of the peer group, in our view the level of relative losses is likely to be at the lower end of the peers group given the scale back of exposures. Fig 39 NZ divisional asset exposure split Fig 40 Dairy exposures and 3yr CAGR NZ$b Commercial 29 Retail Institutional Exposures 3yr CAGR (RHS) Note: Split based on 1H15 disclosure as division split no longer provided Source: Company data, Macquarie Research, July 2016 Note: We have used growth in total agri loans due to limited disclosure Source: RBNZ, Company data, Macquarie Research, July 2016 Included in the RBNZ s May 2016 Financial Stability report was the results of two stress testing scenarios conducted by the RBNZ. While the results were an average across the five largest lenders in the sector (the majors and Rabo NZ), it provides some insight into the potential impact across the majors. The assumptions used in the RBNZ scenarios were as follows: Fig 41 RBNZ stressed scenario assumptions Scenario 1 Scenario 2 Fonterra payout ($/kgms) Dairy land prices (YoY change) Fonterra payout ($/kgms) Dairy land prices (YoY change) 2015/ / / / / Source: RBNZ, Macquarie Research, July 2016 Applying the average losses from the RBNZ stress test to each of the majors would lead to a cumulative three-year impact on earnings of 2-5 in scenario one and 5-13 in scenario two. It is important however to note that the final Fonterra price for 2015/16 is expected to be $3.90, slightly above the payout used for the same period in scenario 1. Current expectations for 2016/17 vary and appear to be between scenario 1 and 2. The Fonterra opening forecast is currently $4.25/kgMS, with Westland Dairy in NZ forecasting $ /kgMS and Synlait forecasting $4.50/kgMS. Our current loss expectations for the sector are based on the mid-point between Scenarios one and two. 7 July

14 Fig 42 Loss rates assuming equal impact from RBNZ stress tests $m Loss rate NZ Dairy exposure (NZD) Scenario 1 Year Year Year Cumulative losses (NZD) Cumulative losses (AUD) of FY17 group earnings Scenario 2 Year Year Year Cumulative losses (NZD) Cumulative losses (AUD) of FY17 group earnings Source: Macquarie Research, July 2016 Loss rate expectations We believe our new ANZ loss rate expectations for FY16-18f are conservative, both in absolute and relative sense. We incorporated a higher level of losses for the domestic business driven by the relative riskiness of its book (as we outlined in Entering the syndicate analysis). Our international BDD charge expectations are now based on ANZ s geographical mix and our relevant analyst expectations for that market. While in absolute terms charges do not appear large we note that a large part of ANZ s portfolio is exposed to lower yielding multinationals and short term trade business which historically was lower risk. We also adjust ANZ s impairment charge expectations to incorporate larger losses in NZ diary portfolio given its relative book size. Our FY16-18f credit expense of ~$6.1bn for ANZ is ~50 above peers. Fig 43 Loss rate expectations BDD charge / GLA (bps) FY15 GLA FY15 BDD FY15 FY16f FY17f FY18f ($m) charge ($m) ANZ ex o/s insto 487, Offshore Insto 70, Asia Retail 12, Weighted charge Additions (ANZ specific): NZ Dairy Group charge Majors (ex ANZ) Source: Company data, Macquarie Research, July July

15 Domestic business is performing While ANZ s offshore businesses have underperformed relative to expectations, ANZ s domestic business has been performing relatively well. In the last year ANZ has gained market share in housing with above system housing lending growth over the past four years (6.5 CAGR vs. 5-6 for peers). Fig 44 Australian loan growth vs. peers Fig 45 Housing credit growth vs. System Majors May-12 May-13 May-14 May-15 May-16 ANZ CBA WBC Note: FY16 loan growth calculated as 1H16 annualised Revenue growth over the last four years has been broadly in line with peers with ANZ, CBA and WBC all growing at ~6-7 on a compound basis. ANZ s cost growth in the domestic business has been relatively well contained with an expense CAGR of 2.6 vs at peers over the last four years. Based on these high level measures it is difficult, in our view, to justify putting a discount on ANZ s domestic business relative to peers. Fig 46 Australian revenue growth vs. peers Fig 47 Australian expense growth vs. peers ANZ CBA WBC ANZ CBA WBC 7 July

16 Dilution from divestments vs. capital surplus As we highlighted earlier in this report, ANZ is looking to optimise its balance sheet both through organic means as well as through divestments. While, in our view, the key upside to ANZ s fundamental value is from efficiency benefits and the reduction of low yielding assets, selling some of its non-core investments should also unlock value and simplify the business, which we expect to be positive for the share price. While we don t expect ANZ to dispose its entire non-core asset portfolio in the next three years, we believe there is a strong likelihood that some of the assets in the figure below will be divested. Based on our estimates, a sale of two Asian partnerships and the Life Company would release ~$4.4bn of equity and have ~3 dilution on FY17 earnings. While we think it s unlikely that ANZ will use the released capital for buy-back until capital rules for the industry are clearly defined, we believe it s useful to estimate the impact on returns from a potential buy-back to estimate the benefits of these transactions. We estimate that ANZ s ROE could improve by 60bps as a result of selling these assets with the estimated impact to the fundamental value of ~3. Fig 48 Impact from divestments Earnings Estimated sale ($m) price ($m) Earnings dilution () Capital uplift (bps) Earnings impact from buy-back () Impact on Group ROE () Implied impact to fund. Val. () AMMB Holdings Berhad PT Bank Pan Indonesia Bank of Tianjin Life Company Total Total (ex Bank of Tianjin) Asian partnerships are assumed to be sold at discount to their current valuations Source: Company data, Macquarie Research, July 2016 In the short term however, these potential divestments are likely to be a drag on earnings (~3) as ANZ is likely to retain capital. In our view, this would increase ANZ s implied PE multiple as certainty around the capital position is likely to be valued at a premium by the market. We believe ANZ would re-rate for carrying $3-4bn of surplus capital with the possibility of a buy-back in the future. Fig 49 Sector PE multiples Fig 50 Core tier one positions across the majors ANZ ANZ post divest. FY17f CBA NAB WBC FY18f 4 ANZ ANZ Intl CBA CBA Intl NAB NAB Intl WBC WBC Intl Estimated capital ratio FY16-FY19 est. capital generation (ex) DRP APRA Internatioanlly Comparable CET1 (1H16) 7 July

17 Upside of getting it right In our view, ANZ s focus on costs and balance sheet optimisation should deliver upside to its longer-term profitability. If ANZ is successful in implementing our base case scenario outlined in figure 28, we expect its Institutional business underlying profitability could improve from ~16 currently to ~19. In turn, this should result in an overall improvement in ANZ s returns. Based on our forecast, ANZ s returns would improve by ~7 over the next three years, while we expect the returns for peers to decline by ~11. This is largely the result of ANZ addressing their cost base, while peers appear reluctant to do the same at this point. Fig 51 Institutional business projected profitability Fig 52 Return on NTA profile H16 FY17f FY18f FY19f FY20f -15 URoIC RoIC 2H16 RoNTA FY19 RoNTA Change in returns We see sizeable value upside at current levels. Based on our fundamental valuation we believe ANZ offers ~28 upside, even after we apply a 15 execution risk discount. We believe this is a conservative valuation approach and our 15 discount is based on the following: Discount of 5 to capture the risk of ANZ missing our cost-our targets or revenue leakages exceed our forecast; Discount of 5 for unexpected credit quality issues, which equates to potential credit losses of ~$3.5bn; Discount of 5 for broader execution risk. We note that as ANZ addresses the issues outlined above we would look to remove this discount from our fundamental valuation. Fig 53 Fundamental valuation based on RoNTA profile 2H16 RoNTA FY19 RoNTA Change in returns Valuation based on current returns Valuation based on future returns Embedded franchise discount Relative upside (based on current returns) Relative upside (based on future returns) Source: Macquarie Research, July 2016 We also note that based on the current share-price, the market appears to be attributing negative value to the Asian business (~$2.20/share). Valuing the Asian franchise at zero and the rest of ANZ on peers multiple, suggests that ANZ s fair value would be ~$25/share implying ~ upside. 7 July

18 Jan-2000 Jan-2001 Jan-2002 Jan-2003 Jan-2004 Jan-2005 Jan-2006 Jan-2007 Jan-2008 Jan-2009 Jan-20 Jan-2011 Jan-2012 Jan-2013 Jan-2014 Jan-2015 Jan-2016 Jan-00 Jan-01 Jan-02 Jan-03 Jan-04 Jan-05 Jan-06 Jan-07 Jan-08 Jan-09 Jan- Jan-11 Jan-12 Jan-13 Jan-14 Jan-15 Jan-16 Mar-96 Mar-97 Mar-98 Mar-99 Mar-00 Mar-01 Mar-02 Mar-03 Mar-04 Mar-05 Mar-06 Mar-07 Mar-08 Mar-09 Mar- Mar-11 Mar-12 Mar-13 Mar-14 Mar-15 Mar-16 Fig 54 Implied valuation ex Asia Retail and APEA FY17E EPS Peer FY17 multiple Implied value ANZ APEA Asia Retail ANZ ex APEA and Retail Upside assuming APEA and Asia retail are not value destroying Source: Macquarie Research, July 2016 As the figures below highlight, ANZ is currently trading at a ~12 discount to its long-term average and a ~11 discount to its five-year average. Also relative to peers it s trading at a ~8 discount to long-term average and a ~6 discount to five-year average. While the elevated risk profile arguably justifies this we note that our FY16-18f credit expense of ~$6.1bn for ANZ is ~50 above peers, suggesting the higher risk profile has been largely been incorporated in our forecasts. Fig 55 ANZ absolute 1yr forward PE ratio Fig 56 PE rel to majors (ex ANZ) x 16 x ANZ PE LT average 5yr average ANZ PE Rel LT average 5yr average Source: Factset, Macquarie Research, July 2016 Source: Factset, Macquarie Research, July 2016 On a dividend basis, ANZ offers a yield at a ~30 premium to its long-term average and ~19 premium to its five-year average. It also offers ~76bp relative premium to peers versus its long-term average and a ~78bp spread premium to the five-year average. Fig 57 Absolute Div yield Fig 58 ANZ dividend yield spread to the majors (0.5) (1.0) (1.5) ANZ Div Yield Long term 5 year av. ANZ Spread to majors Long term av. 7 July

19 Valuation and risks We have decreased our price target to $28.00/sh (from $29.00/sh) based broadly on the midpoint of our SOTP ($25.81/share) and GG ($30.76/share) based valuations. SOTP (sum of the parts) valuation $25.81/share Our SOTP valuation captures earnings contributions from banking and wealth management and attributes a peer-based multiple. We apply a 9.9x FY17F P/E multiple to our banking earnings, which is representative of the peer average banking P/E multiple after adjusting each bank s multiple to exclude the funds management business. For the wealth business, we apply a 13.8x FY17F P/E multiple, consistent with AMP s multiple. We assume that ANZ should trade at a ~ discount to peers (in line with the LT average). Fig 59 Segment valuation Division Cash Earnings (A$m) PE Multiple (x) Valuation Bank 6, ,777 Wealth management ,511 Total 7,380 75,288 Number of shares (last reported) 2,918 Valuation ($/share) Source: Macquarie Research, July 2016 Note: Wealth Management multiple is based on AMP FY17 multiple. Bank multiple is based on the average of peers adjusted for their respective WM contributions. We assume that ANZ should trade at a ~ discount to peers (in-line with the LT average). Gordon Growth (GG) valuation $30.76/share We have derived a GG valuation of $30.76, based on ANZ s estimated return on tangible equity of ~14 in FY16. Based on this methodology ANZ is currently trading at a ~34 discount to its fundamental valuation. Fig 60 P/NTA (x) CBA 2.0 WBC 1.5 NAB ANZ RoTE () Source: Macquarie Research, July 2016 Risks Key downside risks are centred on Asia for ANZ, namely a material deterioration in credit quality, as well as revenue, if low returning businesses are run-off without the required offsetting reduction in costs. A key upside risk is from successful completion of cost-out programme without material revenue leakages and if ANZ is able to divest minority interests in a timely manner at prices at or above book value. 7 July

20 Financials summary Fig 61 ANZ Financial Summary Year Ending 30 September 1H15 2H H16 2H Outperform PER SHARE DATA Cash EPS (AUD) - Macquarie Basis Current Price Target Price Cash EPS Growth () $22.96 $28.00 DPS (AUD) Total Shareholder Return 29.0 BVPS (AUD) NTA PS (AUD) Bloomberg: ANZ AU Shares on issue (m) 2,766 2,903 2,903 2,918 2,931 2,931 2,939 2,946 Reuters: ANZ.AX VALUATION METRICS Macquarie Equities Australian Banks P/E (Cash) Analyst(s) Contact(s) P/B (Stated) Victor German P/NTA Anita Stanley RoE () Brendan Carrig RoA () Dividend Yield () Dividend Payout () Cost of Equity () Volumes and margins H16 2H Net Interest Margin () GLAA growth () Efficiency and costs PROFIT & LOSS (AUDm) Net Interest Income 7,138 7,478 14,616 7,568 7,617 15,185 15,490 15,732 Non-Interest Income 3,047 2,855 5,902 2,748 2,841 5,589 5,782 6,115 Fees & Commissions 1,217 1,231 2,448 1,194 1,174 2,368 2,361 2,493 Financial Markets , ,129 1,091 1,139 Life and Funds , ,763 1,835 1,925 Other Revenue Total Operating Income,185,333 20,518,316,458 20,774 21,272 21,847 Total Operating Costs 4,593 4,766 9,359 5,479 4,632,111 9,221 9,335 Employee Costs 2,607 2,656 5,263 2,709 2,621 5,330 5,172 5,169 Other Costs 1,986 2,1 4,096 2,770 2,011 4,781 4,049 4,166 Pre-Provision Operating Profit 5,592 5,567 11,159 4,837 5,826,663 12,051 12,512 Impairment Charge , ,909 2,058 2,175 Pre-Tax Profit 5,082 4,872 9,954 3,919 4,835 8,754 9,993,337 Tax Expense 1,398 1,326 2,724 1,133 1,330 2,463 2,786 2,933 Minority Shareholders Other Post Tax Items Macquarie Cash Profit 3,676 3,540 7,216 2,782 3,501 6,283 7,199 7,396 Extraordinary & Other Items Reported Net Profit 3,506 3,987 7,493 2,738 3,501 6,239 7,199 7, H16 2H Cost / Income Ratio () Cost growth () BALANCE SHEET & CAP AD (AUDm) Risk Weighted Assets* 386, , , , , , , ,276 Average Interest Earning Assets 703, , ,6 754, , , , ,054 Gross Loans, Advances & Acceptances 562, , , , , , ,3 599,9 Interest Bearing Liabilites 755, , , , , , , ,901 Total Assets 860, , , , , , , ,424 Shareholders Equity 52,051 57,353 57,353 56,464 57,695 57,695 59,728 61,816 Tier 1 Capital* 41,088 45,484 45,484 45,062 45,893 45,893 47,926 50,014 Tier 1 Ratio ()* Core Tier 1 Ratio () - Basel III CET1 ratio and BDD/GLA ASSET QUALITY Impairment Charge / GLAA (bp) Impairment Charge / NHL (bp) Provisions / NPLs () H16 2H Core Tier 1 Ratio () - Basel III Impairment Charge / GLAA (bp) KEY RATIOS & GROWTH Source: Company data, Macquarie Research, July Net Interest Income growth () Non-Interest Income growth () Total Revenue growth () Cost growth () Pre-Provision Profit growth () RWA growth () GLAA growth () Deposit growth () Net Interest Margin () Cost / Income Ratio () July

21 Fig 62 Bank investment fundamentals Victor German Anita Stanley Brendan Carrig BEN BOQ CYB ( ) Recommendation Outperform Underperform Neutral Outperform Neutral Neutral Outperform Price target (A$) Upside/downside to TP () month TSR () Last Price (A$) Cash NPAT (A$mn) 2015a f f f Fully diluted EPS (cps) 2015a f f f EPS grow th () 2015a f f f Price/Earnings Ratio (x) 2015a f f f PE rel to All Industrials ex banks (x) 2015a f f f Price/Earnings rel to bank sector (x) 2015a f f f DPS (A$) 2015a f f f Current Yield () 2015a f f f Price/Book ratio (x) 2015a f f f ROE 2015a nmf 2016f f f Price/NTA ratio (x) 2015a nmf 2016f f f yr fwd PE ratio yr fwd PE ratio (adj for div) Relative premium/discount yr fw d div yield Source: Company data, Macquarie Research, July July

22 Fundamentals Macquarie Quant View The quant model currently holds a marginally positive view on. The strongest style exposure is Valuations, indicating this stock is underpriced in the market relative to its peers. The weakest style exposure is Price Momentum, indicating this stock has had weak medium to long term returns which often persist into the future. 372/688 Global rank in Banks of BUY recommendations 62 (/16) Number of Price Target downgrades 18 Number of Price Target upgrades 0 Attractive Quant Local market rank Global sector rank Displays where the company s ranked based on the fundamental consensus Price Target and Macquarie s Quantitative Alpha model. Two rankings: Local market (Australia & NZ) and Global sector (Banks) Macquarie Alpha Model ranking A list of comparable companies and their Macquarie Alpha model score (higher is better). Factors driving the Alpha Model For the comparable firms this chart shows the key underlying styles and their contribution to the current overall Alpha score. Commonwealth Bank 0.4 Commonwealth Bank 0.3 Westpac Banking Corporati 0.2 Westpac Banking Corporati Suncorp -0.1 Suncorp Westfield Corporation -0.1 Westfield Corporation Scentre Group -0.2 Scentre Group National Australia Bank -0.6 National Australia Bank Valuations Growth Profitability Earnings Momentum Price Momentum Quality Macquarie Earnings Sentiment Indicator The Macquarie Sentiment Indicator is an enhanced earnings revisions signal that favours analysts who have more timely and higher conviction revisions. Current score shown below. Drivers of Stock Return Breakdown of 1 year total return (local currency) into returns from dividends, changes in forward earnings estimates and the resulting change in earnings multiple. Commonwealth Bank Westpac Banking Corporati Suncorp Westfield Corporation Scentre Group National Australia Bank Commonwealth Bank Westpac Banking Corporati Suncorp Westfield Corporation Scentre Group National Australia Bank Dividend Return Multiple Return Earnings Outlook 1Yr Total Return What drove this Company in the last 5 years Which factor score has had the greatest correlation with the company s returns over the last 5 years. Price to Cash FY0 EV/EBITDA FY0 Sales to EV FY0 Price to Sales FY1 Change in PPE FY0 Sales Revisions 3 Month Profit Margin FY1 CPS Growth FY Negatives Positives How it looks on the Alpha model A more granular view of the underlying style scores that drive the alpha (higher is better) and the percentile rank relative to the sector and market. Alpha Model Score Valuation Growth Profitability Earnings Momentum Price Momentum Quality Capital & Funding Liquidity Risk Technicals & Trading Normalized Score Percentile relative to sector(/688) Percentile relative to market(/394) Source (all charts): FactSet, Thomson Reuters, and Macquarie Research. For more details on the Macquarie Alpha model or for more customised analysis and screens, please contact the Macquarie Global Quantitative/Custom Products Group (cpg@macquarie.com) 7 July