? Presale Report: ANZ Capital Notes 3 (ANZPF) A fairly priced offer from a preferred issuer. Recommendation: Subscribe at top end of the range, 3.80%. Morningstar Equity Research 29 January 2015 John Likos, CFA Credit Analyst +612 9276 4513 john.likos@morningstar.com Ravi Reddy Associate Analyst +612 9276 4581 ravi-reddy@morningstar.com Joel Bloomer Head of Asia-Pacific Equity & Credit Research +612 9276 4501 joel.bloomer@morningstar.com Executive Summary Australia & New Zealand Banking Group, or ANZ Bank, will raise AUD 750 million via a new hybrid issue, to be listed on the Australian Securities Exchange, ANZ Capital Notes 3 (ASX:ANZPF). These securities will provide additional tier-1 regulatory capital for ANZ Bank, in compliance with the Australian Prudential Regulation Authority's, or APRA's, capital adequacy standards (Basel III requirements). ANZPF is a fully-paid, non-cumulative, convertible, transferrable, redeemable, subordinated, perpetual, unsecured note with an AUD 100 face value and mandatory exchange date of 24 March 2025. This is subject to exchange conditions, unless it is exchanged earlier as a result of a trigger event or ANZ Bank exercising an option to call the security two years early on 24 March 2023. Distributions are discretionary, non-cumulative and expected to be fully, or substantially, franked with a dividend stopper. Distributions will be paid semi-annually in arrears, based on the 180-day bank-bill swap, or BBSW, rate plus a margin in the indicative range of 3.60% to 3.80%. With the current 180-day BBSW rate at 2.64%, this equates to a total estimated gross running yield range of 6.24% to 6.44%. Key Takeaways We recommend investors subscribe to the offer for ANZPF at the upper end of the indicative range, that being 3.80%. ANZ Bank is supported by wide-moat and Exemplary stewardship ratings. The indicative pricing range for ANZPF is above our 3.40% fair margin, however, when priced on a relative basis against comparable major bank hybrid securities, we identify value at the top end of the indicative range. We assign ANZPF a medium investment risk rating, the same as other Basel III tier-1 compliant major bank hybrids. Terms and conditions such as non-viability and capital conversion triggers in this new breed of hybrid securities make them more equity-like and, consequently, riskier than the "oldstyle" issues such as ANZ CPS II (ASX:ANZPA). Although we don't anticipate such triggers being activated, we believe potential investors should understand these risks and be incrementally compensated for taking on that risk. of Morningstar, Inc, without reference to your objectives, financial situation or needs. Refer to our Financial Services Guide (FSG) for more information at www.morningstar.com.au/s/fsg.pdf. You should consider the advice in light of these matters and if applicable, the relevant Product does not necessarily indicate a financial product's future performance. To obtain advice tailored to your situation, contact a professional financial adviser. Some material is copyright and published under licence from ASX Operations Pty Ltd ACN 004 523 782 ("ASXO").
Page 2 of 13 Summary and Recommendation We recommend investors subscribe to the offer for ANZPF at the upper end of the indicative range, that being 3.80%. ANZ Bank is supported by wide-moat and Exemplary stewardship ratings. The indicative pricing range for ANZPF is priced above our 3.40% fair margin, however, when priced on a relative basis against comparable major bank hybrid securities, we identify value at the top end of the indicative range. This brings ANZPF closer to where ANZ Capital Notes (ASX:ANZPD) and ANZ Capital Notes 2 (ASX:ANZPE) are trading. Furthermore, we anticipate increased Basel III tier-1 compliant bank hybrid issuance in the coming months, which could put pressure on ANZPF pricing, particularly at the lower end of the indicative pricing range. It's a clear sign of the changing sentiment towards hybrid pricing when we compare the ANZPF offer with the last Basel III tier-1 compliant major bank hybrid issue, CommBank PERLS VII (ASX:CBAPD) issue, which was announced in August 2014. Margins had become very tight around that time but have widened to more attractive levels now. In fact, the margin on CBAPD of 2.80% was below the margin of the security it was replacing, PERLS V (ASX:CBAPA), 3.40%, despite having inferior terms in the form of non-viability and capital triggers. Our "Do Not Subscribe" recommendation on CBAPD was justified when CBAPB listed at, and has continued to trade below, face value. We reiterate our approach of taking a longer-term view when determining our fair margin, as we try to look through the credit cycle. We assign ANZPF a medium investment risk rating, the same as other Basel III tier-1 compliant major bank hybrids. The terms and conditions such as non-viability and capital conversion triggers in this new breed of hybrid securities make them more equity-like and, consequently, riskier than the "old-style" issues such as ANZ CPS II (ASX:ANZPA). Although we don't anticipate such triggers being activated, we believe potential investors should understand these risks and be incrementally compensated for taking on that risk. While some investors look to hybrids to fulfil the need for fixed-income diversification in a portfolio, we view them as a complex form of equity with only mild improvements in risk and limited diversification in an adverse economy or market. We suggest investors consider comparable alternatives to gain an understanding of the risk/reward merits of an investment on a relative basis, such as bank deposits, bank equity or other hybrids. Online savings accounts have the benefit of a guarantee under the Australian government Financial Claims Scheme, but offer approximately 220 to 240 basis points less than the ANZPF, based on its indicative trading margin range. We have a forecast gross yield of about 8.3% on ANZ Bank ordinary shares for fiscal year 2015, approximately 190 to 210 basis points higher than that of ANZPF. Equity securities may allow investors participation in capital upside, but present higher volatility and risk than hybrid securities. Investors often underestimate the tendency of hybrids to become volatile in times of distress, similar to shares and unlike traditional senior bonds.
Page 3 of 13 Exhibit 1: Comparable Major Bank Hybrids ANZPF CBAPD ANZPD ANZPE WBCPE ANZ Capital Notes 3 Commonwealth Bank ANZ Capital Notes ANZ Capital Notes 2 Westpac Capital Notes 2 PERLS VII Security Type Mandatory Conversion Mandatory Conversion Mandatory Conversion Mandatory Conversion Mandatory Conversion Issuer ANZ CBA ANZ ANZ WBC Issue Size ~AUD 750 million AUD 3,000 million AUD 1,120 million AUD 1,610 million AUD 1,310m Face Value AUD 100 AUD 100 AUD 100 AUD 100 AUD 100 Issue Date 5-Mar-15 1-Oct-14 7-Aug-13 31-Mar-14 24-Jun-14 Margin above Base Rate 3.60% - 3.80% 2.80% 3.40% 3.25% 3.05% Base Rate 180-Day BBSW 90-Day BBSW 180-Day BBSW 180-Day BBSW 90-Day BBSW First Call Date 24-Mar-23 15-Dec-22 1-Sep-21 24-Mar-22 23-Sep-22 Mandatory Exchange Date 24-Mar-25 15-Dec-24 1-Sep-23 24-Mar-24 23-Sep-24 Distributions Capital Trigger Event Discretionary, non-cumulative, fully or substantially franked distributions with a dividend stopper. Yes, if common equity tier-1 ratio is equal to or below 5.125%. Discretionary, non-cumulative, fully franked distributions with a dividend stopper. Yes, if common equity tier-1 ratio is equal to or below 5.125%. Discretionary, non-cumulative, fully franked distributions with a dividend stopper. Yes, if common equity tier-1 ratio is equal to or below 5.125%. Discretionary, non-cumulative, fully franked distributions with a dividend stopper. Yes, if common equity tier-1 ratio is equal to or below 5.125%. Discretionary, non-cumulative, fully franked distributions with a dividend stopper. Yes, if common equity tier-1 ratio is equal to or below 5.125%. Non-Viability Trigger Event Yes Yes Yes Yes Yes Conversion into ordinary shares Yes Yes Yes Yes Yes Ranking in windup Above ANZ ordinary shares and equal to other preference shares. Above CBA ordinary shares and equal to other preference shares. Above ANZ ordinary shares and equal to other preference shares. Above ANZ ordinary shares and equal to other preference shares. Above WBC ordinary shares and equal to other preference shares. Gross Running Yield * 6.24% - 6.44% 5.90% 6.36% 6.29% 6.05% Gross Yield to Reset * 6.24% - 6.44% 6.42% 6.67% 6.73% 6.37% Trading Margin * 3.60% - 3.80% 3.57% 3.84% 3.89% 3.53% Recommendation N/A HOLD HOLD HOLD HOLD * As at 28-Jan-15. Source: Morningstar Exhibit 2: Morningstar ANZ Bank Forecasts * Historical yields are base on average share prices. Forecast yields are base on the share price as at 28 January 2015 FY 2013A FY 2014A FY 2015F FY 2016F FY 2017F Net Profit after Tax ($M) 6,492 7,117 7,728 8,295 9,137 EPS Growth 8.9% 9.5% 7.0% 5.8% 8.6% DPS Growth 3.6% 22.8% 6.7% 5.8% 10.0% Dividend Yield (incl. franking)* 7.4% 7.9% 8.3% 8.8% 9.7% Net Interest Margin 2.22% 2.13% 2.14% 2.15% 2.16% Cost to Income Ratio 44.9% 44.7% 44.0% 43.5% 42.9% Dividend Payout Ratio 61% 68% 68% 68% 69% Loan growth 12.5% 7.7% 7.4% 7.4% 7.5% Bad Debt Expense to Average Loans (bps) 26 19 20 22 22 Source: ANZ Bank, Morningstar Pre-Tax Pre-Provision Earnings Growth 8.6% 6.7% 9.0% 8.0% 10.0%
Page 4 of 13 Exhibit 3: Ranking of ANZPF in a Winding Up of ANZ Bank ANZPF ranks ahead of ordinary shares, equally with equal-ranking capital securities (ANZPD and ANZPE), behind senior creditors, liabilities preferred by law (such as bank deposits) and secured debt (covered bonds). Exhibit 3 provides a summary of ANZ Bank's capital structure ranking, highlighting the relatively low position of ANZPF in the event of a winding up. Valuation Our valuation on ANZPF is based on a combination of absolute and relative value analysis. On an absolute valuation basis, we believe ANZPF should offer a margin at, or above, our fair margin assessment of 3.40%. Our fair margin reflects the return we believe the investor requires for the commensurate risks, which includes credit risk, liquidity risk, non-viability risk and extension risk. On this basis the indicative pricing range of ANZPF appears attractive at the top end of the indicative range. For the purposes of relative valuation, we price ANZPF against comparable Basel III tier-1 major bank hybrid securities. As can be seen in Exhibit 4, ANZPD and ANZPE both offer similar trading margins to the ANZPF indicative pricing range, however, ANZPF is priced significantly cheaper than Westpac Capital Notes 2 (ASX:WBCPE) and CBAPD. ANZPF is also supported by an attractive running yield. While we acknowledge the strength of both Commonwealth Bank of Australia and Westpac Banking Corporation, we have a wide moat rating on all four major banks. With this in mind, we are comfortable with the ANZPF relative pricing at the top end of the range.
Page 5 of 13 Exhibit 4: ANZPF Relative Pricing Issue Size Trading Margin 4.0% 3.9% 3.8% NABPA NABPB ANZPD ANZPE ANZPF 3.7% 3.6% 3.5% CBAPC WBCPD WBCPE CBAPD 3.4% Source: Morningstar 3.3% 3 4 5 6 7 8 9 Years to Reset The Offer The offer comprises: a securityholder offer for holders of other ANZ securities (ANZ, ANZHA, ANZPA, ANZPC, ANZPD and ANZPE); a general offer to Australian residents; a broker firm offer for clients of eligible brokers; and an institutional offer. Security Risks Capital Trigger Risk ANZPF has a capital trigger event clause which requires immediate exchange of some or all securities into ordinary equity if the bank's core capital ratio falls below 5.125%. ANZ Bank's common equity tier-1 ratio, on a Basel III basis, was 8.80% as at 30 September 2014 (Exhibit 5), representing a healthy buffer of about AUD 13 billion over the 5.125% minimum. From 1 January 2016, APRA will require banks to maintain a 3.50% buffer above the minimum requirement of 4.50%. This ratio is not likely to trickle down to 5.125%, as action would be taken beforehand. Any fall to, or below, 5.125% would likely be sudden, possibly the result of a major operational failure or a significant increase in bad debts. Put in context, such an event would have to erase about AUD 13 billion of capital, or almost two years' profit based on Morningstar forecasts not impossible, but highly unlikely. If this ratio did fall below 5.125%, ANZPF holders would likely suffer a capital loss as a result of the maximum exchange number of shares condition, where holders could potentially receive ordinary shares worth less than the AUD 100 face value of ANZPF securities. For example, if we assume an issue date volume-weighted average price, or VWAP, of AUD 32.00 for ANZ Bank shares, the price would have to fall to below AUD 6.40 for ANZPF holders to receive ANZ Bank ordinary shares worth less than AUD 100. We think this scenario is highly unlikely, reiterated by our AUD 27.00 bear-case fair value estimate for ANZ Bank ordinary shares.
Page 6 of 13 Non-Viability Risk ANZPF has a non-viability trigger, which is required by the prudential regulator, APRA, as part of the Basel III reforms. The non-viability trigger gives APRA the discretion to require some or all of ANZPF to be exchanged into ANZ Bank ordinary shares, making ANZPF more equity-like, or risker, than ANZPA, which was issued under the previous, less-stringent, regulatory regime in December 2009. Similar to exchange following a capital trigger event, holders could potentially receive ordinary shares worth less than AUD 100. A non-viability trigger event occurs if APRA believes that ANZ Bank would become non-viable without an exchange of some or all of ANZPF or a public-sector injection of capital or equivalent support. The use of this trigger event by APRA is at its discretion so may not be limited to its concerns about ANZ Bank's capital levels and could extend to funding and liquidity concerns. Exhibits 6 to 8 suggest this is an unlikely scenario given ANZ Bank's strong funding and liquidity position. Write-Off Risk If, following a trigger event (capital trigger or non-viability), conversion has not been effected within five business days of the conversion date, ANZPF will be written off. Mandatory Exchange Risk A fall in ANZ Bank's share price to below the minimum exchange price near the mandatory exchange date (24 March 2025) would result in ANZPF not being exchanged on that date and remaining on issue until the next distribution payment date when the exchange conditions are met. For example, if we assume a VWAP of AUD 32.00 for ANZ Bank shares for the 20 business days immediately preceding the issue date for ANZPF, the ANZ Bank share price must be above AUD 17.92 on the 25th business day before a possible mandatory exchange date to satisfy the first mandatory exchange condition. We think a scenario where ANZ Bank shares fall below this level is unlikely, supported by our AUD 27.00 bear-case fair value estimate for ANZ Bank ordinary shares. Credit/Default Risk This is the risk of loss arising from ANZ Bank defaulting on its payments, whether in the form of distribution payments or principal repayment. Distributions are non-cumulative, meaning distributions which are not paid do not accrue, and do not have to be paid subsequently. This is largely offset by ANZ Bank's strong credit profile. Subordination Risk ANZPF is an unsecured, subordinated investment, so in a wind-up scenario, investors could potentially lose all of their investment. Furthermore, in the event of ANZ Bank issuing further equalor higher-ranking securities on the capital structure, ANZPF may become further subordinated. Market Price Risk The market price of ANZPF could decrease below that of face value, depending on various marketrelated factors such as credit spreads, interest rates or ANZ Bank's underlying share price performance.
Page 7 of 13 Liquidity Risk There is a risk that liquidity of the security will be low, which will impact the bid/ask spread. Regulatory Risk Investors need to be aware of the possibility of a change in laws and regulations that could materially impact the value of their investment. Extension Risk If ANZPF is not called at the first call date it may trade like a perpetual security. Event Risk Event risk arises as a result of unforeseen or unexpected events such as natural disasters, or mergers and acquisitions. Exhibit 5: ANZ Bank Regulatory Capital Internationally Harmonised Basis Common Equity Tier 1 14% 12% 12.7% 12.2% 12.7% 10% 8% 8.5% 8.3% 8.8% 6% 4% 2% Source: ANZ Bank 0% Sep-13 Mar-13 Sep-14
Page 8 of 13 Exhibit 6: ANZ Bank Funding Mix at 30 September 2014 ST Wholesale 120% LT Wholesale <1 year LT Wholesale >1 year Customer Deposits Equity & Hybrids 100% 80% 60% 22% 7% 14% 15% 14% 3% 3% 12% 12% 40% 50% 62% 63% 20% Source: ANZ Bank 0% 7% 8% 8% Sep-08 Sep-13 Sep-14 Exhibit 7: ANZ Bank Liquid Assets at 30 September 2014 Wholesale Funding Internal RMBS Private Sector Securities & Precious Metals Cash, Govt, Semi-Govt Billions (AUD) 160 140 120 100 80 49 18 60 115 40 73 20 Source: ANZ Bank 0 Sep-14 Sep-14 Wholesale Funding < 12mths to Maturity
Page 9 of 13 Exhibit 8: ANZ Bank Term Wholesale Funding Maturity Profile at 30 September 2014 Billions (AUD) 25 20 15 10 18 23 20 5 13 12 13 Source: ANZ Bank 0 FY15 FY16 FY17 FY18 FY19 FY20+ Key Dates for ANZPF Bookbuild: 4 February 2015. Announcement of margin: 5 February 2015. Offer opens: 5 February 2015. Closing date for ANZ securityholder and general offer: 26 February 2015. Closing date for broker firm offer: 4 March 2015. Issue date: 5 March 2015. Commencement of trading: 6 March 2015. First distribution payment date: 24 September 2015. Optional exchange date: 24 March 2023. Mandatory exchange date: 24 March 2025. Key Terms Face value: AUD 100 per security. Minimum subscription amount: AUD 5,000 (50 units). Additional amounts can be bought in increments of AUD 1,000 (10 units). Amount to be raised: ANZ Bank plans to raise AUD 750 million via the issue of 7.5 million securities but has the ability to raise more or less. Cash distribution rate: (180-day BBSW rate + margin) x (1 corporate tax rate). This assumes the ANZPF distribution is fully franked. Margin: The indicative margin range is 3.60% to 3.80%. The margin will be set via a bookbuild process. Frequency of distributions: Semi-annual on 24 March and 24 September. Franking: Expected to be fully or substantially franked. If a distribution is not franked or partially franked, the cash distribution amount will be increased to compensate for any franking shortfall. Distributions: Payment of distributions is discretionary and subject to payment conditions being satisfied, the most material being that payment does not cause ANZ Bank to breach its
Page 10 of 13 regulatory capital requirements or become insolvent and APRA not objecting. Distributions are not cumulative, so ANZ Bank does not have to make up unpaid distribution payments. From 1 January 2016 there will be restrictions on the proportion of profits that can be paid through ordinary dividends, additional tier-1 distributions (such as ANZPF) and discretionary staff bonuses if a bank's common equity tier-1 ratio falls below 8%. Dividend stopper: If an ANZPF distribution is not paid in full within three business days then ANZ Bank cannot, without approval of ANZPF holders, pay dividends on its ordinary shares, undertake a buyback or reduce capital on any ordinary shares until a distribution is paid in full on a subsequent distribution payment period. Term: Perpetual, with a mandatory exchange date of 24 March 2025, or any subsequent distribution payment date, subject to exchange conditions or if the security is exchanged earlier as a result of a trigger event or ANZ Bank exercising an option to call the security two years early on 24 March 2023. Capital classification: Additional tier-1 regulatory capital. Mandatory exchange date: If ANZPF has not been exchanged or redeemed earlier, on 24 March 2025, ANZPF will convert into a variable number of ANZ Bank ordinary shares worth approximately AUD 101.01 at a 1% discount to the 20 business day VWAP of ANZ Bank ordinary shares. This is subject to exchange conditions. If these conditions are not satisfied, exchange will be deferred until the next distribution payment date upon which the conditions are met. The mandatory exchange conditions are: First condition: The VWAP of ANZ Bank ordinary shares on the 25th business day before (but not including) a possible mandatory conversion date is equal to or greater than 56% of the issue date VWAP of ANZ Bank ordinary shares; Second condition: The VWAP of ANZ Bank ordinary shares during the 20 business days before (but not including) a possible mandatory conversion date is equal to or greater than 50.51% of the issue date VWAP of ANZ Bank ordinary shares; and ANZ Bank ordinary shares are listed and admitted to trade on the Australian Securities Exchange. Capital trigger event: If ANZ Bank determines, or APRA believes, that ANZ Bank's common equity tier-1 ratio is equal to or less than 5.125%, ANZ Bank must exchange a sufficient amount of ANZPF into ANZ Bank ordinary shares to return this ratio above 5.125%. The number of shares on exchange will be based on the VWAP five business days before the exchange date. However, exchange following a capital trigger event is not subject to mandatory exchange conditions being satisfied. This means ANZPF holders could potentially receive ANZ Bank ordinary shares worth less than AUD 100. This is because the maximum exchange number of shares will apply based on 20% of the issue date VWAP. For example, if the issue date VWAP of ANZ Bank ordinary shares was AUD 32.00, the maximum exchange number of shares would equal 15.625 ANZ Bank ordinary shares for each ANZPF (AUD 100/(AUD 32.00 x 20%)). Therefore, if the ANZ Bank share price on exchange was AUD 5.00, then ANZPF holders would receive ANZ Bank shares worth approximately AUD 78.13 (15.625 x AUD 5.00) for each security. A non-viability trigger event occurs if APRA notifies ANZ Bank that it believes that exchange of some or all ANZPF (or some action in relation to other ANZ Bank capital instruments) is required, because without it ANZ Bank would become non-viable; or a public sector injection of capital is required because without it ANZ Bank would become non-viable. Following such an event, ANZ
Page 11 of 13 Bank must immediately exchange such number of ANZPF securities that is specified by APRA or necessary to satisfy APRA that ANZ Bank will no longer be non-viable. Exchange following this event is not subject to mandatory exchange conditions being satisfied. The consequence is similar to exchange following a capital trigger event where ANZPF holders could potentially receive ANZ Bank ordinary shares worth less than AUD 100. Optional exchange: ANZ Bank has the option to redeem, resell or convert some or all the notes early on the 24 March 2023 optional exchange date or following a tax or regulatory event. Exchange is subject to satisfaction of certain conditions and APRA approval. ANZPF holders have no right to request exchange. We have only presented a summary of the material terms. Investors should examine the prospectus in detail. Issuer Details Profile ANZ Bank is Australia's third-largest bank by market value and provides retail, business and institutional banking services to 8 million customers in Australia, New Zealand, and Asia-Pacific. The strategy is to become a super-regional bank in Asia, with an objective to source 25% to 30% of earnings from Asia by 2017, while growing core businesses in Australia and New Zealand. This differentiates ANZ Bank from domestic peers, none of which has an Asia-centric strategy. The bank reported total assets of AUD 772 billion as at 30 September 2014, including AUD 524 billion in gross loans and advances. Cash net profit after tax for fiscal 2014 was AUD 7.1 billion, representing a return on equity of 15.4%. Investment Thesis ANZ Bank is the third-largest of Australia's four major banks by market value and the largest bank in New Zealand and the Pacific, offering a full range of banking and financial services to the consumer, small business and corporate sectors. More recently, it acquired equity interests in banks and financial institutions across Asia. ANZ Bank operates in 32 markets globally. There are strong barriers to entry to the Australian and New Zealand banking sectors. All four major banks, ANZ Bank, Commonwealth Bank of Australia (ASX:CBA), National Australia Bank (ASX:NAB) and Westpac Banking Corporation (ASX:WBC), have extensive pricing power, efficient scale, low-cost operations, trusted brands, and very profitable operations. ANZ Bank's strategy aims to deliver long-term growth and superior returns through funding "connectivity" (trade and investment flows) between Asia-Pacific countries, Australia and New Zealand, particularly in resources, agribusiness and infrastructure. This strategy is called "superregional". It is the strategy with the most defined regional goals of the four major banks and is a direct product of CEO Mike Smith's extensive experience in Asian banking. A central theme is the likely slower growth in the Australian banking system in coming years. There is a structural shift in the world economy, as economic growth shifts from the west to the east, with ANZ Bank positioned in the right part of the world with a credible plan at the right time. The faster growth available in emerging and industrialising Asia was attractive to a board seeking to hire
Page 12 of 13 a CEO with the experience to exploit it. We think the super-regional strategy can succeed, though returns are long-dated and shareholders need to be patient. Progress to date is very encouraging. Returns will rise strongly if ANZ Bank executes successfully, though the upside comes with higher risks. One such risk is the experimental nature of the super-regional concept. Risks arise from increased competition in Asia as international banks target emerging markets for growth. A slowdown in economic growth in the region is an increasing risk. Value-destruction may also occur from overpaying for bolt-on acquisitions, but the lack of data in acquisition announcements about earnings and book value multiples paid makes it hard to gauge the extent to which this occurs. The bank's Asian growth emphasises institutional banking, which is capitalintensive because of higher risk weights for this category. Higher regulatory capital levels could subdue return on equity unless revenue growth is sufficient to provide offsetting economies of scale. Exhibit 9: ANZ Bad Debt Expense to Average Net Advances Basis Points 90 80 70 60 50 40 85 30 20 10 50 32 30 26 19 Source: ANZ Bank 0 FY09 FY10 FY11 FY12 FY13 FY14 Financial Health ANZ Bank is in good financial health and better than peers, with a common equity tier-1 capital ratio at 30 September 2014 of 12.7% based on internationally harmonised Basel III rules. The bank is one of the few in the world that is rated AA- and continues to generate capital organically because of its relatively high return on equity and slow lending growth. The Basel III requirements regarding capital pose no threat to ANZ Bank. During the past three years, the proportion of customer deposits to total funding increased from 50% to 63%, reducing exposure to volatile funding markets. Issuance of covered bonds will incrementally diversify the funding base. Total liquid assets exceed total offshore wholesale debt and, theoretically, ANZ Bank could afford to retire all its offshore wholesale debt in the event these debt markets closed and the maturing debt could not be rolled. This would be disruptive, but at least the bank would be solvent.
Page 13 of 13 Capital Structure Balance sheet leverage (assets/equity) peaked at 17.8 times in fiscal 2007 but declined (improved) to 15.7 times in fiscal 2014. This ratio is the second-lowest among major bank peers, a prudent outcome given the above-average proportion (46%) of business loans on the bank's balance sheet. This decline in leverage reflected a series of capital raisings, strong organic capital generation and slow lending growth, which has led to improved regulatory capital ratios. Net loans and advances, being the largest asset category, grew in dollar terms by AUD 38 billion, but liquid assets grew in percentage terms by 13% as ANZ Bank positioned itself for less reliable funding markets. Holding substantial liquid assets positions the bank to retire maturing wholesale debt if wholesale funding markets close. We are confident the strong capital base will support the bank's pursuit of organic growth in Asia, but any major acquisition would likely require an equity raising. ANZ Bank requires a higher capital buffer because of the riskier Asian growth strategy, but in our view, the bank has sufficient capital to support moderate growth in residential and business lending in Australia. Asian institutional lending is especially capital-intensive. ANZ Bank's capital ratios are strong, and the 1.5% dividend reinvestment plan, or DRP, discount was removed for the final fiscal 2012 dividend. Given the capital strength, we forecast the payout ratio to remain steady at 69%. Economic Moat We assign a wide moat rating to ANZ Bank, mainly because of its sustainable structural advantages of the Australian and New Zealand banking sectors. The wide moat rating recognises the structural competitive advantages Australia's four major banks possess. The four major banks dominate a regulated and rational oligopoly, bestowing structural advantages that are strong and durable. We believe the economic moats surrounding the major banks are sufficiently wide to ensure global sector-leading returns on equity for the foreseeable future. Management & Stewardship We rate CEO Mike Smith highly and ANZ Bank's capital stewardship is very good, providing it with an Exemplary stewardship rating. Smith joined ANZ Bank after spending 26 years in international banking, particularly in Asia. Until June 2007, he was president and CEO of The Hong Kong and Shanghai Banking Corporation Limited, chairman of Hang Seng Bank Limited, global head of commercial banking for the HSBC Group and chairman of HSBC Bank Malaysia Berhad. After starting as CEO in late 2007, shareholder return on equity suffered from a global-financialcrisis-induced decline to lows in fiscal 2009, but has since steadily improved to an impressive 15.4%. It is still too early to gauge the long-term success of the Asian growth strategy, but the Asia-Pacific division's return on equity remains below Australian returns. K
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