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Banking on iron ore – Trim CBA, Buy RIO

The crush of investors into the perceived safe haven of the high yielding banks has served many investors well over the past year. But now is the time to be shifting some of those gains into the underperforming resource sector.

We are recommending investors think about taking some profits on CBA holdings and switching the proceeds into RIO.

The underlying theme to our thinking on the resource stocks is that the cash flow boom is about to begin now that the capital expenditure cycle has peaked.

CBA’s exalted status

There can be little argument that CBA isAustralia’s premier bank, even among its high quality peers.

CBA’s latest half-year result was sturdy with a ‘modest’ 20% increase in the dividend to $1.64 per share for the interim although this is more about evening out the dividend payments across the year.

The cost of wholesale funding has eased over the last year allowing all banks some breathing space on their net interest margins. The chase for deposit funding has also cooled as evidenced by the lower rates now on offer for conservative savers.

The major banks have an even greater stranglehold on the nation’s housing lending after a period when the cost of funding squeezed out the regional and foreign banks from this lucrative part of the market.

CBA’s home lending book reached $356 billion (1.8 million home loans in Australia) and represents a market share of just over 25% and about 52% of the bank’s total loan book. The bank was able to edge up its pricing in this division offsetting it with lower funding costs to keep the net interest margin at 2.10%. The cost of deposit funding, which makes up 63% of total funding, dropped by 13 basis points as rates for deposits declined.

Home loan volumes are not expanding at a rapid pace, but the underlying safety and profitability of this loan book makes it a fortress from the banks’ point of view. Over 81% of customers are paying in advance of the required monthly mortgage repayment representing a buffer of about 7 monthly repayments.

The boom years ofAustralia’s housing market are well and truly over, but there is no sound basis for anticipating a major correction in house prices. Low unemployment, modest GDP growth, a high degree of home ownership and a slight skew towards demand over supply support this idea.

For keen readers, we suggest an excellent document written by Judith Yates for the Reserve Bank of Australiain 2011 entitled “Housing in Australia in the 2000s: On the Agenda Too Late?” It discusses the prevalent factors in the decade that fuelled the country’s frenzy for home ownership.

Credit growth generally is broadly in line with GDP growth but the very low level of bad debts in the banking system means there is little pressure on management. Cost cutting was a valid tactic last year but the banks will find less reason to chop numbers again this year. CBA chose to stay out of that game but has vigorously pursued efficiency gains in other areas.

The bank sector in Australia has spectacularly outperformed the broader market, although this has been dragged down by the underperformance of the resource sector in particular over the last year.

The market has stubbornly refused to give up any ground in the sector as interest rates and dividend payments head in opposite directions.

Term deposit rates that were in excess of 5% last year have sunk towards 4% but even as bank share prices have risen, the gross dividend yield across the four majors has been sustained at an average 8.3%.

The rationale on RIO

As the pace of Chinese economic growth slowed towards the government’s targeted 7.5% level last year, the demand for basic commodities such as iron ore tailed off throughout 2012. This brought the price of seaborne iron ore down from very high levels to under US$100 per tonne, arguably an over-reaction.

The iron ore price has since rebounded to more appropriate levels asChinacautiously resumes its re-orientation towards domestic demand for infrastructure and housing with less reliance on exports.

RIOand BHP’s bonanza profit results of 2010 and 2011 were generated by extreme price movements in iron ore particularly, as well as other commodities.

But for several years, the big iron ore miners have been executing plans for the quantum expansion of infrastructure (mines, rail and ports) to deliver extraordinary new volumes of iron ore into the Chinese market.

While it’s true that some of the longer dated expansion plans have been put on hold, we think that this enhances the cash flow theme we are pushing.

Conceptually, the companies will begin to experience substantially improved cash flow from greater operating earnings and lower capital investment as the peak of the capital investment cycle passes.

RIO’s writedowns in across its aluminium business notwithstanding, the company is in financially good shape. Although Sam Walsh is an old hand at RIO, his fresh eyes in the CEO suite may invigorate the group.

We may update this note following tonight’s release of RIO’s full year 2012 result.

Summary

The Australian banking system, CBA in particular, seems almost impregnable. It is hugely well capitalised, extremely well managed and fiercely competitive despite what some politicians would have us believe.

There is every reason to remain invested in CBA but there is a window of opportunity to trim holdings in CBA and reinvest proceeds in a relatively underperforming RIO.

RIO’s share price does not reflect the long term prognosis for its massive resource base and exposure to the Chinese demand for iron ore. The price also does not reflect the likely strong rise in cash flow as the peak of the investment cycle passes.

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