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Banks to resources

Its official. Bank dividends are on the chopping block. A question, of really, how much. Cuts of up to 30% may become the norm. And the storm may last some time.

APRA’s chairman, Wayne Byres voiced what everyone has been thinking. Bank dividend payouts are too high. And the banks need to repair their balance sheets at a time when net interest margins – their key profitability ratio, are under pressure. And likely to remain that way in the foreseeable low interest rate environment. Shareholders have been tapped on the shoulder with hybrids to boost the bank’s capital ratios. Bank dividends are tracking well above 6% fully franked. And simply, at payout ratios in the high 80%, are too generous.

Newspaper headlines of the past few weeks may have fooled readers into thinking the Medellin cocaine cartel had come to town. Money laundering failures on an epic scale, criminal charges pending and fines running possibly into the hundreds of millions. But it was a bank – Westpac.

Byres put the perspective right. Speaking to the Federal Parliament’s House of Representatives Standing Committee on Economics, about the major banks, the Australian Prudential Regulation Authority chairman said high dividends could easily lead banks to under investing in their businesses.

And his stark warning. “When returns have been very high, as they have been historically, it’s easy to both grow the business, grow the balance sheet and pay out returns to shareholders,” he said. “We are entering into an environment now where that’s no longer going to be the case. There will be much harsher choices for bank boards to make about how much of their reduced returns they need to retain to grow their balance sheet and fund growth. And how much they can afford to return to shareholders.”

The cuts to final dividends at Westpac and NAB announced last month emphasise the pressure on payouts generally. The ability to claw back the higher cost of capital is diminishing through tighter net interest margins. Effectively the net spread between borrowers and lenders. One of the most profitable margin boosters has been the interest spread charged between the front and back mortgage books (new and old home loan borrowers). Something regulators, disruptive fin techs and the banks major competitors themselves are targeting.

It is definitely time to alight the bank dividend gravy train. In fact, this may the last stop before shareholders see capital and dividend returns disappear down a long dark tunnel.

We have suggested over the past couple of years switching from bank to resource stocks. And that has paid handsomely in capital and higher dividend returns (FMG’s div yield last fin year was over 13%). Resource returns are up significantly boosted by prudent company management sweating assets harder. And that is going to continue.

Yes, it wise to keep an eye on China. Arguments that Chinese economic growth is going to disappear down a rabbit hole are just that. If China fails so does most of the Western world. So, depending on your risk penchant, chose your poison. Switch part of your bank holdings or hold your breath and hope.

We still favour BHP and FMG as the best of the bulk producers. Against a backdrop of tight iron ore supply and firm prices (2020 average estimate around $80) shareholder franked returns are likely to exceed or at least match 10%.

BHP’s appointment of Mike Henry as replacement CEO is a positive move. It removes uncertainty over the role. Henry will maintain Andrew Mackenzie’s strategy of careful incremental capital expenditure and strong operational focus. Free cash flow, a very important metric, is expected to come in around 9-10% in the coming two years. And this provides a fair degree of forecast certainty in BHP maintaining a high dividend payout. Supplemented possibly with special dividends.

Our 12 month BHP target is $40 plus. The company is expected to report a robust set of first half numbers in mid-February. And that could be an impetus for the share price’s next leg up. Dividend for the year is forecast around $1.60 a share – a yield of 6.2%. Down from last year’s record of $2.35 boosted by capital returns. But up significantly from the previous years $1.18.

Part of FMG’s outperformance will be down to easing trade tensions between China and USA. FMG rapidly, and continues to, deleverage its balance sheet. But in the short term 62% Platts benchmark has been outpacing FMG’s 58% blend. FMG is addressing that discount with its new Pilbara fines blend at around 61%. Benchmark producers are making a ~$16/wmt incremental margin over and above that of 58% production. FMG’s earnings per share for the current FY are targeted at around $1.40. At a 70% payout ratio this raises the prospect of a potential annual dividend payout of more than 90 cents – a pre franked yield of 9.6 %.

The Chinese steel mills are presently focused on production, rather than input costs. But this paradigm can change and the margin between the two grades could well close up. And the market is anticipating good news when FMG reports its half year. The share price briefly has broken out through $10.00. And I think this signals a move to higher levels, possible $14.00.

Remember hope is not a strategy — and it isn’t, when based on illusion, delusion, fiction or false assumptions. But it is a critical part of achieving a strategy when based what is possible; perhaps not highly probable, but possible. Which makes it a critical call to arms for switching banks to resources.

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