Slow revenue growth, historically high levels of debt impairments and write-offs, narrowing margins and regulatory uncertainty do not present an attractive scenario for the banks sector or investors.
But despite these hurdles local banks now look well positioned for a return to strong growth in earnings and dividends. Assuming the economy recovers as expected this year and we are not heading for a double-dip recession, bank shares look reasonably priced by historical standards and could still be worth considering.
This does not depend on a quick return to the boom conditions of a few years ago, nor is that likely to happen.
Neville Chester
A recovery could flow from declining bad debt and impairments, and a return to growth - albeit slow - from the bleak conditions of last year. "The sector is quite attractive on a two- to three-year view," says Coronation Fund Managers senior portfolio manager Neville Chester.The banks continue to express considerable caution on business conditions and risks. "The economic outlook remains challenging, globally and on the domestic front," says Absa CE Maria Ramos. "We expect to see a return to growth in the domestic economy supported by a modest upturn in consumption and investment in infrastructure by government - but risks remain."
The risks include a weak employment market, high levels of debt and concern about sustainability of the global recovery. Business volumes, says Ramos, are likely to show "muted growth".
Outgoing Nedbank CE Tom Boardman has a similar view: "The economic environment remains fragile, presenting forecast risk." Nedbank expects domestic GDP growth of 2,2% in 2010, indicating "slightly better" prospects for the banking sector.
If bank trading conditions and earnings do begin to recover, they will be rising from an unusually low base. In the year to December, Nedbank's headline earnings per share (EPS) fell by almost 30%, and Absa's EPS declined by 26%.
Return on equity (RoE), a key performance measure for the banks and investors, was 11,5% for Nedbank and 15,5% for Absa. The local banks have mostly remained profitable, but their RoEs are well below their levels of 20%-25% a few years ago.
Sectoral performance varies. Absa has had costly setbacks in its corporate and investment banking operation. Earnings from its retail banking arm fell by 21%, mainly because credit impairments surged 41% to R7,78bn. Nedbank lost R156m (from a R1bn profit in 2008) in retail banking.
Maria Ramos - Cautious tone
Standard Bank, which reports on Thursday ( after the FM went to print), is unlikely to be much different. It has already warned that its headline EPS will be down by 20%-25%. FirstRand followed a similar pattern last year, reporting a 32% drop in normalised earnings and a 14% RoE for the year to June.
Yet recent results from the big banks include important signals of better times ahead. Analysts expect the main driver of earnings over the next two years will be a decline in the cycle of bad debt, with some improvement in market conditions. History shows a decline in the bad debt cycle is usually followed by renewed growth in earnings and dividends, and improved share ratings.
"The important trend in these results is that retail credit quality is starting to improve," says Chris Steward, head of financials at Investec Asset Management. "If you look at the mortgage books and the instalment finance books, they have peaked [in bad debts and impairments]. That's an encouraging sign".
This is most noticeable in the retail sector. Absa says nonperforming advances remained high mainly because of the continued increase in legal balances and balances subject to debt counselling, but the level of new delinquencies is declining. Nedbank says the rate of new defaults in its retail business slowed in the second half of the year.
It may be too soon to conclude the worst is over. Though corporate impairments have been benign, Nedbank says it's cautious on impairments as large one-off charges are difficult to predict, and it's uncertain how economic conditions could further affect consumers.
This points to an unusual aspect of the recent recession. Previous downturns have usually led to some large corporate failures that hit one or more banks hard. An example was the collapse of Tollgate Holdings in the early 1990s, which hurt Absa. Nedbank suffered from a spate of corporate failures in the previous decade. Failures of large corporates have not been a feature of this downturn so far, but the banks say small businesses have been under great pressure.
In the retail sector, banks' bad debts have risen to their highest in 20 or 30 years, says Chester. The benefits from a gradual normalisation of bad debt ratios should be large. "Even if the recovery [in bad debts] is slow, it will be off a high level. That alone will be a strong driver of earnings over the next two years," he says.
Interest margins in the sector have narrowed for some time because of an "endowment effect" that occurs when the Reserve Bank starts cutting interest rates; there is a lag before banks can match their funding costs and lending prices appropriately. Nedbank says it expects further margin declines.
However, analysts say significant repricing of lending on new business is now occurring, indicating that banks are adjusting to the lower rates. That was evident in Absa's results.
"When you put that together with a peak in bad debts, it creates a positive banking environment for 2010," says Steward.
WHAT IT MEANS
 Conditions remain tough and risky
Bank shares could do well in a cyclical recovery
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Noninterest income, such as fees and commissions, is unlikely to improve much, except through better volumes later. Some years ago these charges were regularly increased at double-digit rates, but the industry is now under pressure from regulators and government to curb the increases.
Local banks' balance sheets remain strong. Capital ratios are well above those of many of their international counterparts - and rising. This reduces risk, but will also constrain the potential RoE as growth returns.
Steward says the sector RoE could recover to about 20% over the next few years, and the chances of earnings growth of about 20% this year are "reasonably good". Banks have historically been good income stocks. Dividends and yields should recover with earnings.
The shares have risen strongly from their lows last year. Valuations based on price to net asset value ratios - 1,9 times for Absa and 1,7 for Nedbank - indicate they are not expensive, though no longer screaming buys except on a long-term view.
However, bank shares are intrinsically cyclical and can do well for investors in a recovering economy. They also tend to benefit from a strong rand, and the sector offers diversification from the resources sector.
Ranking the Analysts 2009
