After the bank’s reporting season over the past few weeks, we have become increasingly cautious on the banks.
We now see more headwinds for earnings than tailwinds.
Earnings now looks to be too optimistic, considering headwinds from:
Net interest margin forecasts may be close to peaking – we think this upgrade cycle has peaked.
We are more cautious about credit growth due to a slowing economy and housing cycle – housing credit is already starting to slow at a rapid pace.
Costs have become a key risk. We think costs could keep surprising to the upside over the next 12 months.
As a result, we have taken our neutral position into underweight, trimming our positions in all 3 of our bank exposures – NAB (NAB), ANZ (ANZ) and Westpac (WBC) – by 1%, reducing our banks weighting to 16.5%, vs the ASX 300 weighting of 21%, leaving us ~0.8x the banks.
We have used the proceeds to add Mineral Resources (MIN) to the Focus Portfolio at a 3% weighting. This closes our portfolio underweight to resources which has stretched out over the last few months. Additionally, we are looking to increase our exposure to battery minerals, which we believe has significant upside potential over the next few years.
MIN is one of the highest-quality mining and mining services companies on the ASX. The potential spin-off of its lithium assets could provide substantial returns for investors as the lithium segment is markedly undervalued by the market in the current group structure.
| Company | Ticker | Sector | Old Weighting | New Weighting | Change |
| NAB | NAB | Banks | 8.5% | 7.5% | -1% |
| ANZ | ANZ | Banks | 5.0% | 4.0% | -1% |
| Westpac | WBC | Banks | 6.0% | 5.0% | -1% |
| Mineral Resources | MIN | Resources | 0.0% | 3.0% | 3% |
Source: Refinitiv, Wilsons.
Banks Sector - Locking in Outperformance
Banks have outperformed this year and since the COVID lows in March 2020. Consensus expectations are for bank earnings to grow 13.4% over the next 12 months, which looks very optimistic relative to historical growth and considering the mounting headwinds facing the sector.
Net interest margin (NIM) optimism peaking
Net interest margin expansion – from higher interest rates – has driven earnings upgrades across the sector and been a tailwind for outperformance.
As interest rates likely peak over the next 3-6 months, we expect NIMs to also peak. We believe higher NIMs have now been largely incorporated into analyst estimates, indicating that this upgrade cycle is ending. We are also cognisant of the intense competition in the mortgage market which has been weighing on NIMs and offsetting some of the interest rate benefits.
Weaker credit conditions
While interest rates may be nearing a peak, they could remain elevated for the next 12 months, slowing the economy and the housing market. This could be a significant headwind for banks' earnings over the next 12 months.
There has already been a decline in housing credit. We expect housing credit growth to decline further due to falling commitments for new housing loans. Housing commitments have fallen significantly in recent months - now down 25% overall this year to date - as interest rates have increased and housing prices and turnover have declined.
In FY23, NAB predicts a steep drop in business and housing lending volumes in Australia, with business credit growth slowing to 3.6% from 14.7% in FY22. A more severe downturn could result in further downgrades.
Costs rising and could rise further
NAB joined WBC and ANZ in warning of higher costs from wages as a result of high inflation in FY23. In its most recent result, WBC revised its FY24 absolute cost target to $8.6bn from $8.0bn, citing higher-than-expected inflationary pressures. We still think this target looks over-optimistic.
About 50-60% of banks operating expenses are due to employee costs. Therefore, we believe that wage growth could still be a risk for the banks’ earnings over the next 6 months. This is likely to disproportionately impact the banks that are in the earlier stages of digitalising their businesses, as technology staff are likely to be heavily sought after and remain at a premium.
We think there is a risk that costs could go higher than expected over FY23. The big four banks have a poor record of stripping out costs, and this time is likely no different.
Preference for NAB over CBA
CBA still looks very expensive relative to the other big banks. With such a large expansion in the valuation premium since 2019, can the current level be maintained or will revision set in at some point? Ultimately, we side with a view that elevated valuation multiples of CBA will face a mean reversion challenge.
Of CBA’s 3 peers, we see NAB showing the most convincing signs that its operational momentum can lift its ROE further. This has been evidenced over the past 12 months.
NAB is our largest bank position within our Wilsons Australian Equity Focus Portfolio. The hefty CBA valuation premium is hard to justify on the basis of the fundamental outlook. We see a real risk that the valuation premium erodes to a more modest level over the medium-term. We continue to hold a zero weight in CBA within the Focus Portfolio.
We spoke about this investment thesis in more detail last year.
Banks to Resources: More Conviction in the EV Mineral Boom
We have added Mineral Resources to the Portfolio at a 3% weighting. MIN has a substantial leverage to the EV minerals boom that is currently underway via its lithium assets.
We want to add more exposure to this area of the portfolio to align with our conviction on the sector.
We talk more about our positive view on the sector in our September report.
Why We Like Mineral Resources (MIN)
World class lithium portfolio
Mineral Resources (MIN) is a top 5 global lithium player with a focus on hard-rock assets in Western Australia. It has joint ventures providing part ownership of the Wodgina, Mt Marion and Kemerton mines, and downstream conversion exposure through a stake in the Kemerton Lithium Hydroxide plant.
Leading mining services business
The company is also a world-leading mining services player, providing crushing, screening and processing solutions to tier 1 miners. This segment provides a relatively stable stream of mostly ‘annuity-like’, long-term contracted earnings that have grown strongly over the years, driven largely by clients’ recurring OPEX requirements. Management aims to double the size of its mining services operations over the next 5 years, driven by both external client contracts and the ramp up of MIN’s lithium and iron ore joint ventures.
Low grade iron ore an insignificant earnings contributor
MIN is the fifth largest iron ore producer in Australia. This is the least attractive part of the MIN story for us, given MIN’s relatively low grade, high cost iron ore operations and our cautious stance towards iron ore more broadly.
However, we think it’s worth highlighting that this segment has become an insignificant contributor to headline earnings (and therefore valuation), accounting for just 3% of consensus EBITDA in FY24 estimates, therefore making this part of the business a fairly trivial consideration in our view.
Substantial hidden value
We think the market currently underappreciates the value of MIN’s lithium assets, which are now the company’s major earnings driver and appear to be trading at an excessive discount to peers.
Comparable lithium miners currently trade on FY24 EV/EBITDA multiples of between ~5.5x and ~12x, while the average multiple of key mining services comparables is ~6.7x.
MIN could unlock significant shareholder value by spinning off its lithium business onto the NYSE as a separately-traded entity, which is an option currently being explored by management. However, the likelihood of this occurring and details around potential deal structures are highly uncertain at this stage.
If successful, a NYSE float could narrow the current valuation gap between MIN’s lithium business and its closest peers. Even if we conservatively put MIN’s FY24 forecast lithium EBITDA on a multiple of 5.5x, reflecting the bottom end of the peer group, while assigning a value of zero to the iron ore segment and applying a multiple of 6x to the mining services segment, this still would translate to ~30% valuation upside.
With that being said, we note the iron ore arm has delivered significant earnings over time and is in the process of being transformed into a higher quality business with lower costs, higher production volumes and a longer mine life. Thus, it is not a zero-value business. Plus, in our view, the mining services segment should be valued towards the top end of its peer group given its high-quality earnings profile, tier 1 client-base, and significant growth in the pipeline.
Therefore, we believe there is significant re-rate potential for MIN, even when using the most conservative of assumptions. This valuation story also doesn’t rely on any improved market expectations regarding lithium market pricing or MIN’s production volumes/ costs.
We are attracted towards ‘hidden value’ plays like this as they can provide above-market returns that are less correlated to the rest of the market (and in this case the lithium/ resources sector).
| Segment | Comment | FY24 EBITDA forecast (A$m) | EV/EBITDA multiple | Implied Enterprise Value (A$m) |
| Lithium | Range of global peers | 3,347 | 5.5-7.9x | 18,410 - 26,443 |
| Mining Services | Average of domestic peers | 605 | 6x | 3,628 |
| Iron Ore | We have assigned zero value to the iron ore business in the interests of being conservative. | 123 | 0x | 0 |
| Other | Based on MIN's current 12 month forward EV/EBITDA multiple. | -100 | 4.2x | -420 |
| Total | 3,975 | 5.4 – 7.5x | 21,617 - 29,651 | |
| Less Net Debt | 891.4 | |||
| Implied Equity Value (A$m) | 20,726 - 28,759 | |||
| Per share | $109.7 - $152.2 | |||
| Implied upside | 30% - 81% | |||
*Data as at 14/11/22
Source: Refinitiv, Wilsons.
| Lithium | FY24 EV/EBITDA multiple |
| IGO Ltd | 12.0x |
| Albemarle Corp | 9.1x |
| Ganfeng Lithium Group Co Ltd | 9.0x |
| Tianqi Lithium Corp | 6.0x |
| Pilbara Minerals Ltd | 5.9x |
| Allkem Ltd | 5.5x |
| Average | 7.9x |
| Mining Services | FY24 EV/EBITDA multiple |
| Monadelphous Group Ltd | 8.9x |
| Seven Group Holdings Ltd | 7.3x |
| NRW Holdings Ltd | 3.9x |
| Average | 6.7x |
*Data as at 14/11/22
Source: Refinitiv, Wilsons.
Still Negative Iron Ore
We remain underweight the iron ore miners, although MIN gives us some more exposure to this sector.
Iron ore and iron ore miners have surged on news from China of support for the property sector, while policymakers eased the country's zero-COVID policy, albeit marginally.
The latest changes are favourable for the property market at the margin. However, they do not provide the all-clear to upgrade the outlook for iron ore.
The property market ultimately needs to be boosted by an improvement in Chinese homebuyer sentiment (which is very, very low). The real estate sector, and by extension, iron ore demand, is not yet clearly on the cusp of robust growth.
We still think supply will come back online over the next 6 months, iron ore inventories will increase, and the iron ore price will remain depressed. At the moment, the current rally looks overblown and speculative.
Written by
Rob Crookston, Equity Strategist
Rob is an experienced research analyst with a background in both equity strategy and macroeconomics. He has a strong knowledge of equity strategy, asset allocation, and financial and econometric modelling.
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