Barry Norris (pictured) manages the Argonaut Absolute Return Fund and shares his views on Standard Chartered results for Q3 2015.
Standard Chartered yesterday announced a loss-making Q3, accompanied by a $5.1bn rights issue and a strategic review.
As we wrote in August ( http://blog.argonautcapital.co.uk/articles/2015/08/06/argonautica-august-2015/ ), we believe the company had previously been run with too much emphasis on top-line growth and too little regard to prudent provisioning for potential bad loans: in short, previous management of Standard Chartered forgot banking was a cyclical industry and with Asian and Emerging Market economies continuing to slow, the bank’s balance sheet was ill-prepared for the forthcoming downturn in the credit cycle.
In our view, this meant that not only would Standard Chartered profits over the next few years be significantly lower than market expectations, but existing shareholders would likely be diluted by additional equity capital raised.
Yesterday’s new strategic plan highlighted profitability targets of an ROE of 8% by 2018 and 10% by 2020, which the new management claimed were “conservative” but the market nevertheless found underwhelming, not least because they imply more structural challenges to the Standard Chartered business model than had previously been assumed.
Moreover, we question the management assumptions behind meeting their ROE targets and think the targets actually look much more challenging than is commonly perceived. For Standard Chartered to come to the market to raise $5bn and admit it will not earn its cost of capital for the next five years, even though its macro assumptions behind this disappointing target do not appear particularly conservative, is something of a bombshell.
On the conference call, management stated their 2018 8% ROE target was based on revenues of around $17bn. But Q3 2015 revenues of $3.7bn were down an astonishing 18% YoY and annualise at $14.7bn. Management also said they expected $1.2bn of revenue attrition from asset disposals.
In other words, in order to achieve their revenue target of $17bn in 2018 from an annualized underlying revenue base of $13.5bn in Q3 2015, the company would require 8% annual revenue growth for the next three years, which is slightly below the 10% targeted annual growth for which the old management has been rightly castigated. Moreover, new management would be tasked with achieving this in a far more difficult Asian macro environment at the same time as taking down balance sheet risk.
There was however no convincing explanation of how management might fix this alarming revenue attrition, or why Q3 performance should not be extrapolated, apart from general assumptions that commodities would rebound and that the Fed Funds rate would be 125bps by 2018, thus improving the profitability of the bank’s deposit base by roughly $800m (but apparently without any corresponding downturn in Hong Kong or Asian asset quality, which a period of Fed hiking would undoubtedly accelerate).
We think this revenue attrition is the most alarming feature of yesterday’s communication: it is becoming increasingly clear the bank faces structural challenges in its fee generation model, not only as business cycles in its geographic exposure turn down, but also because wholesale demand for US$ loans in Asia has evaporated and Chinese and Japanese banks are expanding into Standard Chartered core franchises, turning previously profitable niches into low margin commodity lending.
Additionally, concerns over provisioning and gearing to the downturn in the Asian and commodity credit cycles have not gone away. Standard Chartered yesterday increased its coverage ratio of loan loss provisions to non-performing loans to 58% (from 54% in Q2) with NPL’s also increasing from $8.7bn to $9.5bn (3.3% total and +9% QoQ) as the Asian credit and the commodity cycle continues to worsen.
As we have previously noted, average coverage ratios amongst Asian peers are above 100%, which would seem prudent at this stage of the credit cycle. As such, in order to get to Asian peer coverage ratios, we estimated the bank would need to set aside an additional $6bn of loss-absorbing capital as loan loss provisions.
Of the $5.1bn of capital the bank plans to raise, $3bn has been earmarked for restructuring charges with around half of this likely to be used up disposing of assets for below current book value. It would seem further increases in loan loss provisions (both in terms of coverage and in order to provide for increasing non-performing loans) will need to be funded by future profits.
So there has been no “kitchen sinking” of provisions through an extraordinary charge (or earmarking of the capital raised to address this issue), and as such, shareholder profits over the next few years will continue to be weighed down by the need for abnormally high provision charges.
Given no explicit target for ROE before 2018 and the failure to deal with the provisioning issue, it must be likely that the bank is either loss-making or marginally profitable until 2018. In fact, no growth in (or declining) book value over the next few years might be the only way for management to meet its 8% 2018 ROE target.
Standard Chartered yesterday revealed it has a structural Return on Assets (ROA) revenue generation issue as well as a cyclical Return on Equity (ROE) capital problem.
Previously our concerns focused on the balance sheet (non-performing loans, coverage ratios and risk absorbing capital) and the likelihood these get worse as Asia slows and the Fed raises interest rates.
Now it’s clear the company has a revenue generating problem, and although the bank is now committed to taking out $2.9bn of costs by 2018 (which would keep total 2018 costs below 2015), this is unlikely to be enough to compensate for falling revenues at the pre-provision profit level.
So whilst new management has gone a long way to owning up to the previous failings of the bank, it has also admitted to new challenges: Standard Chartered is a broken business model in a cyclical downturn.