If you bought shares in Bendigo and Adelaide Bank (ASX: BEN) in March 2016, you would naturally be cheering today. By mid-January, your total return on your investment was north of 70%. Not bad at all for nine months’ work – and well ahead of the 23% the ASX200 delivered over the same period.
This sort of share price appreciation is surprising to many. After all, Bendigo is a relatively small bank in the Australian banking landscape. It is difficult for such a small player to compete with the four industry behemoths which benefit from scale advantages. It lacks the geographical diversification of the major banks – with a large relative exposure to Victorian and New South Wales mortgages.
Many also suggest that the smaller Australian banks are, to a large degree, left to own the loans and mortgages that the major banks do not want and which are potentially lower-quality credits. Fundamentally, the smaller Australian banks are competitively disadvantaged – and this is clearly evident in the resulting economic returns generated by the business.
So why the 70% share price rally over the last nine months? Well, it is true that Bendigo generated profit growth in financial year 2016. Around 3% pre-tax profit growth, to be precise. And it is also true that the bank increased its full-year dividend by 3% to 68 cents per share. Dividend growth underpinned by earnings growth is just what investors like.
On the other hand, a closer examination of the source of Bendigo’s earnings growth might lead investors to think again. In 2016, more than 100% of the bank’s earnings growth was driven by a “contribution” from the Homesafe Trust, contained in “Other Income” on Bendigo’s profit and loss statement. (This was also true in 2015). Bendigo’s Homesafe program buys shares in future sale proceeds of residential real-estate. The idea is to release home equity into cash that can be used by homeowners – typically retirees who might be asset-rich but cash flow poor.
There is an interesting accounting consequence of this program which directly impacts Bendigo’s reported earnings each period. As property prices go up, the bank values its ownership stakes at higher levels – and books the difference as a non-cash gain through its profit and loss statement. In the words of Bendigo: “The increase in the Homesafe Trust contribution was primarily due to the increase in Sydney and Melbourne residential property prices during the first half of the year.” (Of course, if property prices were to fall, the reverse would be true and revaluation losses would need to be run through Bendigo’s profit and loss statement).
It is not to say this is a bad business for Bendigo. If anything, the bank’s timing could not have been more perfect. They have captured exposure to some of the most significant property price rallies this generation has ever seen. But the question is: what would the underlying bank’s profitability have been absent the current property price boom?
Well, had it not been for the Homesafe gain in 2016, pre-tax earnings would have declined by almost 11%. And therein lies the concern. Bendigo is growing its dividend by growing its earnings. But its earnings are growing solely because of property price growth. What will become of the bank’s dividend should property prices stop rising at such a fast rate?
In the nine months to January 2017, Bendigo returned more than 70% to investors. That is, the bank effectively paid investors more than 12 years’ worth of dividends in one. For a bank whose underlying business is potentially shrinking, one wonders if these returns are justified.
Montaka is short the shares of Bendigo and Adelaide Bank.
Andrew Macken is a Portfolio Manager with Montgomery Global Investment Management.
To learn more about Montaka, please call +612 7202 0100.
