Corporate Strategy Weekly Radar Update

Week ending Friday 17 August 2012 (snapshot: revisiting the granularity of growth) Highlights Financial Services CBA Full Year net profit of $7.1B for FY12 (+11% yoy), slightly below analyst predictions. Revenue increased 2% for the year (with a drop of 1% in the 2H) and expenses grew by 3%. NIM fell to 2.09% from 2.12% last year, due to an increase in funding and deposits costs. CBA's strategy will continue to be focused on new technology and productivity improvements. CBA CEO Ian Narev indicated support for a banking inquiry (following Joe Hockey's and Ian Harper's comments last week) to address concerns that banks would not have sufficient funds to lend should the economy rebound. NAB quarterly cash profit of $1.4B, in line with last year, but below some analyst expectations. 1% drop in overall revenue, largely due to higher funding costs and lower UK revenue, and a higher bad debts charge in Business Banking. ANZ quarterly underlying profit for the 9 months to end of June of $4.5B up 5.5% pcp, driven by Australia, NZ and international and institutional banking, while Wealth continues to disappoint with its income down slightly. Mike Smith also ordered a base salary freeze for senior execs for a 2nd straight year (this excludes bonuses that will be paid). Last month CBA also froze base salary > $150,000. QBE half year profit +13% to $760m. Insurance margin of 13% from 11.2% last year. GWP increased 3% to $US9.22B. Interim dividend of 40pc, down from 62 in 2011. AMP reported a $383M half-year net profit (+11%) largely due to the AXA merger. Interim dividend of 12.5cps, down from 14cps in 2011 due to ongoing volatility in investment markets and increased capital expenditure requirements. The AFR estimates that "Insurers and wealth managers could face a regulatory bill of up to $1.5bn to meet new capital requirements and comply with reforms". o AMP estimates capital, advice and super reforms costs will require $275m ($200m to be set aside within life as capital from 2013 + $75m implementation cost). o Challenger estimates additional capital requirements will total up to $375m o Shadow minister for financial services Mathias Cormann also claims that FoFA would cost about $700m for the advice industry to implement. Other industries Tatts Group announced the relocation of its corporate HQ and IT division from Melbourne to Brisbane (80 to 100 corporate roles + 1000 IT jobs). It makes it the 3th-largest listed company in QLD (behind Suncorp and QR National) The High Court backed the govt legislation on Tobacco forcing plain packaging, which research says reinforce negative perceptions about the pack and smoking. Manufacturing: A report by the PMs taskforce into manufacturing has recommended lower taxes, a sovereign wealth fund, construction stimulus and a buy Australian campaign to help the struggling industry. Wesfarmers: yearly net profit after tax of $2.126B, up from $1.92B in 2011.Revenue of $58.08B was 6%. It was mainly underpinned by Coles which lifted its contribution to EBIT by 16.3% to $1.35bn. Bunnings reported +4.9% in EBIT to $841m, Officeworks earnings increased 6.3% to $85m, Kmart was up 31.4% to $268m, while Target, which is undergoing a turnaround, was the only retail division to report a decline in earnings, down 12.9% to $244m. o Coles Insurance continued to perform ahead of expectations, with more than 100,000 policies written during the period in personal lines. The broking business grew earnings by 28.8% to $67m, reflecting revenue growth of 18.7%. Online advertising expenditure increased 21%, passed the $3B mark in FY12 and is predicted to overtake ad revenue for free-to-air TV next year. Mobile ad spend more than doubled in the year to June to $48m. Australian Economy Global Economy Australian cities have once again rated well in the annual Global Liveability survey (rating stability, healthcare, culture & environment, education, and infrastructure) with Melbourne (1), Adelaide (6), Sydney (7), Perth (9) and Brisbane (20) all in the top 20. This is in consistent with Australia's good health amid the global recession. Lower volatility: The S&P Volatility Index (VIX) is at its lowest level since before the US credit crisis. Commentators have attributed this to investors taking a wait and see approach in the midst of global uncertainty: on watch. Warnings issued in the last months about 'the Boom' are increasingly evolving into calls to rethink how future growth will unfold (See appendix) Insights CBA's results highlight the paradox that fuels the debate on banks: $7.1B is a record profit, however margins diminish, ROE is declining, revenue growth is slowing and markets division perform poorly. To put it differently CBA has $700B of assets, so it made ~1c profit out of every $1 of assets. On the other hand CBA will plan to maintain its position though its IT lead, by containing expenses and improving productivity. NABs UK division remains a drag on Group earnings, however the recent focus on the retail banking sector as part of the break-up campaign appears to be paying dividends. However NAB did not disclose its NIM, so watching brief... QBE: CBA's analyst Ross Curran said QBEs first-half earnings were light of his expectations, citing the bottom line miss, the lower dividend and the more cautious outlook guidance. AMP: The AMP / AXA integration is reportedly going to plan, however questions remain over complex systems integration, loss of AXA planners and targeted integration savings Whilst the WM industry voices concerns about the uncertainty created by the impact of regulatory reforms - including revised capital requirements - these $1.5B cost are to be taken with a pinch of salt as they mix project cost and capital requirements, which is money still sitting on the balance sheet. Besides, markets did actually welcome the "certainty" provided by AMP and Challenger who announced that they will 'only' need an extra $575m to meet their compliance obligations: their shares rose Does Tatts' move open opportunities to develop more offerings towards QLD based corporates? Australia is the 1st country in the world to adopt plain tobacco packaging: it will be scrutinised. The long term effect on Health and Life insurance risk tables will also have to be monitored by actuaries. The Manufacturing sector has shed 100k jobs since the onset of the GFC, with a further 85k predicted to be lost in the next 5 years. The sector now contributes 8% to Australias economy (see appendix for its growth prospects). Coles insurance's progress is a reminder for traditional insurers to keep a close eye on it, which we are doing. The identified tipping point in advertising expenditure is also a reminder of our need to keep appraising our own marketing spend.

Snapshots of the week: Revisiting our Granularity of Growth - There is more to the Australian Boom than a "2-speed economy" + Funding future Growth 1 - Framing the issue: a 4-speed economy
(GVA)

A more granular 2nd speed...

McKinsey challenges the common view of Australia's "2-speed economy" made up of a rapidly growing resources sector and other industries growing more slowly. The current debate tends to focus on how other sectors can benefit from the resources boom, or whether they have been crowed out by it. Instead, McKinsey see 4 sectors on the basis of their exposure to mining activities and exchange rates - the two major factors of the boom. 1 - "Resources": it accounts for 10% of Australia's economic output, just 3% of labour but has generated 35% of the national income growth since 2005. It has capture 64% of the improvement in the terms of trade (because of exports) and 50% of the increase in capital investment (because of the size of the projects) but accounts for 99% of the national decline in capital productivity. For this sector to contribute to future Growth, improving capital productivity is critical.

2 - "Resource riders": transport, utilities, construction need to focus on labour productivity because whilst they saw a 19% increase of hours worked in this sector from 2005 to 2011, the contribution of labour productivity has virtually fallen to zero. One reason is the effect of cyclical investment: eg. water and electricity utilities have invested in improvements that are yet to yield benefits. McKinsey gives the example of electricity capacity staying idle to cater for peak consumption of Air Conditioners a few hours a day: this would be resolved by more integrated and less wasteful infrastructure and grid.

3 - "Local services" (include Finance) account for a major share of the national economy: 42% of hours worked, 40% of value added: it has not benefited directly from the boom as much as the riders did, but has not been penalised by the exchange rate as manufacturing has. For this sector the challenge of Growth is the pressure to keep pace with international operating models and innovation, hence investments required. 4 - "Manufacturing" suffers from a "secular decline": skilled labour has been lost to resources but this is an international trend that cannot just be attributed to the mining boom (notwithstanding it is probably exacerbating it in Australia) . Within this cluster, industries that are innovation driven (eg Pharmaceutical) or location based (eg Food) can resist and grow, whereas industries exposed to overseas competition (eg cars, electronics) will keep declining. 2 - How will future Growth be funded? ... not just by the banks. Bank executives such as CBA CEO Ian Narev and NAB's former deputy CEO Michael Ullmer are calling for a debate about the capacity of banks and capital markets to fund the economys long-term growth. The question is will the $1.9trillion currently lent by financial institutions in Australia be able to keep up with the growth in our $1.4 trillion economy? It has ramifications on key facets of the current debate. eg: o the impact of new regulations on banks capacity to borrow & lend o the potential role superannuation could play in funding, o the need for a deep and liquid domestic corporate bond market, and o whether Australias dependence on offshore markets as a source of capital is cause for concern. In other words according to M Ullmer "If credit growth returns to trend and retail investors switch out of deposits back to the equity markets, then banks may be challenged to meet the increased loan demand while preserving the more conservative regulatory funding ratios"

Source: RBA

However, the funding paradigm has already started to shift: The share of Banks' offshore funding has also fallen and its maturity has Bank Lending growth has slowed to 4% compared with 15% four lengthened. years ago. Household savings levels are around a 20-year high In fact, contrary to the common perception, Australia's current account and savers are pouring billions of extra dollars into deposits. deficit has been funded without the banks. In the last 2 years corporates This has enabled banks to increase deposits as a proportion of have directly sourced capital via direct investments (eg mining projects) their funding from less than 40% pre-crisis to about 55% today, and foreign central banks have been buying Australian Govt bonds. The net stable funding ratio (NSFR) will require banks from 2018 So in effect, alternative sources of funding have already started to to match the maturity of assets with the duration of liabilities, so develop. there is less borrowing short (which creates rollover risk) to lend This is why some also call for the development of a local bond market, so long. Banks are already moving towards this target; that Australian corporates can raise debt without having to go overseas. Commonwealth Banks weighted average maturity of long-term The 1.4T superannuation pool could also play a bigger role in funding wholesale debt is 3.7 years, up from 3.5 years in 2007. Australia's economic growth. In conclusion, the 'granularity of growth' will be underpinned by those dimensions: 1) Industry clusters producing various assets and services that will need to address subtlety different issues to compete, and 2) financial channels supplying liquidity and capital to fund this growth. Both are relevant to our activities: banking to supply funding, and insurance to protect the assets produced by those growing sectors.