The January Australian Edge In Focus takes a look at the Big Four banks Down Under and their wholesale funding exposure, particularly as it relates to Europe. Because of extraordinarily strong domestic deposit growth and generally stronger balance sheets the Big Four aren’t as vulnerable to tightening credit conditions as they were in the fall of 2008, when Lehman Brothers’ bankruptcy caused the most severe global credit contraction since the Great Depression of the 1930s.

This Great Financial Crisis of 2008-09 is still not likely to be repeated in 2012, not because any particular initiative on the Continent will ease debt burdens, but for the simple reason that everyone has or should have enough information to prepare for a worst-case.

But financials have come under significant selling pressure as the crisis across the pond has intensified. The S&P Global 1200 Financial Index is off 15.6 percent for the 12 months ending Jan. 20, 2012, in US dollar terms, compared to a 2.5 percent decline for the MSCI World Index.

Meanwhile Australia’s Big Four have generated an average total return (capital gain or loss plus dividends) in US dollar terms of 6.7 percent over the same time frame. Average one-year dividend growth for the group is 11.7 percent. Canada’s Big Six–like Australia’s “Big” group recognized among the safest, best banks in the world–have generated a negative average total return of 1.8 percent. Major Canadian banks have grown dividends an average of 5.6 percent over the past year.

Our favorite bank Down Under, Australia & New Zealand Banking Group Ltd (ASX: ANZ, OTC: ANEWF, ADR: ANZBY) is currently yielding 6.7 percent for US investors (who don’t enjoy the direct benefits of Australia’s “franking” system of marking up dividends to account for taxes paid by the sponsor). The stock has lagged its domestic peers over the past year but has posted a 24.3 percent total return since its debut along with the rest of the Australian Edge Portfolio on Sept. 26, 2011.

ANZ sponsors (level I) an American Depositary Receipt (ADR) that’s traded on the US over-the-counter (OTC) market. The ADR represents one ordinary share traded on the Australian Securities Exchange (ASX).

ANZ’s performance since late September is second to National Australia Bank Ltd (ASX: NAB, OTC: NAUBF, ADR: NABZY), which is up 25.9 percent, among Australia’s banks. NAB is yielding 7.2 percent at current levels; among the Big Four, however, it has the greatest wholesale funding exposure to the UK and Europe. NAB’s sponsored (level I) ADR represents one ordinary share traded on the Australian Securities Exchange (ASX).

Westpac Banking Corp (ASX: WBC, NYSE: WBK), which trades on the New York Stock Exchange as an ADR, is yielding 7.4 percent in the US after boosting its distribution rate 12 percent last year. One of Westpac’s sponsored (level II) ADR’s is worth five ordinary, ASX-listed shares.

Commonwealth Bank of Australia Ltd (ASX: CBA, OTC: CBAUF, ADR: CMWAY) is yielding 6.4 percent as of this writing. CBA also boosted its payout rate from fiscal 2010 to fiscal 2011, by 10.3 percent in its case.

In a Jan. 20, 2012, “Ratings Update” Canada-based DBRS noted that ANZ’s “credit quality remains supported by its solid financial risk profile and its strong banking franchises in Australia and New Zealand.”

The following “strengths” were identified by DBRS in its report:

• ANZ has a solid retail banking franchise in Australia, as well as the leading market share in New Zealand.
• ANZ strengthened its financial risk profile in response to the global financial crisis and has maintained metrics in this area at strong levels, with improvements to liquidity, funding and capital. Furthermore, post-crisis revenue streams have been further diversified, with non-interest income representing a growing proportion of revenue.
• ANZ has adopted a well-established strategy to create a leading super-regional bank that, while still focused on the mature Australia and New Zealand markets, is aiming to generate 25 to 30 percent of its earnings from the faster-growing Asia-Pacific region by 2017.
• ANZ’s–and its peers’–credit profile is enhanced by conservative, supportive regulators, including the Reserve Bank of Australia and the Australian Prudential Regulatory Authority.

Among the primary challenges confronting ANZ, according to DBRS, is its reliance on wholesale funding. This challenge is the crux of the January In Focus. DBRS also notes that 87 percent of ANZ’s revenue comes from Australia and New Zealand, two economies that could actually be considered one because of their close correlation. Net interest margins are also shrinking, a challenge facing ANZ as well as its peers. ANZ also has more exposure to New Zealand that the other Big Four banks.

DBRS has a “modestly positive” outlook for ANZ’s earnings in 2012, based on the continuing strength of Australia’s economy and demand for its resources. Funding costs are likely to increase as short-term crisis financing arranged and backed by the Australian government is replaced by more stable and longer-term but more expensive debt. Fluctuations in global markets will roil the bank’s asset portfolio, though loan-loss provisions should continue to decline and thus help earnings.

Critically, ANZ’s asset quality remains strong relative to global peers. The loan portfolio provides “a substantial level of safety” against significant market-driven losses, as 53 percent is comprised of what DBRS describes as “low-risk” housing loans.

The source of ANZ’s stability remains its solid deposit growth at home and abroad. Customer deposits have grown from AUD132.7 billion in September 2008 to AUD183.2 billion in September 2011, an increase of approximately 38 percent. Growth from September 2010 to September 2011 was 11 percent. Domestic growth will likely slow due to competitive pressures, but ANZ has also grown deposits in its Asia-Pacific, Europe & America (APEA) unit, with 40 percent growth from September 2010 to September 2011. Overall customer funding has steadily increased from 50 percent to 61 percent of total required September 2008 to September 2011.

The Roundup

SMS Management & Technology Ltd (ASX: SMX, OTC: SMSUF) is a little company in the global IT scheme, but it can and does dominate the Australian management consulting/software services space.

With a market capitalization of just AUD343.5 million SMS looks like a forgotten crumb relative to IBM (NYSE: IBM), at about USD220 billion, and even Accenture (NYSE: CAN), at about USD39 billion. But despite this unfavorable and superficial size comparison SMS has managed to establish what amounts to a subscription/fee-based business that relies on contractual relationships with major Australian companies. It doesn’t quite rise to the level of an “essential service” but an impressive share of cash flow is “repeatable,” meaning it’s locked in under long-term contract.

SMS paid AUD0.30 per share in fiscal 2011, up from AUD0.29 in fiscal 2010 and AUD0.25 in fiscal 2009 and 2008. That’s modest dividend growth, but the stock has shown the kind of market behavior of a 20th-century ’net stock at times, too, posting a total return in US dollar terms of close to 400 percent since it became a dividend payer.

IBM, by comparison, is up about 125 percent since early 2005, Accenture about 150 percent.

The last couple years have been punctuated by worry about a slowing economy’s impact on global IT spending. SMS stock has underperformed IBM stock by close to 40 percent since Jan. 20, 2010.

Meanwhile, SMS still boasts a five-year average sales growth rate of 14.3 percent. IBM is growing sales at an average of 2.1 percent for the comparable period. For the last two fiscal years SMS has reported growth rates of 7.4 percent and 23.7 percent. It’s on course to post another double-digit growth year for fiscal 2011. IBM just reported 7.1 percent growth for the year ended Dec. 31, 2011, on top of 4.3 percent growth for the 2010.

SMS declared its first regular dividend in February 2005 and has never cut. It, like most Australia-based companies, pays twice a year, an “interim” dividend and a “final” dividend. Its fiscal year ends Jun. 30.

The company’s main areas of operation are with clients for whom IT–information technology–is core to their business and for whom investment in processes and systems is part and parcel of staying in business. For folks like the Big Four banks–three of whom are SMS clients–it’s more and more critical part of saving money and operating efficiently.

But IT services companies are very exposed to poor global economic conditions, and research firm Gartner recently cut its global technology spending forecast for 2012 to USD3.8 trillion, 3.7 percent higher than last year but down from a previous growth forecast of 4.6 percent and slower than the 6.9 percent expansion from 2010 to 2011.

This is the major risk right now for SMS and IBM and Accenture and other IT companies around the world. Fewer projects–internal attempts to streamline human resources, accounting or process software, new mining or energy developments requiring specific modeling–mean expensive staff resources sit and eat profit margins. But the ability to survive and thrive is not about size. It’s about talent and execution. The key from an investment point of view is that SMS has proven its ability to manage what can be volatile earnings cycles for IT/consulting companies.

Recurring revenue continues to grow, and management is steadily working its way up to larger contracts. The company has solid and sustaining federal government contracts, which played a large part as revenue grew 23.6 percent during the year ended Jun. 30, 2011. Of the AUD59 million revenue increase AUD10 million was from acquisitions, as the AUD49 million from organic growth was based on market-share gains.

Net profit after tax (NPAT) for the year ended Jun. 30 was up 7 percent to AUD29.8 million, while EBITDA was up 10.8 percent to AUD42.2 million. Earnings per share rose 5.7 percent to AUD0.443. During the year management signed contracts worth AUD351 million–15 percent ahead of revenue–to add to the work pipeline.

Although talent is really the lifeblood of SMS’s business, bringing in new people reduced the overall “utilization” rate for fiscal 2011 and so ate into EBITDA, which didn’t increase at the same clip as revenue because new people were brought on board but weren’t put to work on projects immediately.

SMS has been very active on the acquisitions front since 2004 and is now taking advantage of its strong balance sheet and the competitiveness of its business to execute a new phase of its expansion plan. Management has made five deals since the end of the Great Financial Crisis, including two businesses during the year ended Jun. 30, 2011. SMS also put into place a new program to boost recruitment, retention and development of staff that bore immediate fruit, as total full-time employees increased by 22 percent to 1,675.

Eighty-five percent of the top 20 companies on the Australian Securities Exchange use SMS services. Its international expansion model is based on “following Australian clients into Asia.” It’s done this through major contracts with Telstra Corp Ltd’s (ASX: TLS, OTC: TTRAF, ADR: TLSYY) international division in Hong Kong; by helping Australia & New Zealand Banking Group Ltd (ASX: ANZ, OTC: ANEWF, ADR: ANZBY) execute on its “super-regional” strategy; and via work with BHP Billiton Ltd’s (ASX: BHP, NYSE: BHP) MinEx division in Singapore.

SMS, as management put it during its fiscal 2011 conference call, won’t “speculatively open an office on Mainland China, for example, without riding an existing client’s coattails there.” As you might imagine, management makes no apologies for its conservative capital management. The balance sheet is strong, with zero debt and cash of AUD24.88 million on hand. SMS policy is to distribute to shareholders via dividends 65 to 70 percent of NPAT.

Back in August, discussing results up to Jun. 30, 2011, CEO Tom Stianos said, “Look, the market is pretty good. It’s not bad. The work is there, if you can win it.” He noted financial services, resources, transport and utilities as “areas with activity, all areas where SMS is engaged.” SMS launched an infrastructure consulting practice in early 2011 and has added people, continuing to invest in the future of its business during what “should” be a difficult period.

That’s what the market said in calendar 2011, as SMS was down 32.1 percent on the Australian Securities Exchange (ASX), worse than the S&P/ASX 200 IT Index’ 22.7 percent loss, even though SMS managed to grow revenue at an industry-average beating pace. Among its clients only one is exposed to weak consumer goods and retail sectors.

We’ll have another look at the business when interim results–for the six months ended Dec. 31, 2011–are reported Feb. 22. As of Jan. 20 11 analysts covering the stock rate it a “buy,” while three rate it a “hold” and zero rate it a “sell.”

In the meantime, we rate SMS Management & Technology a strong buy up to AUD6 for a reliable and rising dividend and impressive capital-gains potential.

Following are “on or about” dates for each Holding’s next earnings report and the next date after which it will trade “ex-dividend.”

Conservative Holdings

• AGL Energy Ltd (ASX: AGK, OTC: AGLNF, ADR: AGLNY)–Feb. 23, 2012, Mar. 5, 2012
• APA Group (ASX: APA, OTC: APAJF)–Feb. 22, 2012, Jun. 25, 2012
• Australia & New Zealand Banking Group Ltd (ASX: ANZ, OTC: ANEWF, ADR: ANZBY)–May 2, 2012, May 10, 2012
• Cardno Ltd (ASX: CDD, OTC: COLDF)–Feb. 15, 2012, Mar. 7, 2012
• CSL Ltd (ASX: CSL, OTC: CMXHF, ADR: CMXHY)–Feb. 16, 2012, Feb. 15, 2012
• Envestra Ltd (ASX: ENV, OTC: EVSRF)–Feb. 23, 2012, Feb. 10, 2012
• M2 Telecommunications Group Ltd (ASX: MTU, OTC: MTCZF)–Feb. 25, 2012, Mar. 16, 2012.
• Telstra Corp Ltd (ASX: TLS, OTC: TTRAF, ADR: TLSYY)–Feb. 9, 2012, Feb. 20, 2012

Aggressive Holdings

• BHP Billiton Ltd (ASX: BHP, NYSE: BHP)–Feb. 8, 2012, Feb. 17, 2012
• GrainCorp Ltd (ASX: GNC, OTC: GRCLF)–May 22, 2012, Jun. 15, 2012
• Mineral Resources Ltd (ASX: MIN, OTC: MALRF)–Feb. 17, 2012, Mar. 12, 2012
• Newcrest Mining Ltd (ASX: NCM, OTC: NCMGF, ADR: NCMGY)–Feb. 10, 2012, Mar. 19, 2012
• New Hope Corp Ltd (ASX: NHC, OTC: NHPEF)–Mar. 27, 2012, Mar. 20, 2012
• Oil Search Ltd (ASX: OSH, OTC: OISHF, ADR: OISHY)–Jan. 24, 2012, Mar. 5, 2012
• Origin Energy Ltd (ASX: ORG, OTC: OGFGF, ADR: OGFGY)–Feb. 22, 2012, Feb. 24, 2012
• Rio Tinto Ltd (ASX: RIO, NYSE: RIO)–Feb. 9, 2012, Feb. 29, 2012