ANZ Group’s (ASX: ANZ) cash profit fell 7% on a very strong previous corresponding period, and down a more modest 1% on the second half of fiscal 2023 as the margin tailwind of cash rate increases continued to be competed away.

The negative earnings trajectory has slowed, though, and we expect it will begin to improve in fiscal 2025. With less refinancing activity, a pick-up in new lending, and the term funding facility repaid, we think margins should modestly improve over the medium term on more favorable loan and deposit pricing. However, lower margins might be acceptable if the industry extracts cost savings or reports lower credit losses than historical levels to offset lower revenue growth.

The result is broadly as we expected, with strong financial market income, modest loan growth, and low bad debts, offsetting slightly worse-than-expected margins in the retail segment.

The 65% franked interim dividend of $0.83 per share is up from $0.81 paid last year. We increase our full-year dividend forecast to $1.66 from $1.62, assuming dividends will be held flat in the second half, on a full-year payout ratio of 72%.

The bank’s strong common equity Tier 1 ratio of 12.3%—excluding funds raised to buy Suncorp Bank—remains well above management's target of 11%-11.5%. ANZ joined the bank buyback party, announcing an $2 billion on-market buyback, which lowers the common equity Tier 1 ratio to a still-healthy 11.9%.

Our forecasts assume that ANZ Group's acquisition of Suncorp Bank will go ahead. The 5% increase to our profit forecast from fiscal 2025 is not materially value-accretive given the acquisition price and integration costs, with our $31 fair value estimate for ANZ Group maintained. On modest loan growth, slightly better net interest margins, normalization of bad debts, and low-single-digit expense growth, we forecast annual earnings per share and dividends per share growth averages of 4% over the next five years.

Why James Gruber didn’t include ANZ on his list of 11 ASX dividend shares for the next decade.

Business strategy and outlook

ANZ Group is the owner of ANZ Bank, the smallest of Australia's four major banks by market value and the largest bank in New Zealand and the Pacific, offering a full range of banking and financial services to the consumer, small business, and corporate sectors.

Like the other major banks, ANZ Bank has a well-recognized and trusted bank brand, large advertising and marketing budget, and customer fulfilment capacity (branches, systems, funding capacity) to capitalize on this brand equity. We see the firm’s strategy to simplify and focus on its highly profitable core banking operations as logical. The proposed acquisition of Suncorp Bank came as a surprise but provides an avenue to leverage benefits of recent investment in its retail banking platform. Integration risk can not be ignored, but overall we believe the acquisition makes strategic sense.

Tight underwriting standards, lender's mortgage insurance, low average loan/valuation ratios, a high incidence of loan prepayment, full recourse lending, a high proportion of variable rate home loans, and the scope for interest-rate cuts by the Reserve Bank of Australia, or RBA, combine to mitigate potential losses from mortgage lending.

The main current influences on earnings growth are modest credit growth, with households and businesses adjusting to lower borrowing capacity after a sharp increase in rates and slowing economic growth. Businesses are expected to be more cautious on making large investments as households rein in discretionary spending.

Margins are softening as the banks compete aggressively in a low credit growth and high refinance market, but we expect competition to be rational in the medium term. Despite productivity benefits, operating expenses are increasing due to regulatory and compliance project spend, as well as investments to make the bank more efficient and competitive across its digital offerings—namely home loans and savings.

In Asia, ANZ Bank targets large clients and has walked away from lending to small business. Given ANZ Bank would have no competitive advantage against local (and much larger) lenders, we support the revised strategy.

Moat rating

Learn how to identify companies with sustainable competitive advantages.

We assign ANZ Group a wide moat rating based on maintainable cost advantages and switching costs. ANZ Bank is the smallest of the four major Australian banks, which combined control around 75% of business and consumer lending and a similar share of deposits.

Although smaller than some peers, with around 13.5% share of business and home loans in Australia, it dwarfs its next largest rivals with around 5% share. Despite regulatory changes lifting capital requirements, the bank’s large loan and deposit books continue to deliver robust net fee income, and with the increasing importance of scale to cope with changes in technology and regulation, ANZ Group should consistently earn returns above its 9% cost of equity through the cycle.

Bank moats are typically derived from two sources: cost advantages and switching costs. Cost advantage is an important source of the bank's wide economic moat, and supported by a low-cost deposit base, operating efficiency, and conservative underwriting relative to peers. Given the commoditized nature of the industry, and competition for both loans and deposits, low costs is key to achieving excess returns.

A key pillar of ANZ Bank’s funding cost advantage is the AUD 660 billion or 60% of funding which is sourced from customer deposits. In addition to customer apathy making deposits sticky, market leading digital and mobile applications, and the large presence, gives major banks an edge when it comes to gathering and retaining deposits. In contrast, the lower rated regional banks struggle to access senior debt markets and rely primarily on more expensive residential securitization markets for a large share of their wholesale funding.

All of Australia’s major banks operate on much better cost/income ratios than smaller competitors and most overseas non-investment banks. Large banks can disperse fixed costs across a larger operating base, increasing operating efficiency.

A large and diversified loan book, as well as having the resources and data to support robust credit decisions, also supports a low bad debt/gross loan ratio. While legacy systems can make innovation more costly, we believe the banks’ large annual spend on technology, and large customer data sets and insights, will see it remain at the forefront of a continually evolving digital offering.

The ability to provide customers a full suite of products, and marketing to support already well-known and trusted brands, has historically allowed the major banks to charge a premium on their loans relative to smaller competitors and offer deposit rates lower than competitors. The premium is not offset by higher funding or operating costs, enabling the major banks to generate consistent excess returns.

ANZ Bank’s ability to offer customers multiple products not only increases profitability per customer, but bolsters switching costs. Bank customers often resist moving financial service providers due to the hassle of opening/closing accounts, the lack of perceived benefit, and numerous deposit and payment links. An aggregated view of all personal and financial information, updated in real time, is also advantageous to customers taking multiple products. The cost advantage allows for the strong digital investment and offering, which in turn helps to entrench the switching costs.

We believe switching costs in small and medium business banking are reinforced by relationship managers, specialized sector expertise, breadth of product offerings, and the customers additional focus on system reliability. The threat of losing business due to teething problems after switching banks often outweighs anticipated gains from converting.

On the other hand, we believe competitive advantages in the institutional banking division are less pronounced, as clients often bank with multiple financial institutions. The capital required to play in the space does limit the threat of disruption from new competitors.

Despite being a lower margin and ROE division, the institutional banking segment does support the retail and business bank moats through deposit gathering of low-cost funds which can be redeployed in the higher return on risk weighted asset retail business.

There are a variety of regional and community banks, global banks and neo-banks which provide competition. Despite this, the major banks have been able to earn higher returns on equity for the last several decades, and still do so today. In our view, this demonstrates the barriers to entry in attempting to break down the competitive advantages of the majors.

Foreign banks have not made a serious dent in the domestic majors' market share, while the smaller regional banks compete on service and local brand recognition but face higher wholesale funding costs than the majors and are unable to undercut on price. They tend to follow the majors in loan and deposit pricing.

The Australian government's "four pillars" policy prevents any of the four major banks from taking over each other, negating the risk of peers merging to gain greater scale and competitive advantages. Government legislation limits individual ownership of an Australian bank to a maximum of 15% without the approval of the Federal Treasurer, thereby reducing the potential for a foreign takeover. Our outlook is generally positive from a macroeconomic and political standpoint, unemployment remains low, a perception of safety and government services supports population growth through immigration and low GDP growth is forecast to continue.