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The real earnings growth driver for ASX bank stocks in FY21 isn’t what you think

ASX banks Profits Growth - Make Money

The Virgin Money UK CDI (ASX: VUK) share price will be on watch this morning after the bank posted a big drop in FY20 profit.

But don’t be too caught up in the profit numbers. The real growth driver for the sector isn’t what you think.

The announcement comes on the day that the S&P/ASX 200 Index (Index:^AXJO) is expected to open softer along with other ASX banks.

The UK lender unveiled a 77% crash in full year underlying net profit to £124 million ($225.5 million). This was largely driven by a huge increase in impairments to £501 million from £153 million in FY19.

Virgin Money share price on edge

But even ignoring impairments, operating profit fell 10% to £625 million due to margin squeeze and base rate cuts.

The banks net interest margin (NIM) fell 10 basis points to 1.56%, while non-interest income declined due to lower activity.

The key drag was a 3% drop in mortgage lending to £58.3 billion as the COVID‐19 lockdown in the UK impinged on the housing market.

How much bad news is priced into ASX banks?

This was offset somewhat by growth in business lending (up 13.6%) and personal lending (up 3.9%). But lending to these two segments only amounted to around £14 billion in total.

However, the weak results won’t surprise anyone. It’s much the same story when ASX banks turned in their earnings report cards.

The National Australia Bank Ltd. (ASX: NAB) share price, Westpac Banking Corp (ASX: WBC) share price and Australia and New Zealand Banking GrpLtd (ASX: ANZ) share price rallied despite the big profit drops.

The key to ASX bank earnings growth isn’t lending

This is because investors believe the worst is over for bank earnings. While earnings growth is likely to be missing in action in FY21, there’s an expectation that the large provisioning they put aside for bad debts will be lowered.

This is an important point for investors. Every dollar that’s removed from impairments and provisions flows straight to net profit.

Even if lending growth stagnates, bank earning can soar in FY21 if the banks can release some of the emergency funds they’ve put aside.

We are starting to see signs of this. Commonwealth Bank of Australia (ASX: CBA) made such a move with the blessing of our banking regulator.

In my view, this is what’s driving the re-rating in the banking sector.

Foolish takeaway on the Virgin Money share price

While Virgin Money operates in the UK and is driven by different factors, its huge impairments give it a lot of fat that can be moved back to its bottom line if economic conditions and confidence improve.

This is good news for the Virgin Money share price as management painted a lacklustre outlook for FY21. Net interest margin is likely to be “broadly stable” this financial year, which to me means it could dip more.

But with a number of promising COVID vaccines in the making, the UK economy could see a bounce back next year – just in time for Virgin Money to lower its impairments.

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Motley Fool contributor Brendon Lau owns shares of Australia & New Zealand Banking Group Limited, Commonwealth Bank of Australia, National Australia Bank Limited, and Westpac Banking. Connect with me on Twitter @brenlau.

The Motley Fool Australia has no position in any of the stocks mentioned. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. This article contains general investment advice only (under AFSL 400691). Authorised by Scott Phillips.

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