By Greg Peel

The heavens began opening over the Sunshine State in late 2010 and by early 2011 the state was awash. Cyclone Yasi was the icing on an tragic cake. The reality is Queensland's economy began to slump in 2008.

The GFC was obviously a catalyst, but when we consider Queensland's partner state in commodities boom benefit – Western Australia – has seen its economy surge along, it makes Queensland's poor performance seem that much poorer. The biggest problem has been the savage hit to Queensland's other major industry of tourism and leisure from the constantly rising Aussie dollar. Commercial property has borne the brunt, with the populous South East corner a standout. Before La Nina came to spoil the party, the party was already struggling.

With the rains came flooded mines, lost commodity production and sales and a virtual wipeout of the state's attraction as a tourist destination. It is thus no surprise local lender Bank of Queensland ((BOQ)) posted a rather disappointing first half earnings result on Friday. A 161% increase in bad and doubtful debts (BDD) still took analysts by surprise. Of the further $134m provisioned, $45m was weather related but another $35m came from four large commercial property exposures.

The reality, however, is that bad debts aside the bank posted strong underlying growth of 16%, assisted by a much lauded 5% reduction in costs. Growth was cut back to 4% net of BDD provisions, but that figure fits nicely into the range of Commonwealth ((CBA)) with 7% down to ANZ ((ANZ)) with 2%, Macquarie notes. The majors are nevertheless seeing a reduction in their own BDDs as the business cycle turns. A healthy rise in BOQ's net interest margin was also a pleasant surprise, but this was ascribed to BOQ's recent acquisitions of St Andrews Insurance and CT Asset Finance, such that further increases may yet be reliant of further acquisitions.

Not that BOQ is in a luxurious position to throw money around. Many analysts were surprised the bank went the full 100% payout with a 26c dividend when 24c was expected. Looking ahead, capital is a problematic issue.

The bottom line is that management is confident the bank has seen the worse and that the rebuilding of Queensland will assist in a swift reduction in BDDs over the next 18 months. It's been two months since the floods and already many businesses are back to normal trading. Management retained its FY11 recently updated guidance range but shifted expectation to the low end. In terms of return on equity (ROE), management is still touting a recovery to 15% but has pushed the timing out beyond FY12.

BOQ's first half result represented an ROE of only 5.3%, notes RBS. Assuming bad debts do normalise as hoped, RBS believes a 12% ROE might be possible but that 15% is a stretch. BA-Merrill Lynch suggests a 15% ROE would be quite compelling but believes even reaching double digits is going to be a challenge. JP Morgan had assumed 13% but notes current pricing implies a figure more like 10.5%. JPM has been maintaining a theme that it believes the market is not yet prepared to “pay ahead” for ROE recovery of any Australian bank.

While analysts agree BDDs are not likely to blow out further from here, they are not quite as optimistic as management when it comes to the expected pace of reduction. UBS suggests management's 18 month target “may be unrealistic”. Flood recovery is one thing, but the bank's troublesome commercial property exposures are not weather-related and Queensland's economy remains subdued. BOQ's provisioning was already below that of the majors on a relative basis (albeit in line with regional colleague Bendigo & Adelaide ((BEN))), and while provisions have been increased, provision coverage levels have fallen from 106% to 50%, Macquarie notes. This leaves Merrills “concerned” and Citi suggests its forecasts for BDD recovery are “a little more conservative”.

The BDD issue leads to further concerns regarding the bank's balance sheet. JP Morgan notes that asset growth in the first half was in line with expectations, but the balance sheet was skewed towards lower margin housing loans (+6.5%) and away from higher margin business loans (-9.4%). Analysts expect Queensland property prices, particularly in flood-impacted areas, to come under pressure. Ongoing asset growth has also now shifted into slightly riskier territory post-acquisitions, with higher-yielding leasing, for example, “almost inevitably” leading to a rise in typical bad debts over time, UBS suggests.

With BOQ's credit rating a constraint on the bank's capacity to access mortgage security markets, and the government's deposit guarantee soon to roll off, BOQ is going to have to rely heavily on higher priced deposit funding, UBS suggests. At 7.7%, BOQ's tier one capital ratio is “healthy”, suggests Macquarie, but with the new Basel III regulations soon to come in under as yet unknown APRA interpretation, BOQ's balance sheet will be questionable in a weak Queensland macroeconomic environment still being battered by the ever rising Aussie.

And to top it all off, the bank's driving force over the past ten years, CEO David Liddy, has announced his pending retirement.

It all sounds rather much like a tale of woe. However, of the eight brokers in the FNArena database only one has a Sell (Underperform) rating. Merrills justifies its pessimism on the bases of ongoing asset quality risks, loan volumes remaining subdued in the state and only limited net interest margin upside.

By contrast, RBS (Buy) acknowledges that BOQ has been doing it tough but the analysts are prepared to suggest the bottom in the bank's earnings was marked in the half just gone. Credit Suisse (Outperform) notes BOQ's share price represents a 14% valuation discount to the majors and 6% discount to Bendelaide Bank. Citi (Hold) thinks this discount can narrow while Deutsche Bank (Hold) can't see this happening in the short term.

The remaining brokers all have Hold ratings based mostly on capital and macroeconomic concerns, as does Goldman Sachs which suggests the market will need to see tangible evidence of falling BDDs as the water recedes before investor commitment is revived.

Post the result, BOQ's consensus price target fell to $10.91 from $11.00 which compares to a current share price of around $9.77.

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