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Commonwealth Bank (CBA) – NEUTRAL

August 9, 2018
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August 9, 2018

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Commonwealth Bank (CBA) – NEUTRAL

Commonwealth Bank’s (CBA) FY18 result came largely in line with consensus estimates and, frankly speaking, weren’t as bad as some may have anticipated. Nonetheless, key headwinds we have highlighted before were evident in the second half of the year and will persist into FY19.

COMPANY DATA

Date of ReportASXPricePrice TargetAnalyst Recommendation
09/08/18CBAA$74.81 $74.20NEUTRAL
Date of Report

09/08/18

ASX

CBA

Price

A$4.13

Price Target

A$4.32

Analyst Recommendation

NEUTRAL

Sector : Banks52-Week Range: A$67.22 – 82.66
Industry: FinancialsMarket Cap: A$131,654m

Source: Bloomberg

Company Description

INVESTMENT SUMMARY

We rate CBA as a Neutral for the following reasons:

  • Trades at a 1.9x Price to Book, and dividend yield of ~5.8%, however the stock trades at a premium to peer group.
  • Expected low levels of impairment charges (especially as a low interest rate environment helps customers and arrears).
  • Potential earnings benefits from cash rate hikes in the future.
  • Potential pressure on net interest margins as competition intensify with other major banks.
  • Sector leading return on tangible equity.
  • A well-diversified corporate book.
  • Improving CET1 ratio, which may in due course provide opportunity to undertake capital management initiatives.

We see the following key risks to our investment thesis:

  • Intense competition for loan, as overall market growth rate moderates.
  • Trades at a premium to peer group, with high competition potentially eroding its ROE.
  • Major banks, including CBA, are growing below system growth (i.e. losing market share).
  • Increase in bad and doubtful debts or increase in provisioning.
  • Funding pressure for deposits and wholesale funding (increased funding costs).
  • Regulatory and compliance risk
  • Australian housing property crash

Figure 1: : CBA’s Cash Profits split by Segment 

Source: Company

ANALYST’S NOTE

Commonwealth Bank’s (CBA) FY18 result came largely in line with consensus estimates and, frankly speaking, weren’t as bad as some may have anticipated. Nonetheless, key headwinds we have highlighted before were evident in the second half of the year and will persist into FY19.

FY18 cash earnings of $9.2bn was -4.0% below previous corresponding period (pcp), however this was driven largely by the recognition of one-offs such as the AUSTRAC penalty ($700m) as well as increased risk and compliance provisions ($389m). Second half FY18 (2H18) saw net interest margin (NIM) deteriorate by 2bps to 2.14% driven by discounting / switching and higher funding costs, with deposit repricing, lower institutional lending and higher NZ NIM providing some offset.

We also saw consumer arrears deteriorate in the second half. We remain Neutral. CBA is trading at a premium to peer group average (PE-multiple / Price-to-book) despite growing below system growth (losing market share), will likely experience some erosion to sector leading ROE and increasing costs.

  • FY18 results key points:

1. Reported ROE (cash basis) of 14.1%, down -1.6% from pcp, however excluding one-offs it was 15.3%.

2. Net interest margins of 2.15% rose +5bps on pcp, boosted by asset repricing in 1H18 and favourable changes in funding mix. A deterioration in 2H18 vs. 1H18 was observed due to home loan switching and discounting;

3. Cost-to-income ratio of 44.8%, up 270bps, however again excluding one-offs it was 41.1% (an improvement of 10bps on pcp);

4. Jaws ratio remains positive on an underlying basis (0.3%) reflecting strong operational cost discipline;

5. Final dividend of 231cps, up 2cps from FY17, bringing the yearly dividend to 431cps.

  • Loan growth below system, driven by competition and proactive regulatory measures. CBA’s home loan growth in FY18 was +3.7%, below system growth of +5.6%. As we previously called out, we expect subdued mortgage growth to continue due to an increasingly competitive market (with moderating system growth) and regulatory pressures to tighten lending standards. Interestingly, non-financial institutions grew home lending at +12.5% over the same period. In order to reverse this situation, CBA will likely need to be more competitive with pricing, which likely means limited upside from loan repricing in the near future.
  • Credit quality sound but low impairment charge again provides NPAT buffer. Loan losses continued to cushion CBA’s NPAT, with impairment expenses flat at 15bps of loans ($1,079m in FY18, down -1.5%). Consumer impairments remained at 18bps, while Corporate impairments increased slightly to 10bps (up +2bps).
  • Capital ratio deterioration but expected to strengthen. Common Equity Tier 1 (CET1) capital ratio was reported at 10.1% on an APRA basis, down 30bps on pcp, driven by the one-off items. On a pro-forma post divestments basis, the CET1 ratio is 10.7%, exceeding APRA’s ‘unquestionably strong’ CET1 ratio average benchmark of at least 10.5% by January 2020. However, the adoption of AASB 9 (which requires increased provisioning for credit losses) from 1 July is expected to decrease the ratio by 18bps. Again, we believe that CBA will remain constrained to undertake any additional capital management initiatives.

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INVESTMENT DRIVERS

Loan growth below systems, moderated by risk wariness and proactive regulatory measures. CBA’s home loan growth in FY18 was +3.7%, below system growth of +5.6%.

Figure 2: CBA losing share / growing below system

Source: Company

As we previously called out, we expect subdued mortgage growth to continue due to an increasingly competitive market and regulatory pressures to tighten lending standards. This has implications for CBA, which has a large housing book, and needs to arrest the below system growth rate in the current competitive market. On a positive note, CBA’s growth was driven by increases in owner-occupied mortgages (+6.2%) offset by declines in investment home lending (-1.2%). At the same time, the proportion of internally originated loans (as opposed to brokers) increased 1bps to 63%, representing higher margins.

Positive (underlying) Jaws…with revenue up +3.4% (on higher Banking income, up +4.3%, as volumes grew in home lending, business lending and deposits) versus expense growth of +3.1%. (Underlying) cost-to-income declined 10bps to 41.1%. However, cost pressures are expected to continue in FY19, in our view.

Penalties, provisions, and one-offs. A number of one-off items were recognized in FY18, chiefly:

1. a $700m expense for the AUSTRAC civil penalty;

2. $389 in provisions related to risk, compliance and regulatory costs ($155m of which as recognized as a one-off in FY18) and which represents an increase from what was provisioned in 1H18;

3. $43m in net operating income relating to the consolidation of AHL Holdings (Aussie Home Loans), and $3m in net operating expenses due to the acquisition of eChoice;

4. A number of operations, namely a number of CBA’s insurance interests (CommInsure Life and Sovereign & BoComm Life) as well as TymeDigital, were moved to as discontinued operations in FY18, impacting earnings.

Credit quality. Loan losses remained low for the period, with impairment expenses flat at 15bps of loans ($1,079m, down 1.5%). Consumer impairments were flat at 18bps, while Corporate impairments increased slightly to 10bps (up +2bps). This outcome was driven by increased provisioning in Business and Private Banking as well as Institutional Banking & Markets but offset by reductions in Bankwest. An uptick in consumer arrears was noted with home loans increasing from 0.6% to 0.7% and personal loans increasing from 1.41% to 1.44% due to households experiencing difficulties with rising costs and limited income growth. As we have previously called out, we do expect some deterioration in impairments going forward.

Figure 3: Home loans arrears (90 days)

Source: Company

Figure 4: Home loans arrears by State

Source: Company

Capital ratio deterioration but expected to strengthen. Common Equity Tier 1 capital ratio was reported at 10.1% on an APRA basis, down 30bps from FY17, driven by the one-off items. On a pro-forma post divestments basis, the CET1 ratio is expected to be 10.7%, exceeding APRA’s ‘unquestionably strong’ CET1 ratio average benchmark of at least 10.5% by January 2020. However, the adoption of AASB 9 (which requires increased provisioning for credit losses) from 1 July is expected to decrease the ratio by 18bps. As such, in line with our previous statements, we believe that CBA will remain constrained to undertake any additional capital management initiatives in the near term.

Dividend uplift on higher payout ratio than FY17. CBA was able to slightly lift its dividend to $4.31 per share (from $4.29 per share in FY17) on an 80.4% payout ratio of cash NPAT (74.9% if the AUSTRAC penalty is excluded). DRP remains but with no discount.

Simplification of CBA’s business model.
(1) CBA announced in June its intention to demerge its wealth management and mortgage broking businesses (termed “NewCo”), in a bid to simplify the business and stave off regulatory concerns. This is expected to complete around FY19. Pro-forma, NewCo contributes approximately $568m of CBA’s FY18 cash NPAT (representing ~6% of the business).
(2) Additionally, CBA also announced a strategic review of its general insurance business which may result in a potential sale.

CBA FY18 RESULTS SUMMARY

CBA’s FY18 results are summarized below in the figure below.
Figure 5: FY18 key P&L summary

Source: Company

Earnings much in line with consensus. FY18 statutory net profit after tax (NPAT) of $9,375m, was down -4.0%; Cash NPAT of $9,233m, was down -4.8%. Return on equity (cash basis) of 14.1% fell short of the 15.7% achieved in FY17, however excluding one-offs, would have been 15.3%. Net interest margins (NIM) of 2.15% strengthened from the 2.10% in FY17 – key points:
(1) the margin was supported by asset repricing (+4bps) and favourable changes in funding mix (+2bps) while offset by increased funding costs (-1bps) due to the impact of the bank levy and higher wholesale funding costs.
(2) A slight deterioration was observed in 2H18 vs 1H18 due to home loan switching and discounting, which we discussed in our June note, as well as higher wholesale funding costs, but offset in part by deposit pricing.
(3) Other banking income was down -3.7% driven largely by reductions in interchange revenue, removal of ATM withdrawal fees, weaker Markets performance.
(4) Funds management income increased +9.3% due to positive net flows, higher investment market returns, and lower advice remediation provisions; and (5) Insurance income was up +31.4% due to lower weather event claims and growth in premiums.

CBA COMPS PEER GROUP

Figure 6: CBA comparable table

Source: BTIG, Bloomberg

Figure 7: CBA Price to Earnings (x) multiple

Source: BTIG, Bloomberg

Figure 8: CBA Price to Book (x) ratio

Source: BTIG, Bloomberg

Figure 9: CBA Financial Summary

Source: Company, BTIG, Bloomberg

COMPANY DESCRIPTION

Commonwealth Bank of Australia (CBA) is one of the major Australian Banks. Its key segments are retail, business and institutional banking, wealth management, New Zealand and Bankwest. Across these core segments, the bank provides services in retail, corporate and general banking, international financing, institutional banking, stock broking and funds management.


Recommendation Rating Guide

Recommendation Rating GuideTotal Return Expectations on a 12-mth view
Speculative BuyGreater than +30%
BuyGreater than +10%
NeutralGreater than 0%
SellLess than -10%

Reach Markets Disclaimer

Reach Markets Pty Ltd (ABN 36 145 312 232) is a Corporate Authorised Representative of Reach Financial Group Pty Ltd (ABN 17 090 611 680) who holds Australian Financial Services Licence (AFSL) 333297. Please refer to our Financial Services Guide or you can request for a copy to be sent to you, by emailing admin@reachmarkets.com.au.

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