EUR 850.00 For Business Accounts Only

Morningstar | BOQ Updated Star Rating from 19 Feb 2019

No-moat-rated Bank of Queensland’s update on trading conditions for the first half ending Feb. 28, 2019 portrayed a sombre near-term outlook for both numbers and tone, sending the stock down by around 6% on the day. As foreshadowed in our recent note titled “Growth Outlook Remains Gloomy for Regional Banks, Including Bank of Queensland” published on Feb. 16, 2019, the regional bank’s trading update signalled muted growth prospects in the immediate future, with continued funding cost pressures, price competition for loans, downward pressure on noninterest income and the increase in regulatory costs named as the underlying culprits. We accordingly lower our fair value estimate for Bank of Queensland to AUD 10.40 per share from AUD 10.80, after aligning some of our earnings forecasts in line with management’s guidance.

Management guided towards a drop in first-half fiscal 2019 cash earnings by around AUD 12-17 million from the previous corresponding period, or pcp, to AUD 165-170 million, with the core reason being an expected decline in non-interest income by AUD 8-10 million. Bank of Queensland’s non-interest income has been under pressure since fiscal 2015, and we expect a subdued outcome for noninterest income over the foreseeable future given the industrywide decline in income from interchange, merchant and trading fees. We have lowered our growth assumptions for non-interest income moving forward. Our projections assume an increasingly lower reliance on non-interest income over time, with the now terminated sale of St Andrews Insurance to the fledging Freedom Insurance Group indicating the bank’s desire to shed its noncore operations.

Net interest margin, or NIM, challenges were confirmed with an expected reduction from 1.97% towards a range of 1.93% to 1.95%--bringing it closer to our forecast NIM of 1.90%. We think there is limited scope for improved profitability in the near term given the industrywide slowdown in credit growth, where regional banks like Bank of Queensland remain vulnerable. This is largely due to their limited distribution footprint, concentration on a niche region and higher funding costs which translate to less competitive product rates. A changing regulatory environment post the Royal Commission will also prompt the bank to increasingly tighten its underwriting standards to maintain sound asset quality, while elevated bank bill swap rates continue to add pressure to funding costs. Accordingly, our NIM forecasts are unchanged at 1.90% throughout our forecast period, with profitability to further deteriorate in the second half, echoing management’s warning about challenging market conditions which are expected to persist.

The regional bank hinted towards "some non-recurring costs" that are expected to negatively impact the half-year result. We think this could be related to legal/compliance costs associated with the Royal Commission. While these non-recurring items will likely be recorded "below the line"--which is debatable in itself--they do not directly impact our valuation. We expect increased regulatory compliance requirements are on the way which will flow on to staffing, IT and consumer acquisition costs. Accordingly, we expect future cost/income to trend higher than its five-year historical average, around 46%. Our projected cost/income ratio sits around 50% for fiscal 2019 before trending towards 48% by fiscal 2023, assuming the regional bank’s increased digitisation is successful in reducing its general expenses profile.

The risk of deteriorating asset quality increases with management announcing an expected rise in loan impairment expense as a percentage of gross loans to between 11 and 13 basis points. Considering Bank of Queensland’s relatively benign arrears levels and its historically favourable loan impairments of just 0.08% of gross loans in second-half fiscal 2018, it’s easy to think these levels won’t normalise to longer-term trends. However, our assumption is they will, leading to further profitability challenges.

The prospects of Bank of Queensland’s loan portfolio are mostly tied to the Queensland housing market, which continues to weaken as property prices and confidence fall across the state. We assume an increase in loan charge-off rates from 13 basis points to 17 basis points over the forecast period.