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Morningstar | Earnings Momentum Under Pressure as BOQ’s 1H19 Profit Falls 8%. FVE Cut to AUD 9.60

No-moat-rated Bank of Queensland reported a tough first-half fiscal 2019 result with most earnings drivers softening. Despite the weak result, key performance metrics were broadly in line with the earnings update issued Feb. 18, 2019. No surprises in the 8% decline in cash profit to AUD 167 million compared with previous corresponding period, or pcp, and consistent with the AUD 165-AUD 170 million guidance. Net interest margins, or NIM, declined three basis points on pcp to 1.94%, again in line with guidance of between 1.93-1.95%. Higher short-term wholesale funding costs and intense pricing competition for new owner-occupier home loans were the main culprits for lower margins. The surprise from the result was the expectation of elevated operating expenses to last longer than previously expected.

Following a change of analyst, we upgrade our fiscal 2019 earnings forecasts NIM and lower loan losses for fiscal 2019. We now forecast full-year margins of 1.96% (previously 1.90%) and a loan loss rate of 0.13% (previously 0.20%). Despite upgrading our fiscal 2019 forecasts, our medium-term forecasts are reduced due to expected increases in operating expenses covering higher amortisation expense and increased regulatory, compliance, and technology costs. We reduce our fiscal 2020 earnings forecast 6% to AUD 342 million with similar cuts in outer years. The softer medium- to longer-term growth outlook results in an 8% decrease in our fair value estimate to AUD 9.60 from AUD 10.40 previously. Currently, the stock is undervalued, trading 7% below our valuation.

We are disappointed in the delay in appointing a new CEO following the resignation of John Sutton in December. The bank needs an extended period of management stability, to be able to leverage a straight-forward strategy and achieve long-term EPS growth. Strong risk management is critical given the accelerated pace of change in financial services.

We have been conservative on the outlook for loan growth, NIM and bad debts, and the first-half fiscal 2019 result confirmed our concerns. Bank of Queensland's home lending has been subdued for several years, but on the plus side, home loan quality remains strong. We like the success of Virgin Money and BOQ Specialist, but the owner-manager branch network needs surgery.

Despite the soft outlook we like the regional bank’s increasingly diversified business and distribution mix complementing the bank’s traditional consumer and SME banking businesses. As expected, business banking again overshadowed retail banking with retail banking suffering a 12% decline in cash NPAT on the pcp to AUD 66 million for the half, compared with the 5% decline in business banking cash NPAT to AUD 102 million.

Loan impairment expense of 0.13% of gross loans was in line with the 11-13 basis point
guidance and was an increase on pcp of 0.10%. Importantly the increase was not due to a deterioration in loan quality, but rather the effect of an increase in collective provisioning following the introduction of new accounting standard AASB 9. Impaired assets reduced 12% to AUD 152 million and loan arrears remain at benign levels. The 90-day plus home loan arrears are at 0.51%, up modestly from 0.49% six months ago and 0.44% a year ago. Despite the upward trend, home loan arrears are still very low and no cause for concern.

Capital, funding and liquidity levels are sound with the common equity Tier 1 capital ratio solid at 9.26%. Organic capital generation was good at 0.13% for the half, but the expected increase in capitalised software will exert modest pressure on the key capital ratio. The common equity Tier 1 ratio comfortably exceeds its recently upgraded capital target range of 8.25-9.26%. Future surplus capital will be used to support modest business growth, accelerating modernisation and digitalisation of the bank. Capital management initiatives are unlikely at this stage. Customer deposit growth disappointed with the AUD 31 billion of customer deposits unchanged during the previous six months and up just 1% on a year ago.

Annualised gross loan growth of 2% for the six months to Feb. 28, 2019, was soft, but
expected in a slowing market. BOQ Finance growth was strong at 13% and commercial was sound at 3%, but housing growth disappointed with the positive outcome for Virgin Money offset by a contraction in branch network home loan growth. Housing and consumer loans outstanding were steady compared with end of fiscal 2018.

Based on APRA’s monthly banking statistics for the 12 months to end February 2019, Bank of Queensland continues to grow its home loan book well below the rate of system growth of 3.8%. Bank of Queensland’s growth was just 0.9% for the year to end February, due to a weak performance of its branch network.

Return on equity remains substandard at 8.8% down 1.1% from 12 months ago, due to the 8% decline in cash profit. Statutory profit of AUD 156 million declined 10% on pcp. The 10% decline in the interim dividend to AUD 34 cents per share was in line with the decline in profits but remains at a high 81% payout. The high payout is sustainable if operating conditions continue broadly unchanged with low loan growth, strong asset quality and good absolute profitability.