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Morningstar | Earnings Storm Clouds Gathering for Bank of Queensland; FVE Unchanged at AUD 10.80

Flat earnings, a healthy but weaker capital position, and continued strength in asset quality were key takeaways from Bank of Queensland’s fiscal 2018 result. However, management's warning of challenging times ahead was hard to ignore. Our greatest concern for the banking industry remains the generation of future earnings growth, which, in the face of a potentially normalising nonperforming loan environment, could paint a particularly unpleasant outlook for the sector. Other key risks include a weaker residential property market and regulatory risks born out of the Royal Commission. Our AUD 10.80 fair value estimate is unchanged, representing a grossed-up dividend yield of about 10%, but we forecast a falling dividend payout ratio towards 73% in fiscal 2023 from 80% at fiscal 2018.

Earnings challenges are building, highlighted by management’s statement that there are “significant headwinds facing the sector”. The key positive earnings takeaway from this result was the 5-basis-point increase in the net interest margin, or NIM, to 1.98%, driven by improved funding costs and asset pricing. In other words, a greater proportion of funding was made up of deposits during the year relative to the more expensive wholesale funding alternative, while loan rate repricing also reaped benefits.

On the other hand, front book pricing and mix had a negative 10-basis-point impact on NIM during fiscal 2018, an offsetting factor we expect to continue into fiscal 2019. Although the headline 1.98% NIM was 6 basis points higher than our 1.92% expectation, our forecast NIM of 1.90% through our forecast period is unchanged. The reason behind this, and management guided as such during the earnings presentation, is our expectation for pressure on (1) loan pricing; (2) bank bill swap rates; and (3) deposit pricing. Although the specifics of NIM forecasts are near impossible to predict, directionally we remain confident that the next move will be down.

Earnings pressure will continue in future years through increased investment in IT as the bank moves towards being a more technology-savvy and digital-enabled institution. Although this should bring long-term cost efficiencies, the near to medium term will likely see heightened operating expenses in the form of information technology and amortisation as a result, albeit offset somewhat by lower employee costs. During fiscal 2018, expense growth of 3% increased the cost/income ratio by 90 basis points to 47.5%, marginally above our expectations. Management indicated higher ongoing IT investment, as well as larger amortisation charges that come with it, so we have slightly increased our cost/income assumptions to reflect this towards about 47.5% through our forecast period.

Bank of Queensland’s capital levels remain healthy relative to regional peers, albeit weaker year on year. The common equity Tier 1 ratio decreased 11 basis points year on year to 9.31%, largely due to the impact from risk-weighted asset, or RWA, growth, along with a higher-than-expected dividend impact after a lower level of dividend reinvestment plan participation played out relative to previous periods. Regarding the RWA impact, this was due to the higher mix of capital-intensive commercial loan growth relative to housing loan growth, which is a trend we expect to see continue into fiscal 2019.

One common equity Tier 1 driver that we expected to play out but that now looks increasingly unlikely is the capital benefit of approximately 17 basis points from the proposed sale of the St Andrews insurance business to the now struggling Freedom Insurance Group. Nevertheless, with or without the capital benefit of the St Andrews Insurance business sale, we remain confident in the bank’s ability to maintain a healthy common equity Tier 1 profile, with any potential excess capital likely to be reinvested into the business, particularly their IT development pipeline. This is in line with management’s guidance of “incremental capital spend of 7 basis points of common equity Tier 1 over fiscal years 2019 and 2020 to accelerate investment in digital assets”.

Bank of Queensland's asset quality remains very strong, and it improved during fiscal 2018. Impaired assets were down 15% during the year to AUD 164 million, while impairment expense of AUD 41 million was also down 15% for the period, representing a very low 9 basis points of gross loans. This was materially lower than our expected 14 basis points for the period. We revise our assumptions for impairment expense downwards through our forecast period towards the low to mid-double digits--still trending up, but at a slower rate than originally anticipated. We remain confident in our view that impairments will normalise, putting pressure on future earnings.

While arrears remained benign across portfolios, further increasing the gap from the major bank average, commercial arrears did increase during during fiscal 2018. Thirty-day and 90-day housing arrears were down 10 basis points and 6 basis points year on year, respectively, while same-period arrears for commercial property were up 16 basis points and 22 basis points. Despite management’s guidance of “no areas of concern emerging”, the increase in commercial arrears does warrant some attention, even if it is off a very low base.