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Morningstar | Bendigo’s Flat first half 2019 Signals Difficult Times Ahead; FVE Cut 9% to AUD 10.50

No-moat-rated Bendigo and Adelaide Bank’s below-expectation first-half profit clearly reflects the challenging operating environment currently facing smaller banks. Bendigo continues to struggle against the major banks with their strong market positions, favorable mortgage capital requirements, large scale, and competitive advantages--particularly around funding costs, operating expenses, and regulatory spend. Bendigo’s return on equity continues to disappoint, with a 39-basis-point decline to 7.9% at Dec. 31, 2018 from 8.3% a year ago. An AUD 35 cents per share fully franked interim dividend was confirmed, leaving our full-year fiscal 2019 forecast dividend of AUD 70 cents unchanged. Adjusting for the weaker outlook results in a decrease in our fair value estimate to AUD 10.50 per share from AUD 11.50.

Weak revenue and higher than anticipated expense growth crimped group profitability with little respite on the horizon as the domestic economic environment softens. Earnings were weaker for the period, on both a cash and statutory basis, and we expect their corresponding growth rates to remain subdued in the near term. Cash earnings of AUD 220 million were down AUD 5.5 million, or 2%, on the prior corresponding period, or pcp, while statutory earnings were down over 10% to AUD 203 million for the same period. We have pared our earnings assumptions through our forecast period to reflect management’s more cautious outlook and continued challenges facing the bank. We lower our fiscal 2019 earnings forecast to AUD 430 million from AUD 466 million previously. Expenses grew by 4.2% for the period to AUD 464 million, largely due to higher staff and regulatory costs.

The combination of lower revenue and higher costs saw net interest margins, or NIMs, fall 3 basis points through the period to 1.95% and this will remain challenged near term as front-book lending discounts persist. Although this was in line with our expectations for the period, we have adjusted our NIM assumptions to trend downward toward 1.90% by fiscal year 2023. We expect this to be driven by continued industry competition for both lending and deposits. We also saw a higher cost/income ratio on the pcp to 57.3%, up 310 basis points, although only 3 basis points higher than six months ago. This was higher than we anticipated and so we have subsequently increased our cost to income assumptions through our forecast period as we now believe it will be difficult for management to hit its 55%-56% cost/income target in the near term. Guided higher amortization charges will also detract from second-half fiscal 2019 cost improvements, exerting further pressure on the cost/income ratio.

One bright spot was the continued strength in asset quality. Loan losses were a low 8 basis points annualized, well down on the long-term trend of approximately 11 basis points. We continue to use 11 basis points as our through the cycle loan loss rate assumption. Importantly, residential loan arrears continue to trend down, or improve, to around 0.5% of the portfolio. Portfolio arrears remain at historical lows, with not much stress in the loan book other than isolated pockets and in Western Australia. Business arrears increased because of two individual facilities, but management confirmed the two had returned to performing subsequent to balance date. Provision coverage of impaired assets is strong at 110%.

Loan growth remained below system and doesn’t look like improving in the near term. Housing loan growth remains highly competitive and tracked 60 basis points below system at 2.7% annualized for the six months to December. We estimate this to remain weak in the near term and have adjusted our expectations downwards to reflect it. Agribusiness performance was encouraging, although the industry remains highly competitive with earnings up 3.5% to AUD 38 million on the pcp, despite severe drought in the Eastern states.

Bendigo’s capital position remains strong and above peers. Supporting this was organic capital generation and lower risk weighted assets in the half. The common equity Tier 1 ratio ratio of 8.76% continues to trend up and the bank already comfortably meets APRA’s January 2020 benchmark of 8.5% for standardized banks. Progress toward advanced accreditation around mortgage risk weights continues, with greater clarity expected in 2019 when APRA releases finalized new credit risk weights regulations.

Funding and liquidity levels impressed with retail deposit balances increasing to an industry high 82% of total funding. Bendigo increased total customer deposits by an annualized 4.1% in the six months to end December, well above system at 2.4%. The group has for a long time been run with a tilt toward the liability side of the balance sheet, with the current strength in retail deposits a key advantage. A strong funding position continues to provide a strong base for management to protect itself further against industry headwinds.