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Morningstar | Steady as She Goes as NIM Uplift Drives Bendigo Bank’s FY18 Result; AUD 11.50 FVE Unchanged

No-moat-rated Bendigo and Adelaide Bank announced an in-line fiscal 2018 financial result boosted by a healthy lift in net interest margins, or NIMs. Underlying cash earnings of AUD 445 million represented a 6.5% increase on the prior year and came in slightly under our AUD 452 million forecast, while the fully franked final dividend of AUD 0.35 per share was in line with expectations and a full-year fully franked dividend of AUD 0.70. We retain our AUD 11.50 fair value estimate, suggesting the stock is currently fairly valued.

Profitability remains healthy, reflected in an increase in net interest margin during the year but offset by below-system growth in total lending. NIM was up an impressive 12 basis points during the year to 1.96%, driven by an 11-basis-point pickup in retail deposit pricing. On the other hand, higher bank bill swap, or BBSW, rates led to wholesale deposit pricing pressure in the second half, which is likely to recur should BBSW rates increase again, as we expect. The repricing of the mortgage book in late July 2018 will support NIMs in fiscal 2019, although front book discounts will act as a NIM headwind. We adjust our NIM assumptions upwards from 1.85% for our forecast period to 1.94%, still lower than current levels, on our expectation of continued challenges from higher funding costs, as well as increasing risks of slowing revenue growth amid a slowing housing market and lending challenges.

While revenue growth remains a challenge for the industry, cost management remains a key focus for the bank. A 50-basis-point improvement in the cost/income ratio to 55.6% was encouraging, although as management guided in the earnings call, it is unlikely to see any major improvement in the near term, given increased costs of compliance and regulation. We adjust our cost/income ratio assumption from 58% in fiscal 2019 to 56% trending towards 55% during the duration of our 2019-23 forecast period.

Bendigo’s asset quality remains high, supported by low bad and doubtful debt, or BDD, charges and low loan arrears rates. Bendigo’s BDD of 11 basis points remains in line with its four-year average and slightly lower than that for the major banks. Nevertheless, impaired loans/total loans, while still very low, worsened during the year, with net impaired loans/total loans up 3 basis points to 35 basis points. The stable trend in home loans 90-plus days overdue is reassuring, with over 1.5% of Western Australian loans now falling into this category, and with potentially higher borrowing rates on the horizon a potential trigger for higher arrears in the near term.

Bendigo’s capital position remains strong, evidenced by a 35-basis-point increase in the common equity Tier 1 capital ratio to 8.62% at June 30, 2018, driven by organic capital growth. Bendigo satisfies the Australian Prudential Regulation Authority's "unquestionably strong" benchmark common equity Tier 1 capital ratio of 7.5% and continues to work towards advanced accreditation, which would see its capital position improve further. This would see the bank assign lower risk weightings for loans, freeing up capital for greater lending. The timing of this change is still uncertain, but it's likely to occur once Australian Prudential Regulation Authority, or APRA, announces updated capital levels, due by the end of calendar 2018. Risk weighted assets have remained steady in the year at about AUD 38 billion, which also supported a 65-basis-point increase in the total capital ratio during the period to an impressive 12.85%.

Bendigo’s funding profile remains healthy, although its heavy reliance on customer deposits could be a potential issue in the event of intensifying deposit pricing competition, as well as a need by savers to access those deposits at a higher-than-anticipated rate. Currently, retail deposits make up a high 80% of the bank’s total funding, up 60 basis points on the year. Wholesale funding makes up 14%, up 30 basis points, while 5.7% comes from securitisation, which has fallen 90 basis points in the year. While we like retail deposits as a source of funding, we do like diversity in funding sources to minimise the risk of disruption which may potentially result in a higher average cost of funding. Although Bendigo’s retention rate on retail term deposits has declined in recent months, it remains above the long-run average rate of 80%.

BBSW rates caused a stir in credit markets recently, sparking concern about bank funding pressure. Bendigo sources 42% of its wholesale funding from short-term domestic markets, which are closely tied to swap rates such as the BBSW. Unlike the major banks, Bendigo was able to lift rates on mortgages, and the net interest margin increased to 1.98%. Despite volatile short-term funding costs, wholesale credit markets remain accommodative for banks, demonstrated by Bendigo's issuance of a five-year senior unsecured note in January 2018 at a yield of 3.50%, which continues to trade at par.