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Morningstar | Transferring Coverage; Challenging Outlook Results in a 5% Cut in Bendigo Bank's FVE to AUD 10. See Updated Analyst Note from 14 Apr 2019

We reduce our fair value estimate for no-moat-rated Bendigo and Adelaide Bank by 5% to AUD 10.00 from AUD 10.50 per share as we transition coverage to a new analyst. Our no-moat, medium fair value uncertainty, and Standard stewardship ratings are unchanged. At current prices, the stock is fairly valued trading at an undemanding one year forward P/E of 11 times. We confirm our fiscal 2019 cash profit forecast of AUD 430 million and fully franked dividend of AUD 69 cents per share based on a high 79% payout. But a reassessment of the outlook for Bendigo Bank results in lower earnings forecasts for fiscal 2020 and outer years. In our opinion, Bendigo Bank lacks meaningful competitive advantage and is disadvantaged when competing against the big four banks. Bendigo Bank must rely on a trusted brand, strong customer satisfaction, conservative management, a well-funded balance sheet and very strong credit quality to deliver modest medium-term EPS growth.

The bank reported a soft first-half fiscal 2019 result in February with our full-year forecast expecting a 5% decline in EPS. An improved second-half fiscal 2019 would surprise when the bank reports fiscal 2019 results on Aug. 12, 2019. Cost containment, net interest margin, or NIM, management, underlying asset quality, and strong capital and funding positions need to feature.

Disappointingly, the firm’s return on equity, or ROE, of 7.9% continues to lag the major banks and is a key reason why we do not allocate an economic moat to Bendigo Bank. We expect Bendigo Bank to deliver solid but uninspiring operating results, but returns are not expected to exceed our 9% cost of equity. Our 5-year ROE forecast averages 7.5% per year. Bendigo Bank, and regional bank peers, continue to struggle against the major banks with their strong market positions, favourable mortgage capital requirements, large scale and competitive advantages, particularly around funding costs, operating expenses and technology and regulatory spend.

Despite challenging operating conditions, we think the dividend is broadly sustainable around AUD 69 cents per share levels, equating to an attractive fully franked yield around 7%. We expect soft revenue growth and higher than historical expense growth to crimp group profit growth with little respite on the horizon as the domestic economic environment softens. We expect broadly flat earnings over the next five years, reflecting average lending growth of 1.8%, moderately declining net interest margins, bad-debt levels that are higher but still reflect expectations of a relatively benign credit environment, and improved cost efficiencies.

In our opinion, Australian regional banks lack a moat as they do not possess sustainable cost and switching cost advantages. They struggle to compete with the major banks on price, primarily because of higher funding and operational costs in the face of strong competition across the industry. However, the Australian major banks operate in a highly profitable rational oligopoly structure and despite lacking strong competitive advantages the regional banks still generate attractive earnings and dividend growth.

We expect margins to remain under pressure due to higher funding costs and intense pricing competition for new high-quality owner occupier home loans. Following the Hayne Royal Commission, we expect operating expenses to increase with additional spend on compliance, regulatory and technology. We now expect operating expenses to remain elevated for longer than previously expected. Our forecast cost to income ratio increases to 57% in fiscal 2019 from 56% in fiscal 2018, improving modestly to 56% by end fiscal 2023. The average for the five years ending fiscal 2018 was 56%.

Based on Australian Prudential Regulation Authority’s monthly banking statistics for the 12 months to end February 2019, Bendigo Bank continues to grow its home loan book modestly above the rate of system growth of 3.8%. Bendigo Bank’s growth of 4.0% for the year to end February, has been a good result and we expect the bank can continue tracking around system growth rates for home loans and household deposits.