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Morningstar | A Diaspora of Remediation Costs Reduce Commonwealth Bank’s 3Q19 NPAT. FVE AUD 80 Unchanged

Wide-moat Commonwealth Bank of Australia’s third-quarter fiscal 2019 trading update disappointed, with unaudited cash NPAT of AUD 1.7 billion, down 28% on the average of the two previous quarters. The drop was due primarily to AUD 500 million aftertax of customer remediation costs, or notable items. Excluding the notable items, cash NPAT was down 9% to AUD 2.2 billion, well below our expectation of AUD 2.4 billion. Higher remediation costs, lower revenue and higher expenses detracted for the quarter. Despite the miss, our long-term positive view on Australia’s biggest bank is intact.

These one-off costs and other adjustments reduce our fiscal 2019 cash profit forecast decline by AUD 950 million or 10% to AUD 8.8 billion. Our total fully franked dividend declines slightly to AUD 4.31 cents per share based on a high 86% payout. We now expect a final dividend of AUD 2.31 per share. Based on our updated full-year forecast we expect fourth-quarter cash profit of AUD 2.4 billion. Before today’s announcement consensus estimates for fiscal 2019 cash NPAT were AUD 9.5 billion and a total dividend of AUD 4.31 per share. Despite the reduction in fiscal 2019 earnings forecasts, our outer year growth forecasts are largely unchanged, and we retain our fair value of AUD 80. At current prices, Commonwealth Bank is undervalued trading 8% below our valuation.

Unaudited statutory NPAT of AUD 1.75 billion declined 24% on third-quarter fiscal 2018. Major factors were the previously mentioned one-off costs and a 4% fall in underlying revenue. Net interest income reduced 3% impacted by two fewer days in the quarter, accounting for about AUD 100 million in revenue. These negatives were partly offset by modest volume growth with home lending up 2.5%, household deposits up 2.8% and business lending up 2.3%. Modestly softer net interest margins detracted from NPAT. Other banking income declined sharply due to the temporary impact of higher insurance claims and rebasing fee income.

Underlying operating expenses increased 24% including the increased provisions for customer remediation costs. Excluding the notable items, expenses increased a more respectable 1%. Customer mediation costs of AUD 714 million pretax included AUD 334 million for aligned advice remediation, AUD 72 million for wealth customer refunds, AUD 152 million for banking customer refunds and AUD 156 million for other program costs. In first half fiscal 2019 the bank provided for approximately AUD 282 million in customer remediation program costs. To-date, the bank has incurred AUD 2.17 billion in customer remediation and regulatory costs. The diaspora of regulatory, prudential, royal commission and legal issues facing the bank continue to distract senior management from growing the business and increasing shareholder value.

We increase our total fiscal 2019 operating expense forecast by the AUD 714 million pretax in customer remediation costs with the all-important cost to income ratio deteriorating, or increasing, to around 47% for fiscal 2019. From fiscal 2020 we expect steady improvements in Commonwealth Bank’s operational efficiency with our forecast cost to income ratio closing out fiscal 2023 at around 42%.

CEO Matt Comyn continues to struggle with a raft of regulatory requirements including royal commission recommendations, Australian Prudential Regulation Authority's, or APRA’s, prudential investigation, ASIC’s enforceable undertakings, strengthening financial crime capabilities, improving risk management capabilities, customer remediation programs, dealing with new government legislation and regulatory requirements. We expect these challenging circumstances will remain centre stage for the next 12-18 months, particularly with the potential change in government in Canberra.

Despite the short-term headwinds, over the medium to longer term the bank’s high-quality franchise, strong market positions and reinvigorated senior management will deliver modest earnings and dividend growth. But shareholders need to be patient, with the fully franked dividend yield of about 6%, grossing to an attractive 8.5%, the key attraction. Looking further ahead we forecast average annual EPS growth of 3% and dividend growth of 2%.

Asset quality remains sound, but consumer arrears ticked up suggesting problems down the track. Troublesome and impaired assets increased 7% to AUD 7.2 billion in the quarter, due to emerging weakness in discretionary retail and drought effected farmers and communities and a few single name exposures. We are not overly concerned in the increase in consumer arrears as the quarter is seasonally higher, but higher home loan arrears reflect higher household living costs and limited wages growth. The loan impairment expense of AUD 314 million represented an annualised 0.17% loss rate, higher than the 0.15% annualised for first half fiscal 2019.

We increase our full-year forecast loss rate to 0.17% or AUD 1.3 billion allowing for a fourth quarter loan loss of AUD 360 million. Home loan arrears for 90 plus days continue to climb, but from a low base. The March quarter is a seasonally high quarter, but at 0.71% of the book, home loan arrears have steadily increased from 0.57% two years ago. Home loan accounts in negative equity represent just over 3% of total accounts, based on property valuations at March 31, 2019, with 75% of negative equity loans in Western Australia and Queensland.

The slight decline in net interest margin was not specified but following a soft first half fiscal 2019 result of 2.10% we expected some weakening as switching between higher margin investor and interest only loans to lower margin owner occupied and principal and interest funding loans continued. Short term wholesale funding costs have recently retreated but were relatively high during the quarter. Despite the recent dip in wholesale funding costs, competition for new home loan customers and switching from expiring interest only home loans to principle and interest loans will keep the pressure up on net interest margins. We expect further pressure during the remainder of fiscal 2019 and into first half fiscal 2020 at least.

The balance sheet remains in a sound position with capital, funding and liquidity levels well managed. But the common equity Tier 1 capital ratio of 10.3% at March 31, 2019 declined from 10.8% at Dec. 31, 2018 due to the timing of the interim dividend payment and the additional customer remediation costs. The 0.30% increase in organic capital in the quarter was more than offset by the 0.80% impact of the dividend payment. The net effect of adjustments to the key capital ratio during the next 6-12 months will ensure the bank will have no trouble meeting APRA’s 10.5% unquestionably strong benchmark by the January 2020 deadline. Announced asset sales are expected to increase the common equity Tier 1 ratio by 120 points. We expect a common equity Tier 1 ratio around 10.60% as at June 30, 2019.