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Morningstar | CBA Continues to Reform and Improve its Wealth Management Businesses. FVE AUD 83 Unchanged. See Updated Analyst Note from 08 Oct 2018

Commonwealth Bank of Australia continues the industrywide trend to reform wealth management businesses with the bank’s announcement of belated action on grandfathered commissions and refunds for inappropriate advice provided to Commonwealth Financial Planning customers. Despite the bad news, we believe the bank’s wide economic moat has to-date withstood the unrelenting onslaught of regulatory, legal, political, media, and Royal Commission pressure and threats. Furthermore, we were pleased to see the bank’s pricing power is alive and well with the out-of-cycle increase in variable home loan rates announced in early September. Our AUD 83 fair value estimate is unchanged and at current prices, the stock is undervalued, trading 17% below our valuation.

Estimated pretax remediation costs of AUD 45 million per year are immaterial to Commonwealth Bank’s annual post-tax profit of more than AUD 10 billion, but we take the opportunity to reduce our fiscal 2019 cash earnings forecast 1% to AUD 10.1 billion from AUD 10. 2 billion previously. Prior to the announcement consensus estimates for fiscal 2019 cash earnings were AUD 10.1 billion and fully franked dividends of AUD 4.33 per share. Commonwealth Bank’s announcement is like similar messages from its peers, in that it is not necessarily the cost of owning up to errors and omissions that may go back many years, but the ongoing reputational damage and loss of customer trust.

Poor customer treatment carried out over many years is particularly damaging as major bank CEOs prepare for a grilling at the Standing Committee on Economics in Canberra and then the seventh round of Royal Commission hearings in November on industry policy issues. But Commonwealth Bank’s announcement does advance the reform agenda sweeping the wealth management industry and is an attempt to respond to specific issues raised at the Royal Commission. The removal of grandfathered commissions on superannuation and investment products is long overdue.

We expect the Royal Commission will recommend the banning of grandfathered commissions and a legislative response will likely follow soon. The commission is due to deliver its final report in February 2019. Westpac led the industry announcing in late June 2018, the removal of grandfathered commissions for its employee financial advisors at an annual estimated cost of approximately AUD 30 million.

Commonwealth Bank’s actions should improve customer outcomes, but if the bank had done the right thing originally, then these embarrassing announcements would not be necessary. The announced initiatives include reviewing advice fees charged to deceased estates across all the bank’s financial advice licences and make good refunds where unauthorised fees have been charged. Second, the bank is “taking steps to remove certain fees on legacy wealth products from January 2019, saving customer approximately AUD 25 million annually.” Third, the bank will rebate all grandfathered commissions to Commonwealth Financial Planning customers from January 2019, benefiting around 50,000 customer accounts by approximately AUD 20 million each year. Lastly, the bank will provide “all CFP customers with the option to renew their ongoing service arrangements every two years.”

A broader review of deceased estates is underway across Commonwealth Financial Planning, with the focus on the previous seven years. Any inappropriate fees identified will be refunded with interest. It is a concern that despite spending approximately AUD 580 million during the past six years on improving advice business processes, administration, and risk management systems, the bank is still identifying new issues. The announced removal of grandfathered commissions applies to employee advisors of Commonwealth Financial Planning and does not apply to financial planners employed by aligned dealer groups. Government policy changes are needed to force the industrywide abolition of grandfathered commissions.

The past 12 months had been a tough year for Commonwealth Bank, as the bank has stumbled from one regulatory and legal disaster to another, culminating in a change of CEO in April 2018 and senior management changes. Board renewal is well underway. But despite assets sales, fines, increased compliance provisions, prudential inquiries, widespread business disruption, Royal Commission fallout, unrelenting negative media publicity and political “lashings”, the underlying business continues to perform reasonably well.

Based on banking statistics released by the Australian Prudential Regulation Authority, Commonwealth Bank increased its Australian home loan balances by 3.6% for the 12 months ended Aug. 31, 2018 modestly below the banking system total growth rate of 5.0%. Commonwealth Bank grew its household deposit base by 4.9% for the same period, again modestly below the system growth rate of 6.1%. Net interest margins for the six months to June 30, 2018 of 2.14% impressed as did the low loan loss rate of 0.15%. Return on equity, excluding the one-off AUD 700 million AUSTRAC penalty was 15%.

Commonwealth Bank plans to demerge the Colonial First State Group by the end of 2019. The proposed demerger includes Colonial First Global Asset Management, Colonial First State, Count Financial, Financial Wisdom, and Aussie Home Loans businesses known as “NewCo”. At this stage, we have not demerged “NewCo” from our forecasts or valuation, but the impact to NPAT is at least AUD 500 million per year from fiscal 2020 and beyond, all else equal. For the year ahead, we expect only a modest increase in cash NPAT and dividend. We forecast an average annual 1.5% increase in Commonwealth Bank’s dividend to end fiscal 2023 including “NewCo”. We expect the dividend payout to steadily decline, levelling at around 74% by fiscal 2023, toward the bottom of the bank’s wide 70%-80% target range.