EUR 850.00 For Business Accounts Only

Morningstar | CBA Set to Deliver a Messy FY18 Profit but Underlying Performance Should Impress; AUD 83 FVE Intact

Wide-moat-rated Commonwealth Bank of Australia’s fiscal 2018 results will be messy when released on Aug. 8. We forecast an underlying AUD 9.9 billion cash profit and a final fully franked dividend of AUD 2.30 per share, taking total dividends to AUD 4.30 per share. We exclude the one-off AUD 700 million Austrac fine from our adjusted cash profit and focus on underlying business results. New CEO Matt Comyn continues to impress as he works through important roadblocks, but there remain plenty of challenges ahead. Major regulatory changes, business restructuring, asset sales, and demerger plans make it difficult to forecast future earnings, but based on our current assessment of business growth, net interest margins, operating expenses, loan quality, returns on equity, capital levels, and dividend growth, our AUD 83 fair value estimate is unchanged. At current prices, the stock remains undervalued, trading 8% below our valuation. Consensus profit estimates for fiscal 2018 are around AUD 9.5 billion, with total dividends around AUD 4.28 per share.

If achieved, our adjusted cash profit forecast will be broadly in line with fiscal 2017, with EPS down a modest 1%. We see this is as good outcome, considering the challenges faced during the past year, and we are confident the underlying business remains in a strong financial and market position. Earnings and balance sheet strength are expected to impress with a peer-leading underlying cash return on equity around 15.8% and an Australian Prudential Regulation Authority, or APRA, common equity Tier 1 ratio of around 10.5%, with plenty of upside due to future asset sales and organic capital generation capacity. Ongoing product innovation, peer-high retail customer satisfaction levels, strong market positions, and good credit quality bode well for another solid earnings performance in fiscal 2019 and beyond, but increased regulatory and compliance costs could pressure cost growth for the next two years at least.

The life business will be treated as “discontinued operations” and excluded from our adjusted AUD 9.9 billion cash profit forecast. Wealth management earnings are included in continuing operations at this stage, as the planned demerger is not expected till year-end calendar 2019. We expect to see good business momentum in fiscal 2018, with customer deposits estimated to increase 5%-6% and loans up 4%-5%. Net interest margins should be broadly stable year on year at around 2.12%, but second-half margins will likely be weaker than the impressive 2.16% reported for the first half. Loan quality will again impress, with loan-loss rates estimated to be around decade lows in the 0.15-0.16% range. Our forecast dividend is based on a 75% payout of underlying cash EPS. We forecast a steadily lower dividend payout levelling around 73% by fiscal 2023, toward the bottom of the bank’s wide 70%-80% target range.

Assessing underlying expense growth will be messy, with headline expense growth likely exceeding revenue growth. Commonwealth Bank booked a AUD 200 million provision in first-half fiscal 2018 to cover expected compliance program spending. This provision will likely increase in the second half, but business-as-usual cost growth should be around the 2-3% level, broadly in line with our forecast revenue growth. The first-half fiscal 2018 Austrac provision of AUD 275 million will be increased by at least AUD 425 million to a total of AUD 700 million to cover the penalty plus legal costs.

We expect 90-day-plus home loan arrears to edge up from the low 0.59% at Dec. 31, 2017 and 0.60% at Jun. 30, 2017, but despite widespread media commentary to the contrary, we don’t at this stage see any significant deterioration of loan quality for Australia’s largest consumer lender. Economic growth continues to impress with GDP growth around 3%; in addition, employment growth is strong, population growth is robust, and interest rates remain at historic lows, despite recent pressure on short term wholesale funding costs.

Most smaller lenders in Australia have increased home loan variable interest rates by around 10-15 basis points during the past month in response to surging short-term wholesale interest rates. At this stage, however, major bank home loan interest rates are unchanged. If short-term wholesale interest rates remain at current elevated levels, we would expect the major banks to implement out-of-cycle interest-rate increases in the next few months.

Commonwealth Bank’s premium rating against major bank peers has decreased significantly during the past 12 months but is slowly retracing. Based on current prices and our fiscal 2018 forecasts, the bank’s 5.7% fully franked dividend yield, grossed up to 8.1%, is 60 basis points lower than the peer average. The bank’s fiscal 2018 price/book value ratio of 2.1 is 50 basis points higher than the domestic peer average and is high compared with international peers at approximately 1.0 times. Our forecast fiscal 2019 P/E of 13.1 times is modestly lower than the average for the previous two years of 13.6 times, but has recovered from multiyear lows around 12 times in mid-June 2018.

A key risk is a recession in Australia and/or New Zealand causing a sharp spike in unemployment, a housing market correction, and significantly higher bad debts. This scenario is not our base case, and we expect steady but slow economic growth to underpin solid operating conditions and deliver modest shareholder returns. The Australian housing market appears to be weakening, but at this stage we expect an orderly correction in average house prices, with only minimal impacts to major bank profits. A sharper-than-expected decline in average house prices could increase loan losses if the decline were to coincide with a spike in the unemployment rate and weaker economic conditions.

The Commonwealth Bank will comfortably achieve APRA’s “unquestionably strong” capital benchmark from internal capital generation, asset sales, demerges, and dividend reinvestment plans. In the unlikely event that additional capital is needed, a DRP discount on fiscal 2019 dividends would bridge the gap. An on-market capital raise is possible, but we rate this scenario as having very low probability. The common equity Tier 1 capital ratio was 10.1% at March 31, 2018, but a range of transactions and adjustments will take effect during calendar 2018, and we estimate a common equity Tier 1 ratio of around 11% by Dec. 31, 2018. The adoption of new accounting standard AASB 9 on July 1, 2018, will reduce capital ratios by approximately 0.26%, but the AUD 3.8 billion Life Insurance sale is expected to complete before the end of calendar 2018, with an uplift of approximately 0.70% to capital ratios. We expect more detail on the proposed wealth management demerger with the fiscal 2018 results.

The federal government’s budget repair tax was effective July 1, 2017, and we expect a total cost of approximately AUD 360 million pretax for fiscal 2018.