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Morningstar | CBA’s 1H19 Performance Highlights Challenges Facing Australia’s Major Banks. FVE AUD 80 Unchanged

Commonwealth Bank of Australia’s first-half fiscal 2019 result was messy and slightly below our expectations. Cash earnings from continuing operations of AUD 4.7 billion increased 2% on the previous corresponding period, or pcp. Cash earnings including discontinued operations rose 2% to AUD 4.8 billion, modestly below the AUD 4.9 billion we expected. We liked the solid volume growth in the half with good outcomes for home loans, transaction deposits and business loans, offset by weakness in net interest margins, or NIMs. Non-interest income softened due to lower commissions, weaker trading performance and lower insurance income.

We have excluded the AUD 92 million cash profit from discontinued operations, the life business and the global asset management business, from fiscal 2018 cash earnings. We reduce our fiscal 2019 cash earnings by AUD 200 million to exclude the full-year impact of discontinued operations. We now forecast a fiscal 2019 cash profit of AUD 9.7 billion, with the AUD 4.33 per share fully franked dividend unchanged. Our AUD 80 fair value estimate and wide moat rating are unchanged. Statutory NPAT of AUD 5.6 billion was 4% lower than pcp. Despite the softer outlook, we remain confident in the long-term earnings outlook for Australia’s biggest bank. At current prices, the stock is trading 9% below our valuation.

The performance highlights the challenges facing the major banks, primarily slowing loan growth, a weakening housing sector, pressure on NIMs, elevated remediation costs, and relatively soft returns on equity. However, we have allowed for these headwinds in our forecasts and continue to see slow and steady improvements in operating performance and earnings. We expect the orderly correction in Australia’s housing market to continue for the next year at least, but the strength of Commonwealth Bank’s brand we believe will support good growth in home loan volumes supported by the bank’s large branch network and online capability.

Strong loan quality and dominant market positions stand out, and as the bank moves through the aftermath of the Royal Commission debacle, we can see better times ahead. The historic valuation premium to peers has partially recovered during the previous six months, but the bank’s one-year forward P/E of 13 times remains below the long-term trend around 14 times. Despite the lower relative premium, the bank remains, in our opinion, the highest-quality major bank for earnings and dividend sustainability. Our positive view is underpinned by further efficiency improvements with our forecast EPS growing an average of 2% annually till fiscal 2023. Based on our EPS forecasts, modest dividend growth with the payout easing to 75% in fiscal 2023 from 76% in fiscal 2018.

There is still no sign of a blowout in bad debts, despite high household debt levels and weak wages growth. Bad debts declined 3% on pcp as home loan arrears decreased. The loan loss rate of 0.15% increased marginally on the previous six months but was in line with 12 months ago. Bad debt expense declined to AUD 577 million from AUD 596 million in pcp. Generally, credit quality is strong with benign bad debts, but pockets of stress remain, particularly residential loan exposures in Western Australia, and business loan exposures to the retail trade, construction, and agricultural sectors. Loan losses as a proportion of group loans and acceptances were 15 basis points for both the consumer and corporate portfolios in the half. Group home loan arrears of 0.67% improved marginally on 0.7% for the previous six months and remain at low levels.

The unchanged AUD 2.00 per share dividend was broadly in line with expectations with the payout ratio increasing marginally to 75%. Return on equity of 13.8% is a little low, but still not a bad outcome, considering the larger capital base and modest profit increase. The interim dividend payout ratio has increased steadily during the past few years, up from a medium-term average of 70%.

The improvement in the cost to income ratio to 42.6% was welcome as operating expenses declined 3% on pcp and 5% on the prior period. Good control of operating expense impressed with a reduction of 3% on pcp and a 5% reduction on the prior period, benefiting from the nonrepeat of one-off costs in prior periods. Despite elevated customer remediation costs, management confirmed the target cost/income ratio of sub-40%. Risk compliance and remediation expenses increased AUD 121 million due to spend on financial crimes compliance, customer remediation, and the program for better risk outcomes.

The balance sheet remains strong with the common equity Tier 1 capital ratio increasing to a very healthy 10.8% at Dec. 31, 2018 up from 10.1% at June 30, 2018, boosted by the sale of the New Zealand life insurance business, positive 27 basis points, and good organic capital generation, positive 66 basis points. The internationally comparable common equity Tier 1 ratio of 16.5% places the bank comfortably in the top quartile of global peers. Organic capital generation was strong due to retained earnings, good cost control, simplifying the operating model, focusing on regulatory risk adjusted returns, and improved data and risk management modelling.

The key pillars of balance strength, credit risk, funding, liquidity and capital are all improving and, where applicable, comfortably above regulatory minimum requirements. The estimated common equity Tier 1 capital ratio uplift from announced asset sales is 123 basis points delivering a pro forma common equity Tier 1 ratio of 12%, considerably higher than APRA’s 10.5% January 2020 benchmark. Assuming the divestments complete, the bank will be returning surplus capital to shareholders, more likely via an off-market share buyback.

Operating income of AUD 12.4 billion for the half was down 2% on pcp despite solid volume growth. Lower net interest income, markets revenue and insurance revenue detracted. Lending growth of 2% on pcp is broken down to 4% in home lending, 5% business lending offset by a 6% decline in institutional lending. Home lending growth in Australia is picking up relative to system with the bank reporting growth just below system at 0.9 times, up from 0.6 times in the prior period and 0.7 times in pcp. Owner-occupied lending increased a healthy 6.5% on pcp. Group customer deposits increased at the same 2% rate as lending balances, with transaction accounts up 8% on pcp and customer deposits representing 69% of total funding.

NIMs declined 4 basis points to 2.10% from 2.14% six months ago and 2.16% 12 months ago. Short-term wholesale funding pressure, lower asset pricing and lower markets margin impacted. Asset pricing was affected by customer switching, negative 2 basis points, increased competition, negative 1 basis points. The difference between wholesale short-term funding costs and the RBA cash rate, known as basis risk, detracted 2 basis points from margin.

Business unit performance was mixed with the earnings powerhouse, retail banking services reporting a 8% decline on cash NPAT to AUD 2.2 billion compared with pcp. NIMs declined 17 basis points in the half. Business and private bank cash NPAT declined 3% on pcp and institutional banking declined 5%. New Zealand continued its strong performance delivering a 7% increase in NZD earnings compared with pcp.