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Morningstar | CBA’s FY19 Result Likely to be the Turning Point for Australia’s Once Proud Premier Bank

Wide-moat Commonwealth Bank of Australia releases fiscal 2019 results Aug. 7, 2019 and we expect an 11% decline in cash profit to AUD 8.8 billion, slightly higher than consensus. The result will be heavily influenced by AUD 1 billion in customer remediation costs and additional compliance and regulatory spending. Despite the decline in earnings, the fundamental business remains strong, with the stock price up 18% since late December 2018. Our forecast AUD 4.31 fully franked dividend is not under threat despite the high expected payout for fiscal 2019. At current prices, the 5.3% dividend yield grosses to an attractive 7.5%. There is no change to our AUD 80 fair value estimate and at current prices, the stock is fairly valued.

We will be looking for clear signs the bank is through the worst of its restructuring and clean up phase and is effectively dealing with heightened regulatory requirements. We think the bank will reach newfound levels of operational strength and profitability during the next few years, putting Australia’s biggest bank in a strong position to rebuild its historical valuation premium to peers. Importantly we see the Sydney-based bank steadily moving to the offence after several years on the defence.

Balance sheet strength will improve with the sale of assets during the next 6-12 months. The sales of Colonial First State Global Asset Management, CommInsure Life, BoComm Life and PT Commonwealth Life are expected to complete in second-half calendar 2019. Commonwealth Bank’s common equity Tier 1 capital ratio is expected to be around 10.5% at June 30, 2019 with the sales likely to boost the ratio by 1.20% to a pro forma level of at least 11.5%--well above Australia Prudential Regulation Authority’s 10.50% benchmark. Over time we expect to see the true power of Commonwealth Bank’s franchise, with the bank expected to invest large amounts in technology while keeping its expense base relatively flat as previous investments yield expense savings.

While interest-rate pressures caused by the Reserve Bank of Australia’s, or RBA, two recent cash rate cuts will affect net interest margins, Commonwealth Bank’s fundamentals are strong, and we see no reason for this to change. Commonwealth Bank is one of the strongest franchises we cover, quite a feat for a bank that went through so much during the royal commission in 2018.

Australian bank funding costs are heavily influenced by the domestic 90-day bank bill swap rate, or BBSW, which in turn is heavily influenced by the RBA cash rate. The RBA recently reduced the cash rate to 1.00% from 1.50%. The 1.50% cash rate had been unchanged for nearly three years. Prior to June 2019 the last time the RBA cut the cash rate was August 2016. Australian major bank funding is about 65% customer deposits and 35% wholesale funding.

Variable rate home loan rates are usually first to be adjusted with home loans making up approximately 67% of major bank Australian lending portfolios. Home loans account for 70% of the Commonwealth Bank’s Australian loan portfolio, with 80% of the bank’s Australian home loans variable interest rate. Westpac Banking Corporation holds about 71% of its Australian loans as home loans, with Australia and New Zealand Banking Group 63% and National Australia Bank 61%.

Interest rate changes for entire home loan books, not just new loans, are usually effective about one month after announcement. Following the RBA’s two recent 25 basis point cuts in the cash rate, the major banks passed on a cumulative average of approximate 42 basis points of interest rate cuts to variable home loan rates. Customer deposit account rates were reduced where possible. Commonwealth Bank's cumulative cut to standard variable owner occupied principal and interest home loans was 0.44% compared with the RBA's 0.50% in cuts to the cash rate.

The market expects the RBA to reduce the cash rate at least one more time this year. If so, the major banks will not be able to pass on the full value of the cash rate cut because deposit rates cannot be cut to the same extent. Additional margin pressure would hurt bottom line earnings. We have long argued the major banks have considerable pricing power, and assuming funding costs do not fall to the same extent as future RBA cash rate cuts than the major banks will not likely pass on lower interest rates in full to variable rate home loan borrowers. Margin pressure is increasing but funding costs are declining. Long term international wholesale funding costs are falling for the Australian major banks.

Within the major banks we like Westpac Bank and Commonwealth Bank the best due to stronger market positions in consumer banking and higher net interest margins. Loan quality is robust, and we believe earnings quality is more resilient, with attractive upside for improved operating leverage.