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Morningstar | CBA’s Messy FY18 Profit Hides a Strong Underlying Business Franchise. FVE AUD 83 Intact

As expected wide-moat-rated Commonwealth Bank of Australia's fiscal 2018 result was messy. But the underlying cash profit from continuing operations--excluding the one-off AUSTRAC penalty--increased a solid 3.7% to AUD 10 billion. The AUD 2.31 per share final dividend increased marginally from a year ago, taking total fully franked dividends to AUD 4.31, based on a 75% payout excluding one-offs. A slightly higher divided is a vote of confidence in the outlook from the Board. Net interest margins, or NIMs, underlying operating expenses, loan quality, underlying returns on equity, pro forma capital levels and modest dividend growth stood out and support our positive view and unchanged AUD 83 fair value estimate. At current prices, the stock is undervalued, trading 10% below our valuation.

Despite significant criticism aimed at Commonwealth Bank during the past year, the bank's statutory NPAT declined "only" 6% to AUD 9.3 billion. However, cash NPAT, which includes the AUSTRAC penalty and other one-offs fell 4.8% to AUD 9.2 billion. Operating income increased 3.4% year on year to AUD 25.7 billion on both positive volume growth and NIM. Operating expenses increased 3.1% to AUD 10.5 billion, excluding one-offs due to elevated risk and compliance spend. One-off regulatory costs of AUD 155 million and the non-tax deductible AUD 700 million AUSTRAC penalty are excluded from underlying expenses. Discontinued businesses contributed AUD 179 million to the statutory profit.

The past 12 months had been a horrible year for Commonwealth Bank, with the firm stumbling from one regulatory and legal disaster to another, culminating in a change of CEO in April 2018 and a completely refreshed senior management team. But despite assets sales, fines, increased compliance provisions, prudential inquiries, widespread business disruption, the Royal Commission fallout, unrelenting negative media publicity and political “lashings”, the underlying business continues to perform well.

Many will find this surprising, but the bank's wide economic moat has withstood the unrelenting onslaught with a robust underlying performance. For the year ahead, we expect a modest increase in cash NPAT, dividend, and return on equity, or ROE. But the planned demerger of the wealth management and mortgage broking company, known as "NewCo" will reduce annualised NPAT by at least AUD 500 million per year from fiscal 2020 and beyond, all else equal.

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 73% by fiscal 2023, toward the bottom of the bank's wide 70%-80% target range. At this stage we have not demerged NewCo from in our forecasts or valuation. NewCo is expected to demerge by the end of 2019.

Net customer numbers in Australia increased approximately 200,000 during the six months to June 30 and over one million new personal transaction accounts were opened in fiscal 2018. Lending and deposit growth were positive but below system levels. NIMs increased 0.05% year on year and loan losses were flat at historical lows of 0.15%. Balance sheet strength continues to be supported by pristine credit quality, high customer deposit funding, and strong levels of funding, liquidity, and capital.

The common equity Tier 1 capital ratio of 10.1% increases to an impressive 10.7% on a pro forma basis, modestly above Australian Prudential Regulation Authority's, or APRA's 10.5% benchmark required by January 2020. The underlying return on equity of 15.3% declined from 15.6% a year ago, but remains best in peer group. Including one-offs, the ROE from continuing operations declined 160 basis points to a still-respectable 14.1%.

New CEO Matt Comyn signed-off on a very difficult year, and pleasingly he did not take the opportunity to increase provisions and/or write-off intangibles more than was necessary. Nonetheless, we expect to see more restructuring, asset sales, and portfolio rationalisation in the year ahead, culminating with the planned demerger of the global asset management business and the Australian wealth business. The long road to recovery has started with good progress made during the past six months. Forthcoming share price catalysts include the successful sale of the life business by end 2018, a much cleaner set of financial results for first-half 2019, due in February 2019, and final fiscal 2018 results due in August 2019.

We forecast a cash NPAT of AUD 10.2 billion in fiscal 2019 with EPS growth a modest 1.5%. We expect margins to soften to a 2.13%-2.14% range, loan growth of 4.3%, and loan losses to increase modestly to 0.16%. If achieved, we think this will be as good outcome considering the challenges experienced during fiscal 2018. Management is expecting home loan system growth to ease to approximately 4% by end fiscal 2019 from 5.6% for fiscal 2018. Modestly lower than forecast loan growth does not have much of an impact on our valuation.

Downside risk includes more negative fallout from the Royal Commission, political risk from the current government and/or a possible change of government, increased wholesale funding costs and potential fallout from an escalation in trade tensions between the U.S. and China. 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.

Loan quality again impressed, but 90-plus day home loan arrears increased 10 basis points to 0.7% due to lower loan growth and pockets of household financial stress, particularly in Western Australia and the Northern Territory. We forecast the current (and decade-low) loan loss rate of 0.15% to gradually increase closer to longer-term averages of around 0.21% by end fiscal 2023. The six basis point increase in forecast loan losses represents a significant 40% increase.

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%, employment growth is strong, population growth is robust and interest rates remain at historical lows, despite recent pressure on short-term wholesale funding costs.

Commonwealth Bank estimates NewCo produced an unaudited cash NPAT of AUD 568 million in fiscal 2018. NewCo is a significant business, with 2,850 staff. NewCo has assets under management of AUD 213 billion in CFS Global Asset Management, funds under advice of AUD 138 billion in CFS Super and Investments, and AUD 883 million of net tangible assets at June 30, 2018. Under the planned demerger, existing Commonwealth Bank shareholders will receive shares in NewCo and the new entity is expected to pay fully franked dividends.