EUR 850.00 For Business Accounts Only

Morningstar | No Surprises in CBA’s 1Q19 Update, But Tougher Expected Operating Conditions Reduce FVE to AUD 80

Wide-moat-rated Commonwealth Bank of Australia’s solid start to fiscal 2019 is no surprise with the AUD 2.5 billion unaudited cash profit in line with our full-year run rate forecasts. No change to our AUD 10.1 billion cash earnings forecasts for fiscal 2019. The cash profit for the three months ended Sept. 30, 2018 was 3% higher than the average for the two previous quarters after excluding second-half fiscal 2018 one-off items. First-quarter fiscal 2019 cash earnings were 6% below the strong first-quarter fiscal 2018 of AUD 2.65 billion.

Despite the straightforward quarterly performance, we downgrade our fair value estimate 3% to AUD 80 per share from AUD 83. We reduce our fiscal 2019 cash earnings forecast to AUD 10.0 billion from AUD 10.1 billion previously, reflecting lower credit growth, softer net interest margins and lower noninterest income. Despite the modestly softer outlook, we remain confident in the long-term earnings outlook for Australia’s biggest bank. At current prices, the stock is trading 13% below our updated valuation. Our fully franked dividend forecast of AUD 4.33 per share for fiscal 2019 is unchanged based on a 76% payout.

Key highlights from the quarterly update include a modest 1% increase in operating income, good volume growth with household deposits up an annualised 9%, home lending up 3% annualised, operating expenses down 1% and a loan loss rate at historical lows of just 0.11% annualised. As expected, net interest margins suffered from higher funding costs, increased competition for new loans and mix changes as more homes switch from higher-margin interest only loans to lower margin principal and interest loans.

Commonwealth Bank’s historic valuation premium to peers has shrunk with the current one-year forward P/E of 12 times compared with a long-term trend around 14 times. Our positive view is underpinned by further efficiency improvements with our forecast EPS growing an average of 2% annually till fiscal 2023.

Despite the lower relative premium, the bank remains in our opinion the highest quality major bank for earnings and dividend sustainability. The unaudited statutory profit of AUD 2.45 billion was 12% lower than a year ago. Net interest margins were not specified but based on the 2.14% reported for second-half fiscal 2018 we would expect a margin outcome around 2.10% for the quarter. Variable home loan repricing of 0.15% announced in early September will go some way to restoring margins from the start of second-quarter fiscal 2019. We reduce our fiscal 2019 forecast margin to 2.13% from 2.14% previously.

Balance sheet settings remain strong with the common equity Tier 1 capital ratio of 10.0% broadly stable during the quarter despite the impact of the final dividend for fiscal 2018. After allowing for the dividend reinvestment plan, the final dividend stripped 72 basis points from the key measure of capital. Organic capital generation was strong at 55 basis points, with the Sovereign life insurance divestment in New Zealand releasing a further 27 basis points. The common equity Tier 1 capital ratio increases 120 basis points to a pro forma 11.2% after allowing for announced asset sales. Australia and New Zealand Banking Group leads the peer group with a pro forma common equity Tier 1 ratio of 11.83% at Sept. 30, 2018 with Westpac Banking Corporation at 10.6%, and National Australia Bank at 10.2%. The regulator’s “unquestionably strong” benchmark of 10.5% is effective Jan. 1, 2020.

Customer deposits remained at a high 68% of total funding and the AUD 8.8 billion in new wholesale term funding issued during the quarter had an average maturity term of 5.4 years. The term wholesale funding portfolio average tenor was broadly stable at 5.0 years. The liquidity coverage ratio and net stable funding ratio both remained elevated, comfortably above regulatory minimums. The group leverage ratio was stable at 5.5% across the quarter and equated to an internationally comparable 6.2%.

Loan quality remains a standout with loan losses of AUD 216 million for the quarter equating to a low loss rate of 0.11% annualised. We maintain our fiscal 2019 loan loss forecast rate of 0.15% gradually increasing to 0.18% by end fiscal 2023. Westpac’s loss rate was an unsustainably low 0.09% for the six months to Sept. 30, 2018 in line with ANZ Bank’s outcome. National Australia Bank reported a second-half fiscal 2018 loan loss rate of 0.13%. The low loan loss rate benefited from some single name corporate recoveries, sound portfolio credit quality and continued portfolio improvements in the bank’s institutional business.

Consumer loan arrears rates improved with home loans, personal loans and credit cards arrears all trending down. Home loan arrears rates improved to a low 0.67% as quarter-end, down from 0.70% at June 30, 2018. Group troublesome and impaired assets increased modestly to AUD 6.6 billion due to an increase in impaired home loans and a small number of corporate exposures. Collective provision coverage was stable at 1.03% after adjusting for the adoption of new accounting standard AASB 9 effective July 1, 2018.

The cost/income ratio is a key measure of operational efficiency and based on our forecasts we see the Commonwealth Bank’s ratio edging up modestly to around 42.5% in fiscal 2019. Westpac’s cost/income ratio was a creditable 43.7% for fiscal 2018 and we forecast its ratio to improve to a peer-leading 42.3% in fiscal 2019. ANZ Bank and National Australia Bank’s ratio deteriorated to 48.1% and 45.8%, respectively, in fiscal 2018. We expect steady improvements in Commonwealth Bank’s operational efficiency with our forecast cost to income ratio closing out fiscal 2023 in the 40%-41% range.

Based on our EPS forecasts, we consider sustainable but modest dividend growth with the payout easing to 75% in fiscal 2023 from 76% in fiscal 2018. The modestly lower payout will assist in the capital build necessary to support future lending growth and higher regulatory requirements. We forecast return on equity to average around 15% levels during fiscal 2019-23, the highest in peer group.