EUR 850.00 For Business Accounts Only

Morningstar | MyState Continues to Face Challenging Operating Conditions; FVE AUD 5 Unchanged

Our neutral view on the outlook for Tasmania-based no-moat-rated MyState is unchanged, but following recent share price weakness is trading at an attractive 12% discount to our AUD 5.00 fair value estimate. Our fiscal 2019 cash earnings forecast of AUD 33 million is unchanged, and is based on moderating loan growth, compressed but stabilised net interest margins, improving cost-efficiency, and very low bad debts. Our fair value estimate implies a fiscal 2019 price/earnings ratio of 12 times and an attractive fully franked dividend yield of 6.7%, or 9.6% on a grossed-up basis. Our earnings outlook is intact, with average annual EPS growth forecast to be 4% over the five-year forecast period.

The Australian Prudential Regulation Authority's, or APRA’s, latest banking statistics for October 2018 confirm a challenging landscape for the home loan market with annualised system growth of only 3.3% for the three months to October 2018. Over the same period, MyState's annualised home loan portfolio growth of 6.4% overtook system growth, but we expect it to slow during the remainder of the financial year to 5.4% for fiscal 2019. We like the bank’s strong recent loan growth but acknowledge it is off a very low base. Despite intense competition, particularly for owner-occupied principal and interest home loans with lower loan/value ratios, which represent the majority of MyState's loan portfolio, the bank has benefited from flows sourced from the mortgage broking channel.

On the upside, we see tailwinds in the Tasmanian residential property market offsetting potential home loan stress. CoreLogic Property market data as at November 2018 showed Tasmania's leading position with strong annual housing price growth of about 10%, while Sydney and Melbourne fell 8% and 6%, respectively, over the year. Given about half the bank’s residential loan book remains in its home market, we expect MyState to continue to benefit from the buoyant Tasmanian property market.

MyState’s funding capability remains sound in the near term. From June to October 2018, the bank has grown customer household deposits about 2%, despite lower than system growth of 3% according to APRA's stats. Customer deposits remain the major funding source for MyState, accounting for 68% of total funding. MyState maintains a Baa1/P2 rating from Moody’s Investors Service with a stable outlook, which reflects the bank's sound asset quality and capital position.

The small bank’s balance sheet strength and strong loan quality are recognised in its lower-than-industry bad-debt levels, due to relatively strict lending criteria and focus on high-quality owner-occupier principal and interest home loans. The bank’s arrears rates currently remain well below industry trends, reflecting a lower-risk home loan portfolio. Low loan impairment charges boost MyState’s profitability, but do not outweigh its other cost disadvantages compared with the major banks. We believe the bank’s conservative lending standards will benefit its loan book quality and maintain very low bad-debt levels. We forecast an average loan-loss rate of just 0.02% per year during the next five years, well below the five-year average of 0.16% per year for the four major banks.

Like bank peers, MyState continues to be exposed to funding pressure. The elevated short-term borrowing costs are reflected in the widening spread between the 90-day bank bill swap rate, or BBSW, and the RBA's official cash rate of 1.5%. By the end of November, the BBSW was 45 basis points higher than the cash rate, doubling the spread from the same time last year, despite falling from the recent peak of about 62 basis points at end of June 2018. To maintain net interest margins, banks, especially small banks with funding capacity inferior to the majors, are likely to pass the higher borrowing costs through to customers. The funding pressure has already been reflected in MyState's recent increase to variable mortgage interest rates. For first-half fiscal 2019, we expect net interest margins for MyState to remain under pressure, given the competitive landscape, broadly in line with second-half fiscal 2018 levels of 1.84%.

On the operational side, MyState has a much higher cost/income ratio than its peers due to smaller scale. We expect operational efficiency to improve as MyState leverages increasing scale and the lower cost structure provided by technology. Positively, previous investment in product platforms and digital systems have started to deliver improved cost efficiency as expected and we forecast MyState’s cost/income ratio to improve over the next few years, reaching about 60% in line with the bank’s target. We expect the ongoing extension of MyState's digital offerings, which we believe is ahead of many of its larger peers, to facilitate the increasingly digital-minded customers and to attract online deposits.