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Morningstar | MyState Pursues a Strong Growth Strategy, but Margins Suffer. FVE AUD 5.00 Unchanged

No-moat-rated MyState Limited continues to grow at a fast clip with industry banking data printing a 12% increase in the bank’s home loan book for the year to March 31, 2019. Household deposits increased but at a less impressive 6% for the same period. But strong growth in a very competitive market for a lower loan/valuation ratio, or LVR, higher quality owner-occupier home loans comes at cost, with MyState suffering a sharp fall in net interest margins. Margins declined to 1.82% for first-half fiscal 2019 from 1.91% at June 30, 2018. Intense competition for new borrowers and higher short-term wholesale funding costs exerted pressure on first-half margins, but the pressure has eased somewhat following a recent, sharp fall in the 90-day BBSW rate to below the 1.50% cash rate.

At current price levels, MyState is trading 14% below our fair value estimate. On current market prices, the bank trades at a fiscal 2019 P/E of 13 times, and an attractive fully franked dividend yield of 6.8% or 9.7% on a grossed-up basis. MyState remains a small market player with only 0.3% market share in both Australian home loans and household deposits but is growing strongly from its small base. Despite a competitive landscape, the bank is well placed to leverage an expected rebound in the housing market following the surprise election result. A combination of the Labor loss, an easing in APRA-imposed lending restrictions, the coalition’s first home-owners scheme, and the potential for further Reserve Bank of Australia interest rate cuts could stabilise the property market and boost lending.

Despite upside opportunities for MyState, the bank continues to face challenges from the wide-moat major bank oligopoly. The major banks benefit from risk-weighted asset and capital differentials and "too big to fail" funding cost advantages. Smaller banks will benefit from the resurgence in the mortgage broker sector with less pressure on changes to mortgage broker remuneration.

MyState continues to expand and diversify its loan book, with less than half the loan book in Tasmania and increasing focus in Australian eastern states, particularly New South Wales and Victoria. During first-half fiscal 2019, the bank originated 78% of new loans through mortgage brokers.

MyState relies heavily on mortgage brokers for growth in the higher population states of Victoria and NSW and we expect the bank to continue growing its home loan book above system. The bank is correctly focused on improving its customer service proposition and boosting its customer net promoter score, or NPS, currently at positive 37%, but the main reason for its strong mortgage growth is sharp pricing, resulting in loan margins suffering.

Fiscal 2019 results are due Aug. 22, 2019 and we forecast a cash NPAT of AUD 30 million and fully franked dividend of AUD 29 cents per share. Fiscal 2019 results will be lower than fiscal 2018 due to lower margins and higher costs, but longer term we forecast solid EPS growth around 5% per year with similar percentage increases in forecast dividends. Loan quality is expected to remain strong with loan losses at insignificant levels. Loan arrears rates, both 30 day and 90 day remain below peers and are stable. Major bank home loan arrears levels are increasing modestly but remain at low levels.

MyState home loan quality is strong due in part to the relatively low level of higher LVR residential investor loans and interest-only loans. Despite household deposits growing at around half the rate of home loans, total customer deposit growth has been strong, with an 11% uplift for the six months to December 2018.

The bank’s wealth business is struggling to grow, with both funds under management and funds under advice easing lower in first-half fiscal 2019. The wealth business is a small contributor to group profitability but the bank’s ongoing investment in products and systems should bear some fruit in fiscal 2020 and beyond.