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Morningstar | MyState Remains in a Steady State; FVE Unchanged at AUD 5.00

No-moat-rated MyState’s fiscal 2018 cash profit of AUD 31.5 million represents a 5% increase on the previous corresponding period, or PCP, but 5% below our fiscal 2018 forecast. Lower-than-expected net interest margins, subdued noninterest income, higher-than-system home loan growth, improved cost efficiency, strong asset quality, and a strong capital position underpin the result. The final fully franked dividend of AUD 14.5 cents per share took total dividends to AUD 28.75 cents per share, an increase of 3% on the PCP based on an 83% payout rate.

We retain our fair value estimate of AUD 5.00 per share following the result. Our valuation is based on moderating loan growth, stable net interest margins, improving cost-efficiency, and very low bad debts. Our outlook for earnings growth is broadly intact, with average annual EPS growth forecast of 4% over our five-year forecast period. Our fair value estimate implies a fiscal 2019 P/E of 13.9 times, an attractive fully franked dividend yield of 5.8%, or 8.3% on a grossed-up basis. At current levels, MyState is trading broadly in line with our valuation.

The capital position remains solid, largely driven by organic capital generation. The common equity Tier 1 capital ratio increased 23 basis points to 11.51%, and the total capital ratio increased 18 basis points to 13.47%. MyState is well positioned to meet APRA’s “unquestionably strong” benchmark required by January 2020. The capital structure and solid balance sheet provide comfort that the bank can manage a potential increase in mortgage loan losses.

The bank’s funding and liquidity levels remain sound, backed by a strong retail deposit base, with total deposits growing 9% on the PCP. The funding mix has been relatively stable over the past few years. As at June 2018, retail deposits represented 68% of total funding, wholesale 23.8%, and securitisation 8.2%.

Dominated by owner-occupied home loans with relatively low loan/valuation ratios, MyState’s loan book remains very healthy in terms of asset quality. Impairments remain at historic lows, and 90-day-plus arrears rates have been well below major and regional bank peers. MyState continues to expand its loan book, with less than half the loan book in Tasmania and more focus in Australian eastern states, particularly New South Wales and Victoria. MyState sources approximately 70% of new loans through broker channels, and we expect the bank to continue relying heavily on brokers to expand its loan book. The 6.9% loan book growth amounted to 1.2 times system growth for fiscal 2018, with the second half doubling system loan growth. MyState remains a very small market player with only 0.3% market share in Australian household deposits and 0.2% in home loans.

Profitability was supported by a 3% increase in net interest income. We see positive jaws with revenue growing faster than expenses in the year. Return on equity was steady at 10.1%, modestly above our 9% weighted average cost of capital. Net interest margin dropped by 4 basis points from the prior fiscal year with an exit NIM of 1.86%. The outlook for NIM still looks challenging, particularly for a bank like MyState with a portfolio of mainly owner-occupied home loans, as competition in this segment remains fierce. We expect funding costs to increase, particularly short-term funding costs featured by the bank bill swap rate, or BBSW, which would add to margin pressure. Over our forecast period, we downgrade the NIM outlook and now expect margins to stabilise at 1.85% compared with our previous forecast of 1.91%.

Strong cost management performance continues to drive profitability. The cost/income ratio improved to 64% from 65.9% on the PCP, a 190-basis-point decrease, mainly driven by cost control, with total operating expenses declining 1.5% to AUD 81 million in fiscal 2018. We expect the cost efficiency position to improve in our forecast period, with the cost/income ratio averaging 60% in the next five years. Furthermore, digital advancements will continue to be integrated into day-to-day operations to keep cost growth down.

We expect operational efficiency to improve as MyState leverages increasing scale and the lower cost structure provided through technology. Future earnings growth is leveraged to how successfully the bank manages cost growth, improves productivity, and boosts operational efficiency.

The wealth business, although only a small part of the business, supported fiscal 2018 earnings by delivering an impressive 20% growth in net profit to AUD 4.6 million. Funds under management reached a record high at AUD 1.15 billion in fiscal 2018. We see the wealth management income as a buffer against the bank's earnings volatility, particularly under a situation where price competition is fierce from the major banks for high-quality home loans.