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Morningstar | MyState's Elevated Funding Costs Hurt Near-Term Profitability; FVE Unchanged at AUD 5.00

No-moat-rated MyState Limited’s first-half fiscal 2019 cash profit of AUD 14.4 million or AUD 15.9 cents per share, cps, was down 9% on the previous corresponding period. The result revealed mixed operating metrics. A negative was the dampening of the Tasmanian bank's profitability due to pressure on net interest margin, or NIM, particularly from higher funding costs Conversely, credit quality of its loan book remains impressive. The interim fully franked dividend of AUD 14.25 cents per share was flat on pcp, based on a 90% payout. Following the result, we trim our fiscal 2019 earnings forecasts by 8% to AUD 30.3 million or AUD 33 cps, but retain our AUD 5.00 fair value estimate due to our broadly unchanged longer-term assumptions. At current price levels, MyState is trading 8% below our fair value estimate.

Our forecast imply a 6% fall in fiscal 2019 EPS, with earnings growing at an average rate of 5% over 2020 to 2023. We expect MyState to deliver higher earnings in second-half fiscal 2019 on a strong loan growth trajectory and lower bad debt expense. Our fair value implies a fiscal 2019 P/E of 15.2 times, and an attractive fully franked dividend yield of 5.8% or 8.3% 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 common equity Tier 1 capital ratio and total capital ratio both falling 42 basis points on pcp to 11.1% and 13.4%, respectively, MyState's capital position remains sound. The bank remains well-positioned to meet APRA’s “unquestionably strong” benchmark required by January 2020. The capital structure and solid balance sheet provide comfort the bank can manage a potential increase in mortgage loan losses. 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 bank’s funding and liquidity levels are backed by a strong retail deposit funding base. Total deposit growth was 10.6% on pcp, significantly higher than system growth in the half-year period. The funding mix has been relatively stable over the past few years. As at December 2018, retail deposit funding represented 69% of total funding, wholesale 8%, and securitisation 23%.

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 and 90-day plus arrears rates remain considerably below major and regional bank peers. 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. We forecast an average loan-loss rate of just 0.02% per year during the next five years, significantly below the five-year average of 0.16% per year for the four major banks.

As a regional bank with a restricted branch distribution network, MyState is heavily reliant on the mortgage broking channel to grow its loan book. Over the half, the bank originated 78% of new loans through mortgage brokers. The loan book growth has been strong, doubling the system growth and we expect the growth momentum to continue in the second half. Importantly, most of the loan growth is derived from low loan/valuation ratio, owner-occupier loans which represent lower credit risks and enhance the bank's asset quality.

Return on equity was down to 9.03% from 10.2% in first-half 2018, marginally above our 9% weighted average cost of capital. NIM was compressed to 1.82%, 21 basis points lower from a year ago and largely driven by higher wholesale funding costs. 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 intense. We expect full-year 2019 net interest margin to be 1.82% before gradually recovering to 1.86% in fiscal 2023.

The cost/income ratio has increased to 66.8% from 63.8% on pcp, mainly driven by lower revenue base and higher D&A expenses on new platforms. We expect the cost efficiency position to enhance in our forecast period, reaching 60% by 2023 and in line with company target. Furthermore, technological advancements will continue to be integrated into day-to-day operations to keep cost growth down. Technology and marketing costs remain the key areas of investment for MyState.