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Morningstar | We Reaffirm Our Earnings Outlook and AUD 5 FVE for MyState

Our neutral view on Tasmania-based no-moat-rated MyState is unchanged following our post-result management update. We reaffirm our AUD 5 fair value estimate and fiscal 2019 cash earnings forecast of AUD 33 million. Our fair value estimate implies a fiscal 2019 price/earnings ratio of 14 times and an attractive fully franked dividend yield of 5.8%, or 8.3% 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. At current levels, MyState is trading marginally below our valuation.

We like the bank’s lower earnings risk profile but acknowledge strong loan growth is unlikely to resurface due to 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. Future earnings growth is leveraged to how successful the bank manages cost growth, improves productivity, and boosts operational efficiency. Positively, previous investment in product platforms and systems have started to deliver improved cost efficiency as expected. Increased profit contribution from the small wealth and trustee business provides further upside to the investment case.

Similar to peers, MyState is facing intense price competition and funding pressure, which leads to a subdued net interest margin outlook. The bank bill swap rate, which influences short-term wholesale funding costs, has trended down to 1.92% from the peak of 2.12% three months ago but remains well above the level of around 1.7% at the same time in 2017. Over our forecast period, we expect MyState's net interest margin to stabilise around 1.85%, close to the 1.86% exit net interest margin at the end of the second half of fiscal 2018.

Despite increased competition for home loans, MyState is benefiting from sound economic conditions in Tasmania with above-national-average retail sales growth, strong tourism, and significant growth in exports. Tasmania also leads the home price growth rate across the country, with average house prices in Hobart up 11% year on year based on the CoreLogic home value index to Aug. 31, while Sydney and Melbourne prices have fallen modestly in the same period. Given that about half the bank’s residential loan portfolio is in its home market, we expect MyState to continue to benefit from these economic tailwinds.

The recent regulatory and Royal Commission focus on the mortgage broker industry adds to uncertainty about future loan growth, as 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. On a positive note, MyState’s loan book remains in good quality with impairments and 90-day-plus loan arrears rates well below major and regional bank peers. MyState’s funding mix has remained healthy with retail deposits accounting for 68% of total funding as at June 2018.

MyState’s capital position remains strong with solid organic capital generation. The common equity Tier 1 capital ratio of 11.51% and the total capital ratio of 13.47% as of fiscal 2018 put MyState in a good position 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 dividend payout ratio around 80%, the midpoint of its 70%-90% target range, and can manage a potential increase in mortgage loan losses.

MyState’s investment in modern banking technology has started to deliver improved cost efficiency, with the key cost/income ratio improving to 64% for fiscal 2018 from 66% for fiscal 2017. Key banking systems including new customer and back-office platforms have largely been implemented. We forecast MyState’s cost/income ratio to improve over the next few years, reaching about 60% and in line with the bank’s target.

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.