Regulatory Scrutiny Pinches CBA

This story features COMMONWEALTH BANK OF AUSTRALIA. For more info SHARE ANALYSIS: CBA

Uncertainty regarding penalties for non-compliance at Commonwealth Bank is weighing on the share price, although brokers acknowledge a solid first quarter.

-AUSTRAC proceedings seen weighing on share price
-Expected to have enough capital to absorb penalties
-But could affect timing of any buyback
 

By Eva Brocklehurst

Commonwealth Bank's ((CBA)) trading update signalled cash earnings are ahead of the required rate to reach forecasts for FY18. That much is certain. The first quarter was also supported by lower impairment charges and net interest margin expansion. What is less clear to brokers is the potential outcome of regulatory scrutiny and fines for non-compliance.

Proceedings have been commenced by AUSTRAC and continue to weigh heavily on the bank's share price, which has meant the premium relative to peers has progressively unwound over the year-to-date.

Strong revenue growth in the first quarter was driven by margin expansion, given the modest loan growth and mixed non-interest income. Cost growth was high, at a 4% quarterly average, reflecting provisions for estimated future project costs – but not potential penalties – related to regulatory actions. Ord Minnett assumes these do not recur and hence, has a moderating cost growth outlook.

Net interest margins expanded in the quarter, although the bank did not quantify the increase. Tailwinds from asset re-pricing and reduced liquid asset balances appear strong enough to more than offset headwinds from the major bank levy. Morgans expects the tailwind in the second half from reduced term deposit competition to pick up, as expensive deposits offered over August 2016 to October 2016 roll to lower rates.

Home loan growth was only around half the rate of system home loan growth and it suggests to Morgans that the bank will focus on increasing the proportions of home loans distributed through its proprietary channel. Reducing the reliance on the broker channel generally hurts growth.

Morgan Stanley sticks by its Underweight rating, given declining returns on equity, less strategic clarity and slower home loan growth. As well, there are concerns over conduct and and the earnings hole from asset sales.

The broker acknowledges the underlying margin has expanded materially over the past six months, and the increase in the last quarter has more than offset the bank levy. At the same time, impairment charges have fallen to record lows.

This generally confirms major banks are currently in a sweet spot for earnings, but the combination of increased political and regulatory scrutiny and emerging economic risks points to a resumption of margin pressure and higher loan losses in the second half, the broker suggests.

Capital

Until the issues are resolved Ord Minnett assumes the bank will retain a relatively high CET1 ratio and that will, potentially, limit the short-term prospects for capital management.

Macquarie believes the bank should have a buffer relative to peers for potential fines associated with the AUSTRAC case and the current level of capital is sufficient. Near-term risks appear to be factored into the stock, in the broker's opinion. Furthermore, mortgage repricing benefits have largely been captured and margin trend should remains broadly stable in the second quarter.

Morgans reduces cash forecasts for earnings per share as a result of subdued loan growth. The broker now expects the bank to have an excess CET1 capital of around $4bn by the end of FY19, in the absence of material fines related to the AUSTRAC investigations, and cannot help but suggest that a cynic may suspect that the bank is deliberately slowing down asset growth to be in a better position to manage any material fine.

The CET1 ratio was 10.1% and a boost should come from the completion of the life insurance sale in 2018. Morgans expects every $1bn in excess CET1 capital at the end of FY19 will carry the potential for a special dividend of $0.57 to be paid. Morgans downgrades to Hold from Add, because of the recent strength in the share price.

Citi goes the other way and upgrades to Neutral from Sell. The result was ahead of the broker's estimates on a run-rate basis, because a better than expected bad debt charges. Revenue growth appears stronger than the bank's peers for now but will be harder to come by, in the broker's opinion, given the lack of volume growth and the likely cessation of loan re-pricing benefits.

Despite the necessity to atone for regulatory and compliance weakness the bank appears in good shape, and Citi expects CBA has enough capital momentum to absorb a logical estimate of any likely penalty.

UBS remains cautious about the loss of market share in lending. In the past the bank has responded to this by using price, and remains a price maker in the market. The broker continues to like the stock, especially following the recent underperformance, but upside to the share price is expected to be limited until there is more certainty around the incoming CEO and any lasting impact from the APRA inquiry and potential fines.

The broker points out there is a wide variety of potential outcomes for the regulatory and compliance issues but assumes the bank continues to accumulate CET1 capital.

Deutsche Bank agrees that, while the valuation premium to peers has reduced in recent months, there remains significant risk regarding conduct. Should the outcome of the inquiries prove unfavourable there is a risk to the assumption that the bank conducts buybacks in FY19-20 to return capital.

Conduct

Morgan Stanley identifies seven potential implications for CBA from the AUSTRAC case as well as broader concerns about conduct. Two of these are already playing out, given the pending management changes and the higher costs just announced.

The broker notes the bank is scrutinising its selling practices, mortgage market share, distribution and pricing tactics and its expense management and efficiency targets. Institutional banking, offshore growth options and non-core asset sales also appear to be under review. The potential for an external CEO appointment also creates uncertainty for investors in the near-term.

FNArena's database shows seven Hold ratings and one Sell (Morgan Stanley). The consensus target is $78.53, signalling -2.3% downside to the last share price. Targets range from $72 (Morgan Stanley) to $83 (UBS, Deutsche Bank). The dividend yield on FY18 and FY19 forecasts is 5.4% and 5.5% respectively.
 

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