Australia | Feb 07 2019
Cost reductions and capital management appear likely to underpin Commonwealth Bank financials going forward as the retail banking arm sustains increasing pressure.
-Jump in the CET1 ratio boosts capital management expectations
-CBA targeting a cost-to-income ratio below 40%
-Are the benefits of capital management priced into the stock?
By Eva Brocklehurst
First half results from Commonwealth Bank ((CBA)) shed light on the challenges faced by the banking sector. Top-line growth is slowing, while cost reductions and capital management appear to be the way forward.
The bank reported first half cash earnings of $4.77bn, in line, or slightly softer than some forecasts because of lower operating income. Net interest margin declined by four basis points, largely because of elevated bank bill rates and a weaker treasury and markets performance.
The highlight of the report was the jump in the CET1 ratio, to 10.8%, well ahead of the "unquestionably strong" benchmark set by APRA (Australian Prudential Regulatory Authority), which is expected to receive a further boost once the divestments are completed.
Without signalling a timeframe, the bank will be targeting a lower absolute cost base and a cost-to-income ratio below 40%. The reduction in costs is being sourced from natural attrition as well as assets flagged for divestment.
Ord Minnett found the language vague given there was no firm quantification of core costs in the first half. The broker believes this is unnerving and suggests revenue pressure is becoming widespread, although acknowledges the bank is meeting the challenge head on.
Based on the recommendations of the Hayne Royal Commission final report, Morgans expects the flow of credit to improve in coming months, while Macquarie continues to expect an expense base of less than $10bn by FY22, consistent with the bank's new target.
CLSA, in the wake of the surge in the stock after the RC final report, downgrades the rating to Underperform from Outperform with a $76.27 target. The broker, not one of the eight monitored daily on the FNArena database, finds a lot to like about CBA stock but considers it too expensive.
The capital position was significantly better than Ord Minnett expected and the improvements are likely to be permanent. This suggests capital management could be larger and come sooner than expected, although the broker agrees the benefits appear to be priced into the stock.
Citi suspects investors will be excited by the prospect of buybacks or special dividends and the ability to utilise excess franking credits despite the tough operating conditions. Morgans envisages excess capital of $4.8-6.2bn once divestments are completed. The main caveat is a potentially onerous increase to capital requirements proposed for banks operating in New Zealand. Morgans does not factor in any capital management for CBA until there is further clarity on NZ rules.
Macquarie also finds it unclear as to what stand both the Reserve Bank of New Zealand and APRA will take on capital, but believes it is wise to remain conservative. Longer term, the end of APRA's operational risk penalty should add around 28 basis points to CET1, but CBA will need to comply with its enforceable undertaking and this could take several years.
Credit Suisse factors in capital management, including a $5bn on-market buyback, and reiterates an Outperform rating, although acknowledges this has a lot to do with a relative call in a sector that has macro pressures.
Bell Potter expects an announcement in either the second half or the first half of FY20. The return on equity may be trending down but this is partly because of surplus capital and the broker expects this will improve once capital initiatives are executed. The broker, not one of the eight, has a Hold rating and $76 target. Shaw and Partners, also not one of the eight, on the other hand has a Buy rating with a $76 target.
Macquarie notes the dividend reinvestment plan will be neutralised for the first half, for the first time in four years. This setting is expected to continue in the near future. The company has shifted to a shorter-term duration for invested capital, to three years from five years, which positions the portfolio to be more sensitive to changes in interest rates, although the broker notes this is immaterial to earnings.
Retail banking continues to struggle, with division earnings down -3% in the half year because of margin pressure and customer remediation. The average home loan size marginally increased in the half-year, despite falling house prices.
Historically, the bank's overweight position in retail banking has been the driver of its outperformance but with a challenged housing market, intense competition and higher regulatory impositions Citi expects a significant drag will continue.
Ord Minnett suggests any easing of competitive pressure is unlikely in a period of slowing loan growth and believes the strong returns earned by major banks in retail banking are likely to fall, although acknowledges CBA's sector-leading deposits and of capital management potential.
Both Citi and Macquarie question why the stock trades at such a meaningful premium to its peers, maintaining Neutral ratings, while Morgan Stanley believes the results are not strong enough to justify the recent re-rating and sticks with an Underperform call.
The database shows two Buy, four Hold and two Sell ratings. The consensus target is $70.59, signalling -4.0% downside to the last share price. The dividend yield on FY19 and FY20 forecasts is 5.9% and 6.0% respectively.
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