CommBank’s Premium Keeps Stockbrokers Wary

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

A limited negative reaction to a weak FY19 result for Commonwealth Bank bodes well for the FY20 outlook, brokers suggest, although the stock is considered over-priced.

-CommBank's premium to peers considered unjustified
-Effects of lower cash rate likely to be offset by further mortgage re-pricing
-Capital returns expected in FY20 and more RBA rate cuts likely

By Eva Brocklehurst

Softer revenue and a jump in costs produced a weak FY19 result for Commonwealth Bank ((CBA)) yet the share price reaction was fairly muted and, brokers suspect, probably surprised many investors. Citi attributes the limited reaction to the prospect that FY20 will be better, as lending momentum has returned and compliance costs, while continuing, are unlikely to keep growing.

Morgans also considers the result bodes well for the outlook for major bank earnings, in terms of home lending growth and residential mortgage asset quality. Commonwealth Bank expects an improvement in the housing market, noting there is stimulus on the way from tax cuts and infrastructure expenditure which is yet to flow through.

Cash earnings from continuing operations of $8.49bn were slightly below broker estimates. There was a pick up in mortgage lending in the second half, which grew above system for the first time in a number of months. Business lending growth was 4%. Macquarie points out, on the positive side, new business in the home loan portfolio from brokers was 48% in the second half compared with 41% in the prior corresponding half.

Citi expects, while net interest margins have been flat for the last six months, the effect of a lower cash rate should be offset with the benefit of further mortgage re-pricing. Still, the broker acknowledges Commonwealth Bank has modest prospects given more challenging economic conditions ahead.

While investors may take some comfort in management's guidance regarding the impact of recent official rate cuts, Morgan Stanley envisages downside risk to margins and constraints on home loan and deposit re-pricing. Macquarie is also concerned about industry trends of re-pricing mortgages, assessing this is not a sustainable practice.

Costs were the main disappointment and underlying cost inflation of 2.4% was higher than expected. The bank has reiterated an intention to target a longer-term absolute reduction in costs and a sub-40% cost-to-income ratio.

 Yet Morgan Stanley is sceptical that the bank can lower the absolute cost base, or achieve the sub-40% ratio over the next three years. Indeed, Macquarie calculates it will take around four years for Commonwealth Bank to achieve cost-to-income targets.

The bank has retained its premium to peers, which many brokers believe is unjustified. Citi calculates Commonwealth Bank trades in excess of 15x FY20 estimates, which is too high for a low single-digit earnings growth profile and a low double-digit return on equity. The broker assesses there are better opportunities elsewhere in the sector and there is a risk that the sizeable premium to peers closes over the next 12 months

Morgan Stanley agrees the valuation is stretched, suspecting underlying earnings will decline and return on equity remain below 13% in FY20. Fee and margin pressures, stemming from lower interest rates, will result in declining revenue trends in both FY20 and FY21. In the face of this, Macquarie also judges the current valuation premium to peers of 26% to be excessive.

Capital Returns

Citi expects capital returns will be highly valued in the current environment and a $5bn buyback could be announced as divestments are completed in FY20. The broker does not believe the pending capital changes in New Zealand will be an impediment. Capital remains a point of strength, as the bank concluded FY19 with a CET1 ratio of 10.7%.

Morgan Stanley believes an off-market buyback is a most efficient form of capital management, expecting $2.0bn over the next six months after the completion of the Australian life insurance sale. A further $1.0bn is modelled for FY21. Still, the buybacks are not expected to be enough to offset dilution to earnings per share given the earnings hole stemming from asset sales.

Asset quality is considered benign, although Commonwealth Bank noted pockets of stress within business banking that pushed up troublesome and impaired assets. Specifically this occurred in retail, hospitality and construction sectors. Macquarie points out mortgages in negative equity have risen to 4.5%, with the bank reporting that 72% were in Western Australia and Queensland and over 50% have lenders mortgage insurance.

FY19 net interest income was less than Morgans expected, largely because the institutional lending book contracted significantly in the second half. Still, the broker considers this positive from the perspective of a return on tangible equity, as the contraction stemmed from portfolio optimisation initiatives and a focus on risk-adjusted returns.

Cash Rate Outlook

What if there are further cuts to official rates? Morgans notes the futures market is pricing in further reductions and, if the banks pass on future reductions in full to borrowers, this would be negative for margins.

However, the broker suspects the banks will only pass on enough to keep margins stable, remaining of the view that the Reserve Bank would not want margins and returns for the banks to be adversely affected in a material way, as this would hamper the supply of credit to the economy.

Hence, the central bank may end up using unconventional tools, Morgans supposes, such as a funding program akin to the Bank of England's term funding scheme. Moreover, the broker believes the valuation should be taken into account as well as the earnings impact of further reductions to the cash rate. Major bank dividend yields could become more attractive as a general decline in the cost of equity is factored into share prices.

FNArena's database has three Hold ratings and four Sell ratings for Commonwealth Bank. The consensus target is $72.72, suggesting -6.8% downside to the last share price. The dividend yield on FY20 and FY21 forecasts is 5.5% (for both, indicating no growth in ordinary dividends is expected medium term).

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