Deteriorating Economy Holds Concerns For CBA

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Amid a deteriorating economic environment and with high collective provisioning, the final dividend outlook for Commonwealth Bank is unclear.

-Margin management key in a low interest-rate environment
-Volatility in risk-weighted asset inflation of concern
-Final dividend amount/payment uncertain
 

By Eva Brocklehurst

Commonwealth Bank ((CBA)) provided few surprises in its March quarter update, given much of the speculation in recent weeks has been on the deteriorating economic environment and the impact on bank lending.

The bank saw no income growth in terms of the quarterly average, as a small amount of loan growth was offset by margin decline. Non-interest income fell by -2% because of lower fees and lower markets income.

The bank has sold 55% of its superannuation and investment business, Colonial First State (CFS), to KKR for $1.7bn, which implies a total valuation of $3.3bn. Citi points out this transaction is not a divestment, as both entities are committed to a significant investment program, but the price is "surprisingly strong". A commitment to accelerate investment also suggests wealth management will stay part of the business for the foreseeable future.

Commonwealth Bank has also received final regulatory approval for the divestment of its interest in the Indonesian PT Commonwealth Life, with completion expected in June. This is also expected to provide a small benefit to the bank's capital position.

The main issue for the bank, Macquarie assesses, is margin management in a low interest rate environment. The broker estimates this will provide a material drag on revenue of around -$1.9bn over the next five years.

Commonwealth Bank has outperformed other major banks by over 9%, Morgans notes, since the pandemic outbreak. The broker also ascertains the quality of the retail franchise shows through in this latest update, with above-system growth in both home lending and household deposits. Nevertheless, the stock is expensive and the broker acknowledges other major banks are likely to outperform.

Bell Potter suggests underlying asset quality remains sound, excluding the pandemic-related provisions. There is sufficient capital, funding and the sale of the CFS stake takes the CET1 ratio back to the top end of APRA's preferred range.

UBS regards the CET1 ratio was the most disappointing element of the update, at 10.7% versus a forecast of 11.1%. The asset sales the bank announced are expected to add 66-77 basis points to CET1, which the broker acknowledges will support the ability to maintain a dividend despite the increase in RWA (risk-weighted asset) inflation.

This should allow CBA to also remain above the "unquestionably strong" benchmark for CET1. Macquarie also estimates the bank will still generate around 30 basis points of capital in the fourth quarter adding to the benefit to CET1 from the divestments.

In terms of asset quality, CBA appears slightly less exposed to retail trade and hospitality compared with its peers but Macquarie estimates exposure to the energy sector is much greater. Moreover, while the bank did not provide details of its riskier exposures, the broker understands there is a large exposure to the air travel industry because of the aeroplane leasing portfolio.

Credit Provisioning

Collective provisioning for credit risk-weighted assets (CRWA) is now the highest of the major banks, alongside Westpac ((WBC)). From this perspective, Morgans notes these two banks are relatively robust.

The additional $1.5bn in additional collective provisioning takes the total loan loss provisions for CRWA to 1.65%, ahead of peers. Citi suggests economic forecasts from the Reserve Bank of Australia may have had an influence on the bank's decision to top up provisioning.

The volatility in RWA inflation has concerned both Credit Suisse and UBS. The latter highlights the extent to which banks rely on models to estimate credit provisioning, capital adequacy and liquidity and undertake stress tests and notes these models are unproven through the sort of issues currently being experienced, and the market needs to be mindful of this. Both brokers also remove buyback expectations from forecasts because of RWA inflation.

The bank's dominant position in retail lending has enabled a higher pre-provision profit on RWA versus peers, which should underpin strong capital generation. Nevertheless, UBS points out, Commonwealth Bank remains exposed to a deterioration in mass-market credit quality and it is hard to justify an expansion of its multiple given the significant headwinds.

Dividend

Morgan Stanley believes the final dividend is likely to be cut by around -40% to $1.40m while UBS assumes the bank pays a reduced second half dividend of $1.50, representing an 80% pay-out ratio but has little confidence in forecasts because of the variability in several scenarios that could still play out.

At this point, Morgans expects no final ordinary dividend but, as a caveat, suggests that if APRA considers the macro economic outlook is better by the time of the results on August 12 then a final dividend could be declared. In the broker's view, much will centre on the timing of the domestic lockdown being lifted and the percentage of borrowers that remain in hardship.

Valuation

CLSA, not one of the seven stockbrokers monitored daily on the FNArena database, considers valuation may be stretched relative to the other major banks but this is justified because of the strength of the capital position, and the ability to pay dividends while retaining provisioning levels above its peers. There is likely to be mortgage market share growth as well and the broker has a target of $65.10 with an Outperform rating.

Macquarie disagrees and believes the results do not justify the premium valuation. While the capital position is leading the sector, the gap to peers has narrowed. Morgan Stanley takes the same angle, emphasising the potential impact of an increase in risk weights remains similar to peers, and believing profit trends, the credit risk profile and dividend prospects do not sufficiently differentiate the bank in order to justify the current premium multiples.

Credit Suisse also considers there is better value elsewhere while Bell Potter, also not one of the seven, has a Buy rating and $72 target. The database has two Sell ratings, four Hold and one Buy (Citi). The consensus target is $61.38, suggesting 3.8% upside to the last share price. The dividend yield on FY20 and FY21 forecasts is 5.3% and 5.7%, respectively.

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