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CBA: Oh How The Mighty Have Fallen

Australia | Nov 18 2021

This story features COMMONWEALTH BANK OF AUSTRALIA, and other companies. For more info SHARE ANALYSIS: CBA

Complacent investors were shocked by Commonwealth Bank’s considerably lower lending margin in the September quarter, and most brokers still believe the stock is overvalued even after its big tumble.

-Solid performance from CBA upset by margin crunch
-Still "the best", but more pressure to come
-Debate: how much of a sector premium is justified?
-Dividends safe


By Greg Peel

On November 1, Commonwealth Bank’s ((CBA)) nearest rival in retail banking, Westpac ((WBC)), reported lower than expected net interest margins impacting on its full-year result, and promptly fell over -4%. But rather than see this as a read-through to the bigger CBA, investors switched into CBA on the day.

The problem, they assumed, which also included higher than expected costs, was a Westpac issue and not a market-wide one, despite competition, fixed-rate loan demand and the general low interest rate environment cited by Westpac as the primary issues being the same for all banks.

Yesterday, CBA management cited competition, fixed-rate loan demand and the general low interest rate environment as the causes of a “considerably lower” net interest margin (NIM) – the difference between the net rate the bank borrows and net rate it lends at. Analysts estimate a -7 basis point underlying contraction in CBA’s NIM.

Westpac reported -10 basis points. Yet Westpac fell -4% and CBA fell -8%.

Across the CBDs of Sydney and Melbourne a cry rang out: “We told you so!”

Bank analysts all agree CBA’s is a superior banking franchise to peers, and hence the bank deserves a valuation premium. Indeed, CBA still posted above-sector growth in the September quarter, and a 20% increase in profit year on year is not to be sniffed at, with capital management capacity retained. But on a full-year run-rate, profit growth did slip below analyst forecasts.

The bottom line is some valuation premium is deserved but not the extent the market has been pricing in. Despite yesterday’s -8.3% plunge, not one of the six brokers covering the stock in the FNArena database deigned to change their rating, and five of them were on Sell or equivalent ahead of yesterday.

Margin pressure is not yet over and there will likely be more to come before any relief is felt.

With an RBA cash rate of 0.10%, which might as well be zero, it has been very difficult for banks to make the sort of money they’re used to on the spread between borrowing (including deposit) rates and mortgage rates, as they can’t take deposit rates into the negative and expect to draw customers, and the current 0.01% deposit rate on everyday bank accounts is actually -3% negative if 3% September quarter CPI inflation is cited.

Banks could maintain a more typical gap to mortgage rates, but when there are four of them, as well as smaller banks, plus a growing number of non-bank lenders, too-high mortgage rates would mean customers bailing in droves.

The majors have refrained from lowering their standard variable mortgage rates too far, choosing instead to lower their fixed rates for up to four years to below SVR rates to maintain market share.

You’re kidding

Did they think we’re all idiots? The outlook for mortgage rates can only be a binary one with an RBA rate of 0.10%. They are not going to go down, they can only go up, and have already begun to do so due to overwhelming demand. For why would you not fix your loan at an historically low rate, lower than an SVR, if upside is the only outlook?

I did.

Stuck with lower-margin fixed rate loans, and no capacity to raise those rates on existing loans as they can with SVR loans, until they mature in two to four years, banks have warned the glory days for borrowers is over. Australian government bond yields are on the rise, as are US yields, where Australian banks find most of their non-deposit funding.

It has forever remained a mystery why Australian banks price their mortgage rates off the overnight cash rate. US banks price off the thirty-year Treasury yield, to match duration. Australia doesn’t even have a twenty-year bond. While the official cash rate remains at 0.10%, the RBA has (at least for now) abandoned its intention to hold all rates between overnight and three-year at 0.10%. So, bank mortgage rates must go up.

But even if the RBA hiked rates tomorrow, instead of 2024, a cash rate of 0.25% would still be ridiculously low in historical terms. It’s a long way back to more “normal” rates, if there is such a thing now. Having the biggest mortgage book, CBA is the bank that will most benefit from a rising cash rate. But when?

Any good news?

There were some positives in CBA’s trading update, but all the market saw was NIMs. Strong loan growth, lower than expected bad debts and a still-solid capital ratio are positives, and the bank’s investment into bringing CBA into the digital world are seen as necessary. My word, CBA is now trying to attract the kiddies with access to crypto.

All a bit too-cool-for-school? As Morgan Stanley points out, it’s all well and good but at the end of the day, CBA is “still a bank”. And a bank that will likely see another year of expense growth exceeding revenue growth, with further margin pressure.

What brokers agree on is there remains the prospect of capital management (higher dividends/buyback) despite the NIM crunch.

As noted, five out of six of the major brokers on the FNArena database still believe, even after an -8% plunge, CBA remains overvalued both on an absolute and peer-relative basis. Ord Minnett notes CBA is still trading on a 48% price/earnings ratio premium to peers on FY23 forecasts.

Yet Ord Minnett is hanging on its lone Hold rating, given CBA’s “positive differentiators, including scale, IT, deposit franchise and lending growth performance — sector-leading features that are unlikely to diminish given the bank’s ongoing investment”.

With regard brokers outside the FNArena database, CLSA’s veteran bank analyst Brian Johnson suggests CBA is not a growth stock, but a bank. A good one – but subject to margin and costs headwinds. He retains Underperform.

Despite a strong operational performance, Goldman Sachs suggests CBA’s premium is not justified, and retains Sell.

Jarden, on the other hand, is hanging on to Overweight. The broker agrees NIMs will continue to be pressured in the near term, but this should ease over FY22.

But there is a caveat:

We maintain our Overweight rating for now, but the downside surprise to Q122 margins with risk of further compression ahead, challenge our positive view and expectations of continued strong execution.”

Bell Potter has, like every other broker, cut earnings forecasts and its target price in the wake of yesterday’s numbers. But on that lower valuation, and taking capital management potential into account, Bell Potter estimates a 12-month total shareholder return (share price upside plus dividends) of 15%, and that in Bell Potter’s books is “still regarded as a Buy”.

The FNArena database shows one Hold and five Sell or equivalent ratings. The consensus target price has fallen to $87.25 from $90.50, suggesting -11% downside, ranging from $94.50 from Citi to a mere $73.00 from Morgans. Note that Ord Minnett, the only Hold, has a target of $90.00 (last price $98.10).

Goldman Sachs is on the low end at $81.74, Bell Potter is more positive on $101.00, and Jarden, well, Jarden has $111.00.

On FY22 average forecasts, CBA shares are yielding 3.8% (fully franked). This rises to 4.1% on current average FY23 forecast.

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