Murky Outlook For Commonwealth Bank

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

Brokers suspect downside risk to Commonwealth Bank's financial performance going forward as mortgage re-pricing that has underpinned favourable revenue trends will not be sustained.

-Declining return on equity expected over the next couple of years
-Compliance related expenditure remains well above peers
-More challenging environment ahead for retail banking
 

By Eva Brocklehurst

Commonwealth Bank ((CBA)) delivered a first half result packed full of provisions. Setting these aside, brokers expect that mortgage re-pricing that has underpinned favourable revenue trends will not be sustained and there is downside risk to the bank's financial performance.

The first half cash net profit of $4.87bn included an interim dividend of $2 a share, which reflected a 72% pay-out ratio. The result also included a $375m provision for potential penalties related to the AUSTRAC investigation. Income growth slightly exceeded expenses growth (jaws), considered a small positive.

Several features concerned Ord Minnett, including higher impairments in the institutional bank, the lower-than-expected dividend and a 25 basis points reduction in the CET1 ratio. Along with ongoing regulatory burdens, the broker believes the bank's return on equity will fall to around 15% by FY20.

The retail banking core is resilient and there is productivity potential, yet Ord Minnett wonders how much of this the bank will need to give up to appease regulators.

The dividend missed Credit Suisse estimates as well and this strengthens its view that the final resolution of the AUSTRAC inquiry and the broader governance issues is some way off. The broker liked the margin expansion and the rebound in wealth income but remains concerned about higher impairments and soft capital formation.

The broker suggests this result could be seen as a "read-through" for the other major banks, noting consumer finance and deposit fee income also modestly contracted, with lower interchange fees and the removal of ATM withdrawal fees.

Morgan Stanley expects no earnings or dividend growth and a declining return on equity over the next two years. Given new interest-only lending contracted more than necessary, the broker suggests management has some scope to reinvigorate investment property but this is likely to be difficult without sacrificing margins.

The pre-provision result was better than Deutsche Bank expected but heightened risks make the broker cautious. Net interest margin performed strongly, in part reflecting a significant tailwind from mortgage re-pricing and this is not expected to continue.

The main upside going forward is the funding cost environment which remains supportive. Deutsche Bank notes cost growth of around 3% was a good outcome as the bank absorbed the anticipated cost of regulatory and compliance programs.

Citi suggests, with a new CEO to take over in April, the bank has seen an opportunity to use the mortgage re-pricing benefits to rule off a number of outstanding cost issues.

Regulatory Issues

Although the increased regulatory burden is not unique to CBA, Macquarie notes the bank is fighting on more fronts when compared with its peers. Arguably, while ultimate outcomes are difficult to estimate, the broker believes the current capital position is sufficient to accommodate potential fines.

Moreover, compliance-related expenditure has increased by around 68% over the last two years and remains well above peers, suggesting the likelihood of ongoing cost pressures is limited.

The question for Macquarie is whether underlying momentum can be sustained while management deals with the various regulatory matters. The broker envisages scope for the bank to better manage expenses and benefit from relatively conservative balance sheet settings.

The stock remains Credit Suisse's least preferred exposure among the major banks because of the downside risks from the litigation and the fact it prematurely re-rated recently. Therefore it lacks valuation appeal.

While some of the financial costs of the AUSTRAC investigation have now been incorporated, the broker suggests there is no assurance the $375m provision will be adequate. Remediation actions could also be long dated.

Then there is the bank Royal Commission. Credit Suisse suggests conduct related operating costs are likely to be substantial in 2018, noting the bank's $200m provisioning includes a component for the Royal Commission.

Retail Banking

The full impact of back book re-pricing was the main driver of the revenue-led result. While a slip in mortgage share has drawn a lot of attention, UBS is not overly concerned. There was a sharp fall in broker sales, which partly reflects a need to hit macro prudential targets and focus on the proprietary business.

UBS calculates the lost share in the broker channel means the quality of the book has improved and believes this is prudent at this stage of the cycle. The broker would be more concerned if the bank had turned on the broker tap.

However, there is a problem. The entire growth in banking revenue can be attributed to the mortgage business and the majority from re-pricing. This cannot continue forever. UBS remains a supporter of the stock, given its strong franchise and market position, but agrees the outlook is challenging and risks are skewed to the downside.

In the longer term Macquarie also envisages more challenging revenue settings for retail banks, as mortgage growth slows and competition intensifies.

The sustainability of retail banking returns appears even more precarious to Citi. The industry has fallen out of favour with its political and regulatory masters and the broker suggests there is likely to be a material re-casting of the economics of the industry.

As return on equity fades further this will imply a unfavourable adjustment for shareholders, particularly as CBA is the most profitable and largest retail bank. Citi maintains a Sell rating.

Morgans is much more positive, maintaining an Add rating on all four major banks. That said, CBA is its least preferred, mainly because of the risks stemming from the AUSTRAC case and the APRA inquiry.

Aside from the impairment of a large single exposure, Morgans points to benign conditions for asset quality. The broker suspects the single asset impairment relates to the UK's Carillion. CBA is considered to be the only Australian bank exposed to Carillion.

The broker estimates the exposure is around $200m and calculates an individual provision of around $150m has been raised against this exposure. Morgans also suggests further divestments may boost the bank's capital position. CBA has announced that its strategic review is ongoing.

There are two Sell ratings, five Hold and one Buy (Morgans) on FNArena's database. The consensus target is $77.63, suggesting 0.8% upside to the last share price. Targets range from $71 (Morgan Stanley) to $83 (UBS). The dividend yield on FY18 and FY19 forecasts is 5.6% and 5.8% respectively.

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