Higher Costs Entrenched For Bank Of Queensland

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The impact of rising costs featured in the Bank of Queensland FY18 results and brokers suspect higher expenses are likely to become entrenched after the Royal Commission.

-Bank of Queensland increases focus on commercial segments
-Below-the-line cost accumulation disappoints brokers
-RC may help level playing field and stabilise Bank of Queensland share
 

By Eva Brocklehurst

The outlook for Bank of Queensland ((BOQ)) remains static, amid subdued revenue growth, while the bank's cost burden is likely to increase. Brokers observe earnings quality has deteriorated markedly.

Costs are growing at a difficult time and higher compliance expenses are expected following the recent Royal Commission as well as increased amortisation. Higher project expenditure and software amortisation are here to stay, Citi asserts.

Business banking was the bright spot in the FY18 results and is expected to bode well for the future as the mix shifts towards business lending. Cash net profit was $372m, underpinned by one-offs and margins, as costs were taken below the line. An accounting policy change also supported margins.

Net interest margins were the highlight of the second half, UBS observes, driven by a boost from falling funding costs as the bank reduced term deposit pricing and grew transaction deposits. Going forward, the broker expects reduced deposit costs and changes in the mix towards higher margin commercial and leasing business should be supportive.

Ord Minnett has long expected significant upside, should the bank become better at gathering deposits, and there was some evidence this occurred in the second half. The ability to manage deposit costs also improved, and if the gap to major banks can be narrowed in this way it should help insulate margins from competition pressures. Net interest income increased by 4%, reflecting 2.5% growth in average loans and a five basis points increase in net interest margins.

Morgan Stanley suggests the bank did a good job navigating margin challenges and agrees a key feature of the second half was better management of deposits. Meanwhile, the main positives in the outlook Citi envisages are strong capital, the dividend and the prospect of participating in regional bank M&A.

Morgans believes the bank's relatively inferior mortgage fulfilment times in the broker channel will work against credit growth. For this reason, the broker suggests it will be hard for the bank to achieve system home loan growth without compromising on margins.

Costs

Significant costs in the results included software amortisation as well as regulatory and compliance costs. Brokers were disappointed because typically the major banks take these costs above the line and Bank of Queensland appears to take only positive items above the line.

Shaw and Partners makes the point that these items should now be considered part of normal operations and the concept of cash expenditure and non-cash profit treatment is "nonsensical". "The larger the expenditure, the larger the nonsense," the broker asserts.

UBS calculates, since the financial crisis, Bank of Queensland has taken a net -$355m in below-the-line charges across 57 items considered 'one-off' in nature. This equates to 16% of the profit the bank has reported over the last decade. The broker believes a better indication of the results in the second half was the fall of -11 basis points in the CET1 ratio to 9.31%.

Capital accumulation was the main area of disappointment for several brokers. Moreover, the sale of the St Andrews life insurance business appears in limbo. Still, the valuation appears fair and Ord Minnett upgrades to Hold from Lighten. The broker acknowledges the return on equity is weak, at around 10%.

Morgans had expected a special dividend to be declared but believes the absence of one is explained by a weaker CET1 ratio and the uncertainty around the sale of the St Andrews business to Freedom Insurance. If the transaction proceeds Bank of Queensland expects a 17 basis points boost to its CET1 ratio.

At this stage, Morgans continues to assume the transaction will proceed and expects special dividends in FY19 and FY20. Shaw and Partners, on the other hand, is not expecting the sale of St Andrews to be approved, as Freedom Insurance had an "interesting experience" at the Royal Commission.

The broker, not one of the eight monitored daily on the FNArena database, maintains a Hold rating and $11 target. Morgan Stanley agrees Bank of Queensland's capital options are contingent on completing the sale of St Andrews and that, as Freedom Insurance has suspended all direct insurance sales, there is a risk the St Andrews sale is delayed or does not proceed.

Digital Disruption

Software amortisation expenses associated with the transformation agenda are expected to become an increasing contributor to the growth in costs. Bank of Queensland will increase expenditure on digital technology in response to the growing threat of disruption, although Morgan Stanley suspects this will only partially address the reinvestment burden.

Expenditure on regulatory requirements also continues to rise, and while some of this may be one-off in nature, the broker estimates it will consume around 10 basis points of capital in FY18-20. Morgan Stanley also considers the stock too expensive, given current trading multiples, and maintains an Underweight rating.

Macquarie believes the low returns and elevated pay-out ratio could put pressure on the capital position and there is a risk the dividend is cut. The broker considers the balance sheet outlook is constrained while the most significant part of the portfolio, mortgages, is experiencing outflows.

Outflows in retail housing loans for the Bank of Queensland brand accelerated in the second half and Macquarie does not believe the multiples are justifiable in the current challenged retail banking environment.

In its defence, UBS notes Bank of Queensland has fully verified both income and living expenses of all mortgage applications, placing it at a competitive disadvantage to less prudent peers.

As the Royal Commission is likely to recommend full verification for all mortgages going forward the broker believes this should level the playing field and stabilise Bank of Queensland's market share. For the time being, UBS suspects the bank can maintain its dividend but will need to keep the discounted reinvestment plan for the foreseeable future.

FNArena's database shows three Buy ratings, two Hold and three Sell. The consensus target is $10.64, signalling -3.7% downside to the last share price the dividend yield on FY19 and FY20 forecasts is 6.9%.

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