This article was originally published at MF & Co. Asset Management.
The CBA share price has been under pressure in the past two years.
This was mainly due to the Royal Commission including allegations of misconduct.
The misconduct was mainly in regards to mortgage brokers and the selling of insurance to unemployed customers.
In addition, the banks who are heavily reliant mortgages will have something to worry about with the recent decline in the Real Estate market.
Furthermore, Issues with the tightening of lending also pose a threat to the business.
Because of these issues, the CBA share price has come under pressure in the past two years.
However, CBA shares have held their ground well.
The bank continues to pay large dividends and the CBA share price has held onto the 60-70 dollar price handle even with all the negative news.
This is what we think of CBA shares.
About Commonwealth Bank (ASX CBA)
Commonwealth Bank of Australia (ASX CBA) is the largest and leading retail bank of Australia. It was founded in 1911 by the Australia government and subsequently privatised in 1996.
CBA provides a variety of financial services including retail, business & institutional banking, funds management, superannuation insurance, investment and broking services.
Having invested heavily in technology, CBA has built up a strong base of customers in all facets of its business.
CBA is one of the “big four” Australian banks with a current market capitalization of about $126bn.
This makes it the largest bank in terms of market capitalization in comparison with the “big four” banks.
Key CBA Financials
|Growth Over Prior Year||8.6%||2.2%||(3.41%)||2.08%||1.71%|
|EBT Excl. Unusual Items||14,068.0||13,993.0||–||–||–|
|Earnings from Cont. Ops.||9,786.0||9,394.0||–||–||–|
|Diluted EPS Excl. Extra Items||5.5||5.21||5.2||5.29||5.35|
|Growth Over Prior Year||7.1%||(5.3%)||1.48%||1.73%||1.20%|
|Growth Over Prior Year||4.6%||(0.1%)||–||–||–|
- High dividends – a bedrock of Australian retirement funds
- A leader in retail and commercial banking
- Most popular online-banking app in Australia
- Strong funding and liquidity of group balance sheet
- Highest household deposits in Australia
- A leader in residential mortgages (57%)
- Increasing competition with smaller banks and non-banks
- Increased scrutiny and compliance costs after the Royal Commission
- Cooling housing market
- Opportunities to expand customer penetration through digital and open banking
- Investment in artificial intelligence
- Investment into payment platform, servicing technology and cloud infrastructure
- Increased spending on financial crimes compliance costs
- Allegations of misconduct regarding mortgage brokers
- Tightening of lending standards
- Competition from smaller more nimble banks with innovative products
Profitability Expected To Improve in Banking Industry
The National and Regional Commercial Banks industry has declined over the past five years.
This was largely due to several cash rate cuts by the RBA towards the start of the five-year period.
However, Australian banks have avoided any significant decline.
A surging residential property market for much of the past five years has increased demand for mortgages and the local economy.
Nevertheless, record low interest rates have driven down industry revenue over the past five years, despite greater activity in lending.
Overall, industry revenue is expected to decline at an annualized 0.3% over the five years through 2018-19, to $152.8 billion.
However, profitability is expected to improve. This is due to banks increasing interest rates on their lending products over the past two years.
This is despite the cash rate remaining unchanged over this time.
The primary source of revenue for industry operators is interest earned. This is earned on various types of loans like mortgages, business loans and personal loans.
Record-low interest rates have led to surging residential property prices over the past decade. With banks’ housing loan assets subsequently rising.
However, the slowing housing market has led to weaker mortgage activity for banks.
Overall, the home loans segment has grown as a share of industry revenue over the past five years.
The banking industry in Australia has high market share concentration. The four largest players accounting for over 70% of industry revenue.
Market share concentration has remained largely steady, rising slightly over the past five years. CBA currently has the largest market share of 22.4%.
CBA Leads The Pack In Technology Investment
Commonwealth Bank’s IT services spend grew 13% in FY18.
CBA now spends $1.79 billion on IT alone.
The primary reasons were the $50 million increase in software assets amortization, increased spend on resiliency projects and lower vendor rebates gained.
IT services expenses include:
- Upgrading AML/CTF processing technology
- Applying AI-powered chatbot to assist with banking tasks
- Publishing global first blockchain bond by World Bank on CBA platform
CBA has the reputation of being the number one online banking platform in Australia.
Their platform won Cantstar’s mobile banking award nine years in a row from 2010-2018.
CBA has 6.5 million active digital customers and 5.1 million mobile app logins every day.
The bank also covers 50 per cent of all electronic payments in Australia and enjoys good customer satisfaction.
Commonwealth bank aims to target a full-year payout ratio of 70-80%.
The latest Interim dividend per share was $2.00 per share, which was the same as the interim dividend payment last year.
The payout ratio is 74.3% of cash NPAT. Grossed up dividend yield (including franking credits) on a yearly basis is around 7-8% depending on the CBA share price.
CBA’s Dividend Reinvestment Plan is anticipated to be satisfied in full by an on-market purchase of shares.
Additionally, the bank expects future tax payments will generate sufficient franking credits for the Bank to be able to continue to fully frank future dividend payments.
The Final Report of the Royal Commission into Misconduct in Banking addresses 76 recommendations.
CBA reacted positively and responded with action on Royal Commission recommendations.
In response, CBA is
- suspending the demerger of its mortgage broking and wealth management businesses
- focusing on customer remediation and implementing the recommendations of the Royal Commission
However, the final report estimates the scandal would cost wealth managers and the major banks $850 million in compensation.
CBA may end up compensating more than half a million customers who were sold inappropriate consumer credit insurance products.
CommBank is already paying $46 million to 154,000 customers over the selling of credit card and loan protection insurance.
Other concerns include the sales process and the value of the consumer credit insurance products for another 374,000 customers.
Political Pressure On Compensation
Labor leader Bill Shorten has announced plans for a $640 million levy on the large banks and financial institutions.
This levy is aimed at supporting people ripped off by the financial sector.
The levy would raise $160 million a year over four years, targeting any financial institution in the top 100 companies on the ASX.
A total of $320 million from the fund would be used to double the number of financial counsellors across the country.
This number is expected to increase from 500 to 1,000, to support Australians in financial strife.
Rising Compliance Costs
Investment spending in the 1H199 is $676m, which rose 13% versus 1H18.
Risk and compliance costs account for 64% of the total investment spend. This is an increase of 23% from 41% in the prior comparative period.
This due to the stronger regulatory and compliance frameworks. These frameworks require the implementation of new systems and processes to satisfy regulatory obligations.
This includes financial crimes, AML/CTF & Comprehensive Credit Reporting, New Payments Platform and ATM processing of new banknotes.
Net Interest Margin Falls 4 Basis Points
Net interest margin in 1H19 has decreased 4 basis points from 2H18.
This was due to higher funding costs, home loan competition and switching.
Key contributors to the decline were:
- higher funding costs due to the increased spread between the bank bill swap rate and the overnight index swap rate (‘basis risk’) (-2 bpts);
- lower benefit from the replicating portfolio (-2 bpts);
- the impact of customers switching from interest only to principal and interest and from investor to owner-occupied home loans (-2 bpts);
- reduced fixed rate home loan pricing (-2 bpts);
- and home loan competition (-1 bpt).
Positive contributors to NIM were:
- deposit repricing (+3 bpts)
- and the home loan repricing which took effect from 4 October (+3 bpts).
Rising Arrears Provisions
Home loan arrears decreased slightly on the prior half due to seasonality.
This was partly offset by some households which continued to experience difficulties with rising essential costs and limited income growth.
Both personal loans and credit card arrears showed evidence of more muted seasonal benefits due to continued pockets of stress.
- Individual provisions were lower in the half ($920m versus $978m pcp).
- Collective provisions increased ($3,814m versus $2,772m pcp).
- Collective provisions as a percentage of credit risk-weighted assets increased to 1.03% from 0.76%.
- Total provisions as a percentage of credit RWA increased to 1.28%, up from 1.02%.
A decline in Sydney property prices usually last 14 quarters and has an average real price decline of 21%.
Based on the average length of a downturn in house prices, this means there could be at least another year or two of falling house prices before prices hit a trough.
This will materially affect CBA as it is the largest mortgage lender in Australia.
CBA carries a total balance of $374 billion in loans across 1.5 million home loan accounts.
Further declines in house prices have the potential to seriously put the company’s revenue under pressure.
The risk to the CBA share price is also amplified by interest-only mortgages resetting to principal and interest mortgages.
There is currently $120 billion worth of these loans which will reset in the next three years.
The switch from interest-only loans to principal and interest mortgages will put pressure on the borrower’s ability to repay the loan.
CBA shares continue to have a higher PE than the other 3 major banks. However, this can be explained by CBA’s higher quality revenue line compared to the other banks.
CBA has traditionally carried a higher PE than its peers. At 13x PE, the CBA share price does not look to be overvalued.
|30 Jun 18||30 Jun 17||30 Jun 16|
|EPS (Basic, $)||534.3||577.3||542.0|
CBA EPS fell 7.45% year on year, after a bumper year in FY17. The fall in EPS can be explained by the drop in Net Interest Margin across a number of its products.
|Profit Margin (%)||37.55||33.43||30.33||37.79|
CBA continues to enjoy strong profit margins, slightly behind WBC but well ahead of ANZ and NAB.
In 1H19, Cash Net Profit After Tax from continuing operations of $4,676 million, up 1.7 per cent compared to the first half FY 2018.
CBA continues to have the highest ROE of the four major banks.
|Price to Book (mrq)||1.83||1.26||1.33||1.38|
On a Price to Book ratio, CBA looks overly expensive compared to the other banks.
However, as explained previously, CBA tends to enjoy a higher PE and PB ratio due to its stronger business and higher quality revenue.
- Average interest-earning assets increased $12 billion or 1% on the prior comparative period to $864 billion.
- Home loan average balances increased $14 billion or 3% on the prior comparative period to $462 billion, driven by continued growth in owner-occupied loans.
- Business and corporate loan average balances decreased $4 billion or 2% on the prior comparative period to $223 billion.
- This was driven by a decrease of $7 billion in institutional lending balances due to portfolio optimization initiatives and change in Cash Management Pooling Facilities.
This was partly offset by
- $2 billion in growth in New Zealand business and rural loans
- $1 billion growth in Business and Private Banking lending balances in various industries
In addition, non-lending interest-earning asset average balances increased $3 billion or 2% on the prior comparative period. This was driven by higher liquid asset balances.
CBA Experienced Growth in Core Business
- Volume growth in the core business saw Group lending and deposits grow by 2%.
- Home loan volumes increased 4% and business lending, including New Zealand, was up 5%.
- Transaction deposit balances increased by 8%.
- However, continued optimization of the institutional portfolio resulted in a 6% decline in volumes.
Home lending growth in the half was broadly in line with domestic system growth. This was followed by two halves of moderation as CBA took early action to manage regulatory requirements.
CBA shares have had its fair share of issues in the past year.
However, we think a lot of this will set up the bank to be better going into the future.
By cleaning up misconduct in the industry, the Government can help consumers put more trust into the banks.
In addition, the recommendations from the Royal Commission were quite soft – there weren’t many highly impactful statements in the final report.
We already knew from preliminary reports that there will be higher compliance requirements and compensation. CBA handled this quite well and continues to be proactive in solving these issues.
In fact, the CBA share price and the rest of the banks rallied on the day the report came out. This was due to short covering and buyers who saw that the sell-off prior to the release was overdone.
Even with the royal commission fully priced in, the CBA share price has managed to stay between the 60-70 dollar handle.
This shows just how strong and resilient the stock is.
Deteriorating Real Estate Market is a Major Headwind For CBA Share Price
However, the accelerating decline in the real estate market is a major concern for CBA shares.
With a very large portion of their revenue coming from mortgages, a rise in arrears could see the bank suffer heavy losses.
The continual decline in real estate could also mean that the banks will have to lower their Loan-To-Value (LVR) ratio.
This would mean fewer borrowers will qualify for loans, putting additional pressure on the CBA mortgage book.
Even with these issues, we feel that CBA is a stock that is still worth holding.
However, attention needs to be paid to the real estate market, as well as whether CBA’s EPS will decline.
This is because any shock coming from this area could prompt CBA to cut their dividend.
Considering that the CBA dividend is a bedrock of many retirement funds, any cut in dividends could result in pressure on the CBA share price as investors look elsewhere for income.
Medibank shares (ASX MPL) are also pretty good if you are looking for a stable dividend.
Henry Fung is a Partner Managing Director and co-founder of MF & Co. Asset Management. He is a highly experienced equities, derivatives and financial markets professional with over 12 years of experience. Henry specialises in building trading algorithms & systems, quantitative & qualitative analytics across macroeconomic, fundamental and technical disciplines and currently runs the MFAM VPAC AU/US models portfolios. The management Partners and Adviser team have decades of experience between them, with experience from major Investment Banks and Brokers. Their Advisers are highly experienced, having dealt with some of the wealthiest clients in Australia.