CBA Completes The Picture

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

The company is included in ASX20, ASX50, ASX100, ASX200, ASX300 and ALL-ORDS

By Greg Peel

Commonwealth Bank's ((CBA)) quarterly profit update showed a result largely in line with analyst expectations and confirmed the sector-wide trends evident in all three recent interim reports from CBA's three major peers. Once again a big bank result was balanced out only by a better than expected fall in bad and doubtful debts (BDD) being offset by weaker than anticipated financial market trading profits.

I discussed this trend at length in Riding The Bank Rollercoaster published earlier in the week, but suffice to say faster than expected economic recovery in Australia has meant a faster drop in BDD levels than previously assumed, and the drop off in previously heightened financial market volatility toward the end of 2009 and into 2010 (last week notwithstanding) has meant the earlier opportunity to profit from broking fees and proprietary trading has also dropped rather quickly.

The rate of decline in BDDs is nevertheless expected to slow up from here, leaving a long tail into FY12 as the GFC effect slowly works its way out. Trading profit opportunities are also expected to normalise further. (In both cases, of course, one assumes no GFC2 ahead). A further factor is the reduction in “exception fees” being all those sneaky penalties for bounced cheques etc, which banks have been forced to reduce through political and RBA pressure.

Which brings us to yesterday's out-of-left-field announcement of a class action being instigated against all the banks with respect to those fees.

While it would be a shock if the list of enthusiastic litigants didn't grow exponentially (what have they got to lose?), Citi's opinion is even if the case were successful the actual payout would be immaterial to overall sector profits – something like $200-800m across the sector – and then a win is not all that likely anyway. The banks have already, as noted, reduced such fees so the government is unlikely to push the issue further, and a similar case brought in the UK recently failed.

Nevertheless, those reduced exception fees conspire with reduced trading profits and lower but nonetheless lingering BDD problems to suggest bank sector revenues going forward will not look as terrific as they have done since the bounce out of the depths. Then there is the issue of margin pressure which, again, was discussed at length in the aforementioned article.

The overall outlook was summed up by a cautious CBA management, which yesterday noted:

“Whilst the economic outlook has progressively improved over the past twelve months, operating conditions remain challenging. Credit growth remains muted and margins continue to come under pressure from higher average funding costs and strong price competition”.

On a comparative basis, customer margins held up better for CBA than for peers in the past period and the bank noted a strong pipeline in small and medium enterprise (SME) and business lending. Non-retail lending provides incrementally greater return on capital. CBA's institutional lending book has also stabilised after its period of decline.

The quarterly update implied a first half revenue growth of 13% which, despite the expected decline in growth rate, puts CBA comfortably ahead of major rival Westpac ((WBC)) on 7%, notes Merrill Lynch. Thus as sector-wide momentum diminishes, CBA is at the better end of the trend compared to peers. While the big bank potentially suffers from a higher growth rate in operational costs, the current systems upgrade underway is a bit of a wild card in terms of potential cost reductions.

CBA's tier one capital has risen slightly to 9.2% and its level of liquid assets held remains elevated, notes Citi. While this suggests less opportunity for leveraged profits, it does mean CBA will have no need to raise capital under any particular circumstance, which includes whatever regulatory nasties lay ahead. Stricter regulations nevertheless remain a possible downside impetus for all the big banks.

On that point, Citi notes an APRA proposal to eliminate “double gearing” on bank balance sheets which actually reduces CBA's return on equity premium over peers (down to 22% compared to to 17-20% in FY12) and thus brings CBA back to the pack a bit.

Analysts generally believe CBA now deserves a diminished premium over peers, but a premium nevertheless given better core revenue expectations and better quality earnings. That's the relative view, although all brokers agree the bank sector is facing headwinds of lower revenues and lower margins into the rest of calendar 2010 and beyond. Overall, analysts reduced their earnings forecasts for CBA by around 1-3% in FY10 and up to 5% in FY11.

Target prices were also adjusted accordingly, but the impact was only a 27c reduction in the average FNArena database target to $59.01.

The result did not affect any changes in analyst ratings, and Credit Suisse stood by its decision to upgrade CBA to Outperform earlier in the week based on the 10% thumping the stock incurred during the euro debacle. As to the matter of whether or not CBA is trading at a realistic premium to peers or not, the answer lies in the spread of Buy and Hold ratings (four to six). Those on Hold believe CBA is now correctly priced while Macquarie, Credit Suisse, Merrill Lynch and UBS see further relative upside.

The Buy-raters are still influencing a perceived 8.7% of absolute price upside (based on yesterday's closing prices) which is clearly a reflection of the big hit the banks have taken this past week or so as much as anything else. But this upside is now the lowest among peers. Given CBA still ranks second on average, the difference lies in the volatility (spread) of price targets.

There are no Sell-raters but Morgan Stanley (not a database member) has maintained an Underperform rating suggesting sector earnings growth is running out of steam and CBA is fully valued.

For the last word on the sector in general, the Credit Suisse equity strategists are currently Market-weight banks on the basis of little scope for positive earnings momentum in the near-term. While the mortgage rush has tapered off, the improvement in business lending demand represents only stabilisation, notes CS, rather than any great recovery. The market is awaiting the day the banks can release all those extra BDD provisions set aside in 2008-09 into earnings, but while BDDs tail off only gradually, and stricter capital requirements from likely regulatory changes hang over the banks' heads, that day is yet a-ways off.

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