CBA’s Stunning Result Keeps Premium In Place

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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

A full suite of broker Sell ratings could not prevent CommBank posting its largest one-day share price gain in six years on the release of first half numbers.

• CommBank posts consensus-beating first half result
• Growth in deposits and loans outstanding
• Earnings forecasts rapidly upgraded
• Brokers are unmoved on “overvaluation” calls

By Greg Peel

What is it about Commonwealth Bank ((CBA))?

For as long as anyone can remember, bank analysts have held firm on Sell ratings for the stock, citing excessive valuation relative to the sector and the market.

Valuation remained elevated heading into this February result season, prompting analysts to suggest CBA’s result would need to be stellar to even justify its premium, let alone to prompt any re-rating.

It was.

Stunned analysts watched as CBA’s share price jumped 6.8% on the day of release — delivering the nation’s largest lender its largest one-day share price gain in almost six years.

As Morgans has long noted, as well as being Australia’s largest bank, compared to its peers CBA has the highest return on equity, lowest cost of capital, leading technology, largest position in the residential mortgage market (with the lowest risk portfolio in this low risk market segment) and largest low cost deposit base (with a greater skew to households and transaction accounts than its peers), plus a loyal retail investor and customer base.

Throw in CBA being, due to its capitalisation, a must-have in every index-tracking fund, supported by ongoing super net inflows which fund managers have no choice but to allocate proportionately to CBA, and Australia’s AA-rated banks seen as safe havens for foreign investors, and there is enough to support a premium.

We should also note the positive feedback loop effect: the higher CBA’s share price rises relative to the market, the greater its index weighting, necessitating further fund manager allocation, causing the share price to rise further…

Yet, still analysts cannot justify the extent of premium.

The Result

CBA delivered a solid first half result, with cash earnings 5% ahead of consensus underpinned by better underlying margins and lower bad & doubtful debts (BDDs).

The strength of CBA’s deposit franchise was a key highlight, Macquarie suggests, particularly in the face of increased deposit competition across the sector.

Two things stood out for UBS. The first was the growth in transactional deposits, especially in retail banking (11.6%), widening CBA’s moat in the retail market, supporting group net interest margin (NIM) and growth in net interest income (NII).

Morgans notes net interest income growth (5% versus expectations of 2%) was driven by the “strongest half since 2008” of domestic volume growth and mild decline in underlying NIM.

The second standout for UBS is that CBA’s mortgage business is in full swing with record value of new business written in the half. New mortgages funded during first half increased 24% half-on-half, reaching $105bn.

This stronger-than-anticipated lending growth is expected to support cash profit growth in a stable asset quality and credit environment despite a fluid competitive backdrop, UBS notes.

Deposit growth was also impressive, rising 12% half on half in the retail base and 7% in the business segment, despite, as Jarden points out, paying well below market rates on deposits while charging market rates for loans.

Ord Minnett notes CBA has recovered to a 33.5% market share after some weakness over the past year. The customer mix has changed, however, with the somewhat surprising outcome of increased share of the 25–35 age group but a loss of market share among the 50–64 demographic.

Ord Minnett suspects the difference is more first-home buyers in the former demographic, and fewer investors and savers in the latter.

Cost growth was driven by wage and IT vendor cost inflation, Morgans notes, with tech investment effectively self-funded by productivity savings.

There was discussion in the market briefing about the opportunity arising from CBA’s investment in artificial intelligence. Morgans’ sense is that the size and timing of AI benefits are evolving and uncertain, and that the prize could be meaningful, but there is a risk the gains are offset by the pricing power of key IT vendors.

Competition

Deposit competition has been a strong debate in the sector. However, Citi notes there was nil drag from funding costs in this first half while portfolio mix was positive as deposits grew faster than loans.

While the sector has been debating Macquarie Group’s ((MQG)) impact on competition (Australia’s largest investment bank having moved into the commercial banking space), Citi thinks this result highlights the structural shift in the industry which is seeing market share gains to the majors and Macquarie more broadly.

A positive outlook for CBA, but Citi thinks this is shared by the sector.

Jarden points out CBA’s below-market deposit rates principally drive the bank’s NIM advantage and valuation premium. However, Jarden now finds this a precarious economic model vulnerable to disruption in a time when IT advancement has removed any proprietary distribution advantage that historically justified vast below market payment on deposits.

Macquarie clearly sees this, the broker suggests, and is positioned to compete with a compelling offering that’s still in the early stages.

Even Macquarie’s analysts suggest deposit competition is likely to remain a threat, without naming any names.

Capital Management

CBA exited the first half with CET1 regulatory capital flat at 12.3%. On a post-interim dividend basis the pro-forma CET1 is circa 11.5%, Morgans estimates. On the assumption that CBA ultimately follows National Australia Bank ((NAB)) and Westpac ((WBC)) in setting a minimum CET1 target operating ratio of 11.25%, and noting the broker’s upgraded loan growth forecast results in capital being consumed faster than retained profit is generated,

Morgans sees tightness in CET1 capital by FY28.

Hence, Morgans forecasts assume CBA grows its dividends per share at a slower pace than earnings and does not neutralise its FY28 dividend reinvestment plan (so as to retain more capital to fund growth).

Aside from dividend considerations, CBA continues to leverage the strong revenue environment to invest ahead of peers, Macquarie notes.

In contrast, CBA is not seeking outright cost savings, but focusing largely on revenue growth and improved productivity.

CBA is reportedly already seeing “measurable returns” from its investments.

Change of Heart?

So, in light of this result, have analysts reconsidered their longstanding Sell ratings on CBA?

Not one. All six brokers monitored daily by FNArena retain their Sell or equivalent ratings, as does Jarden. We have to go back to April 2024 to find one single Hold rating among otherwise all Sells, but by July of that year Ord Minnett downgraded and joined the pack.

Brokers have lifted their earnings forecasts and subsequently the consensus target to $129.71 from $119.64. Jarden is a different case in point. Recalling Jarden’s suggestion above of a “precarious economic model vulnerable to disruption”, this broker has cut its target to $90 from $100 and retains Underweight.

It was Einstein who suggested the definition of insanity is doing the same thing over and over and expecting a different result, but analysts are steadfast in their views.

Morgans believes potential medium-term returns are too compressed at current prices considering CBA’s elevated trading multiples.

Despite CBA’s strong results and earnings upgrades, Citi thinks bank peers will share the positive macro environment underpinning these results. Consequently, Citi thinks the valuation premium is full and sees better risk/reward elsewhere.

CBA’s result highlighted the strength of its franchise. Macquarie continues to see upside risk to consensus, underpinned by stronger credit growth and margins. However, valuation is still difficult to justify in Macquarie’s view.

CBA remains one of the economy’s strongest businesses and best performers, Ord Minnett suggests, but even after the broker’s large earnings upgrades, the bank remains the most expensive bank stock in developed-world markets’ history at a price-to-earnings multiple of almost 26x.

The stock could remain at “eye-wateringly expensive” levels while the economy bubbles along, says Ord Minnett, but there is only one way to go when the cycle turns and this leads this broker to reiterate its Sell recommendation.

Despite clear operational momentum, UBS finds CBA’s valuation challenging. Consensus estimates have CBA trading at 3.4x price to book multiple, which is above a two standard deviation level, and a two-year forward forecast PE of 25.9x, which is at a two standard deviation level.

Hard to argue with, but tell that to the market.

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