The market voted with its feet yesterday on Commonwealth Bank when on an otherwise up day, its shares fell by 1.4% to $78.70. This followed the release of a disappointing full-year profit report. The clear message from the investor community was that the bank needs to work harder, smarter and faster to take out cost.
The Bank missed at a headline level with cash NPAT of $8.5bn coming in $300m short of expectations and down 4.7% on FY18. More worryingly, the second half profit of $3.8bn was down 18% on the first half result of $4.7bn.
The second half contains three fewer days than the first half for the Bank to earn interest on loans, so it is always a more challenging half year. And there are other extenuating circumstances, including the cost of customer fee removals, the cost of customer remediation and the extra risk and compliance staff the Bank has hired. But even allowing for these items, revenue fell and costs rose - “negative jaws”! This is the antitheses of the Bank’s much championed “positive jaws” (revenue growing at a faster rate than expenses), which it has delivered year after year and is one of the key reasons that it has been able to command a premium price relative to its major bank competitors.
Last February, CommBank CEO Matt Comyn said that the bank was targeting “no absolute cost growth” and a cost to income ratio of 40%. But this half, costs soared by 13% and the cost to income ratio blew out to an incredible 49.8%.
In a world of flat lending volumes, compressed interest margins, and no willingness or ability to increase fees (in fact the opposite, fee refunds or rebates), it is very difficult for a bank to grow revenue. The only avenue to improve shareholder returns is to reduce costs or return capital. Until very recently, CommBank hasn’t been in a position to do the latter.
On its own productivity measures, the Bank is falling short. Operating income per employee fell from $591,876 in 2018 to $568,644 in 2019, a fall of 4.0%. Employment costs as a proportion of operating revenue hit a five year high at 24.2%. The harsh reality is that CommBank has too many staff, too many managers and some of them are getting paid too much. It is time for a razor gang to bring out the axe.
There were some positives in the result. After falling by 0.05% in the first half, the net interest margin (NIM) remained stable in the second half at 2.10%. Looking ahead, the Bank said that the impact of the two rate cuts announced by the RBA in May and July, plus a technical accounting change, would reduce NIM by a further 0.05% . This is a little less than the market expected. Further, Comyn acknowledged that there was now a NIM “tailwind” arising from a fall in the spread between the 90 day bank bill rate and the RBA cash rate.
The Bank was able to make headway in the home loan market, growing at a rate 1.3 times the system growth rate. It put this down to its speed of decisioning and turnaround times. There was also a gain in transaction deposit balances, the latter up 9% over the year.
With the dividend, CommBank maintained its second half dividend of a fully franked $2.31 per share for a full year payment of $4.31, unchanged on 2018. The second half dividend will be fully “neutralised”, with the Bank buying back on market any shares issued through the dividend re-investment plan.
CommBank’s capital position is strong, with the CET1 (common equity tier 1) capital ratio of 10.7% above APRA’s “unquestionably strong” target of 10.5%. Post the completion of the sale of the asset management business CFSGAM in August and CommInsure later this year, the CET1 ratio rises to 11.8%. With the changes mooted by the Reserve Bank of New Zealand expected to consume up to NZ$3.0bn of capital, this means that CommBank will have around $4bn to $6bn of surplus capital.
The Bank is explicitly flagging the return of the surplus capital to shareholders. Interestingly, an “off-market” buyback, which is particularly tax effective for SMSFs and other low rate taxpayers, looks to be on the cards. The Bank said: “potential future capital management initiatives……..could include forms of a capital return including an off-market share buyback”.
What do the brokers say?
Going into the result, the major brokers were negative on CommBank, viewing it as expensive compared to its major bank peers. They had CommBank trading on a multiple of around 16 times forecast earnings, compared to around 13 times for Westpac and the NAB and 12 times for the ANZ. According to FN Arena (see table below), there were 3 neutral recommendations and 4 sell recommendations from the major brokers, with no buy recommendations. The consensus target price was $73.11, 7.1% below yesterday’s closing price of $78.70.
There is nothing in this profit report to suggest that there will be material changes to the broker recommendations, with the earnings profile a little weaker than expected and the capital position a little stronger. CommBank will continue to be viewed as expensive relative to its peers.
Until CommBank gets its act together on costs, the market will struggle to ascribe it too much of a pricing premium. The prospect of a capital return will provide support, and with the dividend of $4.31 secure and delivering a yield of almost 5.5%, CommBank will remain attractive to yield buyers. But don’t expect it to outperform in a bull market.