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Stock: Commonwealth Bank

Stock code: CBA

Share Price: $50.97 (as at close of trade 27th May 2011)

Broker Sell Recommendations:

Investor First (23rd May 2011, share price closed at $51.42 that day)

Broker Hold Recommendations:

Goldman Sachs (downgraded 25th May 2011, share price closed at $50.01 that day)

Investor Centre: Commonwealth Bank of Australia

Company news: CBA

Chart

Chart: Share price over the year to 27/05/2011

First half profit rises from the big banks seem to show an industry in good health, but regulatory changes and flat credit growth present future challenges. And only last week, shares in Australia’s big banks came under heavy selling pressure from short-sellers attracted by lenders’ exposure to Australia’s housing sector, which some perceive as being overpriced.

Citi Index chief market analyst Peter Esho said short-sellers had been targeting the local banks for months, with much of the interest coming from large offshore players. “Local industry will talk about the demand – supply mismatch (but) overseas investors want a more in-depth argument and to be sold on why they should give Australian banks the benefit of the doubt,” he said. A key vulnerability is considered to be their high cost of funding driven by exposure to offshore wholesale credit markets which caused Moody’s recent ratings downgrade.

Mr Esho said another weakness is banks’ high lending exposure to residential mortgages, which made up 60 per cent of CBA’s loan book at December 31, 2010. ANZ’s housing loans comprised only 44 per cent, meanwhile major UK and US banks have 15 per cent of their lending book as home loans, according to CBA figures. “The jury’s still out on how sustainable residential prices are here,” Mr Esho said. “Under any scenario, those (banks) that will perform better are the ones that have perhaps a larger diversity in their revenue base.”

On top of this, Moody’s lowered its rating on CBA from Aa1 to Aa2, as it did for the other major banks as well. CBA’s Bank Financial Strength Rating was also lowered from B to B-, primarily due to “Moody’s view of a structural sensitivity of Australian banks to conditions in wholesale funding markets.”

The challenge for the banks in the second half of 2011 will be to achieve revenue and income growth in a subdued credit environment, says KPMG’s head of banking Andrew Dickinson. “The major banks’ results reflect flat margins and modest new lending which will present a challenge to future growth,” he said. The banks have said there are signs of a return of business credit demand, but are yet to declare a return of confidence among business borrowers. Home lending also remains flat and is expected to remain so for some time.

“Credit growth in Australia has remained anaemic and, as a result, the banks’ top-line revenue has been sluggish,” PwC banking leader Mike Codling said. Mr Codling said that any second half profit growth is likely to come from wealth management businesses and cost cutting. Longer term, however, the bank sector faced uncertainty from global and domestic regulatory changes, he said.

Chart

Chart: Share price over the 10 years to 20/05/2011 versus National Australia Bank (NAB)

Description

There would be very few Australians who didn’t know what the Commonwealth Bank did, as its reach in the Australian financial sector is second to none. The range of banking and financial products and services it provides includes retail, business and institutional banking, superannuation, life insurance, general insurance, funds management, broking services and finance company activities. The Bank has seven segments: Retail Banking Services, Business and Private Banking, Institutional Banking and Markets, Wealth Management, New Zealand, Bankwest and Other. The CBA operates primarily in Australia and New Zealand, but also has operations in the UK, US and Asia.

As the largest of Australia’s “Big 4” banks CBA has had a solid grip on the banking sector for some time, reaching across Australia and extending to New Zealand and Asia. It’s extensive branch network and strong brand – Australia’s second most valuable brand behind Telstra, and worth a whopping $7 billion according to Interbrand – are huge competitive advantages however CBA is still vulnerable to price competition, an overexposure the residential mortgage market and shrinking margins.

Earnings

Link to company Earnings Report: Commonwealth Bank of Australia Half Year Earnings Report – Dec 31st, 2010

Key financials

2009A2010A
2011E
NPAT
$4,554.0 5,876.0 6865.0
EPS
293.1 370.5 423.7
EPS % change
-14.9 26.4
14.4
DPS 228.0 290 320.0
Dividend Yield
6.3
5.6 6.3
P/E 12.3
13.9 12.0

Broker Recommendations

As would be expected, CBA is a stock covered by just about every broker around town and it’s no suprise that there is a range of opinions on the outlook for Australia’s leading bank. However there are few bulls amongst them, with most citing price competition, an overexposure the residential mortgage market and shrinking margins as warning signs for the banking sector as whole, and CBA in particular.

InvestorFirst

Investorfirst has a firm sell on Australia’s largest bank, citing fragile consumer and business sentiment and ongoing weakness in mortgages. “Credit growth in Australia is fairly weak across the board, the banks are involved in a competitive price war for subdued growth in residential mortgage lending, while business credit is still contracting,” says George Sakellariou of Investorfirst Securities. “CBA is affected by deteriorating economic conditions due to its lending exposure across all segments of the economy,” he adds.

Goldman Sachs

Goldman Sachs recently reduced earnings estimates for CBA and downgraded the stock to a hold. Goldman Sachs banking analyst Ben Koo noted that recent declines in housing lending growth and fragile consumer sentiment were other drivers of its downgrade, causing it to dowgrade its investment view on Australia’s banking sector and specifically CBA and ANZ. Koo is telling clients to expect increased profit-taking given global uncertainties and a weaker domestic outlook and housing market. Annual earnings estimates for CBA and ANZ were cut by 0.2 per cent for fiscal 2010/11, while the estimate for National Australia Bank (NAB) was reduced by 0.4 per cent. Westpac Banking Corporation’s full year earnings estimate was unchanged.

Continued risk aversion in the markets, along with tighter financial conditions, a contractionary fiscal policy and slower global growth delaying investment decisions, would act as a brake on loan growth, Goldman Sachs said.

The broker’s loan growth forecasts for Australian housing were reduced to 2.9 per cent for the second half of 2011, equivalent to six per cent on an annualised basis, down from 7.4 per cent during the first half. Koo notes that catalysts for short-term outperformance by CBA are lacking.

Morgan Stanley

Richard Wiles from Morgan Stanley talks of constrained retail banking profit growth, which is where CBA is most exposed. Morgan Stanley was disappointed with the big four banks’ recent half year earnings results, saying that all four are now “running on ice”.

“We think there are now more investment negatives than positives,” Mr Wiles said. “We feel that pressure on households and small businesses from the two-speed economy points to the risk of disappointment on loan loss outcomes beyond the current year.”

Morningstar

Morningstar believes that international shocks, such as an offshore debt crisis or a hiccup in China’s growth, remain the largest risk to the Aussie economy and the banking sector. There is also the risk of the constrictive effects of domestic monetary tightenings, with two interest rate rises possible this year.

Morningstar says that “Conditions in wealth management remain subdued, with investors preferring deleveraging and bank deposits to managed funds and discretionary superannuation contributions. Funds under administration were flat during the 3Q, with poor net inflows offset by positive investment returns…at the moment consumer and business confidence remains fragile, resulting in subdued spending and muted credit growth.”

Credit Suisse

A rebound in bad debts is the biggest risk facing Australia’s big banks as a divergence emerges in earnings potential between business and retail lenders, Credit Suisse says.

Bank profits jumped to record levels in fiscal 2010 thanks to heavy falls in bad debts that cut profits in 2009 during the global financial crisis, with all four major banks continuing their record profit run in the first half of fiscal 2011. But now Australia’s multi-speed economy, characterised by recent natural disasters amid a mining boom, threatens to reverse the fall in bad debts, according to Credit Suisse bank analysts James Ellis and Jarrod Martin. “Bad debt charges are normalising but not normalising at the pace which you’ve been seeing in the last couple of years, with the impact of a multi-speed economy coming through,” Mr Ellis said.

Mortgage arrears also ticked up for CBA during the first half of fiscal 2011, and could climb higher with rising interest rates, he said. “The seasonality effect will fade, but then you’ve got what is a more enduring impact of the higher repayment burden which is not going away.”

Cost management, rather than revenue growth, drove banks’ interim underlying profits between four and eight per cent higher compared to the September 2010 half. Underlying profits exclude bad debt provisions, and Credit Suisse expects the growth to continue but only if credit growth tracks higher.

Against that backdrop, the broker sees a divergence in earnings potential between domestically-focused, mortgage lending giants CBA and Westpac and their southern rivals ANZ and NAB, which are more exposed to business lending and run much smaller home loan books.

Conclusion

CBA is a lower growth, higher ROE bank hamstrung by its large exposure to mortgages. Rising house prices fuelled home lending growth to an average annual growth rate of between 11 and 12 per cent over the past 20 years, with the rate never dipping below eight per cent over that period. It is now running at six per cent, making the business environment tougher for CBA, which has lost mortgage market share to NAB over the past six months. Many may argue that CBA has been a performer over the years, and that it pays out a healthy dividend yield of about 6%. However with the current uncertainty surrounding the banking sector, if yield is what you’re after, you’re probably better served getting a term deposit – Citibank and ING are currently offering 6.5%-7.0%, without the share price risk.

Please note that TheBull.com.au simply publishes broker recommendations on this page. The publication of these recommendations does not in any way constitute a recommendation on the part of TheBull.com.au. You should seek professional advice before making any investment decisions.