Commonwealth Bank
CBA reported its 1H18 result two weeks ago, when the shares closed down 0.8% despite the All Ordinaries Index’s 51-point recovery that day from the correction of Monday and Tuesday. This was harsh given the underlying operating 1H18 result, while not perfect, was sound and reflects further consistent delivery of the same successful strategy since 2005. The result confounds the predictions of the bears the wheels would fall off due to distraction by regulatory, legal and compliance matters.
CBA remains undervalued with our current valuation at $83.40 per share. We expect a relative value rally in banks at some point and an opportunity to lighten the position, so we will continue to hold.
The main disappointment was interim dividend of 200c, although up one cent, fell short of consensus of 206c. The country’s premier dividend stock didn’t deliver as expected. Only last year the bears predicted the sector would cut dividends, now they mark the stock down because it didn’t deliver as much of a hike as hoped for.
The market was also surprised by the $375m provision for the AUSTRAC fine, and $200m of legal, compliance and regulatory costs in the half. How consensus could not see these costs coming, with all the legal actions and enquiries weighing on CBA and the sector, is beyond us. Total compliance etc. spend over FY13-17 was $3.4bn, up from $295m in FY13, so there was already a strong uptrend here.
After the surprisingly strong September quarter trading update, consensus expectations for the result were high and were disappointed in some cases at various levels of this messy result (exceeded in a few cases).
The result doesn’t change our long-term view of CBA. The underlying result of cash NPAT up 5.8% was sound, with 6.2% growth in net interest income outweighing flat non-interest income and lower trading income, positive jaws, solid earnings growth in all divisions except Institutional, further balance sheet strengthening, another rise in % deposit funding, leadership in customer satisfaction, another improvement in cost efficiency, good volume/margin management, selective growth, increased quality of growth (more via proprietary channels than brokers), another reduction in exposure to apartment developers with further reductions to come, and ongoing technological leadership. One standout was the issuance of wholesale debt with an average maturity of a remarkable 8.9 years as CBA exploited the lowest spreads and funding costs since the GFC to increase its long-term funding to 63% and the average maturity of its wholesale debt to 4.6 years. Organic capital generation was strong so CET1 moved up 30bp to 10.4%. ROE before the fine provision and for continuing operations was flat at 15.7%.
Bad debts expense fell 0.5% and was just 16bp of gross loans, up from 13bp in 2H17 due to one impaired institutional loan and institutional writebacks in the pcp. Bad debts have now been at these ultra-low levels for four and a half years, confounding predictions of normalisation. Arrears in home loans, credit cards and personal loans fell over the half. The home loan book remains conservatively managed with no signs of deterioration. The transition from interest-only loans to interest and principal repayment continues gradually with no signs transitioning borrowers are having difficulty making their new principal repayments. At the time of loan issuance, interest-only borrowers were assessed for their ability to repay principal immediately in addition to extra serviceability buffers. People’s expenses have risen over time but this has not caused any noticeable increase in principal arrears. This means that so far, the original underwriting criteria were sufficiently conservative.
Investor arrears continue to trend higher and this requires monitoring. Excluding WA, group home loan arrears are flat.
 

Figure 1. Aspects of CBA’s strategy
Source: CBA
 

Figure 2. CBA’s selective approach to market share and reduction in exposure to apartment development
Source: CBA
 

Figure 3. Bad debts expense remains historically low
Source: CBA
CBA has no exposure to Steinhoff, the failed global retail group. The impaired institutional loan is to Carillion Group, a failed UK property services group. This loan dates from the early 2000s, before the current policy to lend only to large Australian corporations took effect. The institutional loan book’s trajectory remains to derisk.
 
National Australia Bank
NAB shares closed 2.3% higher on Thursday 8th Feburary in response to the first (December) quarter trading update, making the stock one of the best ASX 50s of the day and the best major bank. Earnings trends appeared to be no worse than expectations and the stock had become oversold in the market correction. While revenue growth was soft at 1%, cost growth of 4% was less than the 5-8% guided for FY18. Interest margins ex markets were stable, loan impairment expense was less than expected and capital generation was a little better than expected – important for a bank still paying out too much in dividends and having to discount the dividend reinvestment plan. The risk of a dividend cut is less than it was but still explains NAB’s premium 7% dividend yield; we predict NAB will hold its dividend and dilute shareholders with the DRP.
Impairment charges were just $160m or 11bp of gross loans. This adds to the evidence from CBA’s result that credit quality ended 2017 in the same historically excellent state as throughout the year. This very low level of impairment expense means minor changes in credit conditions could cause large percentage moves in impairment expense, so this requires monitoring.
Growth in business and institutional banking drove the revenue growth, consistent with the strategy to make business banking easier with NAB.
Common Equity Tier 1 capital on 31 December was 10.2%, up 10bp despite the 2H17 dividend and supported by a $5bn reduction in risk-weighted assets.
Key facts:

  • 1Q18 cash NPAT of $1.65bn, +3% on pcp
  • Revenue +1%, driven by Business & Private and Corporate & Institutional divisions
  • Net interest margin declined given weaker Markets & Treasury results, but underlying result ‘broadly stable’ despite bank levy and mortgage competition
  • Expenses +4%. Still guiding to +5-8% in FY19 (in line with $1.5n investment program announced at FY17 result), then flat over FY19-20
  • Credit quality sound, with bad & doubtful debt charges down 23% vs Q4 17 to $160m
  • 10.2% Core Equity Tier 1 ratio, +10bp given lower RWA and DRP discount. On track to meet APRA’s ‘unquestionably strong’ target by January 2020.

NAB remains cheap compared with our conservative intrinsic valuation (at time of original publication), and is our preferred bank for 2018 because it has demonstrable revenue growth from strategy, the most leverage to any acceleration in business lending, the most defined costs strategy and less legal and regulatory risk than CBA. We will continue to hold for the dividend yield and incremental capital appreciation.
NAB is also inexpensive compared with peers in a year when rotation between them will be much of the banks story. NAB trades on an 11.9x PER, which compares with the sector’s 12.2x average.