CBAUF - Commonwealth Bank of Australia: A Difficult Balancing Act (Rating Downgrade)

2023-12-19 07:58:12 ET

Summary

• It is challenging for Commonwealth Bank of Australia to achieve a balance between growth and profitability.
• CBA's valuations are unappealing, considering its P/E multiple of 19.3 times and its P/B ratio of 2.56 times.
• I lower my rating for Commonwealth Bank of Australia stock to a Sell, after evaluating its financial prospects and valuation metrics.

Elevator Pitch

I have a Sell investment rating for Commonwealth Bank of Australia ( CBAUF ) [CBA:AU], which is referred to as CBA in this article.

Previously, I published an initiation article for CBA on February 8, 2021 highlighting that favorable expectations of an increase in dividends have been factored into its stock price and valuations.

I think that CBA will find it hard to maintain a balance between profitability and growth, and this implies that the bank's prospects in the short term will likely be poor. In addition, CBA's valuations are very demanding. These factors support my decision to downgrade the stock's rating from a Hold previously to a Sell now.

CBA has listings on both the OTC (Over-The-Counter) and Australia Securities Exchange. The three-month average daily trading values for CBA's OTC shares and Australia-listed shares were approximately $100,000 and $150 million (source: S&P Capital IQ ), respectively. Readers can trade in CBA's shares listed on the Australia Securities Exchange with US stockbrokers offering foreign markets access like Interactive Brokers.

Striking A Balance Between Volume And Margin Is Challenging

CBA's management comments and key metrics suggest that the bank aims to maintain a good balance between volume growth and margin preservation, and this represents a tough balancing act.

The bank discloses full financial statements on a semi-annual basis and offers trading updates in the first and the third quarters of every fiscal year. CBA emphasized at its FY 2023 (YE June 30) earnings briefing , that it is "very focused on making disciplined volume margin tradeoff." At its 2023 Annual General Meeting or AGM (transcript sourced from S&P Capital IQ ), the bank acknowledged that its volume share in the Australian home loan market "has reduced", but it stressed that it is "maintaining our share of revenue" and "very conscious of profitability."

The bank's management commentary sends a clear signal that CBA wants to strike a balance between volume and margin. But CBA's most recent quarterly (or Q1 FY 2024) trading update indicates that it will be very difficult for the bank to deliver both loan volume growth and higher profit margins.

CBA registered a net profit after tax of AUD2.5 billion in the first quarter of fiscal 2024 (July 1, 2023 to September 30, 2023). This was roughly on par with the bank's quarterly mean net income for 2H FY 2023, and just slightly (or +1%) higher than CBA's Q1 FY 2023 bottom line.

The home loan balance for CBA decreased by -AUD4.5 billion between end-FY 2023 and September 30, 2023, and the bank attributed this decline in home loans to "a disciplined approach to pricing." However, this didn't translate into an improvement in profitability.

In its Q1 FY 2024 trading update, CBA revealed that "home lending margins stabilized" for the latest quarter, but it also disclosed that it recorded "lower net interest margins" in the most recent quarter as a result of "continued competitive pressure in deposits." The bank didn't disclose actual margins in quantitative terms, as this was only a quarterly trading update.

It will be reasonable to conclude that CBA faces a tough balancing act, taking into account its flattish earnings (on a QoQ basis), a lower home loan balance, and a decrease in net interest margin for Q1 FY 2024.

Competition For Home Loans And Deposits Are The Key Headwinds

The FY 2024 (July 1, 2023 to June 30, 2024) financial outlook for CBA is unfavorable due to intense competition in home loans and deposits.

As per S&P Capital IQ's consensus data, the sell side anticipates that CBA's operating income will decrease by -0.4% in FY 2024 as compared to a +10.3% increase in operating income for FY 2023. The analysts also see CBA reversing from a +5.9% growth in net profit after tax in FY 2023 to registering a -5.7% contraction in its bottom line for FY 2024. I think that the fiscal 2024 consensus financial estimates for CBA are realistic considering the headwinds that it is facing.

A key competitor, Westpac Banking Corporation ( WEBNF ) appears to have the intention to be aggressive in gaining market share in Australia's home loan market, and this is a major negative for CBA. At its recent 2023 AGM (transcript taken from S&P Capital IQ ) held on December 14, Westpac mentioned that "we made it a priority for the company to maintain or grow its position in key markets" after "years of erosion of our market position." Westpac specifically highlighted at the latest AGM that it is "targeting mortgage growth in line with the system in financial year '24" and noted that its "home loan portfolio makes up over 50% of our total lending business."

CBA and Westpac are the market leaders and second biggest players in the Australia home loan industry, respectively. Westpac's goal of share gains in the Australian home loan market puts CBA in a Catch-22 situation. If CBA places an emphasis on profitability, its home loans will suffer from a drop just like what happened for the bank in 1Q FY 2024 as detailed above. On the flip side, CBA's profit margins will take a hit, assuming that it chooses to engage in price competition with the other mortgage lenders.

Separately, CBA noted at its 2023 AGM that it "will only keep customers if we're competitive" on deposit rates, and it highlighted that the bank's net interest margin has "been on a decline since then (October 2022) because of the significant competition on deposits." The market expects CBA's net interest margin to contract from 2.07% in FY 2023 to 1.99% for FY 2024 based on S&P Capital IQ data.

On December 15, 2023, the Australian Competition and Consumer Commission or ACCC issued a research report relating to bank deposits in the country. In its press release announcing the publication of this report, the ACCC mentioned that one of its key proposals is for the Australian government to "consider bank account portability" to "simplify this process for consumers to switch and take advantage of better rates." In other words, there is a meaningful risk that adverse regulatory developments (e.g. making it easier for people in Australia to change to a new bank) could intensify competition for deposits in the Australian market in the future.

In a nutshell, CBA's near-term prospects are poor and this is reflected in the listed company's consensus financial projections.

Valuations Are Rich

I am of the opinion that CBA is overvalued.

CBA currently trades at a consensus forward next twelve months' normalized P/E of 19.3 times as per S&P Capital IQ data. However, CBA's consensus FY 2024-2028 normalized EPS CAGR estimate is a modest +4.3%. This means that CBA is valued by the market at a Price/Earnings to Growth or PEG ratio of 4.5 times.

The bank's consensus forward FY 2024-2028 ROEs are in the 13%-14% (source: S&P Capital IQ ) range. CBA warrants a P/B multiple of 1.3-1.4 times, assuming a ROE of 13%-14%, a perpetuity growth rate of 0%, and a 10% cost of equity. Using the Gordon Growth Formula, one arrives at a fair P/B multiple by dividing [Return on Equity minus Perpetuity Growth Rate] by [Cost of Equity minus Perpetuity Growth Rate]. In contrast, CBA is now valued by the market at a trailing P/B multiple of 2.56 times based on valuation data obtained from S&P Capital IQ .

Final Thoughts

I have a bearish view of CBA and this implies that a Sell rating for the stock is fair. The bank's shares are trading at above fair valuation, and the financial outlook for CBA is challenging.

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