Company Reports

Commonwealth Bank’s earnings highlight the quality of the wide-moat bank. A clear market leader with the lowest cost/income ratio, thanks to scale, cheaper funding costs, and leading digital offerings. Add to this low loss rates, a strong capital position, and strong track record of dividend growth. But competition can't be ignored. Fiscal 2024 cash net profit after tax declined 2% as net interest margin, or NIM, slipped 8 basis points to 1.99%. This reflects industry headwinds from customer deposit price competition and switching, and discounting in home lending. This was a bit better than our 1.97% forecast, and the 1-basis-point improvement on the first half supports our forecast for modest margin improvement over the medium term. Overall, the result was broadly in line with our expectations—flat top line with modest loan growth offsetting weaker margins, 3% expense growth, and below-average bad debt expenses.

Commonwealth Bank of Australia is the largest of Australia's four highly profitable, wide-moat-rated major banks. It offers a full suite of banking services in Australia and New Zealand. In the long run, the bank has consistently increased shareholder wealth in favorable economic times. The loan book's large weighting to home loans and the high proportion of customer deposits reduces risk on bad debts and sudden changes to funding costs.

On a weighted average basis, major bank share prices increased 28% in the 12 months to June 30, 2024, outperforming the 8% increase in the Morningstar Australia Index. It is hard to pinpoint a single specific driver for the turnaround in bank sentiment. On the earnings front, signs of repricing loans and deposits to protect margins and low loan losses, are positives. But global funds increasing ownership and inflows into passive funds has likely also supported prices.

The largest and most profitable Australian bank is not immune from industrywide margin pressures. Commonwealth Bank reported a third-quarter profit of AUD 2.4 billion, down 3% on the quarterly average of the first half of fiscal 2024. The decline is tracking marginally better than we expected, though, thanks to lower expense growth and bad debts. Bad debt expenses and arrears are low at 0.08% of loans, compared with our medium-term forecast of around 0.15%. While continuing to rise, home loans behind on payments are below historical averages, and we suspect equity buffers, the strength of the labor market, and strong house prices will keep actual bank losses manageable even as household stress rises.

Commonwealth Bank of Australia is the largest of Australia's four highly profitable, wide-moat-rated major banks. It offers a full suite of banking services in Australia and New Zealand. In the long run, the bank has consistently increased shareholder wealth in favorable economic times. The loan book's large weighting to home loans and the high proportion of customer deposits reduces risk on bad debts and sudden changes to funding costs.

After reasonably uneventful earnings updates, it is hard to pinpoint a single specific driver for the turnaround in bank sentiment. Still, we think part of it is that a likely lower cash rate eases housing fears and provides banks an opportunity to reprice loans and deposits to protect margins. Major bank share prices increased 23% since November 2023, outperforming the 16% increase in the Morningstar Australia Index over the same period. The major banks' weighted average price/fair value estimate is 1.14, up from 1.05 in the last quarter. Nonmajor banks trade at a price/fair value of 0.85.

Commonwealth Bank of Australia is the largest of Australia's four highly profitable, wide-moat-rated major banks. It offers a full suite of banking services in Australia and New Zealand. In the long run, the bank has consistently increased shareholder wealth in favorable economic times. The loan book's large weighting to home loans and the high proportion of customer deposits reduces risk on bad debts and sudden changes to funding costs.

We reiterate our AUD 90 fair value estimate for wide-moat-rated Commonwealth Bank. First-half fiscal 2024 profit fell 3% to AUD 5 billion. Our full-year forecast of AUD 9.7 billion implies a slightly weaker second half. We trim our fiscal 2024 net interest margin forecast by 3 basis points to 1.97%, but the impact on profit is offset by modestly lower bad debt expenses and higher noninterest income. Shrinking NIM, down 11 basis points from first-half fiscal 2023 to 1.99%, reflects industry headwinds from customer deposit price competition and switching, and home loan discounting.

Australian banks face low credit growth, softer net interest margins, and an increase in loan losses in the short term. Industry returns on equity will be suppressed in fiscal 2024. However, we expect loan and deposit pricing changes in the medium term to lift margins to a level that allows wide-moat-rated major banks to generate maintainable returns above our 9% cost of equity.

We maintain our AUD 90 fair value estimate for wide-moat-rated Commonwealth Bank following a solid trading update. While highlighting lower net interest margins, or NIMs, as an earnings drag, the bank still managed AUD 2.5 billion in profit for the September quarter, up 1% on fiscal first-quarter 2023 and flat on the quarterly average of fiscal second-half 2023. Loans declined modestly as the bank prioritized profitability over volumes. Operating expenses increased 3%, bad debt expenses remained low, and the capital position is strong. On continued wage and vendor cost pressures, we lift our operating expense forecast by 3%, implying 5% growth for the full year. This is offset by lower-than-expected bad debt expenses though, with our full-year profit and dividend forecasts largely unchanged.

Commonwealth Bank of Australia is the largest of Australia's four highly profitable, wide-moat-rated major banks. It offers a full suite of banking services in Australia and New Zealand. In the long run, the bank has consistently increased shareholder wealth in favorable economic times. The loan book's large weighting to home loans and the high proportion of customer deposits reduces risk on bad debts and sudden changes to funding costs.

The short-term outlook for Australian banks is challenging with margins under pressure, loan losses expected to rise, and inflationary cost pressures unable to be offset by cost-cutting initiatives. Industry returns on equity are suppressed, hence we expect loan and deposit-pricing changes in the medium term to lift margins to a level that allows wide-moat-rated major banks to generate returns above our 9% cost of equity.

With interest margins softening and bad debts likely to rise, at least investors could take comfort in the banks sitting on surplus capital. With an average common equity Tier 1 ratio of 12.1%, all Australian major banks comfortably exceed the regulatory requirement of 10.25%. The Australian Prudential Regulation Authority does expect banks to maintain a buffer though, hence major banks have set their own targets of 11%-11.5%. This surplus capital position could be under threat if APRA sees fit to shake up the hybrid market.

Australian wide-moat major banks are comfortably meeting regulatory capital requirements, sitting on an aggregate excess capital of nearly AUD 15 billion as of Sept. 30, 2022. COVID-19 induced conservatism saw major banks cut dividends, tighten lending standards, divest assets, and in the case of Westpac and National Australia Bank, raise equity. Because of this, the majors are entering a downturn both well-capitalised and having enjoyed historically low loan losses given the accommodative monetary policy and fiscal stimulus in response to the pandemic. As at Sept. 30, 2022 on average, the four major banks had impaired and past due loans as a proportion of total loans of 46 basis points compared with 64 basis points as at Sept. 30, 2019.

The Australian major banks expectedly reported improvements in net interest margins, or NIMs, in the fourth quarter of fiscal 2022.

The increases in the Reserve Bank of Australia cash rate to arrest inflation will have an impact on key earnings drivers for the banks. With the cash rate currently at 2.35%, and likely north of 3% by year-end, the increases from just 0.1% in April 2022 have been swift. It is expected to slow credit growth, with less borrowing capacity and confidence (a complete turnaround from the fear-of-missing-out environment of recent years). However, we think bank sector revenue growth will be buoyed by higher net interest margins, with the spread between lending rates and the cost of customer deposits widening.

Given strict regulatory requirements, banks usually have sound balance sheets, making decisions around investment strategy (including loan growth and quality) and distributions more important in determining shareholder returns. On balance sheet strength and distribution strategies it’s a level playing field across the major banks in our opinion, but we think Commonwealth Bank has edged its peers on strategy and execution. We assign a Standard capital allocation rating across the banks, but we think the pendulum is swinging close to an exemplary rating for Commonwealth Bank, while Westpac and National Australia Bank are closer to Poor. We make no other changes to our earnings forecasts or fair value estimates.

Commonwealth Bank plans to sell its general insurance business to Hollard Group for AUD 625 million plus deferred payments if undisclosed milestones are achieved. We agree with the strategy of investing and focusing management attention on the part of the business, lending, which underpins the bank's wide economic moat rating. Potential consumer value-add from getting a loan and insurance in the one place is retained via a distribution agreement. The bank will enter a 15-year strategic alliance with Hollard to distribute home and motor vehicle insurance products.

Commonwealth Bank’s third-quarter 2021 cash NPAT of AUD 2.4 billion increased 24% on the first-half fiscal 2021 quarterly average with growth driven by a loan impairment reversal. We estimate earnings before loan impairments were flat. A 2% increase in revenue was offset by cost growth, but we expect growing loan balances to translate into better earnings in the near term. Longer-term, Commonwealth Bank’s growing market share leaves it best placed as cash rates likely rise and the bank reprices loans.

Environmental, social and governance, or ESG, factors can have a material bearing on the cash flow and valuation of firms. In the past, issues such as James Hardie’s asbestos liability or AMP’s management of its conflicts of interest have had a material impact on the valuation of those firms. Identifying and assessing ESG risks is critical to any thorough assessment of a company’s cash flow and earnings potential. At Morningstar, we incorporate ESG into our long-term-oriented methodology by focusing on issues with the highest risk, defined by likelihood and materiality to a company’s intrinsic value.