Investment view
Best in sector retail bank + network + digital: CBA has managed to convert its leading position in distribution via its branch network, online. CBA has the sector’s most modern technology stack and consumer-facing applications. Whilst we don’t believe that CBA’s online leadership can be as enduring as what a traditional branch network provided (decades of leadership), we believe that peers are unlikely to catch CBA’s technology lead over the next 5 years.
Leading sector returns: over the last ten years, CBA’s asset base (very similar in size to its peers) has produced on average ~50% higher earnings. CBA’s return on equity (ROE) has been ~20% higher than its peers. Consensus forecasts imply CBA will generate ~25% more earnings than peers over the next 4 years. The result is the sector’s most profitable bank for over three decades, and the sector’s leading ability to generate organic capital. The flow-on benefit is CBA’s shares on the issue have grown at less than half the rate of peers over the last 10 years, with clear benefits to earnings per share (EPS).
Key strategic questions:
- What ROE accretive capital deployment opportunities of scale are available?
- Can net interest margins rise enough to offset an uptick in bad debt charges in this cycle? and;
- Can CBA continue to take market share from peers?
Consensus earnings forecasts look conservative into FY25E, with the market forecasting flat net interest margins, despite the prospects of higher rates (we are in the not camp of an outsized bad-debt cycle for the banks). A 25bp lift in margins from FY23E, would imply mid-single-digit earnings upside to consensus forecasts in FY24E. Higher RBA cash rates are likely to provide the cover for out-of-cycle rate increases, directly benefiting net interest margins.
Valuation premium has expanded to a decade high: CBA’s PER and PER relative to the sector has expanded to a decade high. This is partly explained by CBA currently underearning on low margins. On P/B basis 2.4x, compares to 2.5-3.0x over the 2013 2015 period when banks were in an earnings sweet spot. 12-month forward dividend yield of ~4.0%, the lowest of the majors, is partially offset by the prospect of a small lift in the dividend payout ratio, and further capital management over the coming 12 18 months.
Hold recommendation given strong operational momentum and cycle tailwinds for Australian banks. Valuation premiums need a catalyst to unwind, and we think this is unlikely over the coming 12-months if CBA can continue to take market share and execute cleanly. An outright negative view of CBA also looks challenging in the early stages of an interest rate tightening cycle. Our preferred bank exposures are National Australian Bank (NAB) and Westpac Banking Corp (WBC).
Risks to investment view
Upside risks relate to stronger than expected cost control, mortgage repricing, and further market share gains. Additional capital management initiatives would also be well received.
Key downside risks include further deterioration in interest margins, lending competition intensifying, and a material slowdown in credit growth. A significant and rapid fall in house prices would present a risk to the share price.
CBA’s current premium valuation presents a risk if CBA were to show a slowing of its earnings growth and market share gains, or if peer banks displayed stronger operational performance.
Retail bank key to CBA's premium rating
- CBA has been able to generate consistently higher returns on equity relative to peers for more than two decades. The earnings power of CBA’s retail bank drivers the higher ROE.
- The retail bank represents ~55% of CBA group earnings. CBA’s market share in retail/consumer banking at ~34% (well ahead of its nearest peer with only 16%)1. CBA has been able to increase its market share over the last 2 years.
- CBA’s scale advantage in branch numbers, customer numbers, and lending book (~10% larger than peers) has been converted more successfully into the digital world than any of its peers.
- CBA now has the largest digital customer base both by number and percentage of its customers that are digitally active. Increasingly, we are seeing CBA use this technology as a platform to broaden the product offering to clients at a faster rate than peers.
- Scale explains only part of CBA’s ~20% ROE advantage vs peers. Relative to rivals, CBA’s retail bank has a cost to income ratio ~20% lower (2015-2022). This is a key factor in driving CBA’s higher return on equity (ROE), and valuation premium. The lower cost to income reflects the rewards of an ‘investment dividend’ where CBA is benefiting from prior years of technology/systems spending.
- At a time when some of its peers are being forced to lift investment spending to address regulatory issues, CBA can direct a higher proportion of its investment spending into revenue facing activities rather than compliance and regulatory spending. Westpac (WBC) is spending 70-75% of its investment spend over FY21-22E on regulatory compliance vs CBA at ~45% as WBC plays catch-up to the sector in this area.
- Ultimately, we see core banking as being a homogenous experience where returns on equity between players converge over time. Only operational excellence and the cost of the capital provide areas for differentiation.
- Within core banking, retail banking in our view offers the strongest defence against the long terms threat of returns convergence. SME lending, wholesale banking, and markets are all more vulnerable to generating homogenous returns between industry players. Of the major banks, CBA has the largest retail bank, almost 50% larger than WBC by earnings and 10% larger by branch network. Retail represents 55% of group earnings (vs peer average 42%). In our view, this provides CBA with a stronger economic moat relative to peers.
- Looking forward to the next 2-3 years, we believe it’s unlikely that CBA’s lead in retail banking will be eroded given its current competitive position.
Our thoughts on valuation
- Earnings-based valuation measures like PE, and dividend yield, have CBA’s share price trading at the top-end of its historical valuation bands. This suggests a degree of caution in terms of chasing CBA too aggressively from here. The offset is that the bank sector is currently underearning relative to mid-cycle ROEs, which is inflating near term earnings multiples.
- Looking at a price to book measures avoids the earnings debate. CBA P/B basis of 2.4x, compares to 2.5-3.0x over the 2013-2015 period when banks were in an earnings sweet spot.
- We are reluctant to have a more negative stance on CBA given the likelihood of operational momentum continuing. This needs to be watched closely as mortgage and SME lending growth has slowed over the last few months, whilst house price growth in Sydney and Melbourne looks to be rolling over. CBA is still growing assets ahead of peers.
- In the short term, ongoing capital management should also support the share price. CBA is less than 10% through its $2bn on-market share price buy-back, which is likely to be supportive of the share price over the coming months.
- We continue to see mild upside risk for CBA dividend relative to market estimates from both an earnings and dividend payout ratio in FY22E and FY23E. Further capital management over the next 2 years remains a possibility, although we expect any further capital management is likely to be modest.
- Our preferred major bank exposures are NAB and WBC.
