Banking on high returns

PORTFOLIO POINT: Commonwealth Bank’s latest profit, and high return on equity, are strong positive signals for investors.

The Commonwealth Bank of Australia (CBA) is positioned in both my income and growth portfolios and so this week’s result was of immense interest. The announcement of a $7.1 billion profit meant that the CBA produced the largest profit ever recorded by an industrial company in Australia.

The CBA now ranks as Australia’s largest bank (market capitalisation) and it is the most profitable when ranked based on return on equity. The return on equity (ROE) at 19% is an important consideration because it gives us an insight into the potential for CBA’s profit growth in the coming year. Further, when we “normalise” the return to an owner by adjusting for distributed franking credits, then the NROE lifts to 25%. This is very impressive.

I will comment on forecast earnings later, however it is worth noting immediately that the CBA NROE (Normalised Return on Equity) is not only superior to its peers but far superior to the forecasts of the following major companies:

Source: MyClime

That observation alone should lead any investor who owns the above stocks and not CBA to question their basis of their investment logic.

Similar to my review of Telstra last week, I consider that it is important to review the CBA performance in the context of the current economic and market conditions. These conditions are not supportive of bank asset or profit growth. So how do we determine whether the 4% profit growth was good or disappointing?

Whilst Australia is not in recession and unlikely to drift into recession, the environment is affected by a worldwide desire to reduce debt. Specifically since the GFC, large corporations are not seeking debt to grow and households are not accessing credit to consume.

Apart from that headwind, the other key issues to consider are:

• The performance of CBA against its peers in growing assets and maintaining market shares across asset classes. Low credit demand certainly encourages a more competitive landscape;
• The cost of funding for CBA and its performance in holding interest margin. This is particularly pertinent for Australian banks that historically relied on offshore wholesale markets to fund excessive household debt. More recently competition for retail deposits is intense;
• The strength of the CBA balance sheet as represented by its capital ratio;
• The management of CBA’s expense ratio (cost to income) in an environment where international comparisons suggest Australian wages are high on a world scale;
• The performance of CBA’s other banking operations in New Zealand banking, or its wealth management and insurance business, and
• The quality of CBA’s credit risk management and assets as exhibited by its provisioning for loan defaults or problems.

So when we consider the moving parts, what was positive and what was negative in the result?

Funding profile: CBA continued its recent history of growing retail deposits (plus 9.1%) faster than its loan growth (plus 5.1%). This allows CBA to fund new loans from deposits and reduces its need to access offshore funding. I regard this as positive.

Return on assets: Improved 3 basis point (bps) return over the year to 0.99%. Positive.

Cost to Income: Reduced to 45.78% from 46.71% in 2011, driven by flat costs and productivity improvements flowing from a large technology spend. Positive.

Capital Ratio: Maintained its high capital ratio again and now CBA ranks amongst the top five capitalised banks in the world. Earnings growth led to a growth in dividends (to $1.97 from $1.88) and maintenance of the capital ratio. All positive.

Net Interest Margin: Declined 3bps to 2.09% during a tough period for funding. Negative.

Loan Growth: Increased 5.12%. Positive.

Bad Debts: Decreased to 0.21% of loans, down 5bps. Bad debt expense fell 15% and impaired assets fell 15% over the year. Pleasingly this indicates that asset quality is increasing. Positive.

Wealth Management: A disappointing performance, with profits falling 11% as a result of largely fixed costs and a decline in markets. Negative.

As for market share, I note the following table that indicates that CBA and WBC grew market share from 2007 largely via the acquisitions of BankWest and St George. Thus, the combined market shares of the big four banks have increased from 57.9% to 77.9% over the period. The continued strength in the Australian housing market ensures a solid stream of earnings for all the banks.

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Conclusion

I noted earlier that the high level of both ROE and NROE gives me some confidence in forecasting steady earnings growth in the coming year. Think about it this way. From its $7.1 billion of earnings, CBA retained about $1.75 billion in capital. Assuming a 20% ROE on this retained capital suggests earnings will lift by about $350 million in 2012-13, and this amounts to a 5% lift in forecast profits and dividends as well.

I am confident with this outlook because, when you scan the five-year history of CBA, you can see that the company raised significant capital in 2008-09 to shield against the GFC and to acquire Bankwest.

The company has suffered a slight deterioration in NROE but this is a feature of the higher required ratio of capital to assets under new international capital rules. The ROE of CBA is excellent and I note that the highly rated US bank Wells Fargo (held by Berkshire Hathaway) achieves about a 12% ROE.

Figure 2. Five-year financials: Commonwealth Bank of Australia

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Based on these earnings and NROE forecasts I derive an intrinsic valuation of towards $62 by June 2013. With two dividends flowing to shareholders over the period, an attractive return is achieved.

So what could affect this outlook? Well certainly much uncertainty surrounds the debt workout and restructure in Europe. Currently, markets are buoyed by the possibility of a massive quantitative easing/bond purchasing programme from late September. The risk to this is that too much is expected or that the restructure does not achieve consensus. An upheaval in Europe could affect both the cost of European wholesale debt and affect household confidence in Australia.

These are difficult times for Australian companies, but clearly the CBA has done very well on a number of measures. A steady as she goes profile is all that we need to hold this company and the possibility of a recovery in wealth management plus a sustained recovery from Bankwest, which operates in the growth state of WA, suggests a potential upside to our valuation.

Clime Income Portfolio – Prices as at close on 16^th August 2012