CBA's secret weapon

PORTFOLIO POINT: Its new billion-dollar technology system is set to give CommBank a marked lead over its competitors.

When Westpac chief economist Bill Evans forecast lower interest rates for Australia in the year ahead he wasn’t not only recognising the severity of the downturn in the non-mining parts of the Australian economy (click here).

He was also forecasting a deep crisis in Europe and a recession in the US: events that would trigger another leg down for Japan as it recovers from the shocking March earthquake, and place the Chinese economy under serious pressure for the first time since the global financial crisis.

These fears have returned with a vengeance. It was possible that the massive amount of liquidity in the system would underpin a major rally in risk assets but the truth is surfacing and sending the money back to typical safe havens such as gold, US Treasuries and Swiss francs.

The banks of Europe are in serious trouble and I believe this will ultimately infect the US. Accordingly our markets may have further to fall.

I hope by now all Eureka Report subscribers have taken the opportunity to adjust their equity exposure to levels they are comfortable with. Those that haven’t should do so now. Markets are impossible to predict but I do not believe global markets have priced in the risks we face (for more on this click here).

As we head into these troubled times it’s important that we take stock of what our economy has in common with others and what’s unique. One important thing to remember is that Australia is home to what is probably the world’s most expensive major bank: Commonwealth Bank (CBA). But if CBA shares fall sharply in coming weeks they may represent an opportunity because of the bank’s unique position.

There is no denying that our banks did not seem to be appropriately priced when compared to their international peers. But they are also much more successful. The Commonwealth Bank is arguably Australia’s largest and most successful banking operation.

Next December Ian Narev will take over from Ralph Norris as chief executive. The general view in the investment community is that Narev’s main challenge will be to keep the bank on a steady course during tougher times. While that challenge is made more significant by ructions in financial markets, Narev is also facing a challenge that many Australian CEOs have handled poorly in the years gone by.

In the last part of Ralph Norris’s term as CEO, he spent more than $1 billion on building what is perhaps the most ambitious technology system ever introduced by an Australian bank, and one of the most advanced in the world. Such investments have been the undoing of many Australian companies over the years.

This time it appears that the Commonwealth Bank got it right. We won’t be sure for some time yet but the signs so far are good. But importantly, at this early stage very little benefit has been received by the organisation.

Once the introduction phase is completed, Narev will be handed an extra depreciation charge of more than $80 million a year for the next 10 to 15 years.

Norris undertook the expenditure but Narev will be the one who must use it to lift profits to justify the depreciation cost, but then to realise the potential of the technology. Like all such systems, the new CBA system is complex. Its many new features include enabling customers to better monitor their spending because it will process transactions in real time.

What this means is that rather than depositing funds into an account and having to wait overnight or longer for it to register, all transactions will be completed “live” so that customers will be able to withdraw cash or pay bills immediately. This will have enormous implication for mobile phone technology, which is going to revolutionise consumer commerce.

Norris strongly believed it was worth paying $1 billion or more to have a system that would put the Commonwealth Bank years ahead of its competitors and give it a significant advantage in the marketplace. But Narev will be the one to discover whether Norris is right or wrong. Another important part of the system is that the bank will be able to measure its productivity which, in these tougher times is vital.

In the past, banks have increased their productivity by lifting their revenue through doing more business but have never had the techniques available to reorganise their affairs to increase productivity in this manner before.

This week Westpac announced a major staff reduction program, which, in theory, should keep a lid on costs; but in practice unless you devise a different way of doing things labour costs can creep back via contracting. Narev is very confident the new system will remake the bank and give it a serious advantage in tough times.

It’s a development that needs to happen because over the years there has been a growing commoditisation of banking products. Technology groups like Google, eBay and Apple have an eye to enter parts of the banking business in the future, which puts more pressure on them to differentiate their services and stay ahead of the curve.

-The Big Four compared
Bank	ASX	Price 18/08 ($)	Market cap	12-month high ($)	12-month low ($)	Current P/E	Forward P/E	ROE (%)	Tier 1 cap	Div yld (%)
ANZ	ANZ	20.42	53.7 bn	25.96	17.63	9.62	9.41	22.48	10.8 bn	6.76
CommBank	CBA	47.32	73.7 bn	55.77	43.41	11.25	10.52	25.89	28.2 bn	6.76
NAB	NAB	23.16	51 bn	28.18	19.64	10.3	9.31	17.51	31.7 bn	6.99
Westpac	WBC	20.38	61.8 bn	25.6	17.84	10.09	9.75	21.15	26.4 bn	7.36

It’s also important that we recognise that Australian banks face their own deep challenges in this global crisis; they will not be insulated from the fallout. To find out how to protect the value of your bank shares, click here.

Although its true to say that Australian banks are now much better equipped to handle rising overseas wholesale borrowing costs than during the global financial crisis, in recent times there has been a sharp jump (about 0.4% to 0.5%) in cost of money from overseas.

This is likely to rise further and bankers worry about solvency. Most of the banks, including the Commonwealth, don’t have to go to the market at this time but if the higher interest rates on wholesale overseas borrowing were to be maintained it would lift Australian banks’ costs.

Apart from the cost of wholesale borrowing, the greatest threat to all Australian banks – particularly Westpac and the CBA – is that if there rising local unemployment it will cause bad debts. At this stage there is not a major problem but be wary of signs of trouble. A sharp rise that saw unemployment reach double digits would have a serious impact on property prices which would feed back into the banks again.

Currently many Australians are nervous about borrowing large sums of money. It is effectively a re-examination of how much debt is desirable in the community. A lot of companies and individuals are deciding to lower their debt levels, particularly in light of overseas events. This is not good for the banking sector, which needs credit growth to fuel its business.

Accordingly, in the future banks will need to gain an edge on their competitors, which is why technology and related systems are so important. All Narev and the Commonwealth Bank need to do now is execute the strategy.

Meanwhile, overseas investors are nervous about Australian banks because their shares are among the most expensive in the world, and CBA shares top the list. At times Australia’s banks have been targeted by hedge funds who have viewed the banks as a proxy for house prices.

The Commonwealth has declared a fully franked final dividend of $1.88 a share (the bank went ex dividend on August 15) to make $3.20 a share for the year. The $3.20 dividend represents about 73% of the bank’s profits and, with a share price around $46.23, they trade on a yield of 6.9%. For superannuation funds in accumulation phase, the franking credits take the yield to about 8.4%, while those funds in pension mode the yield is about 10%. These are good returns.

If the share price of the Commonwealth Bank is hit hard in the crisis, it will be worth your while gradually increasing your exposure. The combination of a quality company that is streets ahead of its rivals on the technology front represents a big advantage for investors.