Commonwealth Bank/Ralph Norris

Aggressively recommending Commonwealth Bank (CBA) shares on the appointment of Ralph Norris has already proved rewarding. Ralph's done pretty well for a Kiwi! However, the "cultural change" we are backing at CBA, from a sleepy ex-Government entity to a high performance entity, is only just getting started. So far you have only seen performance measures slightly improve, or in some case stop deteriorating. They grey cardigans are on the way out, and the Zegna suits are on the way in.

We believe there is huge medium-term upside for CBA shareholders in the bank embarking on some sensible, and well managed, risk taking. CBA has previously been extremely risk adverse, yet we think that is about to change.

Walter Wriston, the former Chairman of Citicorp, once said "all of life is the management of risk, not its elimination".

It seems the "old" CBA believed in "risk elimination", but we suspect those days are behind us, and the ramifications for potential earnings and dividend surprise over the next 5 years are large.

Sensible risk-taking

One of the most powerful themes in our rationale for preferring CBA is its ability to sustain a superior level of Economic Return (Figure 1). The bank continues to outclass the competition in this measure, generating almost 45% on an annualised basis in the recent interim period. We believe this has been largely due to a strong risk culture that focuses on optimising risk (not minimising risk!) and maximising returns.

In addition to approaching risk in an integrated fashion (managing credit, market and operational risks), the bank is also targeting capital efficient business segments for profitable growth. These include the traditional retail banking, transaction and wealth management businesses, as well as treasury earnings and infrastructure investments that capitalise on the bank's significant balance sheet strength, scale, distribution reach and relationships with corporates.

Strong risk culture

Our key takeaway from the recent Premium Business Services market briefing is the application of integrated risk management to generate earnings. The division's Global Markets & Treasury business acts as a central banker to CBA's business and service units. While its main responsibility is to manage non-traded market risk, we believe the business is also emerging as a force in capital market trading, based on its newly established entrepreneurial spirit.

The manner in which trading income is derived largely reflects the bank's overall risk philosophy - that any incremental risk undertaken by the bank should generate proportionately higher returns. In addition to volatility, our bank analyst TS Lim has come up with proprietary measures to assess the bank's productivity and efficiency in generating trading income.

Figure 1 - CBA leading the pack in 1H07 Economic Return

Source: Company data and SCE estimates

A low risk investment

We estimate the volatility of the major banks' trading income over the last eight years in Figure 2. Our analysis suggests CBA has the lowest volatility of all the comparable major banks with ANZ and WBC not far behind. This supports our view of CBA as a low risk investment proposition.

Figure 2 - Lowest trading income volatility compared with benchmark banks

Source: Company data and SCE estimates

Growing without comprising risk

TS has also come up with a measure to assess productivity in generating trading income. This is based on growing the income for a given level of risk. Banks that generate proportionately higher trading income for lower risk are considered more productive. Our analysis indicates CBA is one of the more productive banks in the world in trading income productivity (Figure 3). Unlike Figure 2, the bank significantly outperforms ANZ and WBC because of better risk leverage.

Figure 3 - Doing something right: higher returns for lower risk

Source: Company data and SCE estimates

Upside in trading income efficiency

TS suggested in a paper dated 8 December 2006 that CBA's Value at Risk (VaR) remains conservative next to its peers. This is reflected in Figure 4, where CBA trails the aggressive and possibly riskier ANZ and WBC given a level of VaR.

VaR can be viewed as risk or economic capital necessary to support trading activity, and the above ratio notionally measures trading income efficiency. While CBA's Economic Return on trading activity is believed to be in excess of 50%, we feel the bank is well positioned to generate even higher returns based on:

• Quality management and execution capabilities;
• Mindset shift towards risk optimisation; and
• Willingness to consider new initiatives given its new entrepreneurial spirit.

We estimate CBA could comfortably add a further $325m trading income without substantially raising its risk profile. This equates to around $200m increase on the bottom line, potentially adding $2.00 to the share price.

Figure 4 - Level of trading income reflects conservative risk nature of CBA

Source: Company data and SCE estimates

Wealth management makes CBA cheap

The highlight of the recent bank reporting season was the performance of the banks with significant wealth management divisions. In addition, at the recent WBC and SGB result's presentations, both CEO's confirmed the strong profit contribution of wealth management and the commitment to future growth. Our long held view is banks with a higher proportion of earnings generated from wealth management will outperform the peer group in an environment of declining net interest margins. In this context CBA is the clear industry leader with nearly 20% of earnings from wealth management compared to 12% from SGB, 11% from NAB and WBC, followed by just 4% from ANZ. In addition, CBA/Colonial remains a clear leader in retail funds under management with roughly 14.5% of the total.

At the strategy update CBA confirmed that the wealth management division remains a key driver of group earnings. The two important issues from the presentation were; firstly the commitment to breaching the cultural divide with traditional banking and funds management, and secondly to focus and promote the scale of the wealth management business through the FirstChoice platform. The bank has introduced a remuneration scheme to allow greater profit share for performing staff to incentivise the growth of retail FUM. We view this as a very important issue, and CBA is leading the industry in an attempt to change the culture and incentivise staff more in line with the financial planners of the listed pure fund managers.

The challenge for the major banks is to achieve a re-rating for their wealth management divisions more consistent with the listed pure plays which trade on 22x to 23x prospective earnings. We believe CBA can achieve a further PE re-rating driven by the recent fund management initiatives and the scale advantage over the peer group in a 12% pa growth. In this context, our analyst T.S.Lim has applied a pure play market multiple to CBA's wealth management business which highlights the inherent value in the traditional banking operations. In fact despite the consensus view that CBA is expensive on a PE basis versus the peer group, our analysis confirms CBA remains the cheapest of the major banks with the exception of ANZ as you can see in the chart below.

$62.50 12-month price target, maintain Buy

Based on expectations of lower managed risk, TS has upgraded CBA's 12-month price target to $62.50 (previously $59.00). CBA remains our top major bank pick and we have maintained our Buy recommendation. The price target is supported by the bank's superior Economic Return (refer Figure 1), and upside from targeting additional capital efficient business segments, e.g. treasury earnings and infrastructure investments, and improving trading income as mentioned above. In terms of potential trading income leverage, NAB remains our second major bank pick.

CBA is 5.86% of the ASX200 index, yet 55% of the register is held by "mums and dads", making it impossible for domestic institutional investors ever to be market weight as a group, let alone overweight. Those "mums and dads" will simple not sell CBA shares while dividend growth remains strong, and we forecast a minimum of 10% dps growth out through fy10.

The point I am trying to make is that CBA has a very tight register relative to its index weight and scale, and any good news on earnings and dividends will multiplied in the share price due to the relative lack of liquidity.

If you buy CBA today you will be on the register for the fy07 result and dividend in mid- August. TS currently forecasts that fy07 final dividend to be 143c ff, yet at the interim CBA delivered clear dps surprise, and you could easily see a 2H (final) dividend of 150cff. The year after, fy08, we forecast dps of 272c (again, a number we consider conservative). On a 15-month view you will be paid a minimum of 415c by CBA in fully franked dividends, which is a 7.5% ff yield. More likely you will be paid 430c, which is a 7.8� 15-month yield. In after tax terms that 15-month rate will beat any unfranked cash deposit rate. Get your money out of the bank, and get it into CBA shares.