CBA: Result 2015 and rights issue

You can see why it's taken a little while for Commonwealth Bank (CBA) to get its capital raising together. Yesterday the bank issued the small matter of 11 ASX announcements (excluding a change of shareholding notice for OzForex), totaling 449 pages – and that's without the retail offer document. Most of it is very dull and very uninformative: lots of 'cultural change driving service and efficiency benefits' and the like.

In amongst it all, though, you can clearly see why CBA is our favoured bank. For starters, its ratio of shareholders' equity to risk-weighted assets (the 'common equity tier one capital ratio') comes to 9.1% on APRA's measures ahead of its capital raising, and 10.4% after (although this will fall below 10% after the final dividend is paid), compared to 9.3% for ANZ and 9.4% for NAB. We'll have to see where this number lands for Westpac after it announces its further capital raising plans, presumably alongside its third-quarter update on Monday, but it starts from below 9%.

Second, deposits amount to 62% of total assets (down 1% on last year, but in line with 2013). ANZ boasts a similar number, while Westpac comes in at 59% and NAB at only 53%. Depositors are typically less demanding about the returns they get than the investors that supply wholesale funding. They also tend to be slower to remove their funding when a banking crisis looms (not least because deposits with authorised Australian banks are guaranteed up to $250,000 by the Government).

Retail focus

Third, retail banking contributes 42% of CBA's net profit, which swells to 66% if you include BankWest, New Zealand and Wealth Management. Again, we – the retail market – are the people that are too busy (or too lazy) to hunt around for better banking services. And while retail banking brings exposure to the housing market, individuals tend to default on their debts in a more predictable fashion than businesses, which are prone to occasional massive blow-ups.

Next comes the sheer size of the numbers. The net profit CBA reported yesterday – as you'll probably have heard – amounted to just over $9.1bn, which compares to about $7.5bn for ANZ and Westpac in the 12 months to March and $5.9bn for NAB. It made that profit on $52bn of shareholders' equity, which is also more than its rivals, although only slightly due to its higher return on equity (of which more below).

Backing up the big financial numbers are big market share numbers: 29.5% of household deposits, 25.1% of home loans and 24.5% of credit cards. Overall, 34% of people named CBA as their 'main financial institution', up from 33% in 2014, with a remarkable 46% of 18-24 year olds. Amongst older age groups, however, the share slips back into the high twenties. Management sees this as a major opportunity if it can use its lead in technology to hang onto its younger customers.

Now of course the other big banks are so named for a reason, but CBA has a significant advantage and it's amplified by its retail and geographical focus – marketing and technology spending just goes that little bit further.

Superior performance

All this is reflected in CBA's financial metrics, most notably return on equity, on which it is first among equals, with a figure of 18% (on a cash basis and ahead of the forthcoming capital raising), compared to 16% for Westpac, and 15% for ANZ and NAB. And this superior performance is achieved in spite of CBA's more comfortable capital position mentioned earlier.

Yesterday's full-year results only emphasised these points. The cash profit of $9.1bn was in line with expectations and 5% higher than last year – way down on the 10%-plus rates of growth we've seen in recent years, but still perfectly respectable in a low-growth environment.

In some ways we're actually quite pleased to see that the bank isn't stretching too hard for growth. While it extended its lead in deposits, for example, with growth of 11.6% compared to 9.5% for the market, it lagged the market in home lending, due to a less aggressive offering in broker and investment lending, and credit cards, due to its non-participation in the zero-balance transfer market. While its competitors fight for these scraps, CBA is able to get along pretty well without.

Margin falls

Which is not to say that the market isn't competitive. With interest rates falling, the net interest margin contracted to 2.09%, from 2.14%, much of it due to lower income from Treasury and Markets. Without these, the margin fell from 2.04% to 2.03%.

Cost growth was pegged to an underlying 2.9%, largely due to improved productivity, and the cost-to-income ratio dipped by 0.1 percentage points to 42.8%.

The charge for loan impairments was up 4% on last year at $988m, but remained at the same skinny 0.16% of average loans outstanding. The same charge in 2009 was 0.73% – if that was repeated it would add about $3.7bn to the impairments charge and knock almost a third off profits. The future long-run average is probably somewhere between these two figures: if you assume halfway then you'd need to knock about 15% off CBA's profit to get to an underlying level across the cycle.

And that's what puts us off. The $5.61 of cash earnings per share gives a multiple for the stock of about 15, but it rises into the high teens if you plug in a higher impairment charge.

Entitlement offer

So what price CBA? Before we get to that, we need to consider the entitlement offer, under which shareholders will get the right to buy one new share, at $71.50, for every 23 shares they held before the announcement. The shares will start trading again (probably on Monday) without this entitlement which, based on the $82.12 price before the announcement, would imply a price of $81.68. That will fall by a further $2.22, to $79.46, when the stock loses its entitlement to the final dividend on 18 August.

Importantly, shareholders can sell their right to buy new shares (starting with an implied price of $7.96, given that the new shares won't get the final dividend). Better still, if you just do nothing, then the company will sell your 'rights' on your behalf and send you the money. This means you have the choice of stumping up the new cash or being fairly compensated for any dilution on account of not doing so (unlike with ANZ, for example, where individual shareholders will be diluted if they don't take up the share purchase plan at least in part).

As a result, the decision about whether to take up the offer basically comes down to whether you want to invest more in CBA at its current price (and with no broking fees) – there is no gun to shareholders' heads. The documentation for the retail offer should arrive in the week beginning 24 August and the offer will close on 8 September. See our guide to retail share offers for a fuller explanation of all the options.

After the steep falls this year, we're slightly closer to buying CBA than we are to selling, but we'll need a wider margin of safety before we do so. We're nudging our Buy price up to $70 and our maximum recommended portfolio weighting to 10%. For the banking sector as a whole, we recommend limiting your exposure to 20% of a risk-tolerant portfolio or 10% for more conservative investors. HOLD.

Note: Our Income Portfolio owns shares in CBA and Westpac.