CBA: Result 2019

The headlines might have you believe that the fallout from the Royal Commission is Commonwealth Bank's biggest challenge. Those challenges, however, pale against the sheer dominance of the bank in the domestic market.

Whilst the bank's reputation was hit, provoking regulatory sanctions and the promise of cultural change, CBA accounts for over 24% of Australia's lucrative home loan market and more than 28% of household deposits. These factors, along with a solid technological lead, mean its position as the country's premier retail bank is beyond doubt.

 Trading conditions, however, are challenging. Home loan market growth, at 3.5%, is near the lowest in 20 years. The company's loan book grew just 2% overall, with home loans up 4%. Although there are some signs of a pick-up in home lending, it's unclear whether this will endure.

Profit pressures

Low interest rates were the primary cause of the group's net interest margin falling to 2.10% from 2.15% a year earlier. CBA has some options to manage margins, such as reducing deposit rates, but that's getting harder to do so. With rates nearing zero, there is less room to move.

Whilst loan loss rates remain low by historical standards at 16 basis points (0.16% of loans) it has not yet been adequately tested. It may soon enough; it is clear the Australian economy is slowing and a downturn will raise loan losses.

Fee income - those pesky annual credit card fees and ATM withdrawal charges - is falling, too. CBA took in $275m less in fees in 2019; more than $415m on an annualised basis. It may not sound much compared to the bank's revenue, but these fees typically fall straight to the bottom line.

Costs, meanwhile, are rising, up 2.5% on the year, largely thanks to $2.2bn in customer remediations to date, a direct result of the Royal Commission. There is every chance this number will rise further.

Down the track, increased spending on risk management and compliance might improve conduct but doing so is costing a pretty penny. There will be no respite from higher costs even after remediation charges are cleared. Those looking for careers in risk management or compliance know which door to knock on. 

About 64% of the bank's $1.4bn in investment spending last year went on compliance and risk management, up from 50% in the prior year. Last year, about 1,400 staff were involved in such activities. Now, there are around 2,000. Costs aren't coming down anytime soon and we need to factor in higher operating costs. CBA won't be able to cut costs to match lower revenue growth.

Changing capital needs

Given these headwinds, this was a creditable result. Cash return on equity fell to 12.5% from 13.6% last year, with cash profit on continuing operations down 5% to $8.5bn, due to low loan demand, falling margins, and fee income cuts.

The bank is playing to its strengths, focusing on traditional banking to retail and business customers in Australia and New Zealand, whilst being cautious on some forms of corporate lending. With these segments accounting for about 90% of earnings, it makes sense to retreat to areas of strength.

Accounting for intended divestments, CBA's pro-forma common equity tier 1 ratio would be 11.8%, well ahead of the 10.5% regulatory requirement by the start of 2020. It might even allow for additional returns to shareholders, although the bank may retain additional capital to satisfy increased regulatory requirements. Higher capital ratios make the bank safer than in the past but it also means it will be less profitable in the future. The more capital is held back, the less can be put to work generating returns.

The bank may need an additional NZ$3bn for its New Zealand operations and a further $13.6bn - primarily debt - by 2024 for its Australian operations. Even a business of this size, with its financial firepower, remains dependant on international capital markets. Shareholders should be aware of that.

Whilst profitability wanes, with little growth at present and not much prospect of it for a few years, CBA remains Australia's premier retail bank. It deserves a premium valuation to its peers, although at twice book value and facing a weakening outlook, it is far from cheap.

Members should focus on the returns from the dividend rather than capital growth as the primary source of prospective returns. That being the case, if your portfolio weighting is nearing our recommended maximum level of 8%, now might be a good time to reduce exposure. If not, HOLD.

Note: Our Model Income Portfolio owns shares in CBA.

Note: The Intelligent Investor Equity Income Fund owns shares in CBA.