Commonwealth Bank of Australia (ASX:CBA) is a play on household and business conditions in Australia. Given that, we like some of the signs coming out of the major bank after its first-half results, including a relatively upbeat outlook from management and positive signs for credit growth.
There are other things we like with the CBA, including cost control and very strong capital position; that, along with size and liquidity and good credible management, helps explain why CBA has the lowest RR of all stocks covered by our StocksInValue service. We’ll look at some of these more closely lower.
Yes, there are risks, including, the fact that provisioning for bad debts has fallen to near historic lows, which exposes the bank to worse-than-expected economic outcomes.
Overall, though, things are looking pretty good for CBA. That said, and as you’d no doubt expect, it all comes down to value. And while we’re positive on CBA, we believe the bank is trading above value, and you’re better off waiting for a dip in the share price to buy.
Management is pretty confident
In mid February, CBA reported its first half results. The media and brokers have trawled over the results, so we won’t get bogged down in the detail. But it did help us clarify a few things regarding performance and outlook.
Firstly, management was cautiously upbeat about the rest of 2014. The bank said global market volatility had suppressed business confidence and kept a lid on the non-resource sector, other than housing.
But it also said there were positives: developed economy growth forecasts have improved; holiday season consumer spending rose from last year; corporate balance sheets are strong; the housing sector is showing positive activity; and the Australian dollar has become competitive.
“Overall, the Group continues to assume that any improvements in economic activity in the next year will be gradual rather than dramatic.”
We’re pretty confident about credit growth, too
CBA’s comments are consistent with recent banking system credit growth, which is off its lows in each sector, though still historically anaemic. In the absence of shocks to consumer and business confidence we expect a gradual increase in credit growth.
CBA, which has the second-largest loan book in the Australian banking system, should benefit. CBA’s average interest-earning assets grew 6% over the year to 31 December 2013 and 5% over the previous six months.
Productivity growth is also good, and capital ratios are ahead of requirements
Another thing we liked was tight cost control. In the half, operating expenses grew 6% on the previous corresponding period and 5% on the prior half, but the ratio of operating expenses to income improved in each comparison because total revenue grew faster (8% and 6% respectively) and technology implementation continued to enhance productivity. There should be further gains from this source.
CBA’s capital position is also very strong, which dampens NROE (Normalised Return on Equity) but reduces the risk of an equity raising to recapitalise if bad debts expense does rise substantially above expectations.
Bad debt provisioning at historic lows is a risk, though
There are risks, however. One of our major concerns is that provisioning for bad debts has fallen to near historic lows, which exposes the bank to worse-than-expected economic outcomes.
The worst case for CBA shareholders is a hard economic landing in China causing a recession in Australia, a sharp rise in unemployment, a sharp fall in domestic property values and a spike in bad debts. Should this scenario, or a recession for any reason eventuate, CBA is unprepared with its historically low provisioning. A return of bad debt expense and total provisioning to 20-year averages could detract $500m and $1.3bn from earnings respectively. These figures compare with our FY14 NPAT of $8.5bn.
An economic contraction of any degree is not our base case but the probability is not zero. If the credit quality environment remains benign CBA can probably lower provisioning ratios a few basis points further and continue to augment earnings growth as it has. Over the last three halves all the reduction in provisioning has been against specific or particular individually assessed loans, with collective provision expense and economic overlays steady.
What is CBA worth?
Below is a screenshot from the Future Value tab for CBA (from StocksInValue) showing our adopted metrics, consensus metrics, and consensus forecast earnings and dividend growth. The only departure from consensus on earnings and dividends is the FY14 dividend, where we are marginally (1%) lower.
Figure 1. Future valuations of Commonwealth Bank of Australia
Source: StocksInValue
We left our adopted metrics unchanged after the 1H14 result. The 24% NROE is deliberately slightly below consensus for conservatism.
For those who are technically minded, the output of the valuation algorithm is a combined equity multiplier of 2.47x. Although adopted NROE is more than twice RR (Required Return), the normalised payout ratio (D/NROE = 20/24) is a high 83%, which reduces the multiplier. This is deliberately conservative, to retard intrinsic value growth slightly, compared with 75% in FY13 and 73% in FY12.
Basically, CBA shares are currently trading about 4 per cent above our projected 30 June 2015 value of $73.07.
We believe investors should seek a rate of return sufficient to compensate them for the risk of investing in a company’s equity.
If the stock were to drop by about 10 per cent, versus the current market price, to about $65.50 per share, it would produce approximately a 19% return over the 15 month period to that 30 June 2015 date, including two projected dividend payouts. This is about the figure we would be looking to generate as an appropriate return for the risk involved in an investment in this company.
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