With Australian reporting season now well and truly over, we take stock and return to our Talking Top Twenty series. To kick things off this time around we take a look at a couple of the Big 4 banks; Commonwealth Bank of Australia (CBA.ASX) and Westpac (WBC.ASX).
When we previously spoke about the banks, the story was very much centred around Covid and its impact upon balance sheets. The issue front and centre this time round is inflation and the potential of rate hikes. To put it bluntly, there are two things that matter for the valuation of Australian banks; 1) volume growth and 2) the market view on interest rates. On the first point, a more aggressive monetary policy has the side effect of dampening loan book growth while conversely (and in relation to the second point) increasing Net Interest Margins (NIMs).
On the cash rate front, what the market is arguably telling us, using the average of 2s and 10s, is a normalised rate of 2.5% by 2024 (a drastically different situation since last writing on the banks). While we don’t necessarily agree with this, if we assume this to be the metric that we do use then the banks may have a way to go in terms of earnings expansion (with stagnant volume growth). This assumes manageable mortgage distress and bad debts.
Commonwealth Bank of Australia (CBA.ASX)
Let’s begin with the numbers. Cash NPAT of $4.746bn (compared to $3.886bn in the corresponding 1H21) with EPS at $2.73. Turning to the all important dividend, coming in at $1.75 p/s (up 25c). While the NPAT does represent a significant increase (+23%) compared to the prior year, it must be viewed in the context of Covid-related impacts. A more adequate metric may be 2H21, compared to which it remains broadly flat. NIMs continue to drop, now stabilising at around 1.96%, compared with 2.01% in the corresponding prior year. This second aspect is predominantly driven by significant growth in fixed rate loans and the need for significantly higher liquid assets (prudence measures), all of which have provided a significant headwind for the market. Growth to date has been driven by volumes with a buoyant property market and lower than expected default rate (i.e. reversal of bad debt provisions).
One thing that we have been surprised by was the rapidity with which the 1-5 year swap rates have increased, especially in relation to the repricing of the fixed rates. On the upside however, the bank now has close to a $170bn in low rate deposits, effectively meaning that the NIMs should increase by 4bps for every 0.25% rise in the headline cash rate.
Red Flags & Risks: Continued pressure on NIMs is perhaps the biggest concern and they have broadly been in line with our expectations from last year. As such, the monetary policy stance (and the RBA has undoubtedly been more dovish when compared to its global counterparts) remains the single biggest factor for the institution. Increased competition from non-bank institutions and commodification is also a factor.
My Expectations: Management continues to deliver on its strategy of streamlining the business. The most recent instance being the sell down of its stake in the Bank of Hangzhou with operational efficiencies continuing to feed through (down 3%). The valuation is very much a function of your view on the cash rate. Should we see a more aggressive stance by the RBA, the sheer volume growth for fixed rate deposits in the past 24 months should see NIMs expand exponentially above even pre-Covid levels (assuming a 2.5% headline and flatlined volume growth with minimal rise in bad debts). In that scenario we see a potential 10-15% upside to the current price to $128 per share. If, however, we use TAMIM’s house view of a dovish scenario, around 1-1.8%, then this would suggest a potentially significant overvaluation at $107 (given that increase will undoubtedly dampen volume growth).
Dividend Yield: 4.2% assuming a share price at $107 AUD and a 68% payout ratio. In absolute terms, $4.00 per share).
Westpac Banking Corp. (WBC.ASX)
Last time we undertook this exercise, this was our the least favourite of the big banks. We were reasonably and pleasantly surprised this time round; management seems to be delivering as well as streamlining with the most recent news being the sale of the NZ insurance business. Looking to the numbers, Q1 profit up at $1.58bn, cash profit at $1.58bn and (surprisingly) an increase in net interest income. NIMs fell to around 1.91%, a decline of 7bps compared to 2H21. This secondary aspect is what makes us rethink our view around Westpac. Assuming that they stabilise around this number, the share price may represent a comparative undervaluation. We continue to note that on the risk front, the business still lags the market leader, CBA, around CET1, which has declined to 12.3%, but this has been offset by increases in credit quality in our view. On the second front, stressed assets have declined by 21bps to 1.15% while provisions have been reduced by $241m, despite rather conservative assumptions.
Red Flags & Risks: The risks remain the same as last time we wrote. Those of operational efficiencies. This is a turnaround story in the works; any misses on continued delivery of the cost cutting measures and the market may be a little less understanding. Its continued concentration of exposure to the NSW housing market could potentially be a significant risk (this business is increasingly a call on the state’s property market).
My Expectations: For the first time in a long time, management seems to be ticking boxes, delivering on efficiencies and stabilising NIMs. We do expect some headwinds but also a stabilisation around this level. Assuming the upside scenario above (headline cash rate of 2.5% etc), the upside to Westpac is substantially higher at $32.15 per share or 30% (again, using the same assumptions we did with CBA).
Dividend Yield: Expected yield of 5.9%, assuming a share price of $24 and a payout ratio in line with 2019).
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TAMIM Asset Management provides general information to help you understand our investment approach. Any financial information we provide is not advice, has not considered your personal circumstances and may not be suitable for you.