Despite serious challenges, the Commonwealth Bank remains in a strong position and its exposure to the Australian property market is a help not a hindrance, says Morningstar senior equity analyst David Ellis.

In his latest note on Commonwealth Bank (ASX: CBA), Ellis says the bank, Australia's largest lender, remains undervalued, and its fair value estimate intact at $83. CBA closed at $75.17 yesterday – a 10 per cent premium to FVE.

The bank will report its earnings on 8 August, and Ellis is upbeat despite some headwinds, which include regulatory changes, business restructuring, asset sales, and demerger plans.

"Our positive view is based on the bank's robust balance sheet, dominant market positions, strong profitability, organic capital generation capability, sound loan book and high returns on equity," Ellis says.

Assessing underlying expense growth will be "messy", however, with headline expense growth tipped to exceed revenue growth, Ellis says.

"We forecast an underlying $9.9 billion cash profit and a fully franked dividend of $2.30 a share, taking total dividends to $4.30 a share.

"We expect to see good business momentum in fiscal 2018, with customer deposits estimated to increase 5 to 6 per cent and loans up by 4 to 5 per cent."

The forecast excludes the $700 million fine the CBA incurred last month following an Austrac investigation into money-laundering and terror financing.

CBA banks lenders Comyn big four article

The Commonwealth Bank of Australia remains undervalued, Morningstar says 

On the vexed question of housing, Ellis says media commentary pointing to a crash in property prices is exaggerated and that CBA's loan book is high quality.

"Some market investors consider CBA's strong emphasis on home loans a weakness," Ellis says, "but we argue it is a key strength. In our view, concerns centred on a housing crash are overdone.

"The Australian housing market appears to be weakening, but at this stage we expect an orderly correction in average house prices, with only minimal impacts to the major bank profits."

Ellis concedes a sharper-than-expected decline in average house prices could increase loan losses were it to coincide with a spike in unemployment and weaker economic conditions.

And while housing is expensive and debt/household income ratios high, Ellis says Morningstar is comfortable with CBA's exposure.

Key factors that may mitigate potential losses include tight underwriting standards, lender's mortgage insurance, low average loan/valuation ratios, a high incidence of loan prepayment, full recourse lending, a high proportion of variable rate home loans, and the scope for the RBA to cut interest rates.

"We cannot rule out falling home prices," Ellis says, "but investors who readily compare the Australian residential market to that of the US and other markets are ignoring fundamental differences."

The forecast is built on the several factors, which include:

  • At the end of last year, the CBA’s average loan/value ratio for the Australian portfolio was 50 per cent, based on current market values.
  • About 77 per cent of customers were ahead with their payments by an average of 33 monthly payments (including offset balances).
  • The bank's allowance for an interest rate rise of 225 basis points in its serviceability tests.

To that end, Ellis says if short-term interest rates remain at current elevated levels, he would expect the major lenders to implement out-of-cycle rate rises in the next few months.

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Lex Hall is a Morningstar content editor, based in Sydney.

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