The largest of Australia's big four banks, wide-moated Commonwealth Bank of Australia, has retained its fair value estimate of $83 despite industry headwinds and management missteps. 

In his analyst note dated 9 October 2018, Morningstar equity analyst David Ellis says his positive view is based on the bank's robust balance sheet, dominant market positions, strong profitability, organic capital generation, sound loan book, and returns on equity.

Also on 9 October, CBA (ASX: CBA) announced it would start rebating all grandfathered commissions to Commonwealth Financial Planning customers from January 2019, benefiting some 50,000 customer accounts by about $20 million annually.

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CBA maintains a robust balance sheet, dominant market positions and strong profitability

The cost of owning up to this – and other errors and omissions that may go back many years – is not only ongoing reputational damage but also the loss of customer trust. The latest example of this is a survey conducted by OmniPoll published on 10 October in which Commonwealth Bank comes off worst of the four majors.

The survey shows that, although each of the big four banks experienced an increase of about 20 per cent in negative sentiment over the past 18 months, almost 50 per cent of Australians have unfavourable impressions of CBA compared with some 40 per cent for the other three.

On the same day, law firm Slater & Gordon filed a law suit against CBA's wealth management arm Colonial First alleging the parent bank pushed members' retirement savings into uncompetitive funds that it controlled. CFS members could have been receiving returns as low as 1.25 per cent, that is below the record-low Reserve Bank of Australia cash rate of 1.5 per cent.

Despite this reputational risk, the bank's financial risk is reduced by the twin pillars of a high proportion of customer deposits and the loan book's large weighting to home loans.
Although many investors are concerned about a significant slump in the Australian housing market, Morningstar remains comfortable for several reasons, says Ellis.

"Any losses on mortgage lending are mitigated by 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 interest rate cuts by the Reserve Bank of Australia," he says.

Numbers underpinning the high-quality loan book include an average loan/valuation ratio of 50 per cent (for the Australian portfolio based on current market values); an allowance of 225 basis points being built into serviceability tests; and about 78 per cent of customers being ahead with their payments by an average of 32 monthly payments (including offset balances).

CBA's exposure to higher global interest rates, fears of which were stoked by the recent surge in US Treasury 10-year bond yields, is limited given that just 32 per cent of total funding is from wholesale funding markets.

Customer deposits comprised 68 per cent of total funding at June 2018. Its superior credit rating and strong reputation in funding markets enable it to raise the remainder from securitisation, hybrids and wholesale funding (about 30 per cent of which was sourced within Australia).

The bank plans to demerge the Colonial First State Group by the end of 2019. This will see Colonial First Global Asset Management, Colonial First State, Count Financial, Financial Wisdom and Aussie Home Loans hived off into "NewCo".

Ellis says, "At this stage, Morningstar has not demerged NewCo from our forecasts or valuation but the impact to NPAT is at least $500m from fiscal 2020 and beyond, all else being equal."

In addition, the $3.8bn Life Insurance sale is expected to complete before the end of calendar 2018. Assuming successful completion of both CFS Group and Life Insurance, Morningstar expects a return of surplus capital to shareholders in fiscal 2020 via a likely share buyback.

Risk management at CBA needs material improvement following a string of prudential, compliance, procedural and regulatory issues; and a wide range of economic, regulatory, reputational and business challenges persist. Despite the challenges, the longer-term earnings and dividend outlook remain positive although Morningstar expects lacklustre financial performance for the next 12 months.

Despite industry headwinds and management missteps, Commonwealth Bank's diversified revenue stream, well-managed net interest margins, sound asset quality and string balance sheet continue to consistently deliver solid financial results.

In the long run, the bank has consistently increased shareholder wealth in favourable economic times.

"We believe the bank will navigate through management missteps and continue to benefit from strong competitive advantages delivering long-term returns on equity comfortably above our 9 per cent cost of capital," says Ellis.

 

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Roger Balch is a contributor for Morningstar Australia.

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