We reiterate our $90 fair value estimate for wide-moat-rated Commonwealth Bank (ASX: CBA). The shares are currently trading at a 28% premium to our fair value.

First-half fiscal 2024 profit fell 3% to $5 billion. Our full-year forecast of $9.7 billion implies a slightly weaker second half. We trim our fiscal 2024 net interest margin (“NIM”) forecast by 3 basis points to 1.97%, but the impact on profit is offset by modestly lower bad debt expenses and higher noninterest income.

Shrinking NIM, down 11 basis points from first-half fiscal 2023 to 1.99%, reflects industry headwinds from customer deposit price competition and switching, and home loan discounting.

We expect margin headwinds to persist in the second half. The bank prioritized profitability over volumes, evidenced by market share loss in the last 12 months, but did lower home loan rates in December 2023, which we expect steadies market share but weighs on margins.

Operating expenses are rising on inflationary pressures, bad debt expenses, and arrears are low, and the capital position is strong. The bank declared a fully franked interim dividend of $2.15 and we forecast full-year dividends to increase around 2% compared with fiscal 2023 to $4.60. Our forecasts assume a payout ratio of 79%, the top of management's guidance range.

Over the next five years, we assume rational competition returns for pricing loans and customer deposits. Most Australian banks, excluding Commonwealth Bank, face single-digit returns on shareholders' equity in fiscal 2024, compared with our assumed 9% cost of equity, supporting our view that current loan and deposit price competition is unlikely to persist indefinitely.

Our positive view on the outlook is more than priced in at the current share price. On a fiscal 2024 price to earnings (“P/E”) of 19.5 times and a dividend yield of 4%, we see better value in peers. Westpac (ASX: WBC) and ANZ Group (ASX: ANZ) trade on forward P/Es of 12.5 times and dividend yields around 6%.

Business strategy and outlook

Commonwealth Bank of Australia is the largest of Australia's four highly profitable, wide-moat-rated major banks. It offers a full suite of banking services in Australia and New Zealand. In the long run, the bank has consistently increased shareholder wealth in favorable economic times. The loan book's large weighting to home loans and the high proportion of customer deposits reduces risk on bad debts and sudden changes to funding costs.

While Australian housing is expensive and debt/household income ratios are high, we remain comfortable for several reasons. Tight underwriting standards, lender's mortgage insurance, low average loan/valuation ratios, a high incidence of loan prepayment, full recourse lending, and a high proportion of variable rate home loans combine to mitigate potential losses from mortgage lending.

With cash rate increases to combat high inflation being swift and large, the risk of higher credit losses has increased materially. It also reduced demand for credit. We expect modest credit growth and margins easing in fiscal 2024 after a strong rebound from 2022 lows.

Operating expenses will continue to rise due to inflationary pressure and the bank investing to capture growth opportunities, this despite productivity improvements being realized.

Bad and doubtful debts expense peaked in first-half fiscal 2009. Elevated loan losses in fiscal 2020 were entirely due to loan loss provisions. With large provision balances, and economic conditions improving, loan losses are expected to be moderate in the short term.

A string of divestments plus strong organic capital generation see the bank retain a strong capital position even after completing share buybacks.

Moat rating

Read more about how identifying a company with a moat impacts investment results.

We assign Commonwealth Bank of Australia a wide moat based on durable cost advantages and switching costs. Commonwealth Bank is the largest of the four major Australian banks, which combined control just under 75% of business and consumer lending, and a similar share of deposits. It’s virtually the same market structure in New Zealand, although Commonwealth Bank is the second largest player there behind Australian and New Zealand Banking Group. With over 16 million banking customers it has the largest single brand retail branch network, most active digital customers, and largest market share of home loans and credit cards.

Despite regulatory changes lifting capital requirements, the bank’s large loan and deposit books continue to deliver robust net fee income, and with the increasing importance of scale to cope with changes in technology and regulation, Commonwealth Bank should consistently earn returns above its 9% cost of equity through the cycle.

Bank moats are typically derived from two sources: cost advantages and switching costs. Cost advantage is an important source of the bank's wide economic moat, and supported by a low-cost deposit base, operating efficiency, and conservative underwriting relative to peers. Given the commoditized nature of the industry, and competition for both loans and deposits, low costs is key to achieving excess returns.

The ability to provide customers a full suite of products, and marketing to support already well-known and trusted brands, has historically allowed the major banks to charge a premium on their loans relative to smaller competitors and offer deposit rates lower than competitors. The premium is not offset by higher funding or operating costs, enabling the major banks to generate consistent excess returns.

The ability to offer customers multiple products not only increases profitability per customer, but bolsters switching costs. Bank customers often resist moving financial service providers due to the hassle of opening/closing accounts, the lack of perceived benefit, and numerous deposit and payment links.

An aggregated view of all personal and financial information, updated in real time, is also advantageous to customers taking multiple products. The cost advantage allows for the strong digital investment and offering, which in turn helps to entrench the switching costs.

While Commonwealth Bank has taken steps to refocus on its core bank offering, we do not believe the loss of wealth management or insurance product cross-sell materially weakens the switching cost advantage, with a transaction account, mortgage, personal loan, credit card, business loan the stronger pillars behind high customer retention. Given the potential for customer dissatisfaction with financial advice or poor investment returns, we do not believe the offering helped strengthen the moat.