Bank of Queensland (ASX: BOQ) shares jumped over 5% after reporting earnings for the six months ending February 29th. Morningstar Equity Analyst Nathan Zaia continues to see a difficult operating environment for the bank.

First-half 2024 cash profit fell 33% to $172 million, and return on equity, or ROE, was just 5.8%. The no-moat bank is grappling with intense lending and deposit competition, in part due to underinvestment in its digital capability over the years, and in part because it has been forced by regulators to address risk and compliance issues.

As the bank progresses through these issues, it is likely to be more risk-averse and cause workflow disruptions to staff who should be focused on lending. The result would have been even weaker if bad debts had not stayed well below historical average levels.

The share price responded positively to the result, a reflection of low market expectations, most likely on net interest margins, or NIMs, which fell a modest 3 basis points from the second half. Pressure from home loan discounting and deposit competition appear to be moderating.

The bank's poor showing supports our view that pricing dynamics won’t persist. Even the major banks, with lower funding costs and scale advantages, are generating ROE just above our estimated 9% cost of equity, Commonwealth Bank (ASX: CBA) excluded. We expect competition for deposits to ease as the term funding facility is repaid, and if there are rate cuts in 2024 and 2025, stronger credit growth could also see competition in lending cool. Bank of Queensland should benefit more than its peers in a falling rate environment as most of its funding should reprice lower.

Our fair value estimate falls 6% to $7.50 per share on softer loan growth and NIM in the short term, and higher medium-term operating cost expectations. We have taken a more conservative view of the bank’s ability to keep cost savings, given ongoing digital investment spending by much larger competitors and rising risk and compliance-related costs. At some point perhaps artificial intelligence can help lower these costs, but we think it would be premature to factor that in.

Business strategy

Bank of Queensland is one of Australia's top-10 largest banks, but is considerably smaller than the four major Australian banks. Preceding the global financial crisis, the bank grew aggressively via acquisitions and the rollout of its distinctive owner-manager branch franchise model. However, expanding the branch network and diversifying from traditional residential lending came at a cost, with additional equity required to fund growth, significantly increased bad debts, and multiple banking systems, which resulted in deteriorating cost/income and returns on equity.

The benefit of higher cash rates have been competed away, and despite the successful integration of Me Bank, growth in operating costs resulted in a poor cost/income ratio. In addition to inflationary pressures, operating expenses are increasing on investment in the banking system and increased regulatory and compliance spending.

Management's strategic focus is centered on digital transformation of core banking systems, which should lead to better customer outcomes and operational efficiencies. The aim is to ensure the bank is more competitive, particularly in the home loan market, but we do not see this investment giving the bank any competitive edge. At best, it can narrow the gap to peers, but with the big investment budgets of the majors, those innovations are likely to be hard to keep up with.

We do not believe the brands—BOQ, Virgin Money, Me Bank, BOQ Business, BOQ Specialist, and BOQ Finance—are key differentiators or a source of competitive advantage. Bank of Queensland has branches owned by branch managers and corporate branches. The model has the potential for the bank to outperform its peers on customer service, with owner branch managers building relationships with local customers, and niche business lending specialists with an understanding of borrower needs and industry. Despite its strengths, a narrower business mix, smaller customer base, and higher funding costs see the bank struggle to generate margins comparable to those of the majors.

Moat rating

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Bank of Queensland does not have an economic moat, as it lacks maintainable cost advantages required under Morningstar’s global bank moat framework. We evaluate bank moats in terms of cost advantages (funding, operational, credit, regulatory); switching costs; and the banking system in which they operate.

The four major banks in Australia are wide-moat-rated, possess structural competitive advantages and control close to 80% of the business and retail lending and retail deposit markets. As a small market player, Bank of Queensland’s market shares for both household deposits and housing loans are small, at about 3%.

The inability to compete on price, due to higher funding and operational costs, has translated to much lower returns on equity relative to the majors. Bank of Queensland lacks pricing power relative to its competitors and is unable to lift mortgage rates independently of the major banks. Net interest margins and profitability are likely to remain squeezed over the near term due to the low-interest-rate environment and competitive lending landscape, particularly for home loans.

Bank of Queensland is at a cost disadvantage to the Australian major banks. Funding costs are higher due to an inability to access wholesale credit markets at the same rates as the majors. The majors have better credit ratings. Bank of Queensland’s funding sourced via customer deposits is also more costly; only 8% is sourced from cheaper less price-sensitive transaction accounts.

A smaller operating base also means operational efficiency is weak in comparison to competitors. Bank of Queensland’s cost/income ratio of 58% in fiscal 2023 compares unfavorably with the major banks. We expect Bank of Queensland’s cost/income ratio to improve in the long term as the bank benefits from consolidating its banking platforms, and modest loan and interest income growth. Ultimately, we view the investment in technology as a “must-do” and not as a point of differentiation that will drive a significant change in loan or deposit growth.

Bank of Queensland also faces a tougher regulatory capital burden, unlike the major banks which are qualified to use internal risk models that result in lower risk weights on various assets (particularly home loans), which require relatively low capital support.

We believe Bank of Queensland does benefit from customer switching costs. Customers often resist moving banks due to the hassle of opening/closing accounts, little or no perceived benefit of switching, and numerous deposit and payment links. Bank of Queensland’s strategy to focus on niche business segments--such as healthcare which is over 20% of commercial lending--means the bank has sector specialists who can appropriately price risk and have quick response times.

We believe this leads to greater customer satisfaction and multiple products per borrower, such as business loan, asset finance, and mortgage. Branch owners being able to support small and medium-size enterprise, or SME, customers (as opposed to calling a bank call center) can also help deepen relationships.

Banks in Australia operate in a stable and tightly regulated oligopoly. This is underpinned by a strong regulatory regime and stable political environment.