While the Commonwealth Bank headlined their profit result as a “good operating result”, the market’s judgement yesterday was “can do better”.  CBA shares lost $1.01 to close at $77.40. Year to date, they are lagging the other major banks with a return of -7.2%.  After a positive response to its third quarter report released on Monday, ANZ leads the way with a return of -1.4%.

And in an industry struggling to grow income and where the differentiation in bank strategy is now so minor, pricing differentials are narrowing. The cheaper banks, ANZ and NAB are doing relatively better, while the expensive banks, CBA and Westpac, are performing less well.

For Commbank to maintain its pricing premium, it needs to perform better than the other banks. While yesterday’s report was satisfactory, it wasn’t brilliant. For example, return on equity in the second half fell to 15.6%, with the gap is narrowing to its peers (Peer3 below is Westpac, Peer 2 is NAB, Peer 1 is ANZ).

Major Bank Return on Equity

CommBank’s year

At a headline level, CBA increased cash NPAT by 3.4% to $9,450m, pretty close to market expectations. However, this result disguised a weaker second half, with cash earnings of $4,646m falling by 3.3% compared to the first half. While the second half had fewer days at 182 compared to 184 days in the first half, and in an annuity business like banking every single day counts, it was still down by 2.2% when an adjustment is made for this. Higher loan impairment expenses of $692m compared to $564m in the first half were partly to blame. Insurance income also dived by $179m.

CBA’s Cash Result

The highlight of the result was a very strong performance by the Retail Bank. This is the powerhouse of the CBA, producing 47% of group earnings. It grew income by 8%, kept cost growth to 3%, for an operating performance increase of 10%. The critical cost to income ratio for the Retail Bank fell to 32.6%.

Retail Banking Cost to Income Ratio

The performance of the Retail Bank was also driven by volume growth, with the Bank improving market share in home loans to 25.3%, and retail deposit market share from 29.0% to 29.2%. The Business Bank (BPB) also enjoyed market share gains in the second half.

CBA Volume Growth compared to System

Despite an increase in long term funding costs, group NIM (Net Interest Margin) remained relatively steady. Over the year, it fell from 209bp to 207bp, with a 1bp decline in underlying NIM in the second half.

CBA’s long term funding costs

Negatives

Disappointing parts of the result included the performance of Bank West, where cash NPAT fell by 4%, and CommInsure, which suffered due to the fallout of the insurance scandal. The Bank’s Institutional Banking and Markets division delivered another shocker, with income up only 2% but expenses growing by 11%. After an increase in loan impairment expenses of 51%, cash NPAT fell by 9%.

Adding insult to the Institutional Bank result is the suggestion that this part of the Bank has recently had its authority to undertake new lending curtailed. Over the year, it grew loans ahead of system growth at 7.7%, yet in the last 6 months, its book went backwards by 1.4%, compared to system growth of 2.5%.

Margins in the business parts of the Bank also shrunk. After a fall from 204bp to 197bp in the first half, they fell further to 192bp in the second half. This points to increasing competitive pressure, with the bank have to re-price business loans to maintain share.

And notwithstanding marginally “positive jaws” for the full year, with income growing at a faster rate of 5% compared to the rate of expense growth of 4%, the jaws were negative in the second half. CBA makes frequent reference to its investment and productivity initiatives, yet staff expenses still increased by 2.5%. Time to take out some heads!

Like all banks, the cost of increased and enhanced regulation is starting to show. CBA also has to deal with the fallout of its mishaps in financial advice and insurance, and as a result, 37% of the Bank’s investment spend is now in risk and compliance activities, compared to just 24% in FY14. 

Bottom Line

Due to the issue of shares during the year and low earnings growth, cash earnings per share fell from 557.5 c to 555.1c. This puts CBA on a multiple of 13.9 times. According to FN Arena, Westpac is trading on a forecast FY16 multiple of 13.0 times, ANZ is now at 12.6 times and NAB is the laggard at 11.1 times.

Commonwealth Bank is still worth some sort of premium because it is delivering the highest return on equity, is the market leader in most of the key products, and has the strongest balance sheet. However, it doesn’t appear to be doing enough and the premium could narrow further. If it can’t grow revenue, it needs to take an axe to its cost base. An okay result for the market leader is not good enough.

That is not to say it is a sell, because although out of favour, banks (including CBA) remain on the cheap side of the ledger. Shareholders can look forward to an unchanged final dividend of $2.22, and an unchanged full year dividend of $4.20 per share. This puts CBA on a fully franked yield of 5.4%. While the payout ratio has crept up to 76.5%, it is unlikely that the dividend will be cut in FY17.  If it is cut, it will be a small cut. Conversely, there won’t be a dividend increase. With credit conditions still reasonably benign and the capital debate taking such a long time to play out, it is premature to suggest that dividends are under pressure.

But, Commbank can do better. Prefer others.