Stock Review

Investors have cast a decisive vote that the worst is over for Australia's banks. We hope they're right; we fear they're wrong.

Commonwealth Bank has clearly improved its strategic position over the past 12 months. With pockets of soothing, almost confident, commentary from management accompanying the latest full year profit result, the spirits of those that prefer to see a glass half full have been bolstered.

This was the industry’s toughest year in more than a decade and a half and yet Commonwealth enjoyed an increase in total income (read ‘revenue’) of 12% to $16.3bn, with reported profit falling by just 1% to $4.7bn. It was an impressive-looking result at the very least.

Bankwest brings bad debts

And yet fodder for the cynics was plentiful. General provisions for bad debts continued to increase although a lack of ‘big name’ failures in the past six months has meant lower charges for ‘individual names’. The collective provision of $3.2bn was up more than 30% on December’s figure and 120% on last June’s. It appears that the opportunistic acquisition of Bankwest in October last year included a number of bad debt bombs in the package.

The $57.85bn Bankwest loan portfolio was less than 12% of the group’s total loan book, yet bad Bankwest loans accounted for more than 32% of total impairments. The impairments as a percentage of gross loans and acceptances were 2.36% for the Bankwest book versus just 0.66% for the original Commonwealth portfolio—more than 3.5 times the rate.

Accounting tricks

Management also elected to boost earnings by capitalising some $352m of computer software expenditure. This amount – up 169% on the same figure in 2008 – found its way onto the balance sheet as an asset, rather than appearing as an expense through the income statement, a more conservative and acceptable practice in our view.

Even including such accounting shenanigans, earnings on a ‘cash basis’ were down 7% to $4.4bn, though the figures were worse when considered in light of what really matters to shareholders; per share results. Cash earnings per share fell 14% over the year to $3.29 as the dilution from new share issues flowed through. The final dividend was also cut by 25% to $1.15 per share (ex-date 17 Aug).

Commonwealth Bank financial summary

	2004	2005	2006	2007	2008	2009	5-yr CAGR
Total income ($bn)	10.5	11.1	12.1	13.3	14.4	16.3	9.2%
Operating expenses ($bn)	5.5	5.7	6.0	6.4	7.0	7.3	5.8%
Prov’n for impairment ($bn)	0.3	0.3	0.4	0.4	0.9	2.9	57.4%
Tax ($bn)	1.1	1.4	1.6	1.8	1.6	1.5	6.4%
Cash profit ($bn)	2.7	3.5	4.1	4.5	4.7	4.4	10.3%
Return on equity (cash basis)	12.7%	18.8%	21.3%	21.7%	20.4%	15.8%
Tier one capital ratio	7.43%	7.46%	7.56%	7.14%	8.17%	8.07%
Earnings/share (cash basis)	$2.07	$2.65	$3.16	$3.47	$3.57	$3.06	8.1%
PER (x)	21.9	17.1	14.3	13.1	12.7	14.8
Dividend per share	$1.83	$1.97	$2.24	$2.56	$2.66	$2.28	4.5%
Dividend yield (fully franked)	4.0%	4.3%	4.9%	5.6%	5.9%	5.0%

Return on equity, another important measure for shareholders to monitor (which you can do in the accompanying table), has fallen markedly to 15.8%. While that’s a figure most businesses can only dream of posting, particularly amid an economic slowdown, shareholders will be hoping the downward trend reverses in the near future. Superficially, this was a good result. Underneath, it was less so.

All in perspective

The sharemarket’s remarkable recent rally has reduced the chances of big-name collapses by allowing most of the formerly shaky property sector, for example, to recapitalise. Yet our general thesis was not dismantled by Commonwealth’s figures; that is we expect bad debts to continue to mount and that more capital will be required as a consequence. This applies not just to Commonwealth but also to all the major banks.

A swelling in bad debts from the unlisted commercial property sector, and consumers, remains a real risk. Slide 48 of the results presentation revealed that property loans accounted for 24% of Commonwealth’s overall ‘troublesome exposures’ despite accounting for just 7.8% of the loan book (slide 95). Personal and home loan arrears have also been rising (slides 46 and 47).

On the capital front, Commonwealth announced that it will soon be marketing a new hybrid security (PERLS V) to investors. It hopes to raise at least $700m (expect much more if it can get it) on similar terms to its previous PERLS IV offer (you can re-visit our review of that pre-credit crisis offer in this analysis).

      

Australian authorities have done everything in their power to support the banks. The Reserve Bank has provided buckets of liquidity by accepting riskier securities as collateral for loans. And it has slashed the cash rate – penalising Australia’s savers in an effort to recapitalise the banks and ease the pressure on over-geared consumers and corporates. The federal government has provided deposit and funding guarantees and the competition ‘watchdog’ wagged its tail as Commonwealth swallowed Bankwest and Westpac gobbled up St George.

Such measures have provided gusty tailwinds for the banking sector and the likelihood of a convulsive domestic crisis seems to have been averted. That has tempered our negative view somewhat. But at today’s price, Commonwealth is priced for a steady economic recovery that has yet to materialise.

Investors are accepting a trailing yield of 5.0% with little prospect of dividend growth over the coming year. That strikes us as too slim a return (particularly given the high payout ratio of 75%) to take on the risks of an economic false start, or that our fears of accumulating bad debts prove accurate.

Mr Market is shouting that our previous Sell recommendations are likely to prove misplaced. The facts speak more quietly but with no less force. Should the results for the half-year to December 2009 show a moderation in bad debts in the commercial property and consumer portfolios then we may revisit our original thesis. Until then, the argument we first made remains unchallenged by anything in the latest result, although the nightmare scenario has receded.

The share price is up 2% since 5 Aug 09 (Sell – $44.53) and, at this price, our negative view remains. SELL.

Note: We’ll be producing a detailed special report on Commonwealth over the next two weeks based on our extensive research framework. It will feature a recommendation guide and an accompanying downloadable financial model which will allow you to make your own assumptions and examine the impact on Commonwealth’s profits over the coming years. Watch out for it.

Disclosure: Staff members own Commonwealth Bank shares but they don't include the author, Greg Hoffman.

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