It’s time to trim exposure to CBA: Morningstar

Strong results at Commonwealth bank are a chance for investors to trim their exposure while prices are high, says Morningstar equity analyst Nathan Zaia.

Zaia raised his fair value estimate for Commonwealth bank (ASX: CBA) to $83 after Australia’s’ largest bank announced its full-year cash profit surged almost 20% to $8.7 billion on Wednesday. The strong result was underpinned by falling expenses from bad loans and a rapidly growing loan book.

CBA will also return $6 billion in off-market share buy-backs to investors as profits rebound from the pandemic.

Despite the upgrade, CBA closed at a 27% premium to Morningstar’s fair value on Thursday. Zaia says CBA's cash splash is an exit opportunity for those who are overexposed to the banking sector.

“With other banks trading around fair value or below, Commonwealth Bank's 27% premium suggests the market is overpaying for the bank's strong balance sheet and growth opportunities,” he says.

“If you are overweight banks then it might make sense to trim your exposure.

“This is a good chance to do it, when a bank is overvalued and you get to sell your shares at a better price, depending on your tax situation, than if you sold on market.”

Large buybacks and dividends were widely anticipated by analysts, including Zaia, following a year of dividend cuts, conservative lending practices, divestments and equity raises.

For shareholders on low or zero tax rates, subscribing to the $6 billion off-market buyback could be a better option than selling the shares directly on the market, says Zaia.

In an off-market share buyback, the offer price is divided into a capital gain and dividend component. Investors with low or zero income may then benefit from franking credit refunds.

Based on the pre-announcement closing price of $106.56, the buy-back could mean a 14% premium for some investors, according to Max Cappetta, chief executive at Redpoint Investment Management.

Shareholders can opt into the buy-back between 30 August and 1 October. The final price will be based on the average price over the five days leading to the 1 October closing date.

CBA also announced a fully franked $2 dividend, bringing the full-year amount to $3.50, slightly short Zaia’s forecast of $3.90. This is more than double the banks dividend of 98 cents this time last year and represents a final dividend payout ratio of 71% of cash earnings.

He expects more dividends or buy backs in the medium term and calculates the bank will still have $5.5 billion in surplus cash after accounting for the buyback and regulatory requirements.

“Our fiscal 2021 forecast of $3.90 assumed the bank would hit the top-end of the 70%-80% target payout range,” Zaia says. “If not when sitting on a $11.5 billion capital buffer, then when? We model the bank to pay out 75% of earning in future years.”

Across the major banks, capital levels remain well above regulatory requirements and Zaia maintains his earlier forecast that billions will be returned between now and 2025.

CBA’s common equity tier 1 capital ratio sits at 13.1%, well above regulator APRA’s benchmark of 10.5%.

Shares closed 1.5% higher after Wednesday’s announcement before falling 2.1% Thursday to 105.88, a 27% premium on Zaia’s new fair value estimate of $83.

NAB (ASX: NAB) closed Thursday at 27.27, above the fair value estimate of $26; ANZ (ASX: ANZ) at 29.35, on the fair value estimate of $29; Westpac (ASX: WBC) at 25.76, below the $29 fair value estimate.

Bank surfing the crest of economic recovery

Only a year ago, CBA cut its dividend for the first time in a decade and set aside billions in preparation for a surge in covid-related bad loans. The bank’s full-year performance is testament to the rapid economic recovery.

Double-digit profit growth was helped by a 78% fall in the bank’s loan impairment expenses. The bank grew its loan book to homeowners and businesses by 7% and 11% respectively.

This growth has outstripped rivals. CBA’s $11 plus billion in business lending more than three times the system average.

Loan quality remains robust. Troubled and impaired assets fell $1.2 billion, driven lower mostly by corporate borrowers. The number of consumers in arrears on their home loans remains below pre-covid levels at 0.64% although the bank expects it could increase modestly in the coming months.

The lockdowns in the east coast capitals have had a limited impact on the bank’s loan portfolio to date. CBA reported 6,800 home loan deferrals and 240 business deferrals in the five weeks from 25 June to 31 July.

Low interest rates continue to weigh on net interest margins—the difference between what the bank pays depositors and charges borrowers—which fell to 2.03%. Zaia expects this to continue declining until fiscal 2023 before starting to rebound if interest rates rise.

Chief executive Matt Comyn highlighted ongoing risks from the pandemic and the low-rate environment in his outlook.

“We are prepared for a range of different economic scenarios and are well placed to support our customers,” he said.

“Looking ahead, we anticipate ongoing economic impacts and earnings pressure from lower interest rates.”

BNPL, NAB and investing in the future

Operating expenses at CBA rose 3% as the bank continues investing in technology and products to handle higher volumes of loan applications.

“With other major banks seemingly more focused on getting the cost base down, we see an opportunity for Commonwealth Bank to grow above system again in fiscal 2022,” says Zaia.

Comyn announced CBA’s buy-now-pay-later product “StepPay” will be rolled out this month.

It will be 25% cheaper than competitors and 80,000 thousand customers have pre-registered for access according to Comyn. Swedish BNPL-giant Klarna, with whom CBA has partnered in Australia, “remains important” to the bank.

Elsewhere on Thursday, NAB announced cash earnings of $1.70 billion for the June quarter, up 10% from a year ago. Home lending rose 2% while lending to small-and-medium-businesses grew by 4.3%.

“Overall, things are tracking as expected for the bank,” says Zaia.