This article was first published for Livewire Markets on Wednesday 15 February 2023.
For the past year, few topics have commanded the attention of markets like the rise in interest rates, as the RBA struggles to moderate inflation. For many asset classes, this has been a challenging environment, but for some industries, such as banking, rising rates have added to already hefty profits.
One beneficiary of higher rates has been Commonwealth Bank (ASX: CBA), which this morning delivered a record profit of $5.15 billion. Markets were unimpressed, however, and saw the CBA share price tumble more than 5% as markets opened.
So, why then did huge profits, growing return on equity, and a bigger dividend payout still leave investors unsatisfied? For Airlie Investment Analyst Will Granger, it all has to do with growing headwinds that he sees affecting the entire banking industry.
We typically take a longer-term view than one year. However, I think the outlook for the banks for the next year is skewed toward the negative. While the expansion in NIMs has been a clear boon to the sector, there appears to be some countervailing factors emerging.
It's not all bad news for Commbank though, as Will explains;
CBA enjoys two enduring competitive advantages in its high-quality deposits franchise as well as its scale advantage relative to peers, both of which should bode well for shareholder returns over the long term.
In this wire, Will discusses these conflicting factors and gives his outlook for CBA, the banking industry, and the entire Australian share market.
Note: The interview took place Wednesday 15 February 2023. Commbank is a holding of Airlie Funds Management.
Cash net profit after tax of $5.15 bn (half year ended 31 December 2022)
Interim dividend of $2.10 per share (up 35c on the corresponding prior period)
Return on Equity (on a cash basis) 14.1%, up 80 basis points on FY22H2
Net interest income increased by 19%
Operating income increased 12% ($13.59 bn)
Operating expenses rose by 5%
In our view, the key takeaway from the result is a period of rapid net interest margin expansion for the banks may be coming to an end sooner rather than later.
CBA is currently trading down around 5% since opening this morning, so at least initially, the market has reacted negatively to the result. I think that's an appropriate reaction.
While the result itself was strong, and largely in line with expectations, the market's focus will be on the outlook for 'net interest margin', or NIMs, which appears to be more cautious than expectations.
And that's really for two reasons. Firstly, the trajectory of NIMs through the half was a little concerning with a peak occurring in October, before declining through the rest of the half.
Secondly, management highlighted a number of margin headwinds in the second half of 2023, including intensifying competition for loans and deposits, as well as higher wholesale funding costs. While that's far from conclusive evidence that NIMs have peaked, it's concerning nonetheless, given the lofty valuations in the sector.
Not really, the result was pretty in line with consensus expectations across most facets of the business. As we just discussed, I think the key surprise really was expectations around NIMs, and the implications for the sector valuations.
It really depends on your time horizon, but we're happy to take a longer-term view, and as a result, I put CBA on hold. CBA enjoys two enduring competitive advantages in its high-quality deposits franchise as well as its scale advantage relative to peers, both of which should bode well for shareholder returns over the long term.
We've just been through a period of very cheap funding for the banks which has obscured the relative advantage of CBA's superior deposits franchise, but with interest rates rising the importance of that high-quality low-cost funding only increases. The chart we love in the CBA presentation is the comparison of CBA's growth in shares on issues versus peers.
CBA - Half yearly report 2023
Over the past two decades, CBA’s shares on issue have grown by just 30% compared to roughly 100% growth in shares on issue for peers. Or in other words, CBA shareholders have experienced roughly a third of the dilution of their counterparts, which is supportive of higher long-term returns for shareholders.
We typically take a longer-term view than one year. However, I think the outlook for the banks for the next year is skewed toward the downside. While the expansion in NIMs has been a clear boon for the sector, there appear to be some countervailing factors emerging.
As we've discussed, CBA has the highest-quality deposits franchise, so if they're starting to pressure on NIMs. What does that mean for the rest of the sector?
And the other obvious risk for the sector is whether we enter a recession and to what extent that recession results in a material spike and bad debts. I don't have any special insight into predicting macro outcomes, but it's hard to see how current bank valuations compensate for this risk. What I can say though, is that CBA is likely in a better position than its peers to weather any downturn, given its superior franchise.
I'd say around a three. But that being said, we're excited about the market. There's been a lot of volatility in recent months, and that's exciting as it invariably throws up opportunities to buy businesses we like at valuations we find attractive.
Source: Market Index, Wednesday 15 February
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