Hugh Dive: Why this big bank is still a big buy

Australian investors love nothing more than a dabble in property and a steady stream of dividends. Throw in rapidly rising interest rates and the banking sector was touted as a potentially big winner before 2022 even kicked off. But just as prospects were beginning to look promising, a new headache was emerging.

How do you box out the competition without sacrificing the payouts investors have become so used to? 

This question is vital to breaking down the Commonwealth Bank (ASX: CBA) full-year earnings result. While mortgage activity continues to climb and bad debts remain low, the reality is also that margins are being crimped even in a rising rate environment.

In this wire, we'll break down the big numbers and issues affecting Australia's largest consumer bank. We will also get commentary from Hugh Dive of Atlas Funds Management. Dive has been analysing the bank for 18 years, and CBA has been a feature of the Atlas Concentrated Australian Equity Portfolio since its inception in 2016.

"The market has been overlooking CBA's ability to pull various levers to maintain profits in response to changing market conditions," he said.

Note: This interview took place on Wednesday, 10th August 2022. This stock is a top holding in the Atlas Core Australian Equity Portfolio. To find out more, click here.

Commonwealth Bank (ASX: CBA) FY22 key results

• Cash earnings +11% to $9.595 billion
• Revenue +1% to $25.1 billion
• Final dividend of $2.10 per share
• Full-year payout +10% to $3.85 per share
• Net interest margins (NIMs) -18 basis points to 1.9%

What were the key takeaways from this result? What surprised you the most?

It was a very good result, as cash earnings lifted 11% while the total dividend for the full year increased by 10%. On top of all that, there was a surprise 10c increase in the second half dividend - though this might not end well politically given increasing mortgage rates.

On the net interest margin front, it's come down by 18 basis points to 1.90%. Excluding the impact from increased low-yielding liquid assets, margins were reduced by 0.1% and were driven by lower home loan margins but partly offset by increased deposit earnings. The good news is that the deposit funding figure was higher than expected. This points to NIM expansion in FY23 given this large percentage of cheap funding.

Best of all, the all-important bad debts are still very low. I expect this to increase over the next few years to 30bps - the average post-1991 recession. Portfolio credit quality is stronger than expected, reflecting low unemployment and significant household savings buffers.

What was the market’s reaction to this result? Was this an overreaction, an underreaction or appropriate?

Looking at CBA, that was a better set of results than NAB (ASX: NAB), for example. Revenues went up and costs went down. The market was looking for costs to go up in line with inflation. While wage costs did increase, they were offset by occupancy costs. In the last two years, they've reduced the number of branches from 1100 to 807. The mix is changing quite dramatically.

The things people were really looking at were the net interest margins and bad debts. On NIMs, it's probably too early to tell. 

On the analyst call, there were a lot of questions about what NIMs will look like in 2023 given it's predominantly financed by deposits which aren't increasing very much. We came away from that thinking net interest margins will increase in the next year. 

Would you buy, hold or sell Commonwealth Bank on the back of these results?

We added to the CBA weight in June going into the result, as we saw that the market price discounted both the resilience of the CBA's key profit centre - retail banking services, as high employment and a cleaner corporate loan book than 1991 or 2007 will see lower bad debts than the market expects.

Our positive investment view towards Australia's premier retail bank has not changed, though, in fairness, this result was better than we expected. It's been a big tussle thinking about what to do with the banks - and you can easily paint a bear case (bad debts, house prices will collapse). Or you could see that unemployment is pretty strong and the fall in house prices might only get us back to those seen mid-last year. 

We wouldn't want to buy it over $110, but buying at $90 looks to be interesting and it is a very well-run bank.

What’s your outlook on Commonwealth Bank and its sector over FY23?

It's all about keeping costs under control. A lot of these remediation charges stemming from the Royal Commission are coming to an end - and that will be a tailwind. The credit quality was pretty good and its CEO Matt Comyn said 74% of their loan book was 36 months ahead. 

The market's been swinging between despair and euphoria, but I think the truth is somewhere in between. 

Bad debts will rise, and they're all expecting 30% loan losses which have been the post-91 average. It will increase and it's just part of banking. You don't expect it to be zero.

Ultimately, they are controlled by the underlying loan demand. They sell a largely undifferentiated product in an oligopoly with three competitors. Where they can change their lever, which is what I was happy to see, is their expenses. The underlying cost of selling a loan varies a little bit but not by much. I was pleased to see CBA, similar to Westpac (ASX: WBC), is closing branches and changing its cost profile. 

Are there any risks to this company and its sector that investors should be aware of given the current market environment?

If they let costs run away, that could be an issue. But that is something they can control, unlike their competitors. Keeping their costs under control will be key in an environment where employment costs are going up in an inflationary environment. That will be tough to manage.

How much value are you seeing in the market right now? Are you excited or are you cautious about the market in general?

Rating: 2.5

There are pockets of value - you don't want to necessarily be owning an index. We don't own NAB - but we own the other three big banks. There is value all around the market but it's not broad-based. We are going through a transition period. There will be companies that are clear losers - companies that can't pass on inflation and haven't hedged their debt properly.

For instance, we saw Charter Hall Long WALE REIT (ASX: CLW) increase its debt cost dramatically because a lot of it is unhedged. Other companies like Transurban (ASX: TCL) have a lot of debt, but it's hedged out 8 to 9 years. So there'll be winners and losers, but I don't think it will be uniform.

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