Under the Spotlight AUS: Commonwealth Bank (CBA)

Commonwealth Bank ($CBA) is the stock that bank analysts and fund managers love to hate. 

They agree the giant of the Australian financial services industry is well managed, has strong market shares across retail and business banking, stable earnings, a robust balance sheet, and it consistently lifts its yearly dividends. What they can’t stomach is its hefty price tag, which sees the stock trade on valuation multiples well above historic averages – and above those of its rival big four banks. 

Concerns about CommBank’s valuation are no trivial matter: the stock’s performance has a significant impact on the broader Australian market. It’s Australia’s largest company by market cap and accounts for just over 10% of the benchmark S&P/ASX 200 Index. That hefty weighting has fuelled a 34% rally over the past year, as money has flowed into bank stocks from superannuation funds and ETFs at a time when large miners like BHP ($BHP) and Rio Tinto ($RIO) have underperformed.

Founded in 1911, Commonwealth Bank has come to dominate the Australian banking industry. Its market cap today is more than twice its nearest rival. While the recent earnings season highlighted its relative strength against other banks, it also cast a spotlight on whether its earnings outlook justifies the stock’s premium valuation. The stock is down 6% from its February highs, offering some hope for fund managers who have shorted the stock. But more on that later.   

Cash machine

There’s no denying that Commonwealth is a well-run bank. Its H1 earnings showcased its ability to cash in on the fact that 1 in 3 retail customers and around 25% of businesses use it as their main bank. 

First half cash net profit after tax rose 2% year-on-year (YoY) to $5.13b, or up 6.5% from the prior six months. Net interest income – the difference between interest revenues and interest expenses – rose 5% YoY to $11.93b. The strength of CommBank’s franchise means it is able to capture 31% of the collective net interest income generated by the big four banks. 

Retail banking is the biggest driver of profits due to CommBank’s strengths in home lending. It has a 24% share of the home loans market. The retail bank’s H1 cash net profit rose 2% to $2.71b. Its home lending grew 5.7% over the 12 months to 31 December, compared to system growth of 5.5%. 

What really stands out is that CommBank sells two thirds of its mortgages through its own channels, whereas around 75% of mortgages across the financial system are sold through brokers. Broker-originated loans are around 20%-30% less profitable than loans coming from proprietary channels.

The modest growth in cash profits masks future-focused investment. Operating income rose 3% to $14.09b, while operating expenses rose 6% to $6.37b as CEO Matt Comyn ramped up investments in technology. CBA will spend $2.2b in FY25 on accelerating a refresh of its technology infrastructure and enhancing its generative AI capabilities. This is all directed to enhancing digital banking, which can be delivered at lower cost than traditional banking. Getting digital banking right is vital as more than 40% of people aged between 14 and 34 use CommBank as their main financial institution. 

Meme stock? 

The rub for the market’s top banking analysts is CommBank’s ritzy valuation multiples. The shares trade on a forward price-earnings multiple of 27x, compared to 16x-18x for NAB, Westpac and ANZ. Its price-to-book value multiple is 3.6x, compared to an average of around 1.6x for the other big banks. Barrenjoey analyst Jonathan Mott, Australia’s top rated banks analyst, said $CBA was ‘trading more like a meme stock’ and its share price has ‘disconnected from reality and left orbit’. Long story short: it’s expensive. 

The issue for analysts is: what happens to CommBank’s margins once rates start falling? Lower rates will place pressure on the rates it charges for mortgages, credit cards and business loans. At the same time, it faces increasing competition for deposits – the source of 77% of its total funding. If it tries to defend its 26.5% share of household deposits by offering generous rates, that will raise its cost of funding and squeeze margins. Most analysts are forecasting low-single-digit profit growth over the next couple of years.  

Fund managers have been betting on a pullback in $CBA shares. One of the most respected of them, Regal Partners Phil King, initiated a short position in CBA shares in early 2024, citing valuation concerns. So did L1 Capital, which said in its most recent update that it preferred quality UK banks that trade at 7x, have stronger earnings growth, higher dividend yields and a better outlook for net interest margins. Additionally, analysts have share price targets well below $CBA’s current share price. Morgan Stanley has a $127 price target, Jarden sees $110, while Barrenjoey and Macquarie have set their targets at $105. Citi goes below three digits, at $90.75.  

Despite price rallies and these high-profile short positions, total short interest in $CBA has declined. Only 1.06% of CommBank shares are held in short positions, down from 1.59% in mid-August. However, that level of shorting is still double the average among its three main rivals. 

Capital returns

It’s understandable why short-term focused investors would make the argument there may be better value elsewhere. But many of CommBank’s shareholders are retail investors with a buy-and-hold focus. As of 30 June 2024, there were nearly 640,000 shareholders – 77% of the total – with less than 1,000 shares each.

The focus for these investors is dividends, stable earnings and a strong balance sheet. The bank continues to deliver on dividends, lifting them consistently. The H1 dividend was $2.25 a share, up from $1.75 a share in H1 FY22. CommBank maintains a full-year payout ratio target of 70%-80%.  

The firm also has around $700m left on its buyback. CommBank bought back very little shares in H1, a wise move given the stock was rallying to new highs. This provides the firepower needed to buy back shares if any sell-off gathers pace.

Net interest

Commonwealth Bank has been a victim of its own success. It’s a powerhouse franchise in retail and business banking that has driven profits and dividend growth, backed by a robust balance sheet. As Australia’s largest stock, investor capital has flowed in its shares. 

The concern for CommBank bears is not that it’s a bad business. Rather, it’s a good business that’s overpriced relative to its earnings power, in an environment of falling rates and elevated competition for deposits. Can this bank prove the haters wrong as it has in the past?

This is not financial advice nor a recommendation to invest in the securities listed. The information presented is intended to be of a factual nature only. Past performance is not a reliable indicator of future performance. As always, do your own research and consider seeking financial, legal and taxation advice before investing.