CBA more vulnerable than rivals as bank stocks get pricey

Rich valuations makes CBA more vulnerable than its rivals to a falling share price as lenders face a profit squeeze.

CBA’s shares look vulnerable as it trades at a steeper valuation than its rivals, and that premium rating is hard to justify.

Rich valuations makes Commonwealth Bank more vulnerable than its rivals to a falling share price as a squeeze on profits threatens to bite lenders.

Shares of Australia’s big four banks — CBA, ANZ, National Australia Bank and Westpac — have on average rallied 15 per cent since early November as Donald Trump’s infrastructure spending plans brightened the outlook for Australia’s commodities-driven economy.

But investors may want to shy away from Australian banks as multiple threats loom. Fitch sounded a cautionary note with its downgrade of its outlook for Australian banks to negative. The ratings agency expects profit growth to slow in 2017. Here’s why:

●Low interest rates, weak loan growth.
●Stiffer competition in the banking market
●Rising impairment charges.
●Rising US interest rates also make the high dividend yields ­offered by Australian banks less attractive to foreign investors.

Put simply, CBA’s shares look vulnerable as it trades at a steeper valuation than its rivals, and that premium rating is hard to justify.

The bank is head and shoulders above its rivals when it comes to valuations. CBA, which was trading yesterday at $82 a share, fetches 14.4 times forward earnings, which is above the 13.1 times for Westpac.

ANZ and NAB trade at an even lower 12.5 times.

Moreover, CBA’s yield of 5.1 per cent is also the lowest among the big four banks. The valuation gap with its rivals looks even starker on a price-to-book yardstick.

CBA trades at 2.3 times, while its three rivals trade in the range of 1.5 times to 1.8 times.

The bank has long been able to command a premium valuation thanks to its sector-leading profitability — its return on equity of 16.5 per cent for fiscal 2016 was well above the roughly 13 per cent averaged by its rivals: ANZ, NAB and Westpac.

But analysts question whether CBA can maintain its superior ­return on equity. Morgan Stanley analyst Richard Wiles warns the gap is narrowing. CBA’s all-­important return on equity fell from 18 per cent in fiscal 2015 to 16 per cent in the second half of fiscal 2016, which ended last June. Wiles expects the gap between CBA and its rivals to shrink to 1.5 per cent in the 2019 financial year from 3.5 per cent in fiscal 2015.

The analyst has an underweight rating on CBA with a $68-a-share target price, which implies 17 per cent downside.

CBA’s management is reluctant to commit to an ROE target — and it’s easy to see why. The lender has the weakest core capital buffer among the big four Aussie banks. While the 9.3 per cent level for fiscal 2016 is an improvement on previous years, it’s still short of the 10 per cent required by the regulators.

Morgan Stanley’s Wiles estimates CBA will need to boost its level of capital by $7 billion to meet the requirement, which is the highest among the big four banks and increases the risk of a dilutive issue of new shares.

The bank’s profit growth is also expected to slow this year. Analysts surveyed by Factset forecast flat earnings per share for fiscal 2017, which compares with a 2 per cent growth pace in 2016.

A tough operating environment could make it difficult for CBA to maintain its strong retail banking margins.

Morgan Stanley’s Wiles expects the lender’s retail margins to fall 4 basis points this year and its retail profit growth to slow to a 5 per cent pace from 11 per cent last year. While CBA has gained market share in corporate banking, the higher exposure may end up diluting returns and increasing risks without materially improving earnings growth.

Impairments charges are also expected to rise by more than 40 per cent this year. And it’s unclear whether CBA’s recent sale of its stake in Visa for a $278 million profit to fund a write-off of software assets would help to plump up the bottom line in coming years.

JPMorgan analyst Scott Manning notes that while the write-off will give CBA a $130m annual ­expense buffer over the next three years, it’s uncertain if the cost savings will flow through to the bottom line or make room for a higher rate of directly expensed project costs.

Manning has an underweight rating on CBA with an $75-a-share target price.

This article first appeared in Barrons.com