Commonwealth Bank of Australia - CBA’s overexposure to mortgages - Research Assignment Help

ASSIGNMENT TASK:

EXECUTIVE SUMMARY

We initiate coverage on Commonwealth Bank of Australia (CBA.ASX) with a SELL recommendation based on a 12-month price target of $70.08 triangulated between our residual income model (RIM), dividend discount model (DDM) and relative valuation. Our target price represents a 12.19% downside from the last close of $79.81 on 9 September 2019. CBA has historically outperformed its Australian banking peers, delivering a consistent dividend yield and a 24.3% ROE premium (vs. Australian majors ex. CBA since 2009) to earn its status as a market darling. Following a surprise Coalition victory and a Royal Commission Final Report that left the banks largely unscathed, a sentiment-driven rally has lifted CBA’s share price to near historic highs. Despite intensifying headwinds, the bank currently trades at ~2x book value for just a 12.5% ROE while its forward P/E of 16.7x represents a 28.2% trading premium to other majors, more than double the historical premium of 13.7%.

CBA’s overexposure to mortgages will bite

With national house prices well below 2017 peaks (-5.2% YoY) and 2Q19 GDP growth figures coming in at their weakest level since 2009, we see CBA as the most exposed of the majors to headwinds facing a deteriorating housing market due to its overweight exposure to home lending. We forecast:

•  Front-book pricing pressures to continue in the mortgage space as CBA turns to aggressive discounting to maintain its dominant position in a hyper-competitive environment
•  A volume-margin trade off to occur as growth in the broker channel continues to drive loan book growth, a strategy which marks a departure from CBA’s core focus on propriety lending. Given the weak housing market, we do not believe now is the right time to be chasing balance sheet growth

BUSINESS DESCRIPTION
Overview

CBA’s history of strong performance has been driven by its market-leading position in retail banking, servicing17.4 million customers in 2019. CBA’s strength in retail banking is attributable to its high-quality deposit franchise, leadership in home lending, and continued investment in its digital offering. CBA boasts superior market penetration with 7 million digital customers and 1 in 3 Australians naming CBA as their main financial
institution (MFI). After a series of significant financial scandals uncovered by regulatory bodies and the Banking Royal Commission (BRC), particularly in CBA’s wealth and insurance divisions, management have shifted theirstrategic focus towards business simplification and effective risk management, implementing a divestment-led realignment to the core banking business.
 

Business Model

CBA provides banking services to individuals, small businesses and institutions through 6 core businessdivisions: Retail Banking Services (RBS), Business & Private Banking (B&PB) and Institutional Banking &Markets (IB&M), Wealth Management and International Financial Services (IFS) (Exhibit 1). CBA’s Australianoperations comprise 85% of group revenue with its New Zealand operations (ASB Bank) comprising 12% of
With CBA’s core competitive advantage lying in retail banking, RBS represents the largest revenue generator of the business (50% of net interest income (NII); Exhibit 2) providing home loan, consumer finance and retail deposit products through CBA’s industry-leading branch and ATM network. CBA generates revenuethrough two main channels: 1) interest income and 2) non-interest income.

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