Value Investors Club / COMMONWEALTH BANK AUSTRALIA (CBA-AU)

Description

The global rout in equity markets hasn’t been kind, particularly to Australian Banks. The country’s

economy is highly dependent on selling dirt to China (32 % of exports go to China). With commodities in

the dog house, Australia’s terms of trade have reversed with no end in sight. The government is pinning

its hopes on housing construction to replace the lost revenues from mining. Housing volume and price

growth are very unlikely to continue their torrid pace, particularly with tightening lending standards and

a regulatory crack down on investor properties. When it corrects, and we think it will as the macro

picture continues to deteriorate, Commonwealth Bank won’t command nearly three times tangible

book. While if there is widespread stress in the Aussie economy, all Australian banks’ valuations will

converge to, or potentially, below tangible book levels, however given CBA’s lofty valuation (particularly

versus peers) and the operational headwinds we outline below, we believe there is material downside

to the share price even without broader economic stress. If the valuation framework shifts from

primarily yield based to P/TB (as it would likely do if investors become concerned about the loan book),

look out below.

Commonwealth is Australia’s second largest bank by assets, and is the leading mortgage lender. Recent

reports indicate the financials look good. Leverage isn’t crazy as compared to the US banks in the mid

2000’s, however, their exposure to the total mortgage market is much higher. Collectively, the big four

(Commonwealth “CBA”, Westpac “WBC”, National Bank of Australia “NAB”, and Australia New Zealand

Bank “ANZ”) make up $1.5 trillion worth of mortgages, each representing ~ 60 – 65% of their total net

loans. Total loans for Australian banks stand at a staggering 210% of GDP.

As of September 30, 2015, total Housing stock was $5.9 trillion AUD (www.abs.gov.au). GDP is only $1.5

trillion. Housing is the largest asset there by far. To give you a little perspective, the chart below

compares household debt to GDP to the US and UK. There was a little correction in 2009, but as the US

and UK household delivered, the Australian household debt marched higher.

Household Debt to GDP % (BIS Data)

	AUS	US	UK
1980	38	48	32
1985	40	46	45
1990	45	58	62
1995	52	61	63
2000	66	65	65
2005	95	85	90
2010	108	95	101
2015	110	78	91

(source: www.debtdeflation.com/blogs -- converted from chart to table for posting purposes. %s are close approximates)

Why now?

The economy is slowing with limited growth drivers on the horizon.
APRA rules limiting Investor property loan growth showing up in investor share of total financecommitments (as a % of total finance commitments it is rolling over hard).
Average house price to median income is north of 6 in major Australian cities (north of 10 in
Sydney alone) (1). Australia, as a whole, is considered very unaffordable.
50% of income is used to service mortgages. (2)
The government is cracking down on foreign ownership (notably Chinese). (3)
Population growth is slowing dramatically.

The Reserve Bank of Australia (“RBA”) has been keeping the housing bubble afloat via interest rate cuts,

which currently stand at 2.0%. On the fiscal front the government has implemented various initiatives

such as providing credits to First Time Home buyers.

Mortgage rates are predominantly floating rate, which has allowed the housing bubble to continue to

inflate even as the macro picture has deteriorated. Fixed rates are not the norm and are only 5 years

max. There are no 30 year fixed rate mortgages. RBA cuts by 25 basis points, and the big banks pass

along 20 of it. Homeowners have a built in refi and have benefited as the RBA has cut from 5% all the

way down to 2% currently. Those are not the actual mortgage rates though. Depending on the type of

loan, rates range from the low 4s to low 5s (%).

Bank Valuations:

You don’t hear anyone down under who is bullish on banks talk about their lofty premiums to tangible

book. It’s all about dividend yields, and to a lesser extent, price to earnings. CBA currently sports a

dividend yield of nearly 6%, and a PE of 13. ROA is a little over 100 bps, ROE is best in class at 18%,

resulting in a premium to tangible book of 285%.

	LAST	Mkt Cap	EV	MRQ	Price Per		pay out	Div Yield	NIM	ROA	ROE	Leverage
	PRICE	($mln's)	($mln's)	TBVPS	TBVPS	EPS	ratio	(%)	last avail	last avail	last avail

NAB-AU	26.16	$ 67,319	$ 323,098	$ 17.07	1.53	2.56	75.32%	7.8	1.87	0.69	12.20	18.3
BOQ-AU	11.23	$ 4,130	$ 13,202	$ 7.07	1.59	0.87	85.25%	6.7	1.80	0.67	9.34	13.9
WBC-AU	29.98	$ 98,478	$ 276,385	$ 12.97	2.31	2.55	73.16%	6.4	2.09	1.01	15.77	14.8
CBA-AU	74.28	$ 123,507	$ 299,277	$ 25.40	2.92	5.55	75.73%	5.8	2.09	1.09	17.90	17.8
ANZ-AU	23.75	$ 67,512	$ 203,168	$ 16.86	1.41	2.72	66.67%	7.8	2.04	0.90	14.08	15.6

You have to go back to the early ‘90s to see CBA trading near book, which incidentally is the last time

the annual change in economic growth was negative. 2008 was a slowdown, not a recession.

Five year CDS spreads on CBA were as low as 52 bps in Q4/14 and have recently shot up to 130. Still

below 2001 levels, but it’s something to watch.

Foreign appetite for Australian Banks is also waning. Some of it is anecdotal, but there are a few articles

out mentioning that the run up in bank stocks was due to the under allocation of Australian financials

for international portfolios. That catch-up (Brian Johnson, analyst at CLSA has written up on this) is

largely done.

The Financial sector has handily outperformed the ASX since 2012

(http://us.spindices.com/indices/equity/sp-asx-200-financial-x-a-reit-sector). The total market

capitalization of the ASX is roughly $1.5 trillion. CBA, WBC, ANZ, and NAB collectively have a market cap

of $355 billion, or ~ 26.5% http://www.asx200list.com/), which is similar to where the US Financial

sector was as a percentage of the S&P 500 back in the mid 2000’s. In the US in 2006, Financials were the

2nd best return sector in the S&P and the proceeded to finish dead last in 2007 and 2008 and was a

chronic underperformer until 2012

(http://www.sectorspdr.com/sectorspdr/Pdf/All%20Funds%20Documents/Document%20Resources/10

%20Year%20Sector%20Returns). I think Aussie banks face a similar fate. I think it’s already started.

Economy:

Leading indicators suggest weaker economic growth

Soft US growth, slowing Chinese demand, and low commodity prices are clouding the outlook for the

Australian economy, as evident by the leading indicators index.

The Westpac/Melbourne Institute Leading Index fell to -1.24 per cent in January, after dropping to -1.0

per cent in December. This is the third consecutive fall in the index which indicates a slowing pace of

economic activity over the next three to nine months.

The Australian banks have been extremely sanguine in their outlook for the Aussie economy, but even

Westpac chief economist Bill Evans called this disappointing. "The index has now been growing below

trend for the last nine months. It continues to signal that growth in the Australian economy in the first

half of 2016 will be below trend," he said in a note.

Australia Terms of Trade:

The commodity bust has been acute. China bought iron ore, copper etc, from Australia hand over fist.

With the exception of 2008-2010, it had marched to dizzying levels before rolling over in 2013. The chart

corresponds well to the commodity super cycle (http://www.tradingeconomics.com/australia/terms-of-

trade).

The hardest hit regions in Australia following the commodity bust (referred to as the “mining GFC”) have

been to the north (Darwin, “Northern Territory”) and to the west (Perth, “Western Australia” region).

Australia’s two major cities, Melbourne and Sydney lie to the east in Victoria and New South Wales

(“NSW”) respectively. The median house price in Sydney stands around $1million. These regions have

received a windfall in stamp duties, taxes that amount to 3 to 4% of the total value of a property sale. In

NSW alone, stamp duty revenues were roughly $ 2 billion in mid-2008. By 2015, thanks to price

increases and the increase in sales, it has more than tripled to over $6 billion. These are meaningful

revenues to those regions, and has been a strong incentive for the central planners to keep the housing

bubble going this long.

Bank Funding:

CBA’s deposit funding stands at 66% of total funding. The Australian Prudential Regulation Authority

(“APRA”) is trying to slow this runaway housing market with various regulations. One of them is the

dependence on short term funding. Banks will have to rely more on long term funding which will likely

dampen net interest margins (which for CBA, stands at just north of 2%). Australian banks are heavily

reliant on foreign funding. With current global conditions, this funding isn’t likely to get much cheaper

and may prove harder to keep going forward. Offshore funding hit 53% of GDP as of the end of

September, 2015, from 10% in the early ‘90s, increasing the risk of capital flight during economic stress.

Capital raises:

CBA raised equity in late Q4 to meeting increasing capital requirements mandated by APRA by July 1

st, 2016. If you go to CBA’s investor site and pull up the most recent earnings presentation, you can see on

slide 51 their Tier 1 Capital position. It stood at 9.1%. The equity raise added 131 bps, and 2

nd half earnings added another 122. Dividends of 77 bps, underlying credit RWA & “other” adjustments of 28

and 38 bps respectively netted out to 10.2%. Come July 1st when banks have to increase their Risk

weighted assets tied to mortgages from 16% to 25% that will knock Tier 1 back to 9.1%. Therefore, the

capital raise is gone on a pro forma basis, likely indicating that subsequent capital raises are required.

These higher capital requirements, in conjunction with more expensive bank funding, will pressure

earnings / ROE’s for all the Aussie banks.

The Australian Household:

The lower income earners are much more levered to housing. On average, as reported in the media,

household net worth is decidedly positive. When you strip out the upper quintiles (need to strip out

multiple quintiles?), it’s a different story. If you remove assets like autos and household items, the net

equity looks even bleaker.

http://www.abs.gov.au/AUSSTATS/abs@.nsf/DetailsPage/6554.02011%E2%80%9312?OpenDocument

Some of you may have seen the “Crack shack or Mansion” site showing how nuts Vancouver, Canada

real estate has gotten. Sydney has their near equivalent. Here’s one example,

https://www.mcgrath.com.au/buy/house/nsw/lower-north-shore/willoughby/282692

Granted, the value’s in the dirt, but still….

Owner-occupied vs Investor mortgages:

For the past few years, the growth in credit has come almost entirely from Investor properties. APRA

has forced new measures limiting annual market growth for investment loans to 10%. Come July 1

st of this year, banks have to increase the % of risk-weighted-assets in mortgages from 16% to 25%. This will

be a decent hit to the banks’ Tier 1 Capital. The minimum is 8% and all of the banks will meet this test,

but its evidence of further tightening at time when the risks are most elevated.

The appeal of Investor-type properties lies in negative gearing. Simply put, it means if your mortgage

payment is greater than the income you receive on your rental, you may take that loss and apply it

against other income at tax time. Something that has not been viewed as peculiar to many given that

house prices only go up. Many Australians have never seen a housing bear market. That’s something

other countries experience. Not down under. As prices correct, as we believe they will, negative gearing

will become much less palatable. You can’t take hits to income and capital for too long. Certainly not

when it’s a vital component of your retirement savings and or income. There has been a lot of

discussion recently about it. Some are calling for it to only be allowed on new housing. I think bank

stocks will correct long before this legislation comes to pass.

A look at where CBA’s stock could go under increases in loan loss provisions:

As of December 2015, CBA’s total provision for loan losses across their entire loan portfolio is 55 bps.

That equates to roughly $3.7 billion. The December 2015 Half reported provisions of $564 million on

their income statement. Total loans are about $675 billion, of which Australian mortgages are close to

$400 billion. If loan impairments double to just over $1 billion or even triple to $1.5 billion, that is a

marketable hit to earnings. NPAT stood at $4.6 billion for the December half. Assuming a 28% tax rate,

NPAT decreases by 10 to 23%, which pushes the payout ratio up from 82% to 96%. These are bank of

the envelope calculations here, but you can see that a sudden jump in provisions puts the dividend in

jeopardy. CBA purchased Bank West that had $60 billion in mortgages tied to Western Australia. They

are more at risk in this geographic region than their competitors. As the economy continues to weaken,

this area will likely put more pressure on their loan book.

If they keep a low 70% payout ratio with this kind of a hit to earnings, the dividend would decrease to

somewhere around $1.50 per half or $3 / share annually. Assuming the current 6% dividend yield, that’s

a $50 stock price, which is still almost 2 times tangible book.

Conclusion:

Extremely favorable risk/reward. Rate cuts will not have the same effects as they previously have.

Unemployment is rising, the economy is slowing, and the average household is living in a home they

can’t afford. APRA rules are crimping demand and credit growth. Given the operational headwinds

outlined, I believe there is significant downside in CBA’s share price even if material stress in the Aussie

economy does not materialize. However, if either a significant housing correction or recession (or both)

were to emerge and investors adopt a different view on risk, shifting from a dividend yield and P/E

framework to P/TB, then CBA is extremely exposed at nearly 3x, given Aussie banks traded near tangible

book during the last recession down under.

Risks:

Credit growth is still positive and as long as it is, the banks will continue to make money. However, it

looks like it has plateaued around 1.8% on a quarterly basis.

Further rate cuts appear more likely given the Fed’s likely pause which will require the RBA to cut to

keep the dollar low. That’ll translate to lower mortgage rates, but it’s also a signal of economic

weakness that they can’t escape. However, they may extend the inevitable. (We were early in 2012,

but debt levels and prices have increased dramatically since then as well as a marked shift to the

negative in the economic outlook).

Foreign buying continues to prop up the Sydney / Melbourne housing markets.

Notes:

(1) http://www.smh.com.au/nsw/classic-ponzi-scheme-sydney-house-prices-cost-12-times-the-

annual-incomes-20151125-gl7fc0.html

(2) http://www.demographia.com/dhi.pdf

(3) http://www.domain.com.au/news/are-you-a-foreign-property-investor-in-australia-what-you-

now-need-to-know-20151201-glck5c/

I do not hold a position with the issuer such as employment, directorship, or consultancy.
I and/or others I advise hold a material investment in the issuer's securities.

Catalyst

Loan loss provisions tick up, putting pressure on earnings and dividends.

Subsequent equity raises and tightening lending conditions.

A continued weakening of the macro picture puts further pressure on bank earnings.

A recession. Whoa, what’s that?

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			2016	2017
Price:	74.28	EPS	5.41	0
Shares Out. (in M):	1,708	P/E	13.7	0
Market Cap (in $M):	126,800	P/FCF	0	0
Net Debt (in $M):	0	EBIT	0	0
TEV (in $M):	283,800	TEV/EBIT	0	0
Borrow Cost:	Available 0-15% cost