Commonwealth Bank of Australia (ASX: CBA) has been a key driving force behind the Australian sharemarket's recovery since the depths of the Global Financial Crisis, and shareholders who have held on for the journey have been well rewarded.
Indeed, since bottoming out at just $24 in January 2009, the stock more than quadrupled in price, hitting an all-time high of $96.69 just under two months ago. That compares to a far more modest 95% return from the S&P/ASX 200 (Index: ^AXJO) (ASX: XJO) in the same time (neither figures include dividends).
But while some investors believe the bank's incredible rally can be sustained, there are strong signs that suggest the contrary. Indeed, the stock has retreated considerably since hitting that high and is now trading at roughly $84, putting it in what is known as a "technical correction".
Given that the bank is one of Australia's most widely-held stocks, it is important to address some of the enormous challenges that could threaten to derail investors' somewhat unreasonable expectations. Notably, this could also apply to each of the bank's major rivals, being Westpac Banking Corp (ASX: WBC), National Australia Bank Ltd. (ASX: NAB) and Australia and New Zealand Banking Group (ASX: ANZ), who find themselves in similar predicaments.
Below, we'll look at some of the key reasons why the bank has performed so strongly in recent years, as well as some important measures that could impact the bank's future prospects.
What's gone right?
One of the key drivers behind Commonwealth Bank's enormous success in recent years has been the low interest rate environment. The Reserve Bank cut interest rates by an unprecedented 400 basis points (from 7 percent to 3 per cent) in the seven months following the financial collapse of Lehman Brothers (as seen in Figure 2, below), which is widely considered as being the most severe stage of the Global Financial Crisis.
Indeed, the nation's cash rate has fallen even further since then. The RBA has cut interest rates twice this year alone, with the most recent one in May having taken the rate to a record low of just 2 percent.
As is the case with all banks, Commonwealth Bank's major profits are generated by charging interest to consumers and businesses whilst also levying other fees. The bank has increased its earnings per share (EPS) dramatically, while it has also nearly doubled its dividend per share since 2009 (more on that later).
Figure 1. Source: CBA Annual reports
The low interest rate environment has not only encouraged businesses and consumers to take out greater loans, but to also pay them off as quickly as possible, resulting in rapidly declining loan impairment charges (that is, bad debts). Although impairment expenses skyrocketed in 2009 as a result of rapidly deteriorating market conditions, they have since retreated considerably as businesses have sharply reduced their leverage, as can be seen in the chart below:
Figure 2. Source: Reserve Bank of Australia, CBA Annual Reports
Bad Debt Charges
To highlight the extent to which bad debt charges have declined, Commonwealth Bank's loan impairment expense as a percentage of average gross loans and acceptances (GLAA) was 72 basis points in 2009, but 16 basis points in the 2014 financial year. It was just 14 basis points as at the end of December 2014.
Indeed, declining impairment expenses and provisions have played a major role in the earnings growth of Commonwealth Bank and each of its major rivals in recent years, but there are concerns that this trend could be nearing a turning point. The fact is, declines in bad debt expenses and provisions are "pro-cyclical", meaning that while they enhance profits today, they could seriously dent earnings as they inevitably begin to rise once again.
While the Australian Prudential Regulation Authority (APRA) has also drawn attention to a possible dip in the major banks' lending standards (i.e. some customers may not be able to repay their loans when interest rates inevitably rise), bad debt charges could also increase due to the strong headwinds facing the local economy (e.g. rising unemployment; poor business confidence) together with Australia's booming property market.
Profitability
The net interest margin (NIM) is a key measure of every bank's profitability. It is worked out by deducting the interest the bank pays on deposits from the interest it receives from loans ("net interest income"), which is then divided by the bank's average interest earning assets.
As can be seen on the chart below, Commonwealth Bank's net interest income has risen strongly over the last 10 years, which is likely due to a boom in Australia's mining and housing sectors which contributed to a massive 175% increase in its loans, bills discounted and other receivables over that time.
But during the same period, the bank's NIM has actually fallen, meaning it is making considerably less profits on the loans that it writes. This is mostly attributed to just how competitive the banks are becoming in the fight for new customers in the low interest rate environment, and is another key concern for regulators such as APRA.
Commonwealth Bank's NIM declined by 2 basis points to 2.12% during its latest half-year period, ended 31 December, 2014. Note that this has not been reflected on the chart below, which shows to the end of the 2014 financial year.
Figure 3. Source: Company annual reports
While there were signs in its half-year report (released in February) that things weren't running as smoothly for the bank as they had been in prior periods, those fears were confirmed when it released its more recent third-quarter update (after which the stock plunged by nearly 6%, its heaviest fall since the GFC).
Although the bank remains on track to deliver a record annual profit, its quarterly earnings actually declined compared to the prior corresponding period, while it also said that its net interest margin continued to be impacted by the market's competitive pressures. Expenses grew during the period, while loan impairment charges were down just 1.5% year-on-year.
The steady decline in Commonwealth Bank's NIM, together with the slowdown in bad debt improvements, will make it increasingly difficult for the bank to continue growing earnings – especially at the rates it has achieved in years gone by.
In the second and final article of this series, we'll dive into some of the various other issues that could threaten the bank's ability to continue generating strong returns for investors, just as it has done in recent years. Of course, this will look at the bank's ability to maintain its all-important fully franked dividend as well. Watch this space tomorrow for "Part 2: Commonwealth Bank of Australia – The end of an era?"
