Company Reports

It’s a difficult operating environment for Bank of Queensland—first-half 2024 cash profit fell 33% to AUD 172 million, and return on equity, or ROE, was just 5.8%. The no-moat bank is grappling with intense lending and deposit competition, in part due to underinvestment in its digital capability over the years, and in part because it has been forced by regulators to address risk and compliance issues. As the bank progresses through these issues, it is likely to be more risk-averse and cause workflow disruptions to staff who should be focused on lending. The result would have been even weaker if bad debts had not stayed well below historical average levels.

Bank of Queensland is one of Australia's top-10 largest banks, but is considerably smaller than the four major Australian banks. Preceding the global financial crisis, the bank grew aggressively via acquisitions and the rollout of its distinctive owner-manager branch franchise model. However, expanding the branch network and diversifying from traditional residential lending came at a cost, with additional equity required to fund growth, significantly increased bad debts, and multiple banking systems, which resulted in deteriorating cost/income and returns on equity.

After reasonably uneventful earnings updates, it is hard to pinpoint a single specific driver for the turnaround in bank sentiment. Still, we think part of it is that a likely lower cash rate eases housing fears and provides banks an opportunity to reprice loans and deposits to protect margins. Major bank share prices increased 23% since November 2023, outperforming the 16% increase in the Morningstar Australia Index over the same period. The major banks' weighted average price/fair value estimate is 1.14, up from 1.05 in the last quarter. Nonmajor banks trade at a price/fair value of 0.85.

Australian banks face low credit growth, softer net interest margins, and an increase in loan losses in the short term. Industry returns on equity will be suppressed in fiscal 2024. However, we expect loan and deposit pricing changes in the medium term to lift margins to a level that allows wide-moat-rated major banks to generate maintainable returns above our 9% cost of equity.

The short-term outlook for Australian banks is challenging with margins under pressure, loan losses expected to rise, and inflationary cost pressures unable to be offset by cost-cutting initiatives. Industry returns on equity are suppressed, hence we expect loan and deposit-pricing changes in the medium term to lift margins to a level that allows wide-moat-rated major banks to generate returns above our 9% cost of equity.

Bank of Queensland is one of Australia's top-10 largest banks, but is considerably smaller than the four major Australian banks. Preceding the global financial crisis, the bank grew aggressively via acquisitions and the rollout of its distinctive owner-manager branch franchise model. However, expanding the branch network and diversifying from traditional residential lending came at a cost, with additional equity required to fund growth, significantly increased bad debts, and multiple banking systems, which resulted in deteriorating cost/income and returns on equity.

Bank of Queensland's fiscal 2023 cash profit fell 8% to AUD 450 million, around 6% below our forecasts. As expected, the bank's funding cost disadvantage, with very little sourced from cheap transaction accounts compared with peers, has weighed on margins and resulted in the bank being less aggressive in chasing loan growth. However, we underestimated the financial impact. Net interest margins fell to 1.69%, well short of our 1.75% forecast, as second-half NIM tanked to 1.58%. We reasoned the declining loan book, as market share in housing fell to 2.81% from 2.92% just six months prior, would have offered more margin protection.

Ahead of reporting first-half fiscal 2023 results next week. Bank of Queensland announced an AUD 200 million goodwill write-down plus an AUD 60 million pretax provision to cover costs of uplifting nonfinancial risk controls over the next three years. The latter includes systems and processes to manage operational risk (cybersecurity, fraud, human error, and so on), risk culture, and compliance with anti-money laundering laws. The goodwill write-down is of little consequence, in our view, but the spending on risk is noteworthy as the board highlighted it when booting the CEO late last year. The costs are expected to be one-off, and in our view “catch-up” investments. Pressure is likely coming from regulators, with management noting internal and external reviews had identified areas of weakness. Given how costly breaches of anti-money laundering law have been for Commonwealth Bank and Westpac in recent years, it is money well spent.

The increases in the Reserve Bank of Australia cash rate to arrest inflation will have an impact on key earnings drivers for the banks. With the cash rate currently at 2.35%, and likely north of 3% by year-end, the increases from just 0.1% in April 2022 have been swift. It is expected to slow credit growth, with less borrowing capacity and confidence (a complete turnaround from the fear-of-missing-out environment of recent years). However, we think bank sector revenue growth will be buoyed by higher net interest margins, with the spread between lending rates and the cost of customer deposits widening.

Bank of Queensland will report fiscal 2022 results on Oct. 12, 2022, and we expect the no-moat-rated regional bank to report net interest margin, or NIM, improvement toward the end of the second half, bad debts and arrears to remain low, provision balances to be little changed, and COVID-19-related provisions simply shifting to economic uncertainty related provisions.

Bank of Queensland’s result was a little stronger than we expected. Cash earnings increased 9% on first-half fiscal 2020, largely a result of net interest margins, or NIM, increasing 6 basis points to 1.95%. NIM expansion reflected cheap funding from increased customer deposits, specifically savings (up 16%) and transaction account balances (up 24%). The earnings turnaround from the second half of fiscal 2020 is even more pronounced, up 66%, after the bank booked significant loan loss provisions last year.

Environmental, social and governance, or ESG, factors can have a material bearing on the cash flow and valuation of firms. In the past, issues such as James Hardie’s asbestos liability or AMP’s management of its conflicts of interest have had a material impact on the valuation of those firms. Identifying and assessing ESG risks is critical to any thorough assessment of a company’s cash flow and earnings potential. At Morningstar, we incorporate ESG into our long-term-oriented methodology by focusing on issues with the highest risk, defined by likelihood and materiality to a company’s intrinsic value.

Bank of Queensland is smaller than its regional bank rival, Bendigo and Adelaide Bank, and is considerably smaller than the four major Australian banks. Preceding the global financial crisis, the bank grew aggressively via acquisitions and the rollout of its distinctive owner-manager branch franchise model. However, expanding the branch network and diversifying away from traditional residential lending came at a cost, with additional equity required to fund growth, significantly increased bad debts, and multiple banking systems, which resulted in deteriorating cost/income and returns on equity. Acquisitions do not appear likely for the bank in the near term.

We have increased our fiscal 2021 dividend forecasts across our banking coverage following APRA’s announcement that from 2021, the regulator will no longer require banks to limit distributions to 50% of earnings. We had assumed the restriction would be in place until fiscal 2022, but the improvement in the economic outlook, sharp decline in temporarily deferred loans, and the banks’ capital positions, provide us comfort the move is not too early. The increase to dividends is not material to our fair value estimates. We continue to see Westpac as modestly undervalued, ANZ and National Australia Bank fairly valued, and Commonwealth Bank overvalued. On our updated numbers, the banks trade on fully franked fiscal 2021 dividend yields of 3.5% to 4.5%.

We retain our AUD 7 fair value estimate for Bank of Queensland, with an update on temporary loan deferral the highlight of the annual general meeting. As at Nov. 30, deferral balances have fallen to AUD 1.3 billion, down from AUD 2.3 billion in October, and a peak of AUD 7.2 billion in June. Current deferral balances represent 3% of home loan balances and 3% of the SME balances. While we had some concern Bank of Queensland’s business loan deferrals were not falling as quickly as peers', we had expected its large exposure to the medical industry would see the majority resume loan repayments once deferral periods ended. Many of these businesses, such as dentists and physiotherapists, were shut during lockdowns. In our view, falling deferrals provide comfort the bank's collective provisions are adequate. Our fiscal 2021 loan impairment expense forecast is reduced to 0.35% of gross loans from 0.45% previously, driving a 15% increase in fiscal 2021 cash profit. Longer-term forecasts are unchanged, hence the impact on our fair value is not material. Our loan expense forecast is still elevated relative to recent years, as stress across businesses and households will likely emerge as government support continues to be unwound. Conservative management teams across the banks are also likely to add to provisions as losses are realised.

Bank of Queensland is smaller than its regional bank rival, Bendigo and Adelaide Bank, and is considerably smaller than the four major Australian banks. Preceding the global financial crisis, the bank grew aggressively via acquisitions and the rollout of its distinctive owner-manager branch franchise model. However, expanding the branch network and diversifying away from traditional residential lending came at a cost, with additional equity required to fund growth, significantly increased bad debts, and multiple banking systems, which resulted in deteriorating cost-to-income and returns on equity. Acquisitions do not appear likely for the bank in the near term.

Bank of Queensland is smaller than its regional bank rival, Bendigo and Adelaide Bank, and is considerably smaller than the four major banks. BOQ grew aggressively through several years preceding the global financial crisis, much of this strong growth achieved through acquisitions and the rollout of the distinctive owner-manager branch franchise model. However, expanding the branch network and diversifying away from traditional residential lending comes at a cost, with additional equity required to fund growth and support significantly increased bad debts. Returns on equity have been subpar for several years.

Bank of Queensland’s first-half earnings result is broadly as expected, apart from the dividend, or lack thereof. First-half fiscal 2020 cash NPAT slid 10% to AUD 151 million, but was stable on second-half fiscal 2019. Annualised loan growth of 3% helped nullify a 3% fall in net interest margins, while a 9% increase in operating expenses to support the group's strategic priorities as well as higher risk and regulatory costs are as previously guided. Even loan losses remained low, flat at AUD 30 million or 13 basis points of loans. Including newly raised shares EPS fell 16%.

We have lowered our earnings and dividend forecasts for the banks, but with share prices down by as much as 40%, all are materially undervalued on our revised fair value estimates, or FVEs. Our fiscal 2021 forecasts are down between 6.5% to 11%, with National Australia Bank affected most by heightened risk of small business' defaults. On average we assume another 5 basis point reduction in NIM from fiscal 2021, with bad debts rising to around 22 basis points of loans, up from our previous expectation of 13 basis points. Dividends are also expected to fall across our coverage list. While near-term headwinds continue to mount, our FVEs are predicated on our view that the long-term cash rates will normalise and the majors will continue to benefit from cost advantages and switching costs, which underpin their competitive advantages.

Despite a recovery in Australian house prices, which supports credit growth and low bad debts, the Reserve Bank of Australia, or RBA, cut the cash rate 25 basis points in recognition of economic risks from the global coronavirus outbreak. The major banks will pass on the cut in full. This is great for borrowers but puts net interest margins, or NIMs, under pressure. We lower our valuations by 2.5% to 5%, with lower near-term earnings driven by margin compression.