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Has Valuation Support Emerged For BOQ?

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Revenue remains the biggest challenge for Bank of Queensland ((BOQ)) as first half results revealed a decline in cash net profit to $182m, largely because of weakness across a number of non-interest income items. Competition is causing the pressure, as banks discount mortgages for new customers, and Bank of Queensland's lending volumes have suffered over recent years.

The bank's prudent underwriting standards, while beneficial in the longer term, have come at the expense of growth in the balance sheet. UBS observes this led to Bank of Queensland's borrowing limits being uncompetitive. Major banks, meanwhile, relied heavily on the household expenditure measure (HEM) benchmark.

Ironically, the broker suggests, while the Royal Commission has instructed major banks to obey responsible lending laws, which could mean a material reduction in their borrowing limits and bring them into line with Bank of Queensland, it could lead to a sharp reduction in system housing finance.

Lending growth lagged UBS estimates and non-interest income was -6% below forecasts, as customers migrated to lower fee products. The result was supported by flat costs and benign bad debt charges.

Bank of Queensland is selling the St Andrews insurance business which will result in a gain on sale of $8m and release around 20 basis points of CET1 in the second half. Yet, UBS calculates this leads to an earnings hole of around -2%.

The broker expects revenue to continue falling from pressure on net interest margins, lower fee income and the potential for mortgage brokers to move to a flat fee-for-service model. UBS requires further declines in the share price for becoming positive on the stock.

Over the long-term Ord Minnett is concerned the competition in retail banking will have more of an impact on Bank of Queensland that on its peers, because of a higher exposure to mortgages, lack of clear product differentiation, and a sub-par digital offering.

While the share price has underperformed recently, and the challenges are now better reflected in the valuation, the broker expects flat growth in earnings per share over the next two years.

Improving volumes via brokers and branches are niche growth options which will provide the differentiation, although Morgan Stanley suspects the end of Australia's mortgage bull market and competition limits the upside.

Shaw and Partners expected little from the first half results, noting previous mortgage re-pricing activity was eroded by the higher discounts being offered for new business. Regardless, the broker points out this is standard banking practice.

Valuation Vs Yield

The current share price still reflects low expectations and, while upside may be limited, the stock seems marginally cheap. As a result, Shaw and Partners, not one of the eight stockbrokers monitored daily on the FNArena database, maintains a Buy rating and $11.30 target.

While it is tempting to argue that valuation support has emerged, as the stock is trading on a PE for FY18 of around 11.7x with a 7% dividend yield, short-term catalysts are absent and the pay-out ratio stretched. Hence, Ord Minnett maintains a Lighten rating.

In contrast, Macquarie believes value has started to emerge and upgrades to Neutral from Underperform. The broker believes the PE multiple and dividend yield should provide the support for the share price, and the bank will ultimately look to recover elevated funding costs through re-pricing initiatives.

While still preferring exposure to the major banks at current levels Macquarie expects the competitive landscape will become more favourable for regional banks in the medium term.

Capital Management

Morgan Stanley believes the need to invest in its digital offering amid uncertainty on final capital requirements reduces the scope for capital management. The broker factors in a 50% neutralisation of the dividend reinvestment plan together with a $65m buyback.

While the profit and loss trends are disappointing, Ord Minnett notes strong leading indicators on asset quality. Ultimately, the broker envisages opportunity for further capital management but does not expect this until after the St Andrews sale, and expects the bank to utilise some of its surplus capital to invest in digital.

Bell Potter believes completion of the St Andrews transaction should free up a further 20 basis points in CET1 capital while the bank should pay another $0.08 special dividend in the second half.

The broker, not one of the eight monitored daily on the database, has a Hold rating and $11.30 target. Credit Suisse also envisages scope for further special dividends and includes a $0.10 special in the second half.

Morgans expects special dividends to be declared as a result of the strong capital position and surplus franking credits and considers this the most likeable feature of the result. The broker maintains an Add rating largely because of the attractive dividend yield.

FNArena's database shows three Sell ratings, four Hold and one Buy (Morgans). The consensus target is $11.19, suggesting 5.8% upside to the last share price. Targets range from $9.80 (UBS) to $13.00 (Citi, yet to update on the result). The dividend yield on FY18 and FY19 forecasts is 7.5% and 7.3% respectively.

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