In early July 2021, Bank of Queensland (ASX:BOQ) completed the acquisition of Members Equity Bank Limited (ME Bank). The acquisition is significant in that it materially improves BOQ’s market position & scale and is accretive to earnings. However, the broader question is whether the acquisition is likely to allow BOQ to generate higher volume growth and improve key financial measures, such as operating leverage and Net Interest Margin.
We recently researched BOQ to determine whether there is potential for further upside in the shares from these factors.
About Bank of Queensland
Bank of Queensland offers core banking (commercial/retail) services, equipment finance, wealth management and insurance. BOQ uses its unique concept of the Owner-Managed Branch (OMB). This is a partnership between the Bank of Queensland (franchisor) and experienced bank managers (franchisees) to provide banking services. The bank operates in two segments – the Retail Bank and the Business Banking division. The loan book is split around 2/3rd residential and 1/3rd from commercial.
Key Fundamental Drivers
Effectively Managing Cost Growth
The Company is currently in year two of its three-year productivity program. This is designed to deliver $90m of productivity benefits over three years in order to fund investment in a “digital transformation” strategy. The key aim of this strategy is to deliver above-system growth and operating leverage (i.e. positive revenue growth in excess of expense growth).
BOQ’s revenue growth lagged expense growth in four of the five years from FY16 to FY20. However, the productivity benefits generated to date have allowed the Company to keep cost growth below revenue growth for the past two half-year periods. These cost savings do not include $70-80m of synergies targeted from the ME Bank acquisition, which positions the Company to continue generating operating leverage in FY22.
Revenue Growth Evident – But Volume Growth Yet to Be Reflected in Net Interest Margin Expansion
In addition to favourable impairment trends which are consistent with the broader banking sector, regional banks are benefitting from improving housing credit growth, with strong demand from owner-occupiers, including first-home buyers.
Accordingly, regional banks continue to take share. Both with Bendigo and Adelaide Bank (ASX: BEN) and BOQ are growing at ~2.5x and ~2.0x system, respectively.
While BOQ has been able to improve volume growth, one concern with BOQ’s recent volume growth is that it appears to have been driven by price. This was evidenced in further Net Interest Margin (NIM) compression in mortgages and commercial loans of ~6 basis points and ~1 basis point, respectively, in 1H21 in comparison to 2H20.
The margin decline in mortgages was driven by competition for new home loans through more attractive front book rates and retention discounting. This is together with increased flows into lower margin fixed rate lending. In relation to commercial lending, the margin decline resulted from lower front book rates on commercial lending. BOQ was able to only partially offset this impact from repricing (+2 basis points).
What are the Avenues to Support Net Interest Margin?
The largest positive contributor BOQ’s NIM is lower funding costs and improved mix. In 1H21, funding costs improved by 13 basis points. This was primarily as a result of repricing at-call, retail term deposit and money market portfolios together with an improvement in portfolio mix as at-call growth continued while more expensive term deposit funding was run-off. However, the benefit from improved funding costs is merely offsetting other negative impacts on NIM. This includes asset pricing and as such, BOQ’s NIM has remained broadly flat.
The relevance here is that ME Bank has a lower NIM than BOQ (ranging from 1.48% to 1.56% from FY18-20) in comparison to BOQ’s NIM of 1.95% as at 1H21 (on a standalone basis). As such, the Pro-forma NIM for the combined group in FY22 is expected to decline to ~1.74%.
The Company has an opportunity to re-price BOQ-branded and ME Bank term deposits, without suffering material deposit outflows. This assessment is based on a comparison of advertised term deposit rates, which show that: i) BOQ’s term deposit rates are 15-25 basis points higher than the major banks and BEN and ii) ME Bank’s term deposit rates are a further ~20 basis points higher than BOQ and are amongst the highest in the market.
Notwithstanding that BOQ shares appear attractive on a P/E and yield basis relative to the major banks and BEN (its main regional bank competitor), we consider that outperformance in BOQ shares is unlikely for the following reasons:
i. Whilst BOQ remains well capitalised to support growth and transformation initiatives, BOQ’s Common Equity Tier 1 (CET1) ratio is well below that of the major banks. The latter group have recorded steady increases in the CET1 ratio (which are slightly higher when including divestments) and appear better positioned to utilise excess capital to fund growth over a longer timeframe than BOQ.
ii. Uncertainty as to whether BOQ can improve BOQ-branded and ME Bank term deposits to improve pro-forma NIM, without suffering material deposit outflows.
iii. Whether the Company can reduce its reliance on price to drive volume growth. While volume momentum continues, there has been evidence of further margin compression. Most notably in mortgages (which account for 2/3rd of the overall loan book) which has only partially been mitigated by re-pricing.
Shares in Bank of Queensland appear to be forming an ascending triangle with the trading range still tightening up even further. This means that if it breaks to the upside, we might get a further push higher in the share price and an opportunity for those looking to sell to get better prices. Otherwise a clear break to the downside would see further share price weakness.
Michael Gable is managing director of Fairmont Equities.
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