Bank of Queensland - Morgans

Banks│Australia│Equity research│March 9, 2018

Bank of Queensland Yield appeal

ADD (previously HOLD) Current price: Target price: Previous target: Up/downside: Reuters: Bloomberg: Market cap:

A$11.69 A$12.00 A$12.00 2.7% BOQ.AX BOQ AU US$3,582m A$4,589m US$12.12m A$15.47m 391.7m 100.0%

Average daily turnover: Current shares o/s Free float:

■ We expect BOQ’s strong capital position and surplus franking credits to result in payment of special dividends to ordinary shareholders over our forecast period. We are conservatively forecasting half-yearly fully franked special dividends of 5cps over our forecast period, however we believe the quantum of any half-yearly special dividends can be as high as 8cps fully franked.

■ We also believe that BOQ’s interim CET1 ratio target of 9.25% will ultimately prove to be too conservative if BOQ remains a standardised ADI. This creates potential for capital management initiatives in addition to our forecast of special dividends.

■ Based on our forecasts, a total dividend yield of 7.4% per annum fully franked is on offer, making the stock very attractive for investors seeking yield.

■ Our recommendation is upgraded to Add (from Hold).

Forecasting special dividends

Price Close

Relative to S&P/ASX 200 (RHS)

14.00

115.0

13.00

108.8

12.00

102.5

11.00

96.3

10.00 8

90.0

With a loan growth forecast of 4-5% pa over our forecast period, and a 1.5% discounted DRP in place, we believe BOQ can pay fully franked special dividends up to 8cps each half-year over our forecast period and still retain enough of a buffer above its interim CET1 target to have the option of accelerating investment spend. Such a scenario should allow BOQ to be compliant with APRA’s ‘profits test’; however, if statutory profits turn out to be less than our forecasts (particularly due to larger than expected non-cash items) then any half-yearly special dividends may be of a quantum less than 8cps to be compliant with the ‘profits test’. We are conservatively forecasting half-yearly special dividends of 5cps over our forecast period.

6

Expecting BOQ to optimise distribution of franking credits

Vol m

4 2 Mar-17

Jun-17

Sep-17

The reason we are expecting BOQ to operate a discounted DRP whilst paying special dividends is so that BOQ can distribute more of its surplus franking credit balance to shareholders. The franking credit surplus was $101m as at 30/9/2017.

Dec-17

Source: Bloomberg

Price performance Absolute (%) Relative (%)

1M -3 -3.9

3M -7.8 -6.9

12M -0.2 -3.4

Potential for accelerated investment spend

T (61) 2 9043 7903

The Company’s annual investment spend in recent times has been ~$60m. We believe the Company may look to use 5-10bps of surplus CET1 capital for its digital transformation program; this would equate to $20m-$40m of pre-tax spend. We believe the Company may take another few months to weigh up this option as it transitions from existing data centres to new data centres managed in a private cloud environment

E [email protected]

Investment view and changes to forecasts

Azib Khan

We have reduced our cash EPS forecasts by 2.0%/4.0%/5.2% in FY18F/FY19F/FY20F respectively as we now expect a 1.5% discounted DRP (with an assumed 35% take-up rate) to operate over our forecast period and we have lowered our NIM forecasts. Also, we are now forecasting half-yearly special dividends of 5cps over our forecast period. Our recommendation is upgraded to Add (from Hold), and our target price, based on our DDM valuation, remains unchanged at $12.00. Key downside risks include increased funding costs and greater-than-expected asset quality deterioration.

Financial Summary Net Interest Income (A$m) Total Non-Interest Income (A$m) Operating Revenue (A$m) Total Provision Charges (A$m) Net Profit (A$m) Normalised EPS (A$) Normalised EPS Growth FD Normalised P/E (x) DPS (A$) Dividend Yield BVPS (A$) P/BV (x) ROE % Change In Normalised EPS Estimates Normalised EPS/consensus EPS (x)

Aug-17A 926 175.0 1,101 -48.00 352.1 0.97 1.99% 11.95 0.76 6.50% 9.67 1.21 10.3%

Aug-18F 979 159.2 1,139 -55.33 373.4 0.98 0.71% 11.93 0.76 6.50% 9.73 1.20 10.1% (1.98%) 1.01

Aug-19F 1,018 160.8 1,179 -64.73 382.8 0.98 (0.30%) 11.92 0.76 6.50% 9.86 1.19 10.0% (3.99%) 0.99

Aug-20F 1,064 162.4 1,226 -75.45 395.6 0.98 0.39% 11.88 0.76 6.50% 10.02 1.17 9.9% (5.23%) 0.98

SOURCE: MORGANS, COMPANY REPORTS

IMPORTANT DISCLOSURES REGARDING COMPANIES THAT ARE THE SUBJECT OF THIS REPORT AND AN EXPLANATION OF RECOMMENDATIONS CAN BE FOUND AT THE END OF THIS DOCUMENT. MORGANS FINANCIAL LIMITED (ABN 49 010 669 726) AFSL 235410 - A PARTICIPANT OF ASX GROUP

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Expecting a series of special dividends We re-iterate that BOQ’s interim CET1 target looks very conservative At the time of its FY17 result announcement, BOQ announced an interim CET1 target of 9.25%. The minimum regulatory capital requirement for standardised banks under the ‘unquestionably strong’ framework will be 7.5% (based on existing risk weight calibrations) and it is reasonable to expect the standardised banks to operate with a 100bps buffer above this level – i.e. we believe 8.5% would be a reasonable target for a standardised bank under the ‘unquestionably strong’ framework. From this perspective, we continue to view BOQ’s interim CET1 target of 9.25% as very conservative and we continue to expect this target to be reduced in time if BOQ remains a standardised bank. Figure 1: Placing BOQ's interim CET1 target in context 9.60% 9.40% 9.20% 9.00% 8.80% 8.60% 8.40% 8.20% 8.00% Minimum requirement set out BOQ's interim CET1 target by APRA's 'unquestionably strong' paper with the addition of a 100bps buffer

CET1 ratio at end-FY17

Morgans forecast CET1 ratio for BOQ at end-1H18F

SOURCES: MORGANS, COMPANY REPORTS

Implications of APRA’s discussion paper on revisions to capital framework The discussion paper released by APRA in February 2018 proposes to recalibrate risk weights for advanced and standardised ADIs. While it is too early to say what the proposals will mean precisely for the total risk weighted assets (RWA) of individual ADIs, in the case of BOQ, we expect the proposals to result in a lower average residential mortgage risk weight and lower average SME risk weight. That is, we expect a reduction in BOQ’s total credit RWA. APRA has re-iterated that the discussion paper “should not require the industry to hold additional capital overall”. More precisely, APRA has said that “to the extent that the result is an overall increase in RWAs relative to current methodologies, it will be necessary to reduce the capital ratio benchmarks from those flagged in APRA’s 2017 information paper on unquestionably strong capital expectations, in order to ensure that the overall (dollar) quantum of capital increase is unaffected”. In the case of the major banks, APRA’s comments are easy to interpret as our expectation at this stage is that overall RWA will increase for the major banks, meaning that the unquestionably strong CET1 benchmark will likely end up lower than 10.5%. However, in the case of BOQ, we are expecting a reduction in total RWA, and APRA has not commented on whether the CET1 benchmark would increase in such a case. What we can conclude at this stage is that BOQ’s regulatory CET1

2

Banks│Australia│Equity research│March 9, 2018

dollar requirement will either be unchanged or lower relative to APRA’s 2017 information paper if there is a reduction in BOQ’s total RWA.

Potential for capital management initiatives As a result of the points raised above, we expect BOQ’s interim CET1 ratio target (based on current RWA calibrations) to end up being overly conservative. However, it is likely that BOQ will stick with this interim target until the implications of APRA’s latest discussion paper are clearer. Even with the interim CET1 target of 9.25% in place, we believe there is scope for BOQ to return capital to shareholders in the form of fully franked special dividends. In the absence of BOQ obtaining approval from APRA, any special dividends which are declared must adhere to APRA’s ‘profits test’ which, as per APS110, means that that the aggregate amount of dividend payments on ordinary shares cannot exceed after-tax earnings, after taking into account any payments on more senior capital instruments, in the financial year to which they relate. ‘Financial year’ here means a period of 12 consecutive months. We are forecasting BOQ to have a CET1 ratio of 9.5% at 31/3/2018. With a loan growth forecast of 4-5% pa over our forecast period, and a 1.5% discounted DRP in place, we believe BOQ can continue to pay a 8cps fully franked special dividend each half-year over our forecast period and still retain enough of a buffer above its interim CET1 target to have the option of accelerating investment spend. Such a scenario should also allow BOQ to be compliant with APRA’s ‘profits test’, however if statutory profits turn out to be less than our forecasts (particularly due to non-cash items being larger than expected) then any half-yearly special dividends may be of a quantum less than 8cps to be compliant with the ‘profits test’. We are conservatively forecasting half-yearly special dividends of 5cps over our forecast period. The reason we are expecting BOQ to operate a discounted DRP whilst paying special dividends is so that BOQ can distribute more of its surplus franking credit balance to shareholders. The franking credit surplus was $101m as at 30/9/2017. We believe there will be further potential for capital management initiatives once revisions to the capital framework are finalised as we believe it is likely that BOQ’s interim CET1 ratio target will turn out to be too conservative. If BOQ remains a standardised ADI, then we expect its CET1 target to ultimately be revised down to 8.5%. If this were to happen and based on our forecast RWA balance at 30/9/2020, ~$290m of CET1 capital could potentially be returned to shareholders in addition to our forecast special dividends and after allowing for potential for accelerated investment spend. This additional return of capital would equate to 69cps at end-FY20.

The option to accelerate investment spend The Company indicated at the time of its FY17 result release that surplus capital in the future may be used in the following ways: 

Organic growth;



Accelerating digital transformation;



Returns of capital to shareholders.

As mentioned earlier, we believe the Company can continue to pay a special dividend of up to 8cps fully franked each half-year over our forecast period and still have enough of a buffer above its interim CET1 target to have the option of accelerating investment spend. The Company’s annual investment spend in recent times has been ~$60m. We believe the Company may look to use 5-10bps of surplus CET1 capital for its digital transformation program; this would equate to $20m-$40m of pre-tax spend.

3

Banks│Australia│Equity research│March 9, 2018

At this stage we are not allowing for investment spend acceleration in our expense forecasts but there is enough of a buffer in our CET1 forecasts to allow for 5-10bps to be used for acceleration. We believe the Company may take another few months to weigh up this option as it transitions from existing data centres to new data centres managed in a private cloud environment.

Expected impact of AASB 9 on CET1 position BOQ will be adopting AASB 9 on 1/9/2018. In October last year, the Company mentioned that it was building a new collective provision model and that the new model is expected to be adopted in 1H18. The new model has been designed to address the requirements of AASB 9. The Company does not expect the new model to have a material impact on collective provisions. However, the Company did say it expects a reduction in the end-FY17 level of general reserve for credit losses (GRCL). We are allowing for a 5bps boost to the CET1 ratio from this factor in 1H18. Separately, we also expect the CET1 ratio in 1H18 to receive a 20bps benefit from changes made to APRA’s APS120 Securitisation standard. In overall terms, our understanding is that AASB 9 will have a mildly positive impact on BOQ’s CET1 ratio to the tune of ~5bps.

Looking for margin expansion Interest-only repricing and reduced TD competion the key tailwinds We continue to expect BOQ’s NIM to expand from 2H17 to 1H18F, largely due to the repricing of BOQ-branded interest-only home loans last August as well as reduced term deposit competition. We pointed out in the aftermath of BOQ’s long-term issuer credit rating downgrade last May that there appeared to be an outflow of term deposits attributable to depositors that have portfolio allocations based on credit ratings, such as councils, churches and family offices. We believe BOQ has since offered attractive term deposit rates relative to the market to ensure good overall term deposit retention and to attract new term deposits. We have lowered our NIM forecasts as a result of this factor. The following chart shows that the decline in BOQ’s market share of general government deposits came to a halt in September last year and has since increased. Figure 2: Deposits from general government 3,500

4.50% 4.00%

3,000

3.50% 2,500 3.00% 2,000

2.50%

1,500

2.00% 1.50%

1,000

1.00% 500

0.50%

-

0.00%

BOQ ($million - LHS)

Market share (RHS)

SOURCES: MORGANS, APRA

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Banks│Australia│Equity research│March 9, 2018

In the case of BOQ’s market share of household deposits, it also has not decreased since September last year as shown in the following chart. Figure 3: Deposits from households 19,400

2.45% 2.40%

19,200

2.35% 19,000 2.30% 18,800

2.25%

18,600

2.20% 2.15%

18,400

2.10% 18,200

2.05%

18,000

2.00%

BOQ ($million - LHS)

Market share (RHS)

SOURCES: MORGANS, APRA

In the absence of the credit rating downgrade, we would have expected BOQ’s NIM to benefit more from reduced term deposit competition, particularly given that BOQ has greater reliance on term deposits as a source of funding relative to the major banks.

Forecast NIM movement from 2H17 to 1H18F The following table shows the composition of our forecast NIM movement for BOQ from 2H17 to 1H18F. Figure 4: Forecast NIM movement from 2H17 to 1H18F Contribution to NIM movement (bps) Mortgage repricing

5

Front to back book and retention repricing

-4

TD spreads

1

Wholesale funding spread

0.5

Capital and low cost deposits

-0.5

Total

2 SOURCES: MORGANS, COMPANY REPORTS

Home loan growth remains sub-system …but not contracting APRA’s monthly banking statistics show that BOQ’s home loan book grew by 1.7% over the five months to 31/1/2018, lower than system growth of 2.1% over the same period. We believe it will be difficult for BOQ to achieve system home loan growth without compromising too much on margins until it has improved turnaround times in the broker channel. We believe the slower turnaround times mean that BOQ is having to rely on competitive pricing in the broker channel just to ensure that its overall loan book does not contract. The other key drag on BOQ’s home loan growth in recent times, in our view, has been closure of owner-manged branches (OMBs).

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Banks│Australia│Equity research│March 9, 2018

Changes to forecasts Figure 5: BOQ changes to forecasts FY18F

FY19F

FY20F

New

Old

Change

New

Old

Change

New

Old

Change

1,139

1,148

(0.8%)

1,179

1,188

(0.8%)

1,226

1,236

(0.8%)

-530

-530

0.0%

-547

-547

0.0%

-566

-566

0.0%

B&DD charge ($m)

-55

-55

0.0%

-65

-65

0.0%

-75

-75

0.0%

Cash earnings ($m)

387

394

(1.7%)

397

404

(1.7%)

410

417

(1.7%)

Cash EPS ($)

0.98

1.00

(2.0%)

0.98

1.02

(4.0%)

0.98

1.04

(5.2%)

Ordinary DPS ($)

0.76

0.76

0.0%

0.76

0.76

0.0%

0.76

0.76

0.0%

Income ($m) Expenses ($m)

SOURCES: MORGANS, COMPANY REPORTS

6

Banks│Australia│Equity research│March 9, 2018

Figure 6: BOQ financial summary

FINANCIAL SUMMARY

2016A

1H17A

2H17A

2017A

1H18F

2H18F

2018F

2019F

2020F

Rep. NPAT ($M)

338

161

191

352

187

187

373

383

396

Cash NPAT ($M)

360

175

203

378

194

194

387

397

410

No. shares (M)

381

387

392

392

393

399

399

411

422

Avg # of shares (M) Cash EPS ($)

377

385

391

388

393

397

395

406

417

0.95

0.45

0.52

0.97

0.49

0.49

0.98

0.98

0.98

-2%

2%

1%

0%

0%

PER (x)

12.2

12.0

11.9

12.0

11.9

Ordinary DPS ($)

0.76

Cash EPS growth (%)

0.38

Special DPS ($) Ordinary dividend payout ratio Total div yield (%)

80%

84%

0.38

0.76

0.38

0.38

0.76

0.76

0.76

0.08

0.08

0.05

0.05

0.10

0.10

0.10

78%

77%

78%

73%

6.5%

7.2%

77%

78%

77%

7.4%

7.4%

7.4%

Franking (%)

100%

100%

100%

100%

100%

100%

100%

100%

100%

NTA ($M)

2,718

2,819

2,916

2,916

2,928

3,009

3,009

3,178

3,352

7.13

7.28

7.44

7.44

7.45

7.55

7.55

7.74

7.95

1.5

1.5

1.5

NTA per share ($) Price to NTA ps (x)

1.6

1.6

Cash ROE (cash NPAT / start NTA)

14%

14%

13%

13%

13%

Book ROE (NPAT / avg ord equity)

10%

10%

10%

10%

10%

INCOME STATEMENT ($M) Net interest income Non interest income Total income Operating expenses

2016A

1H17A

2H17A

2017A

1H18F

2H18F

2018F

2019F

2020F

937

452

474

926

487

492

979

1,018

1,064

173

80

95

175

80

80

159

161

162

1,110

532

569

1,101

567

572

1,139

1,179

1,226

-520

-252

-261

-513

-264

-266

-530

-547

-566

B&DD charge

-67

-27

-21

-48

-26

-29

-55

-65

-75

Pre-tax profit

523

253

287

540

277

277

553

567

585

-163

-78

-84

-162

-83

-83

-166

-170

-176

360

175

203

378

194

194

387

397

410

-7

-8

-5

-13

0

0

0

0

0

Tax Cash NPAT Significant items Amortisation of customer contracts

-15

-6

-7

-13

-7

-7

-14

-14

-14

Statutory NPAT

338

161

191

352

187

187

373

383

396

KEY COMPONENTS

2016A

1H17A

2H17A

2017A

1H18F

2H18F

2018F

2019F

2020F

Net interest margin

1.93%

1.85%

1.90%

1.87%

1.92%

1.90%

1.91%

1.89%

1.88%

Gross LUM growth

5%

0%

2%

2%

2%

2%

4%

5%

5%

Income growth

2%

-5%

7%

-1%

0%

1%

3%

4%

4%

Expense growth

4%

-5%

4%

-1%

1%

1%

3%

3%

3%

Cost-to-income ratio

46.8%

47.4%

45.9%

46.6%

46.5%

46.5%

46.5%

46.4%

46.1%

B&DD charge / start GLA

0.16%

0.13%

0.10%

0.11%

0.12%

0.13%

0.13%

0.14%

0.16%

9.0%

9.3%

9.4%

9.4%

9.5%

9.5%

9.5%

9.5%

9.5%

Common equity ratio - Basel III

SOURCES: MORGANS, COMPANY REPORTS

7

Banks│Australia│Equity research│March 9, 2018

Queensland Brisbane

New South Wales +61 7 3334 4888

Stockbroking, Corporate Advice, Wealth Management

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Melbourne

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Stockbroking, Corporate Advice, Wealth Management

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Stockbroking, Corporate Advice, Wealth Management

Brisbane: Edward St

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+61 2 4227 3022

South Australia

Hobart

+61 2 6232 4999

+61 8 8981 9555

+61 3 6236 9000

Disclaimer The information contained in this report is provided to you by Morgans Financial Limited as general advice only, and is made without consideration of an individual’s relevant personal circumstances. Morgans Financial Limited ABN 49 010 669 726, its related bodies corporate, directors and officers, employees, authorised representatives and agents (“Morgans”) do not accept any liability for any loss or damage arising from or in connection with any action taken or not taken on the basis of information contained in this report, or for any errors or omissions contained within. It is recommended that any persons who wish to act upon this report consult with their Morgans investment adviser before doing so. Those acting upon such information without advice do so entirely at their own risk. This report was prepared as private communication to clients of Morgans and is not intended for public circulation, publication or for use by any third party. The contents of this report may not be reproduced in whole or in part without the prior written consent of Morgans. While this report is based on information from sources which Morgans believes are reliable, its accuracy and completeness cannot be guaranteed. Any opinions expressed reflect Morgans judgement at this date and are subject to change. Morgans is under no obligation to provide revised assessments in the event of changed circumstances. This report does not constitute an offer or invitation to purchase any securities and should not be relied upon in connection with any contract or commitment whatsoever.

Disclosure of interest Morgans may from time to time hold an interest in any security referred to in this report and may, as principal or agent, sell such interests. Morgans may previously have acted as manager or co-manager of a public offering of any such securities. Morgans affiliates may provide or have provided banking services or corporate finance to the companies referred to in the report. The knowledge of affiliates concerning such services may not be reflected in this report. Morgans advises that it may earn brokerage, commissions, fees or other benefits and advantages, direct or indirect, in connection with the making of a recommendation or a dealing by a client in these securities. Some or all of Morgans Authorised Representatives may be remunerated wholly or partly by way of commission.

Regulatory disclosures Analyst owns shares in the following mentioned company(ies): -

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