Is the performance gap between BoQ and the big-four widening?

Given that the one-page missive it released to the market during reporting season raised uncertainty over future direction, it’s hardly surprising that Bank of Queensland Limited’s (ASX: BOQ) share price fell more than14% to $10.87 before bouncing back up to $11.

The bank’s plans to automate back office functionality and digitise the business – resulting in around 50 job cuts – would have arguably found favour with the market.

But what caused many shareholders to panic wasn’t so much the 6% decrease in net income to $1.07 billion for the six months ending 29 February – 4% below consensus expectations – but the underlying commentary within its outlook statement.

CEO Jon Sutton made it unambiguously clear that volatility in funding markets and strong competition for new business was creating ‘headwinds for its margin outlook.’

Higher cost of borrowing on volatile international markets, together with more intense competition for home loans, and especially deteriorating wholesale funding markets has refocused the market on Bank of Queensland’s profitability, with the bank having to closely watch its cost income ratio (CIR).

Analysts prefer a bank’s CIR to remain below 50 and at 51.27% and Bank of Queensland’s is clearly not as good at controlling its costs as Commonwealth Bank of Australia (ASX: CBA), Westpac Banking Corporation (ASX: WBC) and Australia and NZ Banking Group (ASX: ANZ) which have CIRs of 42.54%, 43.77% and 44.76% respectively.

There’s also growing concern that after working hard as a second-tier lender to rival the profit margins of the big-four banks in recent years, Bank of Queensland could start to show signs of the gap becoming even more pronounced.

While Bank of Queensland’s forecast and historical return on equity (ROE) has struggled to get beyond high single-digits, three of the big-four have repeatedly outperformed it with CBA, Westpac, and ANZ achieving historical ROE of 18.08%, 16.06% and 14.54% respectively.

While high single-digit returns within today’s soft earnings environment still look pretty damn good, the point is that Bank of Queensland pales in comparison with three of its big-four rivals.

But ROE aside, its profitability where the bigger gulf between Bank of Queensland and its bigger rivals is surfacing with return on assets (ROA) of 0.67% compared with ROA of 1.08%, 1.01% and 0.90% recorded by CBA, Westpac and ANZ respectively.

What’s clearly taking its toll on the bank’s margins is more costly distribution channel added within recent years, with brokers now accounting for 19% of new loans. Although, it’s also getting 27% of new loans from its more-profitable BOQ Specialist.

But on a more positive note, Bank of Queensland remains an efficient bank – relative to its peers – with a net interest margin of 1.92%, compared with an industry average of around 1.8%.

In response to margin pressure and higher funding costs, the bank announced a 25 basis point lift in home loan lending rates for investors and 12 basis points for owner occupiers effective from 15 April 2016, despite no lift in the Reserve Bank’s cash rate.

Sutton expects rate increases to help achieve the appropriate balance between growth, asset quality and profitability. This is expected to help Bank of Queensland achieve a higher loan growth rate than the market average for the first time in several years. 

Best estimates suggest the interest rate rise will add around 0.06% to its margins in the next half, but will not require the bank to raise extra capital as the major banks have done.

Out of cycle home loan hikes clearly won’t help Bank of Queensland, but in fairness it’s by no means alone with the big-four – including itself – having already moved to increase home loan rates for borrowers.

When banks hit tougher times like these, it’s easier to see what pressure shareholders place on them to maintain their status as yield stocks, with Bank of Queensland paying an interim dividend 2 cents over prior corresponding half to 38 cents per share.

Based on the 25% discount it’s trading at, relative to its high of $14.49 late November 2015, Bank of Queensland does look to have been oversold.

But while it’s still trading on a premium to its intrinsic value of around 10%, the market is concerned that the earnings momentum the stock has enjoyed in the past might be behind it.

There seems little to attract investors to Bank of Queensland over the better performing big-four banks which incidentally are all trading on discounts to their IV of between 13.74% and 17.04%.

If you own the stock, there’s no reason to sell right now. But if you’re looking to buy, any price under $10.70 makes for a more attractive entry point, especially with a median price target of $12.25 likely to be revised downwards.