Value Investor: Westpac's fair weather is on the wane

Provisions for bad debts will inevitably rise in coming years, so Westpac needs to ramp up core earnings to sustain the pace of its dividend growth.

Westpac Banking Corp shareholders are fortunate that interest rates have fallen from the levels of  three to five years ago, as impairments of loans written then are lower than expected. Those borrowing now to speculate on rising property prices will probably face higher interest rates a few years from now. Inevitably, collective provisions will have to normalise and provisions for impaired loans can also be expected to rise. This normalisation will act as a headwind to earnings in coming years.

We do not forecast a sudden normalisation of bad debts assuming economic growth continues at current rates or faster. Our point is more the support to earnings growth from falling bad and doubtful debt charges and collective provisioning is probably nearly over. The low fiscal 2013 provisioning charge makes fiscal 2014 earnings growth more challenging. From here, Westpac needs to accelerate core (pre-provisions) banking earnings growth for bottom-line earnings, ROE and dividends to rise.

Investors need to ask some key questions about profitability and intrinsic value generation at Westpac : 

For how much longer will credit quality improve, driving bad debts expense lower still and supporting earnings and dividend growth?

Will loan growth accelerate, driving faster revenue growth as the support to profit growth from falling bad debts tapers?

We ask these questions because lower provisioning for bad debts was one of the main drivers of the solid fiscal 2013 result and the five per cent higher full year ordinary dividend in an otherwise challenging period. There were also 20 cents of special dividends. Fiscal 2013 provisions fell to 0.57 per cent of loans from 0.63 per cent in fiscal 2012 and 0.69 per cent in fiscal 2011. Statutory profit was 14 per cent higher at $ $6.816 billion.

The contribution to profitability of tapering provisions is set to decline, as bad and doubtful debt charges are at cyclical lows and cannot fall much further. While the downtrend is partly a result of several years of work by the banks to manage their credit quality carefully, a large cyclical component remains and can be expected to revert to a mid-cycle average at some stage.

Graph for Value Investor: Westpac's fair weather is on the wane

Figure: Westpac Bad & Doubtful Debt Charges

Source: Westpac Banking Corporation

Consensus fiscal 2014 earnings forecasts for Westpac deliver mid-single-digit pre-provision profit growth at best. A return to higher provisioning, for example from 16 basis points of gross loans to 20, halves this earnings growth to low single-digit, with corresponding implications for profitability (ROE). As earnings drivers, Westpac's bad debts, costs and capital management are quite optimised now. Interest margins will probably not be supportive as mortgage repricing wanes. Westpac's core IT system upgrade will also keep pressure on costs in fiscal 2015 to 2018.

This means banking income, and especially net-interest income, need to accelerate to meet shareholder expectations for perpetually rising dividends. And for this to happen, the post-election uptick in consumer and business confidence needs to strengthen further and translate into system-credit growth more in the high single digits than the historically weak rates seen recently. The extent and timing of this remain to be seen.

In short it is hard to see normalised return on equity returning to pre-GFC levels soon. Westpac shareholders need to be realistic.

We do not forecast an imminent surge of bad debts; however given the stock's full valuation in the market, we would not be buyers at current prices.

Graph for Value Investor: Westpac's fair weather is on the wane

Figure: Westpac Price vs. Value Chart

Source: www.StocksInValue.com.au

David Walker is Head of Equities at StocksInValue, a joint venture between Clime Investment Management, a value fund manager, and Eureka Report. StocksInValue provides valuations and quality ratings of 400 ASX-listed companies and equities research, insights and macro strategy. For an obligation free, FREE trial please visit www.stocksinvalue.com.au or call 1300 136 225.