Value Investor: Westpac's mixed fortunes

Despite growth in its net profit in recent years, Westpac's return on equity has declined. Looking ahead, there are a number of risks to the downside.

Our third article in our review of the big four banks focuses on Westpac Banking Group.

For fiscal 2014, Westpac posted a 12 per cent jump in net profit to $7.56 billion. It was a strong result, with improved profitability and solid loan growth, with mild declines in net interest margin and cost efficiency.

Its Australian financial services division performed well, with the BT Financial Group leading growth in cash earnings at 16 per cent. St George Banking Group was close behind, with 14 per cent growth, on the back of lower impairment charges and higher revenues driven by an 11 per cent increase in customer numbers.

It was pleasing to see basic equity per share growth of 11.6 per cent and improved profitability, with a 70-basis point rise in Westpac’s reported return on equity to 15.6 per cent.

These improvements bucked some of the trends in Westpac's five-year performance. As seen in our five-year history table, Westpac’s financial performance has been mixed, with growing net profit (blue below) but declining profitability, as measured by return on equity (green).

While net profit grew by 20 per cent to $7.6bn, ordinary equity increased by 40 per cent (red). This reflects a poor return on incremental equity of 8.8 per cent.

Figure 1 – Westpac’s five-year financial history

Source: StocksInValue

Impressively, Westpac’s cost-to-income has trended downwards since 2004. Despite increasing 34 basis points over fiscal 2014, its cost to income at 42.9 per cent makes Westpac the second-most cost-efficient Australian bank behind Commonwealth Bank at 42.6 per cent.

Figure 2 – Westpac historical cost to income metric

Source: Clime Asset Management

Management aims to capture further cost improvements through its continuing productivity and simplification program, expected to deliver savings of $219 million in fiscal 2014, and its significant investment in digital and mobile technologies ($470m).

Westpac is in management transition after Gail Kelly announced her retirement this month (effective February 1, 2015). During seven years as CEO she steered the bank through the GFC, the European debt crisis, the integration of St. George Bank and improved the capital position.

As expected, the board appointed Westpac's Australian financial services head and former Royal Bank of Scotland chief executive of UK Retail Banking, Brian Hartzer, as her successor. There is potential for some disruption to the management team, with speculation the head of institutional banking, Rob Whitfield, will depart.

Immediate challenges facing Hartzer include regulatory change resulting from the Financial System Inquiry and strengthening Westpac’s IT capability.

As expected, the Financial System Inquiry, led by David Murray, recommended banks increase capital levels to ensure their solvency in the event of a sharp economic downturn or another financial crisis, reducing the possibility of taxpayers bailing out banks as occurred in other countries during the GFC. The recommendations were in line with our expectations and our bank valuations do not require adjustment, especially as there will be public consultation ahead of a phase-in period.

Our adopted return on equity of 20.5 per cent (green) is conservative against consensus forecasts (brown). In our view, the risks are to the downside: Westpac is near peak-cycle earnings due to historically low provisioning and loan impairment expenses amid expansionary monetary policy and subdued confidence.

The required return of 11.5 per cent (blue) is low, reflecting WBC’s financial strength, large market capitalisation and predictability of earnings.

Figure 3 – Westpac Future Valuation

Source: StocksInValue

We derive a fiscal 2014 (30/09/14) valuation of $31.73, rising to $33.26 for fiscal 2015. Westpac is trading above valuation.

Disclosure: Our fund partner Clime own shares in WBC.

By Brian Soh and Jonathan Wilson, Equities Analysts, with insights from George Whitehouse and Stephen Wood of Clime Asset Management. StocksInValue provides valuations and quality ratings of 400 ASX-listed companies and equities research, insights and macro strategy. For a no obligation FREE trial, please visit StocksInValue.com.au or call 1300 136 225.

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