Westpac's dividend opportunity

PORTFOLIO POINT: Westpac’s full-year results were broadly in line with expectations. But the potential for increasing dividends has increased.

Westpac’s statutory net profit after tax (NPAT) reported this week was 15% lower than the previous corresponding period, as the prior year included a non-recurring positive tax impact related to the St George merger.

Across the divisions, cash earnings improved over the half throughout the retail business, St George and Westpac New Zealand. BT and Westpac Institutional bank produced broadly flat results. The key metrics for WBC are highlighted below.

Statutory return on equity was softer over the year, dipping to 13.49%. While a falling return on equity (ROE) is generally never a positive, it is encouraging to note chief executive Gail Kelly’s minimum ROE target of 15% going forward. It is uncommon for CEOs across the ASX to target ROE, as most are incentivised through their remuneration packages to increase earnings per share. This fact in itself is why corporate activity (think accretive or debt fund acquisitions) is common.

While it is difficult for management to turn on profit growth through organic means, they are able to control the capital management levers; hence a special dividend may the key driver of an increased ROE in the lower loan growth environment.

The graph below highlights my preferred banking exposures of Westpac and Commonwealth, which both screen highly on return on equity metrics.

WBC has the financial capacity to pay higher dividends, with its capital ratio and franking balance both at elevated levels. WBC’s capital ratio, under the new Basel III system, currently stands at 10.6%, which places WBC as the sixth most well capitalised bank relative to global peers. Capital is supported further by its dividend reinvestment plan (DRP) taking up of around 15%. WBC has franking credits of $1 billion, which will allow the franking of close to $3 billion of dividends. Franking credits are useless when held inside the corporate entity, but have immense value in the hands of shareholders. I appreciate this fact and take the value of franking credits into account in my valuations.

As a holder of WBC in the income portfolio, increased dividends are obviously a major positive, as this allows the increased dividend stream to be reinvested into other securities with attractive prospective returns. Indeed, a rising ROE is also supportive of a rising intrinsic value, which is a further positive.

An interesting metric that appeared in WBC’s presentation was the products per customer slide, as shown below. This same metric is used by the leading American bank, Wells Fargo.

WBC has had recent success by increasing the number of customers with four or more products to 30.2%. However, WBC has a long way to go to become a global leader. Wells Fargo has an average of 5.9 products per customer in its retail banking business. I like this metric, as it is a sign of the “stickiness” of the customer base. The more products a customer uses, the harder it is for them to switch to a competitor. WBC’s market share currently stands at 21% of lending and 23% of deposits.

When you have highly ingrained customers, interest rate changes provide the opportunity to improve the net interest margin (NIM). Falling interest rates give the banks the opportunity to improve NIMs by refraining from passing on the entire cut. Conversely, rising rates gives banks the opportunity to be slow to move on retail deposits.

The consensus view shows earnings growth over the next few years of just shy of 6%. A potential driver of loan growth, in the future, is an improvement in residential home lending. This figure comprised the majority of Westpac’s loan growth in the recent result, albeit at low single digits.

There are deep cyclical lows in building activity throughout Australia. This is evident in the profitability of building materials and property development stocks being well below long-term averages. I am cognisant of the underlying building demand remaining well above current building supply. With starts for FY2013 in the range of 130,000-140,000 and underlying demand as high as 160,000 starts, it appears a latent demand is growing on the back of the increasing population.

Current indicators appear favourable, with affordability and unemployment at reasonable long-term levels.  Indeed, it appears confidence is what is holding back building activity. Should we see a stabilisation and improvement in confidence, then it is likely building activity will be the key driver of loan growth in the medium term. The recent building approvals announcement showed improvement - especially in apartments and high density houses - which shows early effects of improving sentiment in the space.

I think WBC produced an adequate result in a challenging environment and it continues to retain a spot in the portfolio. I expect intrinsic values to increase into the future and the yield to increase.

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Alex Hughes is an analyst at Clime Asset Management. John Abernethy will return next week.

If you’re a sophisticated investor, wholesale investor or have $500,000 or more to invest, Clime is offering you the opportunity to discuss your portfolio and investment options with John Abernethy. Click here to register your details.

Clime Income Portfolio - Prices as at close on 8th November 2012
				Start Value	$ 118,757.19
				Current Value	$131,617.38
Hybrids/Pseudo Debt Securities
Company	Market Price	Margin over BBSW	Running Yield	Franking	TR (%)
ANZHA	$103.95	2.75%	5.78%	0.00%	4.83%
MXUPA	$79.05	3.90%	9.06%	0.00%	10.35%
AAZPB	$95.50	4.80%	8.44%	0.00%	9.35%
MBLHB	$67.20	1.70%	7.38%	0.00%	15.17%
NABHA	$71.50	1.25%	6.31%	0.00%	7.23%
SVWPA	$87.30	4.75%	9.10%	100.00%	10.50%
WOWHC	$106.34	3.25%	6.12%	0.00%	4.22%
RHCPA	$102.31	4.85%	7.86%	100.00%	5.58%
High Yielding Equities
Company	Market Price	FY13 Dividend	GUDY	Franking	TR (%)
TLS	$4.11	$0.28	9.73%	100.00%	17.66%
AAD	$1.37	$0.13	9.52%	0.00%	7.26%
CBA	$58.18	$3.48	8.54%	100.00%	15.28%
WBC	$25.93	$1.73	9.53%	100.00%	21.17%

Average Yield     8.11%

Weighted Portfolio Return

Since June 30, 2012          10.83%

Since Inception 9.68%