Earlier this month chief executive Gail Kelly announced her retirement as of February 1, 2015, after seven years in charge, during which time she successfully guided Westpac through the GFC, integration of St. George Bank and the European debt crisis.
The timing is perfect: Kelly leaves near the top of the cycle, with Westpac in an improved financial position. Incoming chief executive Brian Hartzer, Westpac’s Australian Financial Services head, faces a more challenging environment, with the financial system inquiry likely to recommend banks increase capital ratios, which, if adopted, will weaken banks’ earnings power, and a normalisation of provisioning and loan impairments on the horizon given current unsustainable credit quality conditions.
Westpac’s 2013-14 result was sound, with profit increasing 12%, or $810 million, to $7.56 billion. The bank reported improved profitability and loan growth, with mild declines in net interest margin and cost efficiency.
Figure 1. WBC key metrics – FY14 result
Cost to Income
Net interest margin
0.11% of loans
0.45% of total assets
Source: Clime Asset Management (George Whitehouse)
The SIV five-year history shows Westpac had mixed financial performance over the last five years; net profit increased since 2009-10 but profitability as measured by normalised return on equity (NROE) declined.
Net profit for the period totalled $33.7 billion, of which $24.9 billionn was returned to shareholders as dividends and $8.8bn was retained (orange boxes below). Return on equity averaged 22.4% over the last five years (green box), less than Commonwealth Bank (27.0%), but higher than ANZ Bank (21.0%) and National Australia Bank (17.5%).
Figure 2. WBC five year performance
Westpac remains well capitalised with a common equity tier 1 (CET1) ratio of 8.97% under the regulator APRA’s version of the Basel III standards. This is ahead of the APRA minimum requirement of 8%. CET1 remains within Westpac’s target range of 8.75-9.25%.
Figure 3. Basel III Common Equity Tier 1 (CET1)
Declining impairments expense and provisions have boosted earnings and profitability for the last five years. Impairments as a percentage of loans and provisions as a percentage of assets, however, are at historic lows and we think the end of declining provisions is near.
This is concerning, as earnings may come under pressure as impairments and provisions revert to historical averages over time. These are impairments as to loans of 0.64% and provisions to total assets of 1.1%.
Figure 4. WBC impairments expense and ROE
Source: Clime Asset Management (George Whitehouse)
Timing a normalisation in impairments is difficult. The best-case scenario is interest rates remain low and unemployment does not rise, sustaining favourable conditions in credit quality. The worst case is a nationwide recession where unemployment and business failures rise, especially in Sydney and Melbourne, which account for most of the home loans on major banks’ balance sheets.
We believe Westpac is near peak-cycle earnings given low interest rates and historically low provision and loan impairment expenses. Household debt at 150% of disposable income leaves little room for expansion of household credit.
Figure 5. Australian household debt and debt-servicing
Business and consumer confidence remains subdued due to concerns about employment and government fiscal tightening (Figure 6 below).
Figure 6. Business confidence and consumer confidence
Source: WBC, NAB
Westpac expects interest rates will stay at record lows with continued investor-led demand in the housing market to support credit growth over the coming year. However, strong investor demand for housing due to low interest rates and high demand from overseas buyers have pushed up prices; macro-prudential policy measures such as stricter loan to valuation ratios might be implemented to slow demand.
Figure 7. Private sector credit growth
Source: WBC, RBA
The Murray Inquiry final report should be released any day now. It will probably recommend the banks hold more capital to ensure they have enough to cover losses in the event of a major downturn, and more stringent rules around “risk-weighting” of assets to prevent banks from manipulating risk weightings to artificially boost tier 1 capital ratios. Higher regulatory capital ratios likely exert downwards pressure on profitability and value, however, they would also reduce risk and thus support our very low required returns for the major banks.
Our adopted NROE of 20% is conservative against consensus forecasts and the five-year average. In our view the risks are to the downside: Westpac is near peak-cycle earnings due to historically low provisioning and impairments amid expansionary monetary policy and subdued confidence. The required return (RR) of 11.5% is low, reflecting financial strength, large market capitalisation and predictable earnings. We derive an equity multiple of two times and 2013-14 valuation of $31.73, rising to $33.26 for 2014-15 and $34.82 for 2015-16.
Figure 8. WBC adopted value metrics
By Jonathan Wilson, Analyst StocksInValue with insights from Stephen Wood of Clime Asset Management.
Clime owns shares in WBC.