Westpac: Interim result 2013

In July 2010, fears of a double dip recession in the US dominated the airwaves and some investors were questioning the wisdom of Westpac’s acquisition of smaller rival St George two years previously.

They were wrong. The period proved to be a wonderful buying opportunity. Westpac’s share price has increased 48% since we upgraded it on 23 Jul 10 (Long Term Buy – $22.63). Including dividends, that’s a total return of 70% in less than two years.

Westpac’s latest interim result (the company has a 30 September year end) shows the company remains firmly on track. The question now is what shareholders sitting on such handsome gains should do.

Before answering that, a quick look at the result. Operating income increased 5% to $9.4bn compared to a year earlier. With operating expenses increasing 4% to $3.8bn and bad debt expenses falling 28% to $438m, cash earnings increased 10% to $3.5bn.

The result certainly looks impressive but the large fall in bad debts should be close to a cyclical low. Although in mortgages and other consumer loans 90-day arrears have recently increased, they remain at low levels.

Special dividend

Cash earnings per share increased 8% to $1.14 with the interim dividend increasing from 82 to 86 cents fully franked (ex date 13 May). In addition, shareholders will receive a special fully franked dividend of 10 cents. The company may have considered beefing up reserves for a rainy day instead, but with ample franking credits and comfortably satisfying key regulatory capital ratios an increased dividend was chosen.

While deposits increased 12%, growth in loans was just 3%. Deposits also now comprise 69% of Westpac’s funding, reducing its reliance on overseas wholesale financing, which has become cheaper given the lack of volatility and increased risk appetite in global markets.

Unlike National Australia Bank, for example, Westpac is trying to sell more products to its army of customers to protect margins rather than compete on price to increase loan volume. That should produce fewer bad loans over the long term.

Mortgages still constitute most of the growth in lending (up 4%), but Macquarie Group’s cost advantage over the big four banks could impact industry margins if it increases its market share significantly (at 2.19% Westpac’s net interest margin remained largely flat).

Near historical high

Macquarie isn’t paying high overseas wholesale borrowing rates that the big four had to accept in the recent past, although these borrowings are currently being rolled over at much lower interest rates.

In stark contrast to Macquarie Group, which enjoyed an 11% increase in its share price after announcing a large dividend increase, Westpac’s share price fell 1% despite announcing a special dividend. We’re comfortable with the conservative 4% weighting in the model Income portfolio and would consider selling down if the share price reached $40.

The current valuation is near a historical high but could well rise further if bad debts and interest rates remain low and earnings and dividends continue to increase. In line with our recent shift in approach, we’re increasing the bank’s portfolio limit to 8%, although members might consider a lower portfolio weighting given the stock is approaching the top end of our valuation range.

The share price has increased 6% since 7 Mar 13 (Hold – $31.66) and we’re sticking with HOLD.

Note #1: The model Income Portfolio owns shares in Westpac.

Note #2: In addition to increasing the portfolio weighting for Westpac to 8%, we’re doing the same for Commonwealth Bank. When it reports its upcoming interim result, chances are we’ll do the same for National Australia Bank.

For simplicity we’ve kept the portfolio limits the same for the big four banks, though we prefer Westpac and Commonwealth due to their lack of ambitions overseas compared to ANZ and smaller corporate loan books compared to National Australia Bank.