Westpac: Interim result 2017

First ANZ, then NAB and now Westpac: another flat result from one of the big banks shows that they're in a low-growth environment for the foreseeable future (see Table 1).

Total loans rose 4%, to $667bn, trailing the 8% rise in deposits and leading to a deposit-to-loan ratio of 72%. Risk-weighted assets (regulators require banks to weight their assets by risk to determine the capital they need to hold against possible losses) rose 11% as a result of APRA's sensible decision to increase the risk weights on residential mortgages from around 16% to at least 25%.

Westpac's net interest margin or NIM – the difference between the interest it earns on its loans less interest paid on deposits and other funding – fell from 2.11% at 30 Sep 16 to 2.07%. Competition for term deposits and the rising cost of wholesale funding offset the hike in rates on certain mortgages and business loans.

However, this is likely to be a timing issue as the bank has already seen the trend in rising deposit costs ‘start to ease'. Moreover, Westpac's ‘repricing' of some of its loans during the first half will be fully enjoyed (or suffered, depending on your viewpoint) over the remainder of 2017.

Whether the 3% rise in non-interest income – mainly arising due to greater volatility in the foreign exchange and commodities markets – continues will depend on future macroeconomic events.

Overall, operating income inched up 1%. Nevertheless, the actions of Westpac – and in fact, all the big banks – in unilaterally ‘repricing' the cost of their loans points to their continuing market dominance and the inherent pricing power that comes with it.

This pricing power will come in handy in trying to pass on the recently announced levy on certain bank liabilities. This perhaps will reduce their advantage over smaller competitors such as Bendigo and Adelaide Bank, Bank of Queensland and Suncorp Bank but the big banks still retain significant competitive advantages (see Taking a regional (bank) tour – parts one and two for more).

Prudence on capital

This pricing power will also be handy should additional capital be required by APRA. Westpac's common equity tier one (CET1) ratio is now a little less than 10%, comfortably above its target range of 8.75% to 9.25%.

Once adjustments are made for APRA's more conservative treatment of certain items – for which we commend the regulator – this places Westpac in the top quartile of banks internationally and, it claims, as the fourth-best capitalised among its peers worldwide. (For reference, CBA is third, ANZ fifth and NAB eighth).

Even so, Westpac admits to being ‘prudent' in its capital management and so, while it maintained its interim dividend at 94 cents, it's also offering a 1.5% discount on its dividend reinvestment plan.

With this dividend representing a payout ratio of 79%, above the Board's target of 70–75%, this is a stealthy way of getting its ‘effective' payout ratio below its target without actually cutting the dividend.

We don't necessarily have an issue with the smoke and mirrors because, as we've argued elsewhere, we'd prefer the big banks to have more capital rather than less to minimise the chances of taxpayers being on the hook should things turn sour.

Being ‘prudent' on the capital front also makes sense given the uncertainty over possible additional capital being required by APRA. We should learn later this calendar year what exactly being ‘unquestionably strong' entails, as well as learning any further changes on the level of capital required to be held against different types of loans.

Cost cutting

With APRA still predisposed to imposing higher capital requirements and revenue growth likely constrained, unsurprisingly increased attention is being paid to costs.

Helped by its software shenanigans (see Westpac: Result 2016), costs rose by 1% compared to the prior corresponding period, and the bank now has a cost-to-income ratio of 41.7%. This also places it near the top globally in terms of cost efficiency and chief executive Brian Hartzer believes Westpac is on track to get this ratio below 40%.

As we've seen with the amazing cost-cutting efforts of Rio Tinto, BHP Billiton and even Fortescue, pressure on revenue can work wonders in incentivising ways to find savings, especially in large organisations with lots of inefficiencies. So assisted by the continued digitisation of manual processes, we expect there are still substantial opportunities for further cost cuts.

Provisions still at cyclical lows

Westpac has less control over impairment charges but they currently remain at cyclical lows: provisions as a percentage of average gross loans fell from 0.21% to 0.15%. However, like all averages, this masks a wider range in the underlying portfolio. For example, the mining bust and continuing house price declines in Western Australia mean Westpac's mortgages in that state that are 90 or more days delinquent are more than twice the portfolio average of 0.67%.

Overall though, despite the current slow growth environment and the additional capital requirements imposed by APRA, Westpac reported a respectable return on equity (ROE) of 14%, at the top end of its reduced target.

With around $2.42 of earnings per share expected for the full year, the stock is on a price-earnings ratio of about 13. However, if we bump up the impairment charge from 0.15% of loans to our through-the-cycle estimate of 0.45%, we get adjusted earnings per share of about $2 and a price-earnings ratio of about 16. HOLD.

*Please note our recommended maximum portfolio weightings of 10% for Westpac individually and 20% for the banking sector as a whole. More conservative investors and those with other exposure to the property market should use lower limits.

Note: The Intelligent Investor Equity Income Portfolio owns shares in Commonwealth Bank and Westpac. You can find out about investing directly in Intelligent Investor and InvestSMART portfolios by clicking here.