Westpac: Is the bank boom over?

‘BANK BOOM OVER’ proclaimed the cover of BRW magazine on 19 June 2003, accompanied by a close-cropped image of a po-faced David Murray, then chief executive officer (CEO) of Commonwealth Bank. In the nine and a half years since, CBA's share price and dividends per share more than doubled.

If that’s what the end of a bank boom looks like, deal us in for the next one.

Westpac CEO Gail Kelly is but the latest in a long line of people declaring the boom over (see Boom days are over for banks: Kelly). Thus far, the predictions have been confounded. So, given the precedent set by Murray, are Kelly’s remarks a ‘buy’ signal?

It’s unlikely. Many of the issues raised by Murray in 2003 are even more pertinent today. Before tackling the valuation question in a different (and more simplistic) way than in the recent two-part analysis of NAB, let’s first examine what those issues are.

Back in 2003, Murray believed that ‘above-average growth in demand for credit (was) coming to an end as the interest rate cycle (approached) the bottom of a long trough’.

The official interest rate at the time was 4.75%, compared to today’s 3.00% (via 7.25% in early 2008). Murray underestimated the demand for credit a housing boom can generate; annual credit growth didn’t fall back into single digits until 2009 and has remained at less than 5% since.

Shrinking margins

Murray went on to say that, ‘the long-term average rate of growth for credit is 1.25 times gross domestic product. At some point we have to come back to that. ’ And when we do, said Murray, ‘margins will contract in the face of shrinking demand.’

The ‘margins’ Murray referred to are ‘net interest margins’; the difference between the rate at which banks borrow and the rate at which they lend.

This net interest margin is earned on ‘average interest earning assets’ (mostly loans), so by multiplying those two figures together you get the largest part of a bank’s revenue; ‘net interest income’. In Westpac’s case, net interest income represents more than 62% of its revenue.

In 2003, the banks’ net interest margins had already fallen from over 5% in the 1980s to around 3%. Today, they’re closer to 2%. So why haven’t profits and share prices collapsed? Because lower margins were being earned on interest earning assets that were skyrocketing in the credit boom, as Chart 1 shows.

Today, with credit growth idling, there’ll be little to cushion the blow if margins fall further. And there are good reasons why margins may continue to fall.

First, competition may be emerging for the most credit-worthy borrowers. Technology allows greater segmentation of customer databases. It’s easier now for banks to pick the lowest risk borrower and fight over their business.

Second, as rates fall, so does the margin on the billions of dollars sitting in interest-free transaction accounts. When official rates were 6% the banks captured a fat margin on these deposits. Today, with official rates at just 3%, that margin has halved on this portion of their book.

Lower returns

Recently, Kelly spoke about the returns on equity investors might expect from the banks, implicitly alluding to these two forces; ‘Those days of the 23 to 22 per cent … I think those days are gone’.

John Laker from regulator APRA agrees, as do we. The big question is just how much lower prospective returns will be.

Westpac is aiming for a 15% return on equity. Making an adjustment for the profit-boosting accounting trick examined in ANZ, Asia and accounting shenanigans, a reported 15% return on equity would mean ‘genuine earnings’ of around $6.3bn.

Westpac may struggle to hit that number next year but let’s assume it will. ‘Genuine’ return on equity would then be just under 14% (the difference being a few hundred million in capitalised software costs). Table 1 shows a simplistic model based on reported book value and a return on equity at this level for the next five years.

If Westpac was trading on a 6.4% dividend yield in 2017—as it is today—the share price would be around $28. That means today’s buyer would have received a capital gain of 8.4% plus an average fully franked dividend yield of almost 7% per year. That’s a total before tax annual return of near 9% (or closer to 12% including franking credits). Not brilliant but pretty good in a low interest rate environment.

Reality hit

Of course, reality may intervene. As our recent analysis of NAB made clear, the future could be a lot better or far worse. An annual return of greater than 9% implies a number of ‘heroic’ assumptions, not least a five-year recession-avoiding economic run, continued historically low bad debt levels and the absence of another global financial crisis.

Westpac’s domestic focus means it’s more tied to the Australian economy than NAB or ANZ. That’s been a great thing in the years since the financial crisis. But if Australia slips into recession this advantage quickly reverses. Westpac (and Commonwealth) are most exposed in this regard.

If the resources sector continues to wane and credit growth and broader business conditions remain subdued, the Reserve Bank may need to once again prime the monetary pump and the government do likewise with the budget, giving up on the idea of a surplus (if it hasn’t already done so).

Individuals and businesses have taken advantage of lower rates to pay down debt and the property price boom has moderated. That reduces the risk of a US-style housing bust but also puts pressure on developers and builders.

This year the likes of Kell & Rigby, Reed Constructions, Hastie Group and St Hilliers Construction have faltered. According to The Age, in Melbourne’s outer suburbs distressed buyers and builders are cancelling one in every three new home purchases.

A huge increase in mortgage defaults seems less likely than it did a few years ago but that doesn’t mean there aren’t problems ahead. Housing sector trouble isn’t the only thing that could dent Westpac’s profitability. Corporate collapses can blow big holes in annual profits.

Bank boom over

So Kelly and, belatedly, Murray are probably right. The odds favour an end to the bank boom. But if your expectations are modest (for little or no dividend growth, nor share price appreciation), then there’s a good case to hang on.

The risk of a nasty outcome should be acknowledged but a big four banking licence is an extraordinarily powerful and valuable thing. The big four deserve some valuation leeway because of it.

Westpac’s share price has barely budged since 15 Oct 12 (Hold—$25.74) and our maximum portfolio limit of 10% to the banking sector remains.

Westpac and Commonwealth have long been our favoured picks in the sector and, from a strategic perspective, they still are. But their share prices have run hard this year, reducing the margin of safety. HOLD.

Note: The model Income portfolio owns shares in Westpac.