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Will Westpac’s Relative Discount Close?

Australia | Nov 05 2019

Low interest rates, weak loan growth & wealth income are weighing on the major banks and brokers consider Westpac's measures to shore up its balance sheet are prudent.

-Some of the weakness in FY19 considered self-inflicted
-Extent of capital raising puzzles some brokers
-Is Westpac's discount to peers likely to close?


By Eva Brocklehurst

As predicted by most brokers, Westpac Banking Corp ((WBC)) delivered a subdued outlook with its FY19 results, signalling weak loan growth, lower wealth income and modestly higher costs.

Reductions to official interest rates and a flat yield curve are weighing on profitability and Morgan Stanley forecasts a -3 basis points margin decline in FY20, although this is -8 basis points ex remediation. The broker also envisages downside risk to forecasts if there are further cuts to official cash rates, or the bank does not lower its deposit rates to limit a squeeze on spreads.

The main surprise for Ord Minnett is the extent of the margin impact from lower cash rates at a time when competitive pressures in the mortgage industry are intense. As was the case with ANZ Bank ((ANZ)), the headwinds to net interest margins for the first half of FY20 are greater than forecast.

Shaw and Partners agrees current revenue and expense trends are likely to continue into FY20, with little or no loan growth and softer non-interest income and retains a Hold rating and $27.00 target. The broker, not one of the seven stockbrokers monitored daily on the FNArena database, assesses the reasons for Westpac's declining revenue stem from holding onto its life insurance and wealth management businesses for too long.

Wilsons, also not one of the seven, agrees some of the weakness was self-inflicted, with home lending, a traditional strength for Westpac suffering because of execution errors.

Morgans notes stressed exposure as a percentage of total committed exposures was 1.2% in September, only marginally higher than in March. Yet, what did disappoint the broker was the contraction in the home loan book over the fourth quarter. The bank has indicated it has addressed the issue but expects continued contraction over the first half of FY20.

The negative items that dragged on revenue are transient, Morgans notes, and the underlying result is, therefore, stronger than the headline suggests. These “transient” items include a -$41m hit to non-interest income as a result of methodology changes in derivative valuation, lower non-interest income from the revaluation of financial instruments and an increase in the run rate of regulatory and compliance expenses.

Capital Raising

FY19 cash earnings were $6.85bn, as lower revenue and higher costs were only partially offset by lower bad debts. A reduced final dividend of $0.80, fully franked, was declared. The bank has announced a $2.5bn capital raising, with a fully-underwritten $2bn share placement at a fixed price of $25.32.

The extent of this capital raising puzzles Morgans, because it will take the pro forma CET1 ratio to 11.25% at level II and 11.21% at level I, which makes the bank appear over-capitalised. Westpac has stated the increase in its capital buffer is designed to create flexibility in dealing with potential litigation or regulatory action.

However, the broker believes these are contingent issues and holding extra capital for this reason, therefore, does not resonate. Shaw and Partners also finds the bank's capital raising action odd in that it takes the CET1 ratio substantially above the 10.5% hurdle.

This is particularly strange in the context of the bank expecting hardly any loan growth over the next year. The broker posits a reason in ongoing remediation charges and potential litigation and the possibility that Westpac fears these amounts will be substantial.

Jefferies Australia, not one of the seven, has initiated coverage of Westpac with an Underperform rating and $26.10 target and finds it difficult to envisage how the bank can regain its previous PE (price/earnings ratio) premium.

The broker questions whether the bank is adequately capitalised even now, as the sub-peer housing risk weighting creates a relative residual capital sufficiency risk should APRA adopt tighter floor constraints under its implementation of Basel 4.

Discount To Peers

The "buy" thesis for Westpac is a PE re-rating on the back of reduced uncertainty, in Credit Suisse's view. Westpac is trading at a -17% discount to Commonwealth Bank ((CBA)) vs a 10-year average of -8% which provides relative upside, given capital and dividend issues have been dealt with.

Macquarie also envisages scope for Westpac's relative valuation discount to close, although the ongoing pressures in the sector provide for limited upside. Banks have been attempting to meet aggressive cost-to-income targets which appear increasingly unattainable in the current environment.

UBS is cautious about the banking industry, particularly noting the subdued loan growth and ultra-low interest rate environment. Fee income is expected to fall and credit impairment charges rise.

That said, the broker believes Westpac's decision to reduce the dividend is prudent but this will mean the pay-out ratio eventually rises back to the mid 80% level. This may be sustainable in a low credit growth environment but if the Reserve Bank cuts the cash rate further, or there are additional regulatory imposts and remediation charges, a further reduction in the dividend may be required.

One interesting aspect of the results announcement, Macquarie points out, is Westpac's partnership with 10x, a European cloud-based banking system. These types of technology service providers present a competitive threat to the major banks over the medium to long-term, the broker suggests.

FNArena's database has two Buy ratings, four Hold and one Sell (UBS). The consensus target is $27.84, signalling 5.1% upside to the last share price. The dividend yield on FY20 and FY21 forecasts is 6.1% and 6.2% respectively.

Disclaimer: the writer has shares in the stock.

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