Can Westpac Really Meet Its Cost Target?

This story features WESTPAC BANKING CORPORATION, and other companies. For more info SHARE ANALYSIS: WBC

Westpac has excited the market, outlining a significant cost target over three years. As always, the chorus is "show us the money"

-Asset quality, provisions coverage generally better than expected
-Pay-out ratio could improve if credit growth is lower
-Main savings appear to come from lower regulatory/compliance expenditure
 

By Eva Brocklehurst

There's nothing like cost reductions to provoke interest, and Westpac ((WBC)) garnered attention from such headlines in its first half result. Those quick off the mark to respond have welcomed what Credit Suisse described as probably the biggest planned reduction in core expenses in Australian banking history.

Still, there is some scepticism as to whether the full extent of cost reductions can be achieved. Ord Minnett is a trifle sceptical, and asserts the other major banks will report even stronger trends in terms of revenue growth. Westpac's revenue was flat half on half, excluding notable items.

Citi assesses the results overall are positive and Westpac management has delivered for investors across a number of fronts, including core profit growth as well as a "very ambitious" cost strategy. First half cash earnings of $3.54bn were supported by lower bad debts and a CET1 ratio of 12.3%. Measures of asset quality and provisions coverage were generally better than expected.

First half loan growth contracted -4% because of lower Australian housing investor, business and personal lending. Australian owner occupier lending was up 3% and New Zealand home lending also increased in NZ dollar terms.

Morgan Stanley is encouraged by the Australian mortgage trends, expecting growth of around 3% in the second half. The disappointing element was non-housing loan and banking fee trends which are weighing on revenue growth. On the other hand, non-interest income should benefit from improved economic activity and consumer spending.

Pay-out re-based

Westpac has re-based its dividend pay-out ratio to 60-65%, a move that Citi describes as pragmatic and reflecting expectations for stronger volume growth. The broker suspects the pay-out may surprise to the upside in time, while Morgan Stanley believes it will allow organic capital generation and still mean the dividend can rise to $1.60 in FY24.

Credit Suisse upgrades forecasts by 2-7%, reducing the pay-out ratio to 65% and increasing buyback assumptions to $6bn, split evenly across FY22 and FY23. The broker notes the pay-out ratio is much lower than the FY17-19 range of 83%.

Westpac has indicated it has taken into account a number of factors over a medium-term view. If credit growth is lower, Credit Suisse believes there could be potential for the ratio to increase.

Morgans forecasts surplus CET1 capital of $7.5bn by the end of FY22, before allowing for the sale of non-core businesses and notes the large franking credit balance. The broker infers from the bank's commentary that the distribution of surplus franking credits is being viewed through capital management initiatives as opposed to ordinary dividends.

CLSA upwardly adjusts estimates for FY21-23 earnings per share by 17-26% to incorporate improved margins, credit growth, lower expenses, reduced impairment charges and the buyback.

Cost Plan

The number is $8bn, a three-year cost target that implies costs will need to fall -18% over the period, and compares with $10.2bn in FY20. The means to achieving this target includes exiting non-core business, a reduction in branches, digitisation and a simplification of head office. Costs are expected to increase in FY21 before starting to fall from FY22.

Given annualised costs including specialist business of $9.7bn in the first half, this implies an unprecedented -$1.7bn net reduction in the starting cost base, Ord Minnett asserts. The broker, noting the cost plan was flagged and this lifted expectations going into the result, suspects the market will be wary of the full benefits given the lack of detail about the cost to achieve the target.

The main savings appear to come from a halving of regulatory and compliance expenditure which would require execution on promises to regulators as well as automation.

Ord Minnett also finds it unusual for a business where customer metrics are weak and deteriorating to embark on a bold cost-saving program. Still, the broker is prepared to give credit where it is due, comparing the agenda to what ANZ Bank ((ANZ)) has achieved in recent years – only a slight reduction in costs, excluding divestments.

Morgans points out no restructuring provision has yet been raised as part of this re-set of costs and also notes Westpac has stated it will not increase annual investment expenditure. So cumulative investment expenditure is likely to be $3.6-4bn over the next three years.

Credit Suisse asserts the market has been calling for a meaningful cost reduction program from Westpac for more than a decade and whether the whole amount is achieved or not is irrelevant as the bar was so low it can only be positive. The broker expects upside will depend on whether there is evidence the bank is progressing towards its target.

Morgan Stanley forecasts a core Westpac cost base of around $8.4bn in FY24 and, all else being equal, would upgrade cash profit estimates for that year by a further 3-4% if the target is achieved. Goldman Sachs assumes Westpac does not meet the target, retaining a forecast that is around 10% ahead of the $8bn for FY24.

Citi is pleased with management's ambitions and believes the building blocks to the target are in place. The balance of risk remains skewed to the upside with the broker also incorporating a FY24 target for costs around 10% above management's plan.

Citi suspects management may have been concerned about potential reactions from government, media and the public and this has prevented a more fulsome disclosure. Hence, the "unknown" could provoke the bears, the broker adds. The main concern is execution, as regulators are expecting rapid progress on risk and compliance issues.

Citi incorporates only part of the savings in short-term forecasts and requires more evidence of progress before allowing for the full benefit. That said, multi-year earnings upgrades amid sector wide asset quality improvement mean Westpac has a differentiated investment thesis and remains the broker's only Buy rating in the sector.

Among those stockbrokers that are not monitored daily on the FNArena database, CLSA also calls the target ambitious and retains an Outperform rating with a $29.27 target while Goldman Sachs has a Buy rating and $29.03 target.

The database has five Buy ratings and two Hold (Ord Minnett, and Macquarie – yet to comment on the result). The consensus target is $27.85, suggesting 5.7% upside to the last share price. Targets range from $25.75 (Macquarie) to $29.50 (Morgans, Citi). The dividend yield on FY21 and FY22 forecasts is 4.5% and 4.8%, respectively.

See also, Westpac, The Dud Among Australian Banks? on March 31, 2021.

Disclaimer: the writer has shares in the stock.

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