Market Wary As Westpac Sticks To Cost Target

This story features WESTPAC BANKING CORPORATION. For more info SHARE ANALYSIS: WBC

Margins remain tight and Westpac has stuck to its aggressive cost reduction strategy, making the market wary.

-Weak outlook for Westpac's margins over FY22 and concerns over cost reduction target
-Return to mortgage growth achieved via price and at the expense of margins
-Fewer significant items to feature in results going forward
 

By Eva Brocklehurst

The road ahead for Westpac Banking Corp ((WBC)) is likely to remain bumpy, as costs and margins continue to dominate discourse on the stock in the wake of the FY21 results.

Ord Minnett was concerned expectations may have been too optimistic about the revenue outlook yet even so did not anticipate the drop in net interest margins in the second half, or the weak exit point, which suggests FY22 will be challenging.

The broker suspects the bank was intent on getting back to mortgage growth in line with system, regardless of the costs. This meant lending margins were squeezed.

This is the main concern for Jarden as well, as more margin compression is anticipated, given the September 2021 exit rate of 1.91%, although going forward there are several factors that should moderate the drag from margins, including lower front book discounts.

Morgan Stanley was disappointed, given the efforts to fix the bank's problems are having a large impact on profitability, and remains less confident about the ability to turn the business around in FY22, downgrading to Equal-weight.

The outlook for margins and expenses is worse than the broker anticipated, which highlights the challenges of addressing some legacy issues and the weak momentum in the franchise.

Westpac had guided to lower margins in the second half but the decline of -10 basis points was double what the broker had been expecting. Morgan Stanley downgrades margin estimates and now forecasts a decline of -18 basis points to 1.86% in FY22. This in turn has a material impact on earnings estimates.

Hence, evidence of a turnaround needs to come from sustained mortgage improvement, stabilisation in business banking, further progress on asset sales and a more modest decline in margins.

Macquarie is equally cautious about the stock in the short term yet on a medium-term view considers the valuation attractive. The broker agrees there are challenges in the core franchise and a lack of clarity regarding the trajectory of earnings, so the valuation discount is likely to continue.

Citi is more optimistic, despite cash earnings of $5.35bn missing expectations. What has mitigated the softness is the large provision write-back, the $3.5bn buyback and a better-than-expected final dividend of $0.60. The broker will be scrutinising how the exit run rate will be affected by the steepening yield curve throughout October.

Cost Strategy

Management has reiterated a target of $8bn for a slimmed-down cost base by FY24. Timing will depend upon incremental productivity and run-off of fixed costs as well as the removal of specialist businesses, Citi asserts. Ord Minnett notes the bank's staunch commitment to the $8bn target, while suspecting the savings will be weighted to FY23 and FY24.

Any disruptions to the bank's ability to generate revenue growth will be of concern for Jarden. Moreover, some costs may be stranded, such as those incurred from the cancelled sale of the Pacific banking business and the need to retain part of the automotive finance book for run off. Still, the broker is encouraged by the bank's confidence and the extra clarity on the cost reduction plans.

Macquarie believes the execution risk on costs justifies the discount in the shares, and suspects the market will be unlikely to give the bank credit for reaching the target until there is more evidence it is on track.

Morgans points out Westpac had always indicated the decline in costs would not be orderly and was, therefore, not so underwhelmed, forecasting an annual cost base of $8.25bn by FY24, which compares with $10.2bn in FY20.

Sustainably achieving this target should be a good outcome for shareholders, the broker adds. Furthermore, the credit impairment benefit of $590m was substantially better than the $42m Morgans expected. The broker also highlights the increase in sustainable dividend pay-out ratio to 60-75% from 60-65%.

Mortgage Lending & Income

While Westpac has experienced a return to mortgage growth, brokers observe this was achieved via aggressive pricing and at the expense of margins. Credit Suisse downgrades to Neutral and expects further declines in margin, forecasting a FY22 margin of 1.85% and 1.80% in FY23.

The broker was surprised with the extent of margin re-basing and concludes the downside risks are specific to the bank as it re-positions its mortgage portfolio, while upside risks are sector based, likely to stem from a steepening yield curve and ultimately higher interest rates.

Westpac experienced fixed-rate mortgages at 52% of flows versus variable rates. The low interest rate environment and low fixed rates on offer have dragged on margins. Yet, mortgage growth is now back in line with the system and the bank has improved processing time.

Australian home lending results suggest the trade off between margins and volumes could have been managed better, Morgans acknowledges. The bank competed for fixed-rate loans with the percentage of fixed rate mortgages increasing to 38% from 28% a year ago.

The Australian Bureau of Statistics has indicated fixed rate home lending as a percentage of flows may have peaked in August and, with recent increases in rates on fixed rate home loans from some lenders, the broker assesses this should be a positive development for the margin outlook.

Among the positives Macquarie draws from the results are the fact Australian mortgages that were more than 90 days in arrears fell and treasury and markets income was ahead of expectations.

Furthermore, the bank has highlighted fewer notable items will feature in results going forward. The main one will be a -$1bn one-off charge from the sale of the life insurance business FY22.

There may be material upside from the transformation over time yet Jarden anticipates the recovery will not be smooth. The broker, not one of the seven stockbrokers monitored daily on the FNArena database, has an Underweight rating and $24.30 target.

The database has two Buy ratings and four Hold. The consensus target is $26.17, suggesting 11.7% upside to the last share price. The dividend yield on FY22 and FY23 forecasts is 5.2% and 5.8%, respectively.

Disclaimer: the writer has shares in Westpac.

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