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Date : 21/06/2021

Westpac Banking Corp.

ASX :

WBC

Market Cap : $98.5 Billion

Dividend Per Share : $0.58

Dividend Yield : 3.31 %

Hold

52 Week Range : $16.00 - $27.12

Share Price : $26.88

With a limited growth outlook, Westpac is cutting costs to swell earnings. Given current prices, we recommend a "Hold" amid the fairly high dividends.

Company Analysis

As every Aussie and Kiwi already knows, Westpac Banking Corporation (ASX: WBC) is one of the big 4 Banks here in Australia and they have had a tremendous run in the low-interest rate environment. Westpac is a traditional bank that operates across the usual segments – that is, Consumer, Business, and Westpac Institutional Banking (WIB) services. To these clients, Westpac provides financial services such as lending, deposit taking, payments services, investment portfolio management and advice, superannuation and funds management, insurance services, leasing finance, general finance, interest rate risk management and foreign exchange services.

Westpac in Australia represents a big chunk of the retail and institutional banking market share, with 21% of household deposits, 22% of mortgages, and 16% of business credit. The bank serves more than 12 million clients nationwide. We should also not forget that the group has a presence as well in New Zealand, and accounts for 19% of the country’s consumer lending and 18% of the total deposits.

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Source: Tradingview.com

Westpac earns a majority of their revenue from Australia – by up to roughly 86%, and the remaining 11% comes from New Zealand, and a marginal part – amounting to about 3% comes from overseas. Analysing the business segments of Westpac, we see that the company earns a majority of its revenues from the Consumers segment – up to 44% as of FY2020. Whereas Business segment makes up about 23%, and the remaining comes from WIB and Westpac New Zealand segments with a fairly even split. Therefore, it is important to note here that Consumer and Business segments are the biggest drivers to the banks profitability, and what do the big banks do with their profits? The one that matters the most is dividends, while the rest is reinvested for growth. Given Australia’s demographics and maturity however, the growth is limited in a fairly captured market.

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Source: Westpac

When it comes to Consumer and Business segments, a banking institution such as Westpac is exposed to interest rates. The bank accepts bank deposits from its customers and agrees to pay them a rate of interest, which is extremely low given the low-interest rate environment. Westpac then lends this money out to retail customers and businesses for loans such as home loans, car loans, business loans, etc for a rate of interest. This is the interest that the bank earns, and the difference between the two rates we just discussed is the primary source of revenue that Westpac generates, also called Net Interest Margin (NIM) – arguably the most important metric for banks.

Increase in Margins

The Net Interest Margin (NIM) has increased by 6 basis points as of the latest half year results compared to where it was in the previous 6 months. First half earnings were considerably higher than the prior corresponding period, mainly due to an impairment benefit reflecting improved asset quality and a better economic outlook. Notable items were also lower. The balance sheet strength was improved, with Common Equity Tier 1 capital ratio rising 153 basis points to 12.34%. Australian mortgage book increased $2.6 billion over the past six months, with good growth in owner occupier loans partly offset by lower investor lending. Owner occupier loans increased 3%, with first home buyers making up 13% of new loans – resulting in NIM increasing by 6 basis points.

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Source: Westpac

Where to next for NIM? Well, data is everything. Inflation plays a central role for banks, more so than other industries. The theory will tell you that once inflation picks up to levels expected or goes over expectations, interest rates have to be increased by the RBA in order to limit the damage high inflation can cause. However, data suggests, and it is even backed up by Westpac’s expectation that we may see hikes in interest rates in 2023. The first measure to control inflation will be a tapering of stimulus and then followed by hikes in interest rates.

Therefore, interest rate hikes are still some way away, especially here in Australia. This means that in the short to medium term, Westpac will have to rely on increasing volumes of their lending business to increase profitability. With CommBank’s dominance and the recent market share grab, this is a rather difficult task for Westpac.

Cost Reduction

Westpac is revamping its business towards digital banking. COVID-19 is an accelerator of the pivot to digital banking that did well on Westpac. Social distancing, lockdowns forced the company to adjust quickly to the unprecedented situation. Westpac realised that it is a necessity to adapt to new customer demands and to compete with the fintech disruptors. Cost reduction is also a decisive factor for the long-term profitability of the institution. All these considerations are pointing to one solution: Digital banking. Digital transformation is essential for Westpac to remain cost-competitive, particularly during an extended low-rate environment.

The bank is taking the bull by the horn and is pushing forward its three-year cost-cutting campaign which involves the digitalisation of its banking services. Westpac has an ambitious goal to cut about 20% of its expenses to $8 billion by FY24 compared to about $10 billion as of today. The digitisation programme will also involve the simplification and streamline of the business, which means that Westpac will reduce the number of bank branches.

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Source: Westpac

The narrative here at Westpac and most Aussie banks is that with future growth extremely limited, cost reduction takes centre stage. Westpac’s digital powered solution will increase their margins in the future once fully implemented.

Half Year Earnings

Westpac reported an optimistic H1 FY21 performance on the back of the fantastic economic recovery here Down Under. Westpac’s first half of FY21 result was positive. The company did actually present some solid figures stressing the economic recovery to support the return of Westpac in the positive territory. Liquidity was really well maintained by the bank with a reported increase in cash earnings by 256% to $3.54 billion. That is about $100 million more than the consensus estimates.

If we are to exclude the notable items related to AUSTRAC, cash earnings still rose by 60% to $3.82 billion. We also saw the comeback to a well-received declared fully franked dividend of 58 cents per share, the first interim payout since FY19 when Westpac paid 94 cents distribution. Along with the economic rebound since the first COVID-19 outbreak, revenue from ordinary activities went up by 1% to $10.7 billion. Westpac’s revenue was supported by an increase in its mortgage book of $2.6 billion.

Westpac reported a statutory net profit of A$ 3,443 million, a big jump of 189% year-over-year. Again, liquidity appears to be at a comfortable level with cash earnings soared by 256% to A$ 3,537 million, exceeding expectations. Cash earnings, excluding notable items, were up by 60% to A$ 3,819 million, also a strong result vis-à-vis the 2HFY20 A$ 2,835 million.

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Source: Westpac

Dividends

Ample liquidity brought dividends back on track with cash earnings improved by 60% during the period, Westpac declared a higher-than-anticipated fully franked dividend of 58 cents per share after a cancelled distribution amid the first COVID-19 outbreak, whilst the second half of FY20 saw a depleted dividend of 31 cents per share. Comparing the second half of FY20 with the first half of FY21, we can see a tremendous improvement in statutory net profit which increased by 213% with cash earnings up as well by 119%. Solid figures brought back the return on equity to two digits, 10.2% from last year’s 2.9%.

These numbers have underpinned the fully franked 3.31% dividend yield that Westpac paid out. End of the year dividends are also estimated to be in line with the first half. Covid19 aside, since the Australian economy looks to be well and truly over the impacts caused by the pandemic, Westpac is estimated to continue paying its highly stable dividends payouts going forward.

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Source: Westpac

Forecasts and Valuation

With margins fairly flat and growth from cost reduction expected to kick in a few years down the line, Westpac’s growth is by and large highly correlated to the performance and growth of the Australian economy. Westpac’s margins show just how correlated the performance of the company is relative to the Australian economy. We can even see a V-shape recovery in the chart below.

New lending for housing has surged, up 49% over the past year, including a 75% jump from the May 2020 low. While we expect continued increases in home prices, as the supply of houses for sale increases, the rate of house price growth will likely moderate. With the tapering of stimulus, and a general reduction in the growth of lending due to banks now starting to increase their lending rates, FY2022 is expected to be a flat year for the firm. However, with the effects of a digital product starting to kick in and the added benefit of increased lending rates, the profitability of Westpac will see some improvement.

FY2023 onwards, we forecast Westpac to grow along with the Australian economy of about 2% annually. The limited growth is due to the exhausted demographics that Australia seems to be stuck in. With 2023 expected to be the year in which interest rates will start to go back up, margins will be further improved to around 33%.

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Westpac does look expensive at these current prices. Based on the current prices and our forecasting, WBC shares are trading at a 15.25x Forward P/E

Westpac has been really bullish since reaching the COVID-19 low in March last year. Since then, Westpac shares recovered well and appreciated by an impressive 100%. WBC shares have been recently in the spotlight of many investors which saw an opportunity for the bank to further grow following the three-year cost-cutting programme the company is embarking on. However, we believe that Westpac is trading at expensive multiples at the moment as attested by the company’s P/E ratio at 27x whilst the average ASX 200 P/E sits at 22.73 times. Fundamentally, Westpac is in a good place with a healthy balance sheet and a substantial pickup in revenue. However, the further growth outlook is not very bullish. Even on a forward multiple basis, Westpac looks expensive with a P/E of over 15x, relative to its 5-year average P/E of 14x.

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Recommendation

Westpac has performed extremely well on the backdrop of a stunning economic recovery here in Australia. Their half-year performance was very positive, and dividends are back, albeit not to the highs seen prior to the pandemic. With limited organic growth forecasts and a close to impossible task of gaining market share from CommBank, the growth outlook is rather limited, and Westpac is now looking to cut costs to increase their profitability. Thus, Westpac is expected to perform similarly to the broader index. At current prices and the macroeconomic outlook, we recommend long-term investors to “Hold” their positions and reap the dividend income.

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