Company Reports

Westpac Bank is the second-largest of Australia’s four major banks. The bank provides a range of banking and financial services to retail and business customers, including mortgages, consumer finance, credit cards, business loans, and term deposits. Most nonbanking units have been divested, including general, life, and mortgage insurance.

Westpac’s first-half fiscal 2024 cash profit of AUD 3.5 billion is largely as we expected, flat on second-half fiscal 2023 and down 8% on the previous corresponding period. Westpac is finally showing it can compete effectively across all key segments, increasing its home loans, business loans, and deposits, in line or faster than market, and without resorting to undercutting peers on price. Home and business lending approval times have reduced, and more consistent service is supported by the bank’s net promoter score in the mortgage broker channel.

After reasonably uneventful earnings updates, it is hard to pinpoint a single specific driver for the turnaround in bank sentiment. Still, we think part of it is that a likely lower cash rate eases housing fears and provides banks an opportunity to reprice loans and deposits to protect margins. Major bank share prices increased 23% since November 2023, outperforming the 16% increase in the Morningstar Australia Index over the same period. The major banks' weighted average price/fair value estimate is 1.14, up from 1.05 in the last quarter. Nonmajor banks trade at a price/fair value of 0.85.

Westpac Banking provided additional insight into its technology simplification program. Named Unite, the plan has three objectives: better customer experience, improved employee experience, and improved shareholder returns. The bank's plan to simplify processes, reduce duplicated efforts, and cover the program with its annual AUD 2.0 billion investment, is unchanged from that unveiled in November 2023.

Westpac Bank is the second-largest of Australia’s four major banks. The bank provides a range of banking and financial services to retail and business customers, including mortgages, consumer finance, credit cards, business loans, and term deposits. Under new leadership, most nonbanking units have been divested, including general, life, and mortgage insurance.

Westpac’s first-quarter 2024 profit of AUD 1.8 billion is little changed from the final quarter of 2023, with margin pressure and higher bad debts well managed. Net interest margin, or NIM, slipped just 1 basis point to 1.93% compared with the second half of 2023. Despite some modest pricing changes recently, headwinds from customer deposit price competition and switching and home loan discounting, persist and is expected to see margins ease further in 2024. Concerns about Westpac’s ability to compete should be subsiding though, as the bank is now growing deposits and home loans in line with the market, even growing ahead of the market in the six months to December 2023. Bad debt expenses/loans increased 3 basis points to 0.10%, below our fiscal 2024 forecast of 0.12%, and medium-term expectation of 0.17%. With credit stress rising from low levels, it is likely bad debts have bottomed, but the bank is sitting on large provision balances which helps soften the impact on earnings.

Australian banks face low credit growth, softer net interest margins, and an increase in loan losses in the short term. Industry returns on equity will be suppressed in fiscal 2024. However, we expect loan and deposit pricing changes in the medium term to lift margins to a level that allows wide-moat-rated major banks to generate maintainable returns above our 9% cost of equity.

Westpac Bank is the second-largest of Australia’s four major banks. The bank provides a range of banking and financial services to retail and business customers, including mortgages, consumer finance, credit cards, business loans, and term deposits. Following the divestment of its financial planning and advice business, even its wealth arm--BT Financial Group--is likely to go at some stage. Under new leadership, most nonbanking units have been divested, including general, life, and mortgage insurance.

In line with our expectations, Westpac’s fiscal 2023 operating profit increased 26% to AUD 7.2 billion. Westpac has disappointed on numerous fronts in recent years, but we think the renewed momentum in home and business lending volumes, improved net interest margins, or NIM, and a lower cost/income ratio are encouraging signs things are heading in the right direction. Return on equity of 10%, up from just 8% last year, is much closer to the 11% returns we expect from the wide-moat major bank over the medium term. Inflationary cost pressures drive a modest downward revision to our short-term profit forecasts, but our long-term forecasts are largely unchanged. We retain our AUD 28 fair value estimate, and on a forward P/E of 11.3 times and a fully franked dividend yield of 6.6%, we continue to believe shares are cheap.

The short-term outlook for Australian banks is challenging with margins under pressure, loan losses expected to rise, and inflationary cost pressures unable to be offset by cost-cutting initiatives. Industry returns on equity are suppressed, hence we expect loan and deposit-pricing changes in the medium term to lift margins to a level that allows wide-moat-rated major banks to generate returns above our 9% cost of equity.

With interest margins softening and bad debts likely to rise, at least investors could take comfort in the banks sitting on surplus capital. With an average common equity Tier 1 ratio of 12.1%, all Australian major banks comfortably exceed the regulatory requirement of 10.25%. The Australian Prudential Regulation Authority does expect banks to maintain a buffer though, hence major banks have set their own targets of 11%-11.5%. This surplus capital position could be under threat if APRA sees fit to shake up the hybrid market.

Westpac’s third-quarter 2023 update was a little better than we expected, prompting a 3% upgrade to our fiscal 2023 profit forecast, and no change to our AUD 28 fair value estimate. Net interest margin being up 10 basis points on the first half to 2.06% is a welcome sight, but it masks an underlying downward trend reflecting competitive pressures. Still, excluding gains on hedges, NIM only fell 2 basis points to 1.96%. It is a positive outcome given we’d had some concerns around the impact of discounting being undertaken to restore momentum in home lending. On this front Westpac is making headway on growing in line with the system, growing ahead of the market in June. We still expect NIM to soften further in fiscal 2024 due to funding cost pressures, but given weak margins and poorer-than-expected returns smaller banks are reporting, competitive intensity is expected to gradually ease.

Australian wide-moat major banks are comfortably meeting regulatory capital requirements, sitting on an aggregate excess capital of nearly AUD 15 billion as of Sept. 30, 2022. COVID-19 induced conservatism saw major banks cut dividends, tighten lending standards, divest assets, and in the case of Westpac and National Australia Bank, raise equity. Because of this, the majors are entering a downturn both well-capitalised and having enjoyed historically low loan losses given the accommodative monetary policy and fiscal stimulus in response to the pandemic. As at Sept. 30, 2022 on average, the four major banks had impaired and past due loans as a proportion of total loans of 46 basis points compared with 64 basis points as at Sept. 30, 2019.

The Australian major banks expectedly reported improvements in net interest margins, or NIMs, in the fourth quarter of fiscal 2022.

The increases in the Reserve Bank of Australia cash rate to arrest inflation will have an impact on key earnings drivers for the banks. With the cash rate currently at 2.35%, and likely north of 3% by year-end, the increases from just 0.1% in April 2022 have been swift. It is expected to slow credit growth, with less borrowing capacity and confidence (a complete turnaround from the fear-of-missing-out environment of recent years). However, we think bank sector revenue growth will be buoyed by higher net interest margins, with the spread between lending rates and the cost of customer deposits widening.

It may not sound like much of an achievement, but Westpac maintaining its market share of home and business loans in the third quarter supports our thesis. As the nation’s second largest lender, we expect funding and operating cost advantages, which underpin our wide moat rating, arms the bank with the resources necessary to profitably grow its loan book over the medium term. Investments to make loan approval times faster, have a leading mobile offering, and even pulling the lever on price, will all contribute. Sharp pricing is being used to get brokers back on side now, and while it hurts margins, we are encouraged volumes in the retail and broker channels have both turned a corner.

Given strict regulatory requirements, banks usually have sound balance sheets, making decisions around investment strategy (including loan growth and quality) and distributions more important in determining shareholder returns. On balance sheet strength and distribution strategies it’s a level playing field across the major banks in our opinion, but we think Commonwealth Bank has edged its peers on strategy and execution. We assign a Standard capital allocation rating across the banks, but we think the pendulum is swinging close to an exemplary rating for Commonwealth Bank, while Westpac and National Australia Bank are closer to Poor. We make no other changes to our earnings forecasts or fair value estimates.

Westpac’s first-half fiscal 2021 result was solid, with cash profit of AUD 3.5 billion up 256% on first half 2020 and 119% on second-half 2020. The most interesting news is management’s aggressive target to bring costs down by approximately 15%, or AUD 1.5 billion, to AUD 8 billion by fiscal 2024. The reductions exclude costs from businesses earmarked for divestment. We think there is a high chance the bank falls short on its target given changes could begin to impact customer and employee satisfaction, and see the bank lose market share. In addition, there could also be unforeseen costs around risk and compliance, regulatory change, or competitive disruptions. We have lowered our long-term operating cost forecasts by 5%, which implies an underlying cost base of AUD 9.5 billion by fiscal 2024. We increase our fair value estimate by 7.5% to AUD 29 after factoring in a portion of the planned lower costs and the time value of money. Shares traded up 5% on the day of the result and trade at a 9% discount to our updated fair value estimate.

Environmental, social and governance, or ESG, factors can have a material bearing on the cash flow and valuation of firms. In the past, issues such as James Hardie’s asbestos liability or AMP’s management of its conflicts of interest have had a material impact on the valuation of those firms. Identifying and assessing ESG risks is critical to any thorough assessment of a company’s cash flow and earnings potential. At Morningstar, we incorporate ESG into our long-term-oriented methodology by focusing on issues with the highest risk, defined by likelihood and materiality to a company’s intrinsic value.

Westpac Bank Corporation is the second-largest of Australia’s four major banks. The bank provides a range of banking and financial services to retail and business customers, including mortgages, consumer finance, credit cards, business loans, and term deposits. Following the divestment of its financial planning and advice business, the wealth arm--BT Financial Group--will contribute less than 10% of group earnings. Under new leadership, most non-banking units could be divested.