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Morningstar | Westpac Increases Customer Remediation and Litigation Cost Provisions. FVE AUD 35 Unchanged

Wide-moat-rated Westpac Banking Corporation announced recognition of an estimated AUD 235 million in provisions to cover a litany of customer payments and recent litigation costs. The provision will be recognised in fiscal 2018 results scheduled for release on Nov. 5, 2018. Costs associated with responding to the Royal Commission are not included in the provision and the program of reviews is expected to continue into fiscal 2019. The ongoing program of work includes investigating and potentially recognising further costs relating to advice fees charged by Westpac’s aligned financial planners.

The customer refunds and legacy product reviews were prompted by the reputation-damaging Royal Commission hearings, and we are disappointed the bank had not previously identified and remedied these serious breaches of customer trust on a prompt basis. Nonetheless, the AUD 235 million provision is immaterial to profit and our positive view. Westpac remains our preferred major bank, trading 22% below our AUD 35 fair value estimate and despite the embarrassment around provision increases we maintain our Exemplary stewardship rating. Shareholder capital has not been permanently damaged or impaired and we still maintain Westpac benefits from the least amount of management distractions compared with major bank peers.

Details of the AUD 235 million provision are being finalised, with further information expected in late October, just before the release of full-year results. Westpac estimates approximately two thirds of the AUD 235 million will be treated as negative revenue with one third reported as additional costs. We reduce our fiscal 2018 cash earnings forecast to AUD 8.18 billion from AUD 8.43 billion previously to reflect the higher provisions. To account for ongoing remediation work and Royal Commission costs we reduce our fiscal 2019 cash earnings forecast by AUD 188 million to AUD 8.55 billion from AUD 8.74 billion previously.

Our forecast fully franked dividend per share for fiscal 2018 and fiscal 2019 of AUD 1.88 and AUD 1.90 respectively are unchanged, as we expect the payout ratio to increase 200 basis points to 78% and 77% respectively. At current prices, the fiscal 2018 forecast dividend yield of 6.9%, grossed up to 9.8%, provides some valuation support, but negativity around the Royal Commission and an expected tougher regulatory environment continue to weigh on the stock price. The current one year forward price/earnings ratio of 11 times remains well below the five-year average of 13 times.

The AUD 235 million provision includes five unquantified key elements, including refunds for certain financial advice fees, refunds for customers who received inadequate financial advice, refunds for certain bank products, and the cost of processing the above refunds.

The provision will also cover recent litigation around the responsible lending and bank bill swap rate, or BBSW, cases. In early September 2018, Westpac Bank announced a settlement with the Australian Securities and Investments Commission, or ASIC, in response to responsible lending proceedings launched by ASIC against Westpac in the Federal Court. Westpac agreed to pay a penalty of AUD 35 million to ASIC and ASIC’s legal costs, but the settlement is subject to court approval.

The BBSW case was decided in late May 2018 in the Federal Court with Westpac found not to have “engaged in market manipulation or misleading and deceptive conduct under the Corporations Act. However, the Court found that Westpac did engage in unconscionable conduct on 4 of the 16 [ASIC alleged] occasions and that Westpac had breached its supervisory duty.”

Despite the setback of the AUD 235 million provision, we believe Westpac will benefit more than peers from a stronger long term earnings growth profile, superior operational efficiency, and strong loan quality. Our forecast returns on equity average 13.5% to end fiscal 2022. The bank’s pricing power remains intact, as evidenced by the recent out of cycle 0.14% increase in variable home loan interest rates to offset higher wholesale market funding costs. Despite the increase in provisions, organic capital levels continue to build, and we anticipate no problems achieving the regulator's definition of "unquestionably strong" by the January 2020 deadline.