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Morningstar | Westpac’s FY18 Result in Line, but the Growth Outlook Slows. FVE Cut to AUD 33

Westpac Banking Corporation’s fiscal 2018 cash profit of AUD 8.1 billion was unchanged on fiscal 2017, in line with expectations and consensus, and importantly, it was clean and straightforward. There was no major restructuring, discontinued operations or plans to sell wealth businesses. The steady profit reflected modestly higher year-on-year net interest margins, multidecade low bad debts, good customer deposit growth, and modest loan growth. Offsetting these positives was a steep increase in operating expenses, driven by customer remediation costs and increased investment in compliance, and regulatory costs. The cost/income ratio bumped up to a still creditable 43.7% from 42.1% a year ago. As expected, the unchanged AUD 94 per share final fully franked dividend took total dividends to AUD 1.88 based on a high 80% payout.

Despite the relatively straightforward fiscal 2018 performance, we downgrade our fair value estimate 6% to AUD 33 per share from AUD 35. We reduce our fiscal 2019 cash earnings forecast to AUD 8.3 billion from AUD 8.5 billion previously, to reflect lower credit growth, lower net interest margins, lower noninterest income and higher-than-expected expenses with similar changes in outer years. Despite the softer outlook, Westpac remains our preferred major bank, trading 19% below our updated valuation. Shareholder capital is well managed, and we like the fact Westpac is the least exposed to management distractions and organisation restructuring compared with major bank peers. The balance sheet is strong and credit quality is a standout.

In our opinion, Westpac’s wide economic moat is withstanding the intense pressure of the past nine-12 months. Despite a very wide range of bad publicity, brand damage, the storm of the Royal Commission, political criticism, media hysterics and a breakdown in consumer trust in the major banks, Westpac increased net Australian customer numbers by 250,000 or 2% during the 12 months ended Sept. 30, 2018.

Commonwealth Bank of Australia reported a similar outcome for the six months ended June 30, 2018. Westpac’s dominant market position and strong franchise have so far survived the firestorm of negativity experienced during calendar 2018. Retail bank customer satisfaction survey results are down, but not as much as many would assume.

Return on equity eased modestly to 13.0% from 13.8% in fiscal 2017, with the key common equity Tier 1 capital ratio remained at 10.6%, just above the regulator’s "unquestionably strong" 10.5% benchmark required by January 2020. New shares are being issued to fund the dividend reinvestment plan. The bank retains its medium-term return on equity target range of 13%-14% and we forecast an average of 13.3% during 2019-23. Organic capital levels continue to build, with a net 0.2% in common equity Tier 1 capital in the second half. Westpac’s internationally harmonised common equity Tier 1 capital ratio of 16.1% places the bank comfortably in the top quartile of global peers.

Second-half earnings fell sharply by 10%, compared with first-half fiscal 2018, due to higher costs and lower net interest margins. Higher short-term wholesale funding costs, intense competition for home loans and loan mix changes drove down second-half margins to 2.05% from 2.17% in the first half. Variable home loan repricing of 0.14% announced in late August will go some way to restore margins closer to our lowered fiscal 2019 forecast of 2.06%. Margins remain under pressure from competition, elevated funding costs, and changes to credit card interest calculations.

Operating expenses increased 5.3% year on year and 6% second half on first half due to recognition of AUD 281 million in aftertax provisions to cover a litany of customer remediation and litigation costs and AUD 158 million pretax incurred for the Hastings exit. 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. Adjusting for "one off" items fiscal 2018 expenses increased a more respectable 2.7% year on year.

Headline operating expenses are guided to reduce approximately 1% in fiscal 2019 from the AUD 9.6 billion incurred in fiscal 2018. We forecast the cost/income ratio to improve to 42.5% in fiscal 2019 and closer to the long-term target of less than 42% by the end of our five-year forecast period. Structural productivity improvements resulted in AUD 304 million in ongoing operating expense savings in fiscal 2018 and management are guiding for an additional reduction in underlying expense of approximately AUD 400 million in fiscal 2019.

Customer deposit growth of 6.4% year on year was a standout and fully covered total lending growth of 3.6%. Home lending increased 4.1% with system credit growth expected to moderate. We reduce our forecast average annual loan growth to about 3.5% from 4.5% previously as tighter home lending criteria, interest only switching to principal and interest loans and a weaken housing market slowdown the demand for new credit. We expect a continued orderly decline in average house prices in Sydney, Melbourne, and Brisbane, but we do not expect a market crash. Westpac expects housing credit growth to slow to around 4% in 2019 and total credit to slow to 3.5%. Based on Reserve Bank of Australia data, total system housing credit grew 5.2% for the 12 months to Sept. 30, 2018 and total credit growth increased 4.6% year on year.

Credit quality is a standout with all metrics broadly steady or improving. Australian mortgages 90 plus days in arrears edged up only slowly to 0.72% from a low 0.67% a year ago. Loan losses of just 0.10% of gross loans are unsustainably low and we forecast a gradual increase to around 0.19% by end fiscal 2023. No new impaired loans greater than AUD 50 million have been incurred during the past 18 months. Again, there are no signs of changes in the positive asset quality trends experienced during the past several years. Home loan arrears remain high in Western Australia, but group houses in possession remain extremely low at just 396 properties from a total portfolio of about 1.6 million loans. Approximately 69% of the bank’s Australian home loan customers are ahead of their repayment obligations, including off set accounts.

Our forecast fully franked dividend per share for fiscal 2019 and fiscal 2020 of AUD 1.90 and AUD 1.91, respectively, are unchanged, as we expect the payout ratio to modestly decrease to 79% in fiscal 2019 and 77% in fiscal 2020. We expect the payout will gradually decline to 75% by end fiscal 2023, towards the bottom of the banks medium term 70%-75% target.

At current prices, the fiscal 2019 forecast dividend yield of 7%, grossed up to 10%, 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.

Despite the setback of higher expenses, we believe Westpac will benefit more than peers from a strong long-term earnings growth profile, superior operational efficiency, and impressive loan quality. 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.