Morningstar | Westpac’s 1H19 Profit Disappoints but Interim Dividend Intact. FVE Cut to AUD 31. See Updated Analyst Note from 06 May 2019
Wide-moat-rated Westpac Banking Corporation’s first-half fiscal 2019 cash profit of AUD 3.30 billion disappointed despite announcing AUD 753 million aftertax in one-off remediation and restructuring costs. Cash earnings fell 22% including the one-off costs but if excluded, the interim profit of AUD 4.05 billion was 5% lower than a year ago and only 1% lower than second-half fiscal 2018. Customer remediation costs and refunds dominate the messy result, but softer underlying business conditions highlight a competitive and low growth environment. Despite cash profit printing 7% below our expectations, the AUD 94 cents per share fully franked interim dividend was in line, with the payout ratio increasing to an unsustainably high 98%. We maintain our fiscal 2019 dividend at AUD 1.88 per share, based on an 89% payout as we think the first-half one-off major items will not repeat. Longer term we think the board will progressively reduce the payout towards the medium-term target of 70%-75%, maintaining a flat dividend offset by modest increases in EPS.
The bank’s scale, ability to grow customer numbers, achieve productivity improvements and leverage strong market positions continue to offset tough operating conditions. But CEO Brian Hartzer points to further pressure on net interest margins, or NIMs, and slowing demand for credit with system housing growth to slow to 3% in fiscal 2019 and 2.5% in fiscal 2020. We reduce our fiscal 2019 forecast cash profit to AUD 7.32 billion from AUD 7.47 billion previously as a result of lower loan growth and lower NIMs. We make similar adjustments to outer years and reduce our fair value estimate 6% to AUD 31 per share. At current levels, the stock is undervalued, trading 13% below our valuation. First-half positives include strong asset quality with loan losses a very low 9 basis points, broadly flat operating expenses and robust balance sheet settings with the common equity Tier 1 capital ratio at 10.6% at March 31, 2019.
Despite the disappointing result, Westpac remains our preferred major bank. The withdrawal from the provision of financial advice, announced March 19, 2019, effective June 30 for salaried advisors and Sept. 30 for authorised representatives, will over time remove most compliance and operating risk from Westpac’s remaining wealth businesses. Longer term we are confident Westpac can deliver modest earnings growth, based on sustainable lending growth, steady NIMs and superior operational efficiency. Sustainable dividends and attractive returns on equity will follow solid earnings. The bank has a good track record of discipline around credit quality, cost control, and lending risk management. We expect Westpac and major bank peers will retain pricing power underpinning wide economic moats.
Operating expenses increased just 1% on the previous half and declined 3% when the major items are excluded. We like the confirmation of a AUD 400 million cost savings target for fiscal 2019, excluding major items. The run rate cost base decreased 1.3% in the half compared with the previous half.
Australian Regulation Prudential Authority’s, or APRA's, January 2020 common equity Tier 1 ratio benchmark is 10.5%. Organic capital generation of 27 basis points was good, but the bank announced a 1.5% discount to the dividend reinvestment plan to partially offset expected capital headwinds in the second half. New accounting rules will detract approximately 20 basis points of common equity Tier 1 effective July 1, 2019 and APRA is yet to release its final response to the revised Basel capital framework. The Reserve Bank of New Zealand’s proposal that banks must increase capital increases uncertainty, but it is too early to calculate the likely impact.
Disappointments include weaker NIMs, a sharp decline in noninterest income, weaker Markets and Treasury income, and soft loan growth. Group total loans outstanding increased just 1.8% on the previous corresponding period, or pcp. The group home loan portfolio increased 2.6% mainly due to a strong performance from New Zealand. The Australian home loan portfolio increased 2% on pcp. The sharp fall in earnings resulted in a disappointing return on annualised equity of 10.4%, well down on the average for the previous six half years of 13.6%.
Including remediation costs, NIMs declined 6 basis points during the half to an adjusted 2.12%. Loan repricing in September 2018 broadly offset higher funding costs and intense competition for hew home loan customers. Treasury and markets margins were down just 2 basis points half on half. We expect some improvement in second half due the sharp decline in short-term wholesale funding costs, but the sharp decline in the three-year bond rate will detract from interest earnings sourced from the bank’s capital and liquid assets.
The AUD 753 million aftertax in major costs included AUD 484 million in wealth remediation, AUD 133 million in banking remediation, and AUD 136 million in wealth restructuring. The second round of customer remediation costs of AUD 357 million after tax was announced April 30 covering refunds and related costs for clients of the bank’s authorised financial advice representatives between 2008 and 2018. The first round of costs of AUD 260 million aftertax was announced on March 25 and covered the bank’s in house, salaried financial advisors.
Despite historically low loan losses, and sound group credit quality, Australian home loan arrears continue to trend up, or deteriorate. Australian 90-plus days mortgage arrears increased to 0.82% at March 2019, from 0.72% six months previously and 0.67% a year ago, with Western Australia the main culprit. Despite the increase, Australian mortgage loan losses remain at very low levels around 0.2% of the mortgage portfolio. Mortgages with negative equity represent just 1.6% of the portfolio. Group stressed exposures remain broadly steady and new impaired assets were low at just AUD 173 million.