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Morningstar | Westpac’s 1Q19 Supports our View the Bank Is Doing Well Despite Industry Challenges. FVE Intact. See Updated Analyst Note from 17 Feb 2019

Wide-moat Westpac Banking Corporation’s first-quarter fiscal 2019 trading update confirmed the bank is making good progress despite increasingly challenging operating conditions. The unaudited cash profit of AUD 2.04 billion was up a healthy 7% on the average of the previous two quarters of AUD 1.91 billion. Excluding second-half remediation costs of AUD 281 million, the first-quarter cash NPAT was broadly stable on the average of the two previous quarters. The unaudited statutory NPAT for the December quarter 2018 was AUD 1.95 billion. The quarterly profit was modestly lower than our fiscal 2019 quarterly cash profit run rate of AUD 2.08 billion, but we make no changes to our full-year cash NPAT forecast of AUD 8.3 billion and fully franked dividend of AUD 1.90 per share. Our AUD 33 fair value estimate is unchanged, with the stock undervalued, trading at a 20% discount to our valuation.

Highlights from the brief update included higher net interest margins due to home loan repricing in September 2018, offset by weaker margins in Treasury and Markets. Group net interest margins fell sharply in six months ended Sept. 31, 2018 to 2.07% and we reduce our fiscal 2019 margin forecast to 2.10% from 2.12% previously. Balance sheet settings remain sound with the common equity Tier 1 ratio easing to 10.4% at Dec. 31, 2018 from 10.6% three months earlier due to the payment of the final dividend for fiscal 2018, accounting for 69 basis points of decline. Organic capital generation was solid, with a positive 47 basis points of common equity Tier 1 capital. Funding and liquidity levels remain above regulatory minimums. Operating expenses were lower in the quarter due to a small business divestment and the nonrepeat of costs from the customer remediation program. Additional customer remediation costs are expected in second-quarter fiscal 2019. We maintain our full-year forecast for a 3% increase in operating expenses and a cost/income ratio of 43.4%.

The bank remains well positioned to achieve Australian Prudential regulation Authority’s 10.5% “unquestionably strong” requirement effective Jan. 1, 2020. The loan book is well provisioned and remains in good shape. The ratio of group stressed assets to total committed exposures were broadly stable during the quarter with no new individual loans over AUD 10 million impaired during the quarter. The loan impairment charge of AUD 204 million for the quarter was modestly higher than previous quarters in fiscal 2018 but below levels incurred in fiscal 2017.

The annualised loss rate of 11 basis points is lower than expected and we reduce our fiscal 2019 forecast to 13 basis points from 14 basis points previously. Home loan arrears rates are gradually rising, up 4 basis points in the quarter, to a still low 0.76% for 90 plus day delinquencies. The increase was driven by problems in Westpac Bank’s collections department and higher arrears in NSW and WA. Unsecured consumer lending arrears rates are trending higher, up to 1.83% of the AUD 20.6 billion portfolio from 1.71% six months prior.

Customer switching in the home loan portfolio (from interest only home loans to principal and interest loans) is progressing in an orderly way with a total of AUD 8.8 billion switching during the three months to Dec. 31, 2018. Based on Westpac Bank analysis 16% of the interest only home loan portfolio expires in less than one year, 21% between one and two years and 18% between two and three years.

We do not expect a sharp increase in loan delinquencies during the next few years as most of the interest only borrowers have the capacity to afford higher principal interest repayments. Interest only home loans settled in the quarter represented 23% of new flows, down from 47% reported in the quarter-ended Sept. 30, 2017. Mortgage lending growth continues to ease in the quarter, with just 0.8% increase in investor loans compared with 5.2% for owner occupied.