Westpac And Macquarie: More Yield

This story features WESTPAC BANKING CORPORATION, and other companies. For more info SHARE ANALYSIS: WBC

– WBC offers a special while MQG lifts its payout
– earnings growth low for WBC and volatile for MQG
– share prices lofty for both

By Greg Peel

Last week ANZ Bank ((ANZ)) announced an interim profit result which beat consensus due to better than expected cost reductions and lower than expected bad debt impairments. Significantly, ANZ announced a higher than expected interim dividend and lifted its dividend payout ratio guidance, playing right into the hands of a market hungry for yield.

The market then wondered whether ANZ, as first cab off the reporting season rank, had set the scene for similar capital management initiatives from Westpac ((WBC)) and National Bank ((NAB)). Morgan Stanley, for one, suggested Westpac would not raise its already peer-leading payout ratio but did have the scope, and the franking credits, to either pay a special dividend or buy back its dividend reinvestment plan (DRP) shares. The analysts favoured a DRP buyback.

Westpac went the other way. On Friday the bank announced a profit result which also beat consensus, rising 10% on last year’s first half, and an interim dividend of 83c. The dividend was in line with expectations and no payout ratio increase was forthcoming, but the bank did announce a 10c special dividend.

Once again, yield is king.

While the profit result might have been a “beat”, analysts were not all that enthusiastic about the factors behind the beat. Westpac has managed to reduce its cost ratio to a level below peers, but 4% growth in costs from last year was more than analysts had expected. Bad and doubtful debt charges fell 26% due to one-off write-backs for the institutional bank, and a bad debt expense of 17 basis points was the lowest since 2006. Beyond these two significant factors, underlying operational growth was not so flash. Underlying revenue only grew 1% for the half, and that included contributions from trading and wealth management which reflect the recent solid run in the market.

With a tier one capital ratio of 8.7%, Westpac has the strongest capital position of the Big Four. The other three are sitting on ratios just above 8%. It is this strong capital position, which Westpac has been focusing on and quietly improving since the GFC shock, as well as a surplus of franking credits, which has allowed the bank to pay the special dividend and maintain its sector-leading payout ratio. Capital has been able to grow due to falling offshore funding costs and a rising deposit base, over which all of the banks have fought. Capital growth does not reflect earnings growth, which is modest.

At the moment, the earnings growth outlook for all banks remains modest.

Westpac’s lending growth rates, notes JP Morgan, remain below-system and the bank’s net interest margin has stalled at 2.19% rather than climb to provide at least some revenue growth in a time of low volumes. Unless the deposit spreads can improve, management suggested on Friday, downside margin risk remains. Many a broker suggests that while Westpac has been ahead of the pack in cost reduction, there’s little more room for improvement now while others catch up. Bad debt levels are low, which is great, but as low as they are likely to get. Last year’s RBA rate cuts provided scope for advantageous loan repricing but the cash rate is unlikely to see as many cuts this year. And now that interest rates are generally lower, earnings are more difficult to come by.

The first half FY13 may well be “as good as it gets” for Westpac, suggests Morgan Stanley.

The other problem, of course, is Westpac’s share price. Different brokers arrive at different valuations but picking one example, Goldman Sachs suggests a sustainable return on total equity of 21% implies the stock should trade on 1.9x net tangible assets, or 2.4x NTA taking franking credits into account, but it is trading at 2.8x and is thus 15% expensive. Furthermore, Westpac’s superior return suggests a 9% premium to peers but the current premium is 17%.

The BA-Merrill Lynch analysts cite a PE multiple of 14.8x in suggesting they “can’t get too excited” about buying the stock. UBS is not even all that fussed with a 5.1% (before franking yield) at this price. All brokers nevertheless agree there remains more room for capital management, irrespective of a low earnings outlook, given strong capital generation and franking credits.

Citi believes there’s scope for as much as 40cps in further special dividend capacity, and is expecting another 10c special in the second half. That’s before franking credits run out. Macquarie suggests 20-30c capacity over the next 12 months. UBS is backing two 10c dividends in the next two halves before Westpac then moves to buy back its DRPs. All brokers point out franking credit limitations.

Westpac’s yield may have been a lot more attractive a few months ago, but yield is king in this market. That’s why Morgan Stanley is sticking with its Equal-weight rating. Goldman Sachs joins CIMB on Sell, while JP Morgan maintains a sector-relative Underweight rating.

No database brokers have changed their ratings in the wake of the interim result. Macquarie, Merrills, UBS, Credit Suisse and Deutsche Bank all remain on Hold. Citi is the only broker with a Buy rating, believing Westpac is well positioned in the low growth, low rate environment. On a net basis, earnings forecasts have been ticked up to reflect those lower than expected bad debts charges. The consensus price target has risen to $30.54 from $29.40 to suggest 8% downside.

Westpac and its peers are considered “commercial banks” due to an emphasis on loans and relatively minor focus on broking and proprietary trading. In contrast, Macquarie Group ((MQG)) is an “investment bank” with a strong focus on broking, trading and corporate finance. An investment bank is typically a “risk” proposition, while commercial banks are supposedly defensive. On that basis, commercial banks are bought for yield and investment banks for growth.

Well there’s no doubting the Big Four are still yield stocks, but Macquarie has now joined the fray. The Group surprised on Friday with a better than expected full-year profit but somewhat shocked with an announced final dividend of 125cps, some 67% above the first half, way ahead of analyst expectation, and representing a payout ratio of 86%. Management has guided to future payouts of 60-80%, with a leaning to the upside, when payouts of less than 70% have always been the norm.

That puts the FY13 payout ratio ahead of the Big Banks. But Macquarie is not meant to be a capital-returning business but a business that invests in growth. Could it be that Macquarie has found itself in the same dilemma as Woodside? That is, no prospects for growth in the near term so best just to give out the money? Or is Macquarie also just pampering to the current yield-hungry investor environment?

The latter may well be true, but brokers also suspect that having run around the world snapping up broking and trading units post-GFC, and more recently invested in some more typical banking businesses, Macquarie is done with acquisitions for now as attractive targets are more difficult to come by. A $250m share buyback was also meant to be underway in the second half but has gone nowhere, so given a share price rally in excess of 40% over the period it is likely a capital return is the alternative.

Driving Macquarie’s better than expected profit were further gains in the annuity-based businesses that have now become a fundamental contributor to the Group. Improved market conditions also allowed for the sort of rebound in financial market broking/trading revenues management has been waiting for, nay praying for, since 2009, but the improvements are only modest at this point, not all areas have returned to profit, and earnings in these markets are always potentially volatile. Advisory fees (such as M&A) remain subdued.

Could the 80% payout ratio guidance signal that Macquarie has decided to move toward a more “capital light” model, in which higher payouts are more justifiable? asks UBS. Another point to note is that a solid profit was also as a result of reduced costs, and this includes a reduction in the staff compensation ratio. Macquarie’s payout model has always involved paying out staff bonuses first, often handsomely (remember the Millionaire’s Factory?), and then looking after shareholders. Macquarie executives were once both admired and envied. This is not so much the case anymore, following post-GFC staff consolidation and a shift away from peer-leading compensation.

Which is another reason why there is now more in the kitty to give to shareholders, even after a hefty increase in the Group’s tax rate due to a greater global spread. As CIMB puts it, Macquarie has shifted “from star to cash cow”.

So should investors now consider Macquarie in the same light as the Big Four? No, is the general answer. Macquarie’s new payout might look commercial bank-like but the Group does not run loan books of note. The annuity-style businesses are growing but earnings still rely heavily on the financial market backdrop, which even management admits is still subdued and analysts are yet to feel particularly confident in. An 80% earnings payout ratio still means lower dividends if earnings fall.

Underpinning share price support is yield, which has now jumped to 6%. But caution is needed, say Deutsche Bank, given Macquarie is still an investment bank. UBS suggests a shift to “capital light”, with more emphasis on asset management and advisory fees, may be the best chance of increasing return on equity back to above the cost of capital. CIMB thinks a lift in returns and earnings is “still several years off” given it hinges on market-linked revenues.

As is the case with the Big Four, Macquarie’s value as an investment has to be judged in the context of a solid share price rally to date. Only two FNArena database brokers, UBS and Credit Suisse, are comfortable enough with further upside potential to maintain Buy ratings. Everyone else is on Hold, as is Goldman Sachs.

The earnings surprise and increased dividend nevertheless force earnings forecast upgrades among brokers and increased target prices. The consensus target in the database has risen to $41.44 from $36.88 but, in keeping with the more volatile nature of investment banking versus commercial banking, the spread of targets is substantial. CIMB is the low marker at $36 and Credit Suisse the high marker at $48. The consensus of $41.44 suggests 6% downside.

Watching on warily has been National Bank ((NAB)) which will report on Thursday.

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