Australia | Oct 30 2008
This story features WESTPAC BANKING CORPORATION.
For more info SHARE ANALYSIS: WBC
The company is included in ASX20, ASX50, ASX100, ASX200, ASX300 and ALL-ORDS
By Greg Peel
It is suggested that Queen Elizabeth must believe the whole world outside Buckingham Palace smells of fresh paint.
Back in February, the previously credit crunch “immune” Australian banking industry scored a big spoonful of reality when the likes of Centro, Allco and MFS collapsed under a mountain of debt. All of the Big Five were exposed to the basket cases to varying degrees, and thus followed the first big round of provisions and restated earnings guidance. None were left unscathed. None, that is, other than St George Bank ((SGB)).
St George decided the uncertainty of the times called for an unscheduled trading update, and analysts applauded the initiative. But they soon became perplexed when the Dragon offered reconfirmed FY08 earnings growth guidance of 10%, which included no provisions for potential losses from the aforementioned corporate implosions. The analysts took it in their stride, but flagged downside risk and duly dropped price targets dramatically despite the bank’s potential for takeover.
When the half-year result came out in March, analysts were spitting chips. Only one month after reconfirming FY08 guidance, suddenly guidance was slashed from 10% to 8-10%. The bank also put aside provisions against those same corporate loans that only a month earlier it was assuming would be recovered. Yet nothing had changed in a month.
To top things off, St George qualified its guidance by suggesting “targets exclude impact of hedging and derivatives and assumes a reasonably sound economic environment and no further material credit losses”. Thus guidance assumed a Perfect World. It may be with the benefit of hindsight that this qualification seems so laughable today, but it was extraordinary even back in March. One bank, for example, offered a sector outlook at the time that suggested “national home loan credit to slow, national business lending growth to moderate, credit dislocation to persist in the short term, and investment market volatility to continue”.
That bank was St George. The Dragon had descended into a comedy act.
It was thus of little surprise that knowing nods accompanied the announcement in May that Westpac ((WBC)) was making a takeover offer for St George. St George’s CEO Gail Kelly had jumped ship to join Westpac in August last, and despite her protestations no one believed for a second that this wasn’t all part of a grand plan.
In March St George also sparked incredulity by raising its dividend payout. In light of the credit crunch and subsequent crunching of bank capital, dividends were being slashed or at the very least maintained across the globe. Yet St George – the one bank in the local Big Five with little deposits to speak of and a significant reliance on the now dead securitisation market – announced it was paying out more of its capital. As JP Morgan noted at the time, it was a deceptive little sweetener ahead of the dilutive underwritten dividend reinvestment plan (DRP) that would surely follow.
St George announced its full-year profit yesterday and an underwritten DRP if the Westpac merger did not succeed.
The analyst fraternity was not silly enough as to expect anything other than a sow’s ear dressed up as a silk purse given the final shareholder decision on the merger will be along soon. As far as anyone was concerned, this was the Dragon’s final curtain. And the Jolly Green did little to disappoint.
Macquarie commented that “in light of the merger there should have been little doubt that SGB would use all of its ‘powers’ to meet or beat guidance”.
Only UBS decided there was little point in extensive commentary on the result, simply rattling off the numbers and suggesting it was “a fitting farewell”. But there was a bit more cynicism from other parts of the CBD.
Earnings ultimately met the 8-10% earnings growth guidance offered back in March, coming in at 8.3%, but as JP Morgan put it, the result “was riddled with what we considered to be non-operational items”. While JP Morgan’s banking analyst veteran Brian Johnson was arguably the most cynical of his peers, his assessment was by no means unique.
The more polite among the analysts agreed that earnings quality was “mixed”. Various one-offs bolstered earnings and some pretty severe cost cuts, which won’t happen again, added to the apparent success. These included the suspension of certain projects that now won’t go ahead as St George is assuming it will be no more.
The Deutsche Bank analysts went on the attack, noting that the small decline in second half impaired assets (bad loans) “contrasts with material increases by every other major bank that has so far reported”. The final figure even contrasts with St George’s own 44% increase in loans 90-days past due, notes Deutsche, which as a proportion of total loans is now “the highest of the major banks”.
JP Morgan calculates that if one were to look through the “noise” of this dressed-up result, normalised FY08 cash earnings would have been 4.2% lower and earnings growth only 3.7%, not 8.3%.
This is all well and good, but the realistic question now is: What is Westpac getting? And if the Westpac bid does not succeed: What would happen to St George if it had to stand alone?
The answer the second question is the easiest. St George would be on a slippery slope to hell. JP Morgan suggested months ago that the St George model is broken. Deutsche suggests the bank’s credit quality “could come under considerable pressure in FY09 as the real economy slows”. ABN Amro believes St George “would face significant capital and earnings risk”.
Irrespective of the foolish Rudd government initiative to throw $8bn of taxpayer money at a dead patient – the mortgage securitisation market once relied upon by non-banks, small banks and St George – the game is over. There will be no more lines of credit for trumped up mortgage securities. If there were, their cost of funding would be simply prohibitive. The world has learnt a lesson, and that lesson has only begun to be played out. St George has managed some increase in its deposit base, but given its capital position it would be only a matter of time.
And it is the bank’s announced capital position that has all analysts worried. What on earth is Westpac getting itself in to?
St George announced a tier one capital ratio of 6.6% – well below even the worst of the Big Four. The announced underwritten DRP would beef this up to 7.2% (while diluting shareholders) but (a) this is still well below everyone else and (b) if the merger goes through there will be no DRP. Westpac will inherit a 6.6% capital ratio.
This low ratio is undermining the scrip bid Westpac has made for St George. If the merger goes ahead, analysts expect the strong Westpac to cope, but ABN Amro, for one, would not rule out the need down the track for Westpac to raise further capital of its own.
Moreover, the cost cutting that is a feature of the “strong” St George result is taking away from Westpac’s hopes of valuable synergies in a merged entity. And just how realistic are those bad loan provisions? Will Westpac have to beef them up straight away?
All up, the analysts believe there is little chance the merger will not go through, and believe that Westpac is in good enough shape to still benefit from the deal. It’s not quite as cut and dried a picture as it was back in May, however.
Vale Mr Dragon – you’ve been nothing if not entertaining.
Click to view our Glossary of Financial Terms
CHARTS
For more info SHARE ANALYSIS: WBC - WESTPAC BANKING CORPORATION
