Westpac’s Reality Dose

This story features WESTPAC BANKING CORPORATION, and other companies.
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The company is included in ASX20, ASX50, ASX100, ASX200, ASX300 and ALL-ORDS

By Greg Peel

As I write the ASX 200 has added back over 100 points this morning, flipping a Friday sell-off into a Wall Street-inspired recovery rally matching recent euphoric sentiment. While positive signs of the housing market stabilising in the US have provided further relief, the issue remains that a trigger for Friday’s weak session was a quarterly update from Australia’s largest bank, Westpac ((WBC)).

It took a long time over the course of 2007-08 for most bank analysts to realise the building GFC would translate into possibly historic levels of bad debts for Australian banks, but having woken up to reality, analysts started looking at the bad debt peaks of the 1992 recession and seeing a potential repeat. More recently, as signs of economic recovery across the globe have forced analysts to start rethinking what had become very bearish stances, they have been forced to chase market sentiment by improving valuation multiples.

A price-to-forecast-earnings-ratio, or “forward PE multiple” is a key indicator of sentiment – that intangible element of a share price which is driven by confidence. Clearly the “E” can change as elapsed time converges on forecast time, but share prices are lead indicators and rising multiples suggest the market believes that earnings will ultimately rise to justify leading sentiment. The market has recently pushed up forward multiples on the big banks based on rapidly improving confidence, and bank analysts have not only chased this sentiment with forced target price increases, they have swung from being bearish at the bottom to being mostly bullish now.

Markets, by their nature, will nevertheless always over-sell on downside and over-buy on the upside as panic turns to euphoria and sentiment runs ahead of reality. This was the climate into which Westpac delivered its third quarter update on Friday.

As a result of improving sentiment, analysts have been winding back their bad debts expectations. They now suspect peak ratios of bad debts in loan books will not be as high as first thought, and that the timing of that peak will be earlier than previously assumed. Then Westpac came out and announced a very big jump in its “watch list”.

Bank analysts make reference to “BDD”, which is “bad or doubtful debts”. Bad debts are debts that are never going to be repaid and are thus written off, while doubtful debts include those in arrears or with some other factor suggesting repayment is not a given. To keep a handle on things, banks move debts into a “watch list” before they reach the in-arrears (also called  “impaired”) or simply bad category, and then make provisions on the balance sheet in case those debts on watch do indeed turn bad. Westpac announced on Friday that its impaired loan count had risen by 24% in the third quarter, and that gave the market a bit of a shock.

One third of these newly stressed loans are New Zealand based – not surprising given the Kiwis are suffering badly from “the recession Australia was meant to have”. Of that third, half is represented by two single names. The other two-thirds relate locally to commercial property and small and medium enterprises (SME).

Should the market now resume a more nervous approach?

While analyst views differ to some extent, the pervading feeling is that Westpac is simply being a lot more conservative now than it was in the boom. This means there has been a natural growth in watch list numbers of loans that three years ago would not have caused concern. SMEs are the natural victims of recessions, and analysts have always expected bad debts to grow in this sector. Commercial property, on the other hand, is another case in point.

Commercial property loans are another obviously risky sector in a recession, and it was commercial property that sent bad debt levels spiralling and bank share prices tanking back in 1992, to the point where Westpac would no longer be with us if it wasn’t for one Kerry Packer. However, the 1992 recession was all about commercial property, in contrast to this downturn which is all about housing and household debt. Having learnt a stark lesson in commercial property lending in the nineties, banks have since become more wary. This may change as another generation moves onto the board, but lending on commercial property leading into 2007 was at lower loan-to-value ratios than the heady days of the eighties. While commercial property is clearly at risk in 2009, and worth being concerned about, analysts believe the risk of a big property price collapse is comparatively minimal this time around.

The BA-Merrill Lynch analysts summed up the more conservative view this morning by suggesting Westpac “will need low loss intensity [meaning low conversion of loans from watch list to bad debt], and so is reliant on a follow through in recent economic strength and no further stress on commercial property prices”. Others were not so concerned however, with UBS suggesting the watch list was “in line with forecasts”, Deutsche Bank noting “whilst the watch list for problem loans is rising we do not believe that this will follow through to bad debts”, and Citi highlighting management’s expectations that the rate of impaired loan increase will slow from here.

RBS analysts, who had previously forecast higher peak bad debts than peers before suddenly becoming a lot more bullish on the sector lately, remained circumspect: “We caution that we are not entirely through the pain given impaired assets and watch lists are still increasing”.

Westpac’s response to its growing watch list was to increase its bad debt provisions. This is another factor for the market to consider. Over the course of the GFC banks have increased their tier one capital ratios through secondary share issues, reduced the level of earnings paid out as dividends, and put money aside on the balance sheet to cover bad debts. As bad debt levels continue their lagging trajectory towards a peak – some time in early or late, 2010 depending on which analysts you ask – there will be no balance sheet impact if provisions are adequate.

What a more confident market is hoping for, nevertheless, is the day when bad debts do appear to have peaked and banks are left with provisions they no longer need which can be brought back to the bottom line as earnings. This is the balance game, and as far as Westpac is concerned Macquarie believes increased provisions are “typical of the balance sheet conservatism we are used to”.

On the other side of the equation from bad debts is operational earnings – actual profits made from ongoing and new business. On this front, Westpac scored well, with broker responses ranging from “few surprises” to “relatively upbeat”. Its net interest margin – the difference between a bank’s borrowing and lending rate and the fundamental driver of profit – is maintaining a healthy level under the circumstances, and GSJB Were notes NIM will continue to improve when banks begin to raise standard variable mortgage rates on the back of, or even ahead of, expected increases in the RBA cash rate in 2010.

While analysts have a responsibility to be sceptical of management comments, they were happy to hear Westpac’s suggest there were “early encouraging signs of improvement” and that the “third quarter had been a period of transition”. This suggests to Citi a move “from uncertainty to more certainty”, which is good news when one knows bad debt provisions are conservatively well topped up.

So the conclusion is that Westpac’s update was not as confronting as the market may have first thought (and one notes the shares are now back up 3.5% today), provided one keeps sentiment in reasonable check. Macquarie’s summation was to suggest the market should not expect everything to go back being rosy again quite as quickly as sentiment might be suggesting:

“A healthy degree of caution in management’s outlook statements and similarly cautious provisioning trends,” note the analysts, “leave us unconvinced that a significant turnaround in either credit growth or asset quality is coming anytime soon (not before late in 2010)”.

The Macquarie analysts nevertheless suggest that if their own analysis proves too conservative, Westpac has now “positioned itself extremely well” for a rapid turnaround.

Most analysts, Macquarie included, have already looked beyond FY10 and into FY11 forecast earnings in determining whether the big Australian banks are offering value or not. While earnings forecasts two years out are important for valuation, they are not nearly as important as earnings one year out under normal circumstances (note that price targets are based on six to twelve month views). So to all but ignore FY10 and look straight to FY11 is rather unusual.

But these are unusual times, and in this instance valuing banks based on FY10 earnings is simply to see rising bad debts and weak credit demand and thus to arrive at low valuations. If FY10 is assumed as the trough in the cycle, however, then the big banks should recover into high rates of return on equity very quickly thereafter given their competition has been all but destroyed. Thus FY11 forecasts become overriding, given share prices do actually look fair to cheap on that basis as far as most analysts are concerned.

That’s the sector view, but within the sector one must consider the relativities of the Big Four. Westpac’s size, domestic focus and return profile does provide some justification for the shares to trade on a premium PE multiple to peers, but as Merrills points out “the continued build up of property related impaired and watch-list loans will place this premium at further risk and the outperformance in 2008 from asset quality has long passed”.

In other words, analysts expect Westpac to come back to the pack in a relative sense. They originally assumed the riskier loan book inherited from St George would be the catalyst for premium reduction, but so far those loans are not notably significant watch list contributors. Westpac clearly has troublesome exposures in New Zealand, and its loans are weighted locally to property in general and the weakest state economically – New South Wales – in particular. This in itself is enough for broker’s to prefer ANZ ((ANZ)) and National ((NAB)) given their relative discount to Westpac and also to Commonwealth ((CBA)).

The FNArena database shows a 3/5/2 Buy/Hold/Sell ratio for Westpac which is unchanged post the update. The average target has nevertheless risen from $23.12 to $24.04 as analysts take the opportunity to adjust valuations to higher multiples.

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