Westpac Fails To Excite

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The company is included in ASX20, ASX50, ASX100, ASX200, ASX300 and ALL-ORDS

By Greg Peel

Westpac's ((WBC)) full-year result yesterday marked the last of the big bank earnings season, albeit Commonwealth ((CBA)) which runs on a June full-year rather than September like the other three will provide a trading update on November 15.

Bank analysts had not been expecting anything spectacular from Westpac, and weren't disappointed. When the Australian government offered first home buyer stimulus in 2009 and the RBA dropped its cash rate to 3%, it was Westpac and CBA in particular who rushed to gobble up the spoils in an attempt to balance out “risky” business loans with “safe” mortgages. The two gobbled up more mortgages as well by acquiring St George and BankWest respectively. But a small child will continue to eat too much cake until he regrets it later.

Pretty soon the two big retail lenders realised they were offering home loans to people who would never have been otherwise able to afford a home but for the fact mortgage rates were historically the cheapest they'd ever been and the government was effectively paying the deposit. While not exactly US-style “subprime”, the loans were very much at risk from the inevitable rate hikes that must one day follow. And these people never actually had any equity in the first place.

First the banks responded by requiring at least some portion of a deposit to come from savings and not from the government. Then late last year once the RBA had already hiked twice, Westpac drew the ire of politicians and the public by hiking its standard variable mortgage rate (SVR) by 45 basis points to the RBA's 25. All Westpac was doing was saying “we have enough mortgages now, thank you”. Between Westpac and CBA, the two ultimately controlled 75% of all Australian mortgages.

So what was CBA telling us yesterday by doing exactly the same thing? Well, apart from flipping the bird at Comrade Joe and an incumbent Treasurer now scrambling to be seen to be doing something effective, CBA was suggesting its retail loan book was dragging on its earnings growth at a time when funding costs were rising such that the only way to restore margins was to make a solid independent rate hike, or an “asset repricing” as the jargon goes. Higher margined business loan demand is still foundering as the cash rate rises and the housing market has stalled.

For a discussion on politics and rising bank funding costs, see Australian Bank Sector Wrap from last week.

We are waiting with baited breath now to see what Westpac will do this time. There is only one thing the politicians and public are focused on this week – Westpac's 84% jump in headline profit. That and the fact it intends to reduce costs by axing staff. You've gotta hand it to the biggest of the Big Banks – their PR departments must be run by retired Centurion tank drivers.

But as far as bank analysts are concerned (not geniuses by any means, but at least they have some inkling of what they are talking about), the Westpac result was either in-line with or slightly better than expectations. Any “beat” was mostly due to a slightly larger amount of unneeded bad debt provisions being brought back to the earnings line, although there was some surprise in that Westpac's fourth quarter net interest margin ticked up ever so slightly (3 basis points). Its second half margin nevertheless fell 9 basis points from the first half, which reflects Westpac's ongoing cry that net offshore funding costs are on the rise and please won't somebody listen. Even the RBA disputes this fact (more fodder for Comrade Joe) but only because funding costs now are lower than they were earlier in the year. But Westpac, like every other bank, is still carrying pre-GFC funding at cheapo rates that will be soon rolling off and into history. So its net funding cost will continue to rise, according to the bank, into FY12.

In the meantime, Westpac's loan growth for FY10 was a soft 1% but that's what hiking by 45bps in December was intended to achieve. It's deposit growth – the source of “cheap” local funding – was at 3% growth lower than its peers. It's revenue was down 3% in the half.

Profits from money market trading were down 22% in the second half which is unsurprising given everything's now settled down volatility-wise. At the end of the day, half of Westpac's underlying earnings result came from cash earnings and the other half from bringing back bad and doubtful debt provisions. Those BDDs are just profits retained in FY09 and released in FY10 which qualifies the 84% profit “jump”.

The good news is that Westpac's capital position is sound based on the new Basel III requirements. That has allowed the bank to increase its dividend payout ration and thus its yield for shareholders.

The bad news is that there's not much excitement ahead for the big retail banks, as far as most analysts are concerned. The only joy will come from independently raising SVRs so as to reprice the existing loan book. Neither Westpac, who it is assumed will announce its rise shortly, nor CBA, are looking to attract more mortgages. The one's they have are now suffering from 1.75% worth of RBA cash rate increases alone.

New business loans would be nice, but as the recent data suggested business credit demand growth remains negative even this far past the GFC. The only comfort here is that the tide appears to be slowly turning given the rate of contraction in demand has become less negative. Analysts are putting a lot of faith in such demand soon returning, but the banks will be weathering higher funding costs while they wait for this outcome.

Analysts also consider it a positive that Westpac is in the process of reducing costs. Westpac's “productivity “ strategy is, of course, code for “please clear your desk and hand security your pass card on the way out”. But costs were still rising in the fourth quarter, so Westpac had better get cracking. Oh – it is.

In general, analysts found nothing to be upset about in Westpac's numbers or forecasts, but then they couldn't find anything to suggest outperformance ahead either. Most prefer the smaller ANZ ((ANZ)) and National ((NAB)) as they have less exposure to the retail banking drag. Macquarie bucks the trend however, preferring the two big banks for the same reason given the greater benefits the two will glean from “asset repricing”.

Macquarie nevertheless has only a Neutral rating on Westpac, and today has downgraded CBA to Neutral as well. Where the two differ as far as Macquarie is concerned is in capital base. Westpac's is comfortably inside Basel requirements, but CBA is going to have find underwriters for perhaps its next four dividend reinvestment plans in order to stay above limits. An underwritten DRP is akin to a backdoor capital raising. This implied dilution sees Macquarie downgrade its CBA earnings forecasts.

And Macquarie has today downgraded ANZ from Neutral to Underperform. The analysts are not as keen as their peers on the bank which has proven to be this season's star performer given they believe the star performance is now behind ANZ and there can only be a let-down from here.

ANZ management has itself confirmed that institutional lending margins have turned and the latest data, as noted, show business loan demand remains weak. Macquarie thus expects ANZ's margin gap to fall back towards its peers from now on. Given ANZ's share price has run up since the announcement of its result last week, Macquarie has decided value no longer exists.

For Westpac, the FNArena database brokers are all lined up like little black ducks on Hold positions, and that's with all assuming an additional SVR rate hike of at least 15bps above the RBA. At $25.20, the consensus target price is offering only 7.4% upside. Brokers usually need about twice that for a Buy rating.

Come the CBA update in a couple of weeks I'll fully wrap the banking sector assessment.

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