Revenue Headwinds Confront Westpac

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This story features WESTPAC BANKING CORPORATION, and other companies.
For more info SHARE ANALYSIS: WBC
The company is included in ASX20, ASX50, ASX100, ASX200, ASX300 and ALL-ORDS

Westpac's first half results benefited from re-pricing of mortgages, steady provisioning and improved treasury & markets income. Yet the uncertainty emanating from the Royal Commission looms large.

-Challenges exist in the cost base from a lower-growth environment
-Potential for further positive contributions from the treasury & market segment
-No changes to pay-out ratio or dividends expected until end FY19
 

By Eva Brocklehurst

Westpac ((WBC)) may have provided a robust first half result compared with its peers but brokers envisage the near-term operating environment will be tough for all banks. Citi described the result as "old school", driven, as it was, by re-pricing benefits from mortgages which led to superior margin management.

Unlike ANZ Bank ((ANZ)) and National Bank ((NAB)) the rhetoric from management was not about transforming the current business structure and operations. Still, Citi believes Westpac faces numerous longer-term challenges, in particular its cost base in a lower-growth environment, as well as managing the decline of retail banking profitability.

The sound first half result prevented Morgan Stanley downgrading FY18 estimates but given the uncertain operating and regulatory environment, the outlook for 2019 is considered clouded because of the end of the mortgage bull market, increasing capital intensity for retail banking and growing scrutiny of conduct.

Morgan Stanley retains an Equal-weight rating given the bank's settled strategy, cost consistency and some relative valuation support and believes Westpac can achieve underlying revenue growth of 4% in FY18, based on the first half margin and better than forecast markets & treasury income.

The impact of higher bank bill rates may be adding to revenue headwinds from front book competition and slowing loan growth. Hence, Morgan Stanley forecasts revenue growth to fall to around 2% in FY19.

Home loan re-pricing may be a source of upside but it could be difficult for the major banks to contemplate this in the near term, given the Royal Commission and other inquiries into the banking sector.

Going forward, CLSA observes Westpac's cost guidance is now the top of the 2-3% range and net interest margin pressures are building. With the Royal Commission likely crimping Australian bank pricing power, the broker suspects offsets from house re-pricing are unlikely.

Macquarie agrees the bank will not be immune from challenging revenue settings across the industry but also envisages scope for mortgage re-pricing.The bank's share of interest-only loans has reduced materially, dropping -6% in the first half to around 40%. Still, this remains 7-14% above peers.

UBS remains concerned about the bank's mortgage serviceability assessment from APRA. The broker believes the bank has further to go in tightening underwriting standards before the concerns of the Royal Commission are addressed.

This is especially the case given concerns about gross household income being overstated across the industry, while the total debt position of customers is not yet fully visible.

Morgans was pleased with the results, particularly as Westpac has not had to top up the $169m provision for customer remediation that it raised in FY17, and believes this bodes well for the outlook of customer remediation costs. While the sector is subdued the broker expects Westpac to continue to deliver positive "jaws" as a result of its strong focus on cost management.

Net Interest Margin

UBS agrees that, while Westpac has successfully re-priced for higher funding costs in the past, it may be more challenging to justify this in the near term. As a result, the broker expects net interest margins to begin contracting from current levels.

UBS maintains a Sell rating and cautious view and expects housing credit growth to slow, as banks tighten underwriting standards and loans roll forward to principal & interest from interest only.

The highlight for Ord Minnett was the net interest margin, which rose to 2.05%. The broker expects the environment will become tougher because of the pressure on retail margins from loan switching and competition.

While management did a reasonable job defending mortgage standards, the broker doubts this will change the mind of its critics. One of the criticisms is that Westpac lacks cost flexibility, and expenses growth is likely to be stuck in the 2-3% range for some time.

While agreeing Westpac lacks the self-help capability of ANZ the broker envisages upside potential from cost savings once the customer services hub is rolled out, although this is a future story. Ord Minnett considers the share price weakness has more than priced pressures and maintains an Accumulate rating.

Treasury & Markets

Morgans suggests the treasury & markets contribution in the half is not super-normal, rather it is a reversion to more normal levels because the contribution in the second half of FY17 was unusually low.

While the elevated 90-day BBSW-OIS* spread is a concern from a margin perspective, a potential positive is that it may result in improved income from this segment in the second half, as a result of increased customer demand for interest-rate hedging and, potentially, greater trading opportunities.

*Australian bank bill swap rate to the global overnight indexed swap rate

Dividends

Despite the bank carrying $1.3bn of surplus franking credits, CLSA does not believe Westpac will resume dividend growth before the FY19 final, while special dividends and buybacks are considered unlikely. The broker, not one of the eight stockbrokers monitored daily on the FNArena database, maintains an Underperform rating and reduces the target to $28.40 from $32.53.

While the bank could potentially increase pay-out ratios and pay special dividends, UBS also considers this likely only if the tightening of mortgage underwriting standards and the slowdown in credit growth are benign.

Macquarie envisages scope for Westpac to pay a special dividend in FY19, should credit conditions remain benign. The broker has removed the likelihood of a special dividend in the current year but notes that Westpac's approach to capital now appears to be closer aligned to peers, and the impact from the implementation of APRA's final capital rules is likely to be diminished.

FNArena's database shows four Buy ratings, three Hold and one Sell (UBS). The consensus target is $31.95, signalling 8.6% upside to the last share price. Targets range from $26.50 (UBS) to $35.00 (Morgans). The dividend yield on FY18 and FY19 forecasts is 6.4% and 6.6% respectively.

Disclaimer: The writer has shares in the company.

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