Costs Continue To Drag On Westpac

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

With Westpac’s FY24 earnings expected to continue to decline on stubbornly high costs, capital management provides support but will it last?

-Westpac’s FY23 result largely in line
-Increased costs the key issue
-Further earnings decline expected in FY24
-Jury out on ongoing capital management

By Greg Peel

Westpac ((WBC)) saw a positive share price response to its FY23 earnings result released yesterday, despite profit and earnings being in line with to slightly below broker forecasts, although at the time of writing (pre-RBA) most of that gain has been reversed.

Australia’s second-largest bank has a similar asset (loan) base, funding mix (deposit/debt issuance) and domestic retail concentration as large peer Commonwealth Bank ((CBA)), notes Morgans, but its growth, profitability and return on equity have been significantly weaker.

A decline in full-year profit was roughly in line but helped by better than expected credit quality (lower bad & doubtful debts than assumed), offset by lower revenues. Pre-provision operating profit came in slightly lower than forecast, but the second half credit loss ratio was substantially lower.

The problem is costs. Underlying cost growth came in 5% higher than the market was expecting. Westpac has reduced its staff headcount by -6% including a -34% reduction in temporary staff, but technology expenses were 15% higher half-on-half as the bank continues its technology upgrade.

Management expects further inflationary pressures, amortisation and expensed investment spend in FY24, but did not provide quantified cost guidance.

Management also outlined high-level plans to "accelerate" its technology transformation, in order to improve customer service, grow in line with system, and achieve a cost-to-income ratio "closer to peers”, but again, without providing detail.

The bottom line is brokers expect costs to continue to be a headwind in FY24, but at some point thereafter assume investment in technology will begin to pay off. Westpac agrees the cost trend in the second half is likely to persist into the first half FY24.

The problem is as the bank does what it can to reduce costs, persistent inflation, and a step-up in both amortisation and expensed investment spending fight back the other way.

Operationally, Westpac grew its asset base by 2% in the second half, but saw a -2 basis point decline in net interest margin to 194bps as competition forced higher deposit rates, balanced by the benefit of RBA rate hikes allowing loan rate increases.

Ord Minnett assumes the bank can grow loans and deposits roughly in line with the market, without having to resort to heavy discounting. The bank’s new mortgage origination platform has reportedly improved approval times which should help lift mortgage broker satisfaction (providing evidence that technology spend can indeed pay off).

Home loans increased by 3.0% in the second half compared to market growth of 2.3% (noting CBA had been happy in the period to cede market share to the competition in order to improve profitability, but evidence suggests that bank may be set to become more competitive once again).

Aided by modest revenue growth, Ord Minnett assumes Westpac’s cost-to-income ratio will improve to 46% by FY27. The current CTI of 49% still stands out as high among peers, but should reduce as the bank reduces headcount, as customer remediation and risks and compliance projects complete (hangover from the Royal Commission), and the benefits of technology investment are realised.

Capital Management

Westpac cited “data refinement” as driving the bank’s tier one capital ratio to a higher than expected 12.4%. This allowed for an announced final dividend of 72cps, up 2c from the first half, and a fresh $1.5bn share buyback, which was widely expected.

It is likely these announcements were behind yesterday’s share price rally.

Looking ahead, brokers are divided on whether Westpac can maintain its dividends and/or implement a further buyback.

The full-year dividend payout ratio of 69% fell roughly in the middle of the bank’s 65-75% target range. Most brokers thus believe Westpac can maintain dividends in the face of an expected FY24 earnings decline by lifting its payout ratio, and that the $1.5bn buyback underscores this assumption, otherwise why do it?

The key is Westpac’s target tier one capital range of 11.0-11.5%, vis a vis its current ratio of 12.4%. Even after the announced buyback, the bank will still have plenty of excess capital.

Ord Minnett sees modest dividend growth ahead as Westpac tweaks the payout ratio. The broker does not expect additional buybacks unless an improved economic outlook leads to a material release of bad debt provisions.

Morgans suggest it’s unlikely the dividend will be cut, given the strength of the capital position. The broker foresees an increase in the buyback with the first half 2024 result.

Morgan Stanley also expects a further buyback to be announced with the May result, but doesn’t see “much scope” for dividend growth in the coming year.

Macquarie is the outlier.

While noting the announced buyback reduces the share count and thus supports future dividends, with an expected return on capital of around 11% and FY24 earnings decline of around -10%, Macquarie believes Westpac will need to cut its dividends by some -10% to support future capital generation.

The broker expects the bank to use its surplus capital to maintain an elevated payout ratio and distribute franking credits, but with surplus capital reducing, sees a greater need to reduce dividends.

Recommendations

Ord Minnett remains the most upbeat on Westpac among brokers monitored daily by FNArena, with an Accumulate rating (one below Buy on its five-tier system) and a standout target price of $28.00.

Following the result, the consensus target has risen to $22.40 from $22.00, largely due to slight forecast increases in outer years and the impact of capital management. Take out Ord Minnett’s target and consensus would be at $21.28.

Morgans cites recent share price strength compressing Westpac’s total potential return as reason to downgrade to Hold from Add. Morgans joins three other brokers with Hold or equivalent ratings.

Among those, Citi sums up the view by noting valuation at current levels is arguably undemanding, particularly if technology simplification delivers a long-anticipated benefit to returns. But the near-term looks challenging, and execution risk is material.

There is one Sell rating and it’s not Macquarie.

UBS has to date only provided an abbreviated “first glance” response to Monday’s result, noting Westpac is trading on a forecast 1.0x price-to-book value ratio and an 11x price/earnings, well below historical averages, but retains Sell, and the lowest target ($20.00).

UBS believes cost pressures are likely to remain “sticky”.

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