Summary: With Westpac’s (WBC) provisioning nearing cyclical lows and household credit growth restricted by highly indebted households, it is difficult to see significant earnings and dividend upside from the bank’s traditional businesses.
Key take-out: We derive a financial year 2014 valuation at September 30, 2014 of $31.60, rising to $32.86 in FY15. Investors should target a 15% total first-year shareholder return when investing in a major bank at this stage of the cycle. The WBC share price at which the current forward return is 15% is $30.70.
Category: Value Investing
Recommendations:
Stock
Company
Call
Call price
Projected price
WBC
WESTPAC BANKING CORPORATION
Hold
$34.765
$31.60
The Westpac Banking Corporation (WBC) share price is currently supported by its attractive yield and expectations of continued earnings and dividend growth. Near-perfect results have been demonstrated by the majors, with WBC no exception.
Last month WBC reported a first-half fiscal 2014 statutory net profit after tax of $3.62 billion, an increase of 10% on the previous corresponding period. Basic earnings per share grew 10%, outperforming equity per share growth of 5%, representing increasing profitability or normalised return on equity (NROE). Dividends per share increased 5%.
It was an impressive result, however the majors appear to have entered “peak of cycle” earnings. With Westpac’s provisioning nearing cyclical lows and household credit growth restricted by a highly indebted household sector (household debt to disposable income is at approximately 150%), it is difficult to see significant earnings and dividend upside from WBC’s traditional banking businesses.
Figure 1. Household finances
Source: RBA
Business gearing levels do not appear to be stretched, so a recovery in business credit growth may assist in driving incremental earnings for WBC. However, business confidence and conditions are patchy and WBC faces fierce competition from ANZ Banking Group (ANZ) and National Australia Bank (NAB).
Asset quality was a highlight at WBC’s first-half result. The bank’s performance has benefited from its commitment to conservatively manage its risks across all business areas after a near-death experience in the early 1990s. Provisioning and impairment expenses have now reached cyclical lows (see chart below).
Although the downtrend is partly a result of several years of work by the bank to manage credit quality carefully, a large cyclical component remains and can be expected to revert to a mid-cycle average at some stage.
Figure 2. Impairment expenses and provisioning
Source: Clime Asset Management (George Whitehouse)
WBC is reporting outstanding profits, however below the surface its resilience is weakening. This increases WBC’s risk in the event of an economic downturn.
WBC attracts income investors due its track record of delivering consistent dividend growth to shareholders. The bank has delivered dividend increases of at least 2 cents per share per half year since 2H11. WBC’s dividend compounded annual growth rate is significantly higher than the average of Australian peer banks on a two, five, and 10-year view.
Figure 3. WBC dividend CAGR versus major bank peers
Source: WBC
The current share price at nearly 10% above value assumes the uptrend in dividend and earnings growth will continue. In our view WBC’s current performance should not be extrapolated into the future given the cyclical nature of banking. Our adopted normalised return on equity (red) of 20% is marginally below consensus forecasts (orange) and the five-year average.
Figure 4. WBC adopted metrics and future value
Source: StocksInValue.com.au
The required return (green) of 11.5% is low, reflecting WBC’s financial strength, large market cap and predictability of earnings. We derive an equity multiple of 2.03x and FY14 (September 30, 2014) valuation of $31.60, rising to $32.86 in FY15.
WBC is currently trading above our FY16 valuation of $34.12, highlighting its current overvaluation. Expectations of continued earnings and dividend growth are attracting investors but implies a lack of margin of safety.
Loan growth and growth from non-banking businesses will have to accelerate to meet shareholder expectations of future dividend and earnings growth.
We think investors should target a 15% total first-year shareholder return when investing in a major bank at this stage of the cycle. The WBC share price at which the current forward return is 15% is $30.70.
Banks are leveraged cyclicals exposed to changes in economic conditions, interest rates, exchange rates, unemployment and inflation.
Analysts: Amelia Bott, Analyst Equities with insights from George Whitehouse and Stephen Wood of Clime Asset Management
Disclosure: Clime Asset Management owns shares in WBC.
The post Will Westpac wobble? appeared first on StocksInValue.