Risk/reward equation still looks good at Westpac
Morningstar maintains fair value despite a fall in margins and slower progress on cost reductions.
Lewis Jackson: On Monday, Westpac announced full year results, including $5.4 billion in profit and a $3.5 billion share buyback. In response, investors sent the shares tumbling 7%. They're down another 3.5% today on Tuesday. I'm joined by Morningstar's banking analyst, Nathan Zaia, to talk through what happened and what investors can take away from the full year results.
Nathan, thanks for joining me.
Nathan Zaia: Hi, Lewis. Thanks for having me.
Jackson: So, with billions on the table in profits and buybacks, what did chief executive Peter King say that's got markets so roiled?
Zaia: Yeah, it's funny. The actual result wasn't too far off what we expected. I mean, the release of some provisions actually made the bottom line look a lot better. But I think there's two things that were a bit disappointing for us, and obviously the market is much more disappointed in. The first one is around the net interest margins. So, Westpac has been losing a little bit of share in home loans for a few reasons, mostly around their loan approval processing times. So, we thought they'll have to reduce the price to sort of win back brokers, and that seems to be happening, and it seems to be costing them a little bit more than we thought. The other thing that's dragged down their margin more than we thought as well is just the ongoing switch to fix and also owner-occ which are lower margin than investor, variable and interest-only, which Westpac typically has had a larger weighting to compared to the other banks. So, that's had an impact as well.
Then, the other part of the piece is actually on the operating expenses. So, Westpac, they've set a target to get their cost base down to 8 billion, but it looks like it's going to be – (the base) going to be spending a lot more in the short term before they can get there than we thought and the market thought. So, that's really what all the negativity is about. The buyback was a little bit smaller than we thought. But then, the dividend was a little bit bigger, and it sort of offset each other. So, I think that part of it was fine.
Jackson: And when we talk about the net interest margins, that's a really important figure for banks. Can you just walk us quickly through what is that exactly and how some of those changes, moving from owner-occupied to investor, how that impacts it?
Zaia: Yeah. So, it's basically what the borrower or you or I are paying the bank on our mortgage less whatever it costs the bank to fund that. So, that can be customer deposits, it can be funding through wholesale markets. So, that spread is what's coming down. And the banks charge more typically on an investor loan than an owner-occ. So, that spread is smaller for the bank. It can be beneficial on a risk-weighting. So, returns can be different as well. But on the profitability line, that's where they're getting squeezed. And I mentioned as well, the bank, their weighting has been more to investor than some of the other banks. So, that's hurting them more. And fixed – the banks have been able to, and all lenders really have been able to get funding secured at really, really low rates. So, as a result, they're offering the best fixed rates we've ever seen, and I think we will ever see. I think they're already starting to trend higher. So, that's hurting at the moment. But I think these are things that will pass through over time. I think Westpac will be able to make better margins over time as rates rise. It's just, right now, everyone is disappointed at the numbers they're printing. So, hence the sell-off.
Jackson: And I guess, kind of, staying on that point of the longer-term trajectory, as the markets – Westpac has been really punished in the markets over the last day or two. You haven't changed your fair value for the stock, and I believe it's now undervalued, maybe 10% even. What did you see in the results that others in the market didn't?
Zaia: Yeah, I think, we actually increased our operating expenses over the short term. So, we thought they had a path to some of these costs that I just mentioned. Their temporary costs to fixed is a past issue. So, it's never good they have to wear those costs. And they're going to be phased out slower than we thought. So, that had a slightly negative impact on our fair value, but it's not really material enough for us to have moved where we're at. And I think some in the market are probably either more skeptical, or they want to actually wait and see the results that the bank can deliver on these cost outs and at the same time, keep the momentum going on the top line and grow their loan book which was one thing that was a positive. They finally did get that turnaround at the top line at the loan level, which had been missing for some time.
Jackson: So, the markets responded quite negatively to less money the bank is making and the difference between what it pays depositors and what it actually brings in in loans and a longer timeline to take a bunch of costs out of the business. And is there anything else that people need to be thinking about if they were potentially looking at buying Westpac right now?
Zaia: Yeah, I think that's where the uncertainty is. How much more pressure might there be in the short term as those sorts of tailwinds we're talking about on margins continue. Is there – there's a scenario where they don't get those costs out that we're anticipating, and not just that, we're not even anticipating that all those costs do come out. I think it's unfortunate, but often you're adding these costs and you think you'll take them out, and then you realize, oh, we need to spend on something else. But we're not even giving them the whole benefit of the doubt here either. But yeah, I think if you think about moving past these years, cash rate should go up and they should make a better margin. They're very well capitalized. They well provisioned. They're still generating huge profits, and they can pay out dividends. So, I think the risk-reward equation actually looks pretty good for Westpac at the moment.
Jackson: Fantastic. Well, Nathan, thanks so much for your time.
Zaia: Thanks for having me.