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Loan losses Westpac’s chief concern

Lex Hall  |  25 Sep 2020Text size  Decrease  Increase  |  
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The record fine inflicted on Westpac (ASX: WBC) for criminal activity provides welcome certainty for the bank, which remains at a 35 per cent discount to the fair value estimate set by Morningstar’s banking analyst Nathan Zaia.

Zaia has made no change to his FVE of $25 for Australia’s second largest lender and expects the 35 discount at which it’s trading will contract as the bank’s earnings momentum improves.

While the certainty around the $1.3 billion Austrac fine is welcome, other concerns loom, however, most notably loan losses.

Over the past three years, Westpac has had loan losses of about $2.4 billion. However, Zaia expects this to jump to $9 billion between 2020 and 2022, largely because of covid-19.

“While one risk to earnings has been removed, the uncertainty around future loan losses remains the greatest risk to the sector, especially as the covid support packages are withdrawn,” Zaia says.

“We assume that paying out 50 per cent of earnings in the short term and keeping its common equity Tier 1 ratio at 10 per cent, the bank will need to raise an additional $1.5 billion in equity over the next 24 months.

“Asset divestments, a less severe economic impact, or lower dividend payout ratio could negate the need for more capital.”

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Westpac had put aside $900 million for the Austrac penalty, which in part related to delays in reporting suspicious transactions linked to child exploitation. Zaia had forecast the fine to be $1 billion.

Zaia says the additional $300 million reduces his fiscal 2020 net profit after tax forecast by 8.5 per cent to $3.2 billion but has “no bearing on outer-year forecasts” or his $25 fair value estimate.

“Putting the $300 million into context, it represents less than 0.5 per cent of the firm’s equity value, and over the next five years, we expect the bank to make cumulative profits of $28.5 billion," he says.

Zaia’s dividend forecast shrinks to just $32 cents per share, assuming a 50 per cent pay out of second-half earnings.

Growth of $10,000 in Australia's big four banks

A chart showing growth of $10k invested in Australia's big four banks

Source: Morningstar Direct, data as at 1.45pm, 25 September 2020

The big four banks surged on Friday amid the government’s plans to ease responsible lending laws. Westpac led the charge, up by more than 6 per cent.

The new lending laws aim to help mitigate the effect of the pandemic. As part of the reforms, small businesses will be able to access more money.

And in a bid to speed up the credit approval process, the loan verification process will be eased for borrowers, and lenders face no penalty if borrowers mislead on their loan applications. 

Zaia welcomed the move, saying it put greater emphasis on self-responsibility.

“If a borrower gets themselves into trouble, we shouldn’t automatically blame the lender. Borrowers need to be held to account.

“Simplifying the loan application process for borrowers will reduce barriers to switching between credit providers, which is obviously always a bigger risk for the incumbents with the large market share, but the majors are probably the big winners from these changes.

“The majors receive large numbers of applications and getting through them faster will improve the experience via the broker channel and likely mean they keep a large share of the market.”

Westpac has a 23 per cent share of home lending.

How Australia's big four match up

a chart showing Morningstar ratings for the big four banks

Source: Morningstar Premium; data as at 1.45pm, 25 September 2020

According to Zaia’s fair value estimates, Commonwealth Bank (ASX: CBA) is fairly valued, while Westpac, ANZ and NAB are at discounts of about 30 per cent.

“We believe Westpac’s large price/fair value discount in comparison to Commonwealth Bank owes to less dividend certainty, a weaker capital position, and larger weighting to investor loans.

“Commonwealth Bank’s lower cost/income ratio, higher ROE, and loan processing efficiency in the mortgage market warrant a premium, but 1.6 times book value compared with 0.9 times for Westpac is too much. We believe the discount will close as Westpac’s underlying earnings momentum improves.”

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is senior editor for Morningstar Australia

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