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Westpac earnings tipped to recover despite exec cull

Lex Hall  |  27 Nov 2019Text size  Decrease  Increase  |  
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Westpac’s earnings will recover, and the bank remains undervalued despite the fallout from the money-laundering and child exploitation scandal that has forced the departure of the top brass at Australia’s oldest bank.

Morningstar analyst Nathan Zaia retains his fair value estimate of $29 and maintains his recommendation that shareholders should participate in the latest round of the share purchase plan, given the large discount to his fair value estimate.

At 3.30pm on Wednesday, Westpac (ASX: WBC) was down 0.95 per cent, trading at $24.66.

Zaia says the leadership changes – which include chief financial officer Peter King stepping in as interim chief executive – are a crucial step in resolving the scandal and improving the bank’s fortunes.

The bank yesterday announced Brian Hartzer will quit as chief executive next Friday while chairman Lindsay Maxsted will retire in the first half of next year. And director Ewen Crouch, chair of the boards' risk and compliance committee, will not seek re-election.

Westpac, Australia’s oldest and second largest bank, could be hit with the biggest fine in Australian corporate history after AUSTRAC alleged it breached anti-money laundering and counter terrorism financing laws 23 million times and failed to detect the funnelling of money to child pornographers in the Philippines.

In the past week, Westpac’s $85 billion market cap has fallen by almost $7 billion, which is also the amount of its annual profit.

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Zaia has based his latest estimates on a potential fine of $1 billion - $300 million more than the $700 million Commonwealth Bank (ASX: CBA) incurred in 2017 for money-laundering breaches.

As a consequence, the $300 million hit to net profit after tax would increase the likelihood of a lower dividend, Zaia says.

Brian Hartzer will quit as Westpac chief executive next week

Brian Hartzer will quit as Westpac chief executive next week

He also factors in a downside scenario in which the fine is $2 billion and the share price falls to $26.

“We expect that over the medium term earnings will recover and benefit from the bank's competitive advantages in the home and business lending markets,” Zaia wrote in a note on Wednesday.

“We do not believe the bank is willingly taking excessive risks and will learn from recent experiences to prevent a similar recurrence.

“Earnings uncertainty has increased in the short-term, but we retain our $29 fair value estimate and believe Westpac is undervalued.”

Zaia says Westpac’s response plan is estimated to cost about $80 million and is covered by his prior cost estimate, which retained an allowance for unforeseen remediation costs or litigation.

The plan includes taking action to ensure issues raised by AUSTRAC do not repeat, such as closing products and increasing resources. All financial crime systems will be reviewed by an external expert.

Investors urged to participate in SPP

Zaia has recommended participating in the share purchase plan, which closes on 2 December, and aims to raise $500 million.

“Despite these near-term challenges, we maintain our recommendation to participate in the SPP, given the large discount to our fair value.

“The current share price makes it likely the offer price will be set at a 2 per cent discount to the five-day average share price to 2 December, as opposed to the $25.32 placement price.

“With a potentially negligible discount to purchasing on market, investors should weigh up the need to increase portfolio weightings to Westpac and the banks more broadly.”

Under the SPP, eligible shareholders can apply for up to $30,000 of new fully paid ordinary shares as part of Westpac’s capital raise designed to generate $2.5 billion in funds. 

The SPP, which is targeting $500 million, follows the $2 billion institutional share placement completed on 5 November following the release of the bank’s full-year results. 

However, Westpac has noted that it could scale back applications or issue a higher amount depending on demand from investors.

The SPP is only open to shareholders who were registered holders of shares at 1 November and shown on the register to have an address in Australia or New Zealand.

Eligible shareholders can apply for SPP shares at the lower of:

  • $25.32 per SPP share, being the price paid by institutional investors under the institutional placement; and
  • the VWAP2 of Westpac shares traded on the ASX during the five trading days up to, and including, the SPP closing date (expected to be 2 December 2019), less a 2.0 per cent discount, rounded to the nearest cent.

Westpac also noted that SPP shares will rank equally with existing shares from their date of issue (expected to be 11 December 2019), and will not carry an entitlement to receive the 2019 final dividend, as the SPP shares will be issued after the record date for the 2019 final dividend.

Westpac says the capital raise will help provide an increased buffer above the APRA’s “unquestionably strong” common equity tier 1 (CET1) capital ratio benchmark of 10.5 per cent.

Downside scenario

In a downside scenario, in which he is wrong about the economic implications of the anti-money laundering breaches, Zaia says Westpac is worth $26 – about 10 per cent lower than his base case.

This scenario assumes the bank raises nothing from the current SPP, cops a $2 billion fine, and that reputational damage results in lower loan growth and pressure on net interest margins.

Here, the SPP price represents only a small discount to fair value and shareholders have little incentive to participate, he says.

However, Zaia warns that much uncertainty remains.

“On the plus side, while customers will have been disgusted by these claims, seeing leadership face the axe should go some way to reassure customers it is clearly not something the bank takes lightly.

“But as a downside risk, state governments which bank with Westpac could also end their relationships.

“We estimate that in this scenario the bank would still meet its capital requirements, but the dividend will be cut materially. On a dividend payout ratio of 80 per cent the dividend would be lowered to $1.10 per share.”

Stewardship rating reflects ‘longer-term view’

In the wake of the scandal, Zaia stripped Westpac of its Morningstar Exemplary moat rating, meaning that none of big four banks now carries a moat rating.

“Not downplaying the severity of the claims, and the destruction of shareholder value both on the market (even if temporary) and via litigation, our standard stewardship rating aims to encompass a longer-term view,” Zaia says.

“Over a number of years we believe the bank has done well in growing the loan book with adequate lending standards and balancing capital requirements and dividends, a combination which has been rewarding for shareholders.”

is senior editor for Morningstar Australia

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