Earnings bright side for Westpac
Westpac has endured one of the most torrid weeks in its 200-year history but there's an upside, says Morningstar banking analyst Nathan Zaia.
Mentioned: ANZ Group Holdings Ltd (ANZ), Commonwealth Bank of Australia (CBA), National Australia Bank Ltd (NAB), Westpac Banking Corp (WBC)
Lex Hall: Hi, I'm Lex Hall from Morningstar and welcome to another edition of "Ask The Expert". I'm joined today by Nathan Zaia, who’s Morningstar's banking analyst. We're going to talk about Westpac, the week it's had, and in particular its share purchase plan.
Now Nathan it's safe to say that Westpac has had one of its worst weeks in its 200-year history. It's Australia's second largest bank. AUSTRAC, the financial crimes agency, alleges it breached anti-money laundering laws, counterterrorism financing laws, almost 30 million times. And it also failed to detect funneling of money to child pornographers in the Philippines. So pretty a sordid turn there. The CEO’s gone, the chairman's going, and it's had $7 billion wiped off its market cap. Is this the worst – is the worst over for Australia's oldest bank?
Nathan Zaia: It's hard to say if it's the worst for the share price. But in terms of what it's going to have to go through, I think unfortunately, no, it's probably not the worst. Like you mentioned, the leadership changes, I think that’s important; it shows accountability. But I mean, we still don't have a permanent management team in place. So, when they come in, we don't know if this $80 million they've earmarked is going to be enough or will they come in and throw more money in resourcing, and compliance, regulatory systems and that sort of thing. So, there could be a little bit more of a cost increase to come down the road. We obviously still don't know what the penalty is going to be. I mean, we're using CBA's AUSTRAC penalty of $700 million as sort of a guide and we expect Westpac to pay more than that. So, we've got $1 billion in our numbers. I mean, that's really uncertain. So, I think for shareholders that buy these banks because of that history of reliable dividends, I think now is probably a time when Westpac sees a little bit more uncertain than it usually would be.
Hall: OK. And on that you talk about in your latest note, you talk about a downside scenario and you assume a fine of $2 billion. What sort of effect do you think that will have on the bank's bottom line?Â
Zaia: So, if you just take a $2 billion penalty on its own, so before these AUSTRAC penalties were announced, we assumed $7 billion Westpac's earnings would be. So, you take $2 billion off that it's $5 billion, it's obviously a lot of money.
Hall: Yeah. And this is a bank with a market cap of…
Zaia: It's about $85 billion. So, if we look at one year's is earnings, it's huge. But if you look at … if it's not going to impact the bank's ability to generate earnings year-after-year, then in terms of its long-term valuation, it doesn't really have that much of a bearing. I think there's probably a greater risk that your short-term dividends are lower, just simply because they need to ensure that they maintain their capital position. So, there's that risk. But I think longer term, the penalty alone isn't a make or break for the bank. But we did in our downside scenario though, so we assume that $2 billion penalty; we also assumed some reputation or brand damage amongst consumers. So, we assume the loan book falls over the next couple of year; we assumed Westpac have to price a bit more aggressively as well. So, both of those having pressure on their income. And in that case, in that situation, our fair value came out around $26. So around 10%, lower. So, in a more downside scenario, that's where we would see it.
Hall: And you've currently got it at $29.
Zaia: $29.
Hall: $29. OK. Let's move to stewardship. Because last week when it was all unfolding, when everyone was calling for the head of Brian Hartzer and Lindsay Maxsted, you lowered the stewardship rating on Westpac from Exemplary to Standard. What stopped you from going a step further and taking it to Poor?
Zaia: It's obviously very disappointing, what's come out we're not trying to defend by any means what has happened. But what we're trying to do is look at this business as a whole. And over the long term, the bank's grown its loan book, been able to grow profits for its shareholders. It's had a good handle over bad debts, over operating costs. So, I think shareholders have benefited from that over the long term. And I think these dark clouds and pretty grim days for Westpac will come to an end. And what they've built up is the second largest mortgage book and deposit base in the country. I think their competitive advantages are still intact. So, I think over time, that business can, once these expenses normalize, be delivering pretty attractive returns for shareholders again. I mean, it's not as if Westpac had an investment strategy, which weakened the bank's competitive advantage or threatened shareholders' capital. I think mistakes were made, obviously, but I don't think it was necessarily because of poor strategy.
Hall: We've also got Westpac's share purchase plan, the $2.5 billion share purchase plan, what's this raising for and why did you recommend it?
Zaia: So, the raising is predominantly to shore up the bank's capital position to meet APRA's 10.5% benchmark by January 2020. When they made the raising they also said that they wanted to have a little bit more room just in case there were additional capital requirements placed on them or penalties, as we've seen, which look likely now. So that was pretty much their why they needed to do it. And why we've recommended the SPP is simply because the offer price is at a large discount to our fair value. And look, we recognise typically, when you're getting into an SPP, it's attractive because it's at a discount to the current market price. So, for shareholders that are already well positioned or happy with their weightings towards Westpac and the major banks in general, then it probably, that's something they need to consider as well. It's not that this is just a steal at these prices. So, I think you need to consider both.
Hall: Yeah. OK, Nathan, thank you very much for your insights.
Zaia: Thanks Lex.
Hall: I'm Lex Hall from Morningstar thanks for watching.