Westpac’s (ASX: WBC) first-half fiscal 2024 cash profit of $3.5 billion is largely as we expected, flat on second-half fiscal 2023 and down 8% on the previous corresponding period.

Westpac is finally showing it can compete effectively across all key segments, increasing its home loans, business loans, and deposits, in line or faster than market, and without resorting to undercutting peers on price. Home and business lending approval times have reduced, and more consistent service is supported by the bank’s net promoter score in the mortgage broker channel.

The result also supports our expectation of moderating net interest margin (“NIM”) pressure, with some home lending rates lifted and discounting of existing loans generally less aggressive. Adjusted NIM was flat on the second half at 1.94%, or down 5 basis points to 1.89% after notable items.

We expect similar in the second half and modest improvement in the medium term. As refinancing activity slows, new lending picks up, and the term funding facility is repaid, banks are likely to shift focus from holding market share to delivering an adequate return on equity for shareholders. There are also margin tailwinds from higher returns on capital and deposit hedges that are gradual.

With credit quality sound, the bank is making another dent in its surplus capital position by increasing its existing buyback by $1 billion and declaring a fully franked special dividend of $500 million, or $0.15 per share.

The ordinary dividend rose 7% to $0.75 per share, the top end of management’s 65%-75% payout guidance. We support perhaps modest ordinary dividend growth given short-term earnings headwinds, and considering the capital position and outlook. Westpac's common equity Tier 1 ratio of 12.5% falls to 12.1% after the buyback and special dividend. This still leaves a decent buffer to its 11.5% target range to fund investments and growth.
Westpac trades at a modest discount to our unchanged $28 per share fair value estimate.

Business strategy and outlook

Westpac Bank is the second-largest of Australia’s four major banks. The bank provides a range of banking and financial services to retail and business customers, including mortgages, consumer finance, credit cards, business loans, and term deposits. Most nonbanking units have been divested, including general, life, and mortgage insurance.

Westpac's multibrand strategy owes to acquisitions, such as St. George Bank in 2008, to provide access to a broader customer base and add scale. Only recently has Westpac began colocating branches and building IT systems which allow any customer to be served in any branch. A focus on digital channels to improve the customer experience are required to remain competitive, and have the potential to lower the cost base.

While risks directly related to coronavirus have abated, wage pressures, labor, and supply chain challenges, and high inflation pose challenges as the cash rate increases. The main current influences on earnings growth are modest credit growth and intense competition limiting margin upside from a higher cash-rate environment. Operating expenses should rise modestly as the bank resets its cost base after completing a number of remediation and technology projects. The bank has suffered from slow approval times in home lending, but expects increased resources and digital investments to improve service levels.

After enjoying super-low impairment charges pre-2020, we expect a return to midcycle levels around 0.17% in fiscal 2026. There is a risk of higher losses in the short term as households and business face a material increase in interest costs, but our base case is that only a small percentage will default.

Moat rating

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We assign Westpac Banking Corporation a wide moat based on maintainable cost advantages and switching costs. Westpac is the second largest of the four major Australian banks, which combined control just under 75% of business and consumer lending, and a similar share of deposits. It’s virtually the same market structure in New Zealand, although Westpac is the third largest player there.

Running a multi-brand strategy under Westpac, St George, Bank SA, and Bank of Melbourne, it has 13 million banking customers and is the number-one or -two player across mortgages, business loans, and cards. Despite regulatory changes lifting capital requirements, the bank’s large loan and deposit books continue to deliver robust net fee income, and with the increasing importance of scale to cope with changes in technology and regulation, Westpac should consistently earn returns above its 9% cost of equity through the cycle.

Bank moats are typically derived from two sources: cost advantages and switching costs. Cost advantage is an important source of the bank's wide economic moat, and supported by a low-cost deposit base, operating efficiency, and conservative underwriting relative to peers. The latter manifests in lower loan losses on average through the cycle. Given the commoditized nature of the industry, and competition for both loans and deposits, low costs is key to achieving excess returns.

Westpac’s key funding cost advantage is over AUD 650 billion or around 65% of funding which is sourced from customer deposits. While rates offered on fixed term deposit rates are typically more expensive than wholesale funding markets, customer funds held in transaction and saver accounts typically earn little or no interest. In addition to customer apathy making deposits sticky, market leading digital and mobile applications, and the large presence (marketing and branches), gives major banks an edge when it comes to gathering and retaining deposits.

Diversity in funding sources is important, and the major banks benefit from a funding cost advantage in the wholesale debt markets. This reflects their balance sheet strength, strong profitability, tight risk management and favorable credit ratings--boosted by the government's strong sovereign credit rating.

As domestic systemically important banks, rating agency's expect the banks to receive support from the government in a crisis, reflected in the explicit 2 notch uplift in their ratings. This was evident during the global financial crisis. In October 2008 the government announced a guarantee scheme for wholesale funding, in order to assist authorized deposit-taking institutions, or ADls, access funding at a reasonable cost during a period of market stress. This guarantee was provided for a fee of 70 basis points for AA-rated institutions (the major banks), 100 basis points for A-rated institutions (Macquarie and the regional banks), and 150 basis points for BBB-rated institutions.

From 2008 to 2012 customer deposits up to $1 million were guaranteed by the government without charge, with the cap now reduced to $250,000. The lower rated regional banks struggle to access senior debt markets and rely primarily on more expensive residential securitization markets for a large share of their wholesale funding.

Westpac is an efficient domestic bank, operating on much better cost-to-income ratios than smaller competitors and most overseas non-investment banks. Large banks can disperse fixed costs such as branches, technology spend, compliance costs, and support staff across a larger operating base, increasing operating efficiency.

A large loan book, diverse by customer, region, and sector, as well as having the resources and data to support robust credit decisions, also supports a low bad debt/gross loan ratio. While legacy systems can make innovation more costly compared with a new entrant, we believe the banks large annual spend on technology, and large customer data sets and insights, will see it remain at the forefront of a continually evolving digital offering. While budgeting tools, pro-active alerts, or Siri shortcuts, may not be crucial for all customers, this investment will help prevent switching of customers based on the digital offering alone.

The ability to provide customers a full suite of products, and marketing to support already well-known and trusted brands, has historically allowed the major banks to charge a premium on their loans relative to smaller competitors and offer deposit rates lower than competitors. The premium is not offset by higher funding or operating costs, enabling the major banks to generate consistent excess returns.

The ability to offer customers multiple products not only increases profitability per customer, but bolsters switching costs. Bank customers often resist moving financial service providers due to the hassle of opening/closing accounts, the lack of perceived benefit, and numerous deposit and payment links. An aggregated view of all personal and financial information, updated in real time, is also advantageous to customers taking multiple products.

The cost advantage allows for the strong digital investment and offering, which in turn helps to entrench the switching costs. Like the other banks Westpac has taken steps to refocus on its core bank offering by exiting the financial planning/advice space, but intends to retain the platform administration and investment product offering. We do not believe retaining this business strengthens the switching cost advantage, with a transaction account, mortgage, personal loan, credit card, business loan the stronger pillars behind high customer retention.

The Royal Commission into Financial Services in 2018 publicly shamed the large banking and financial advice players in Australia. There have been specific costs to remediate customers, the exit of certain businesses, removal/reduction of some fees, as well as a step up in compliance and regulatory costs.

While difficult to quantify, it’s likely the major banks' loan growth also suffered as a direct result. Not from brand damage, but as the first in the industry to adopt and implement APRA’s changes to responsible lending standards, the big four banks were temporarily at a disadvantage to smaller competitors. One noticeable shift post the Royal Commission is the increased use of mortgage brokers. The ability to handle large volumes of applications and the capital required to fund such loans see the majors continue to take a large share of flows. Mortgage brokers are paid on settlements, hence are likely to recommend lenders which increase the likelihood of a timely loan approval.

We believe switching costs in small and medium business banking are reinforced by relationship managers, specialized sector expertise, breadth of product offerings, and the customers additional focus on system reliability. Westpac holds an 19% share of business deposits, with around 16% of the business loan market. We believe this is in part reflective of the bank’s appetite in certain markets, for example the decision to reduce exposure to property development, but also the difficulty in converting transaction banking or payments customers to borrowers.

The threat of losing business due to teething problems after switching banks often outweighs anticipated gains from converting. Switching costs for institutional clients (listed companies and government entities) is lower, as clients often bank with multiple financial institutions. The capital required to play in the space does limit the threat of disruption from new competitors. Nevertheless, the institutional banking segment does support the retail and business bank moats through deposit gathering of low-cost funds which can be redeployed in the higher return on risk weighted asset retail business.

The Australian banking market is quite concentrated in terms of assets, but there are a variety of regional and community banks, global banks and neo-banks which provide competition. Despite this, we note that the major banks have been able to earn higher returns on equity for the last several decades. In our view, this demonstrates the barriers to entry in attempting to break down the competitive advantages of the majors. Foreign banks have not made a serious dent in the domestic majors' market share, while the smaller regional banks compete on service and local brand recognition but face higher wholesale funding costs than the majors and are unable to undercut on price. They tend to follow the majors in loan and deposit pricing.

Competition from non-bank and digital banks have also had limited impact on the banking landscape to date. Neo-banks focused on a digital offering are growing in number, and while some are reporting large percentage growth rates in their loan books, they have made only a minor dent in terms of market share.

There are numerous boom and bust examples in Australia. Commonwealth Bank acquired Bankwest in 2008 after its UK parent at the time HBOS ran into financial trouble during the global financial crisis. Its Australian operations incurred hefty impairments following a period of rapid expansion (growing at multiple times system for 3-5 years), but evidently the bank took on high-risk loans other lenders did not want.

Westpac Banking Group acquisition of RAMS Home Loans is another notable industry failure. In 2007 RAMS Home Loans business model of lending to low-income earners using cheaply sourced debt in the US came unstuck when credit markets froze, and it was unable to roll $5 billion in commercial paper. Prioritizing loan growth over credit quality has also caught out smaller local players, such as Suncorp which required a capital raising after incurring large corporate and commercial property impairments.

The Australian government's "four pillars" policy prevents any of the four major banks from taking over each other, negating the risk of peers merging to gain greater scale and competitive advantages. Government legislation limits individual ownership of an Australian bank to a maximum of 15% without the specific approval of the Federal Treasurer (equivalent to the Treasury Secretary in the US), thereby reducing the potential for a foreign takeover.

Our outlook is generally positive from a macroeconomic and political standpoint, unemployment remains low, a perception of safety and government services supports population growth through immigration and low GDP growth is forecast to continue. The proposed Labor Party changes to the favorable taxation of property, which would likely have impacted demand for property investment and property prices, were shelved when Labor surprisingly lost the May 2019 Federal election.