Strong credit quality boosts earnings and more capital returns to shareholders likely

Westpac's WBC first-quarter 2025 underlying profit of $1.9 billion is up 3% on the second-half fiscal 2024 quarterly average. Net interest margin slipped marginally to 1.94%, but loan growth ensured that revenue outpaced 1% expense growth.

Why it matters: We lift our fiscal 2025 forecast by 3% to $7.4 billion, thanks to further low loan impairment expenses. For the next five years, we estimate the bank achieves profit growth of 4.5% per year, on mid-single-digit loan growth, steady NIM, and operating cost savings. 

  • Loan impairment expenses/loans averaged just 0.05% in the quarter, well below our medium-term expectation of around 0.17%. Our fiscal 2025 forecast is reduced to 0.08% from 0.12%, but is unlikely to persist over the medium term, given that less buoyant house price appreciation is expected.
  • Other underlying operating trends are tracking as expected. Modest revenue growth is driven by annualized loan growth of 4%, with underlying NIM tracking close to our 1.95% full-year forecast. Price competition is being offset by better returns on capital and deposit hedges.

The bottom line: Shares in wide-moat Westpac are overvalued, trading at a 14% premium to our unchanged AUD 29 fair value estimate.  

  • On a forward P/E above 15 times and fully franked dividend yield of 4.7%, we don’t see enough of a margin of safety given modest earnings growth and potential risks of higher credit stress, competition squeezing margins, or failure to successfully execute its technology simplification.
  • Westpac bringing its cost/income ratio down from 50% to our forecast of 46% by fiscal 2029 is crucial. Efficiency should improve as the bank reduces headcount and the benefits of technology investment are realized.

Between the lines: Westpac is well-capitalized. Its common equity Tier 1 ratio of 11.9% exceeds regulatory requirements and its 11%-11.5% target range. The bank is well-positioned for potentially higher borrower defaults yet still pays steadily growing dividends.

Westpac loan growth resumes but more efficiency improvement required

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. 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 increased resources and digital investments have improved service levels.

After enjoying super-low impairment charges pre-2020, we expect a return to midcycle levels around 0.17% in fiscal 2029. 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.

Westpac bulls say

  • A higher cash rate environment gives customer deposit funding banks an opportunity to expand margins and drive higher return on equity.
  • Cost and capital advantages over regional banks and neo-banks provide a platform to win back market share.
  • Consumer banking provides earnings diversity to complement the more volatile returns generated from business and wholesale banking activities.

Westpac bears say

  • Slow core earnings growth resurfaces because of low loan growth, margin compression, subdued wealth and markets income, lower banking fee income.
  • Increasing pressure on stressed global credit markets could increase wholesale funding costs.
  • The bank failing to reset the cost base would leave it at a large disadvantage to peers when it comes to operating efficiency and ROE.

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Moat Rating: An economic moat is a structural feature that allows a firm to sustain excess profits over a long period. Companies with a narrow moat are those we believe are more likely than not to sustain excess returns for at least a decade. For wide-moat companies, we have high confidence that excess returns will persist for 10 years and are likely to persist at least 20 years. To learn more about how to identify companies with an economic moat, read this article by Mark LaMonica.