Westpac Banking Corp: Trading update points to over-pessimism in price
About the author:
- Author name:
- By Azib Khan
- Job title:
- Former Senior Analyst
- Date posted:
- 04 February 2022, 8:30 AM
- Sectors Covered:
- As part of a 1Q22 trading update, Westpac Banking Corp (ASX:WBC) has announced 1Q22 unaudited cash earnings of $1.58bn.
- We believe the trading update supports the view that the challenges facing WBC are not unsurmountable and that the stock should not be priced like a value trap. We believe the update particularly serves to alleviate investor concerns around the cost outlook.
- Retain Add recommendation. WBC is our preferred major bank.
Too much pessimism in the share price
One way for us to arrive at a valuation – predicated on a cost of equity of 9% pa – which matches WBC’s current share price of $21.07 would be to assume that WBC only manages to reduce its annual cost base to $9.3bn by FY24F (compared with an underlying cost base of $10.2bn in FY20), experiences NIM contraction of ~50bps from 2H21 to 2H24F and conducts no further capital management with all other elements of our forecasts unchanged.
We expect WBC to do notably better than this and we consequently believe that the extent of pessimism being reflected in WBC’s current share price is overdone.
NIM down but outlook looking less concerning
WBC has reported a 1Q22 NIM of 1.91%, down 8bps from 2H21. Of this net 8bps contraction, 6bps is due to a $29bn increase in average liquid assets to support the reduction in the Committed Liquidity Facility (CLF). We envisage a further NIM drag of 2bps by the time that the build in liquid assets (corresponding to the reduction in the CLF) is complete.
A pleasing element in the NIM movement is a 9bps positive contribution from Treasury & Markets, which is a welcome turnaround from this factor.
The concerning element in the NIM movement is the 10bps drag from ‘loans, deposits & capital’. WBC has said that this drag is the result of competition in mortgage and business lending as well as the mix impact of continued growth in lower spread fixed rate mortgages, partly offset by deposit repricing.
We believe the drag from growth in fixed rate mortgages has now peaked, and WBC has today said that the percentage of Australian mortgage flow in fixed rate products reduced from 52% in 2H21 to mid-40s in 1Q22 and is most recently down to the mid-30s.
Separately, with the RBA’s announcement that its bond purchase program will end on 10 February 2022 and with prospects of rising interest rates, we believe there are growing prospects of normalisation in basis risk which we generally expect to hit the NIMs of non-bank lenders harder than the NIMs of banks.
We consequently see diminishing ability of the non-bank lenders to compete on price and we see potential for the prevailing fierce competition in the variable rate home loans space to abate.
With reduced percentage flows into fixed rate mortgages and potential for abatement in mortgage competition, we expect the magnitude of the drag from ‘loans, deposits & capital’ seen in 1Q22 to moderate going forward.
Pleasing reduction in operating expenses
WBC’s FY21 result led to increased investor scepticism about the outlook for operating expenses and the ability of WBC to achieve its $8bn cost target by FY24. We believe today’s trading update will serve to alleviate some of this scepticism.
1Q22 operating expenses (excluding notable items) are broadly in line with our expectation. Expenses reduced 7% from 2H21 to 1Q22 on a run-rate basis. Including notable items, operating expenses reduced 26% over this period.
The decline in expenses has been partly driven by a reduction in headcount (FTE and third-party contractors) of over 1,100.Expenses decreased despite further investment in the franchise and ongoing programs to improve the management of risk. WBC has reiterated its commitment to its $8bn cost target by FY24.
WBC has today announced its plan for organisational simplification. This will involve creating a smaller, more focused head office which will reduce the size of corporate functions by around 20%. The changes are primarily across head office and support functions, and not customer-facing roles.
Investment view and changes to forecasts
We have reduced our cash EPS forecasts by 3.7%/1.0%/0.9% for FY22F/FY23F/FY24F respectively due to reasons mentioned inside this report.
Our target price, based on our DDM valuation, is unchanged at (login to view).
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