Westpac Banking Corporation: A 6.7% Dividend Yield

| About: Westpac Banking (WBK)

Summary

Australia has a banking oligopoly, in which four large, entrenched, wide moat banks dominate the banking market.

Over the last few months, stock prices have fallen, and these banks can now be bought with high dividend yields.

In this article I examine one of those, Westpac Banking Corporation, which has a long history of strong performance, and a solid financial position.

This provides an opportunity for dividend growth investors to purchase a high-quality, high-yielding, dividend-growth company for significantly less than its fair value.

Introduction

As I move into retirement, like many others on Seeking Alpha, I am faced with the task of converting my assets into dependable, long-term income, which for me, means investing in safe, dividend-paying equities-preferably those with a high probability of dividend growth. It is fairly easy to find good US dividend-growth stocks with 2% - 3% yields-the S&P list of dividend aristocrats, or David Fish's list of dividend champions are obvious places to start. Indeed such stocks should probably form the core of any US retirees' portfolio. But the dividends are not particularly high; even the higher yielding stocks rarely pay more than 3.5%. A million dollar retirement fund-not a trivial amount-will only provide about $30,000 dividend income per year, which is less than most professionals are used to living on. I feel that in the US, higher yielding stocks tend to come with significantly higher risks. Perhaps it is possible to do better outside the US? The purpose of this article, and hopefully three following articles, is to explore such a possibility.

Australian Banks

Australia has a mature, western-style economy, with four major banks that dominate a regulated oligopoly. These four banks control over than 90% of the business and consumer lending markets, as well as holding the large majority of bank deposits. They are: Westpac Banking Corporation (NYSE:WBK) with a market capitalization of US$66.5 billion1, Commonwealth Bank of Australia (OTCPK:CMWAY) with a market capitalization of US$83.9 billion, Australia and New Zealand Banking Group Ltd (OTCPK:ANZBY), with a market capitalization of US$54.5 billion, and National Australia Bank Ltd (OTCPK:NABZY) with a market capitalization of US$55.1 billion. In their Stock Analysts Report of 08/17/2015 (only available through a premium subscription), Morningstar recognizes the structural advantages of these four banks by awarding them a wide moat rating,. This means that Morningstar believes they have strong, long-term, and sustainable competitive advantages. Each of these banks is required by the Australian Prudential Regulation Authority (APRA-which has the authority of the Australian Government to regulate the financial services industry) to have a common equity tier-1 ratio near 10%. This is the measure of a bank's financial strength. A common equity tier1 ratio of 10% is high, especially given that the APRA tend to be more conservative in their definition of the tier-1 ratio compared to many other regulatory agencies.

Although the four banks hold a protected position-due to the strict regulatory environments and entrenched economies of scale, they do compete strongly against each other. However, since they each provide a wide range of products and customer services, customers tend to be locked into one bank. This results in high switching costs. Hence, people tend to stay with their bank for long-periods of time.

Given that they each of these banks pay a regular dividend, yielding 6.8%, 6.1%, 7.4% and 7.2% respectively, they seem like obvious possibilities for a dividend growth portfolio. In this article I will explore Westpac Banking Corporation. I will explore the others in following articles.

[1] All financial data comes from morningstar.com, and is current as of 3 September, 2015.

Westpac Banking Corporation

Westpac was founded in Sydney in 1817, as the Bank of New South Wales. After various acquisitions and mergers, it was re-named Westpac Banking Corporation in 1982 with a mission to become a significant Western-Pacific bank (from which the portmanteau word Westpac was formed). The bank stock trades on the Australian stock exchange with the symbol WAC, and an ADRA is available, and trades on the NYSE with the symbol WBK. As described above, it is one of the four main banks in Australia, and the second largest bank in New Zealand, with operations that span the Pacific. The bank offers a full suite of banking and financial services to consumers, small business, corporations and institutions. (wikipedia.org)

Finances

Table One gives the key financial information for the last five years. Net Revenues and Operating Income rose fairly consistently, with a 5-year CAGR of 3.85% and 13.32% respectively. Over that period, Operating Margins rose from 47.7% to 57.1%. Net Income also increased with a 5-year CAGR of 17.02%, and EPS grew at 14.14%. Over this last 5 years, the bank has paid an increasing dividend each year, although the recent increase was very small. Nevertheless, at current prices (US$21.39 as of 3 September, 2015), that represents a healthy dividend yield of 6.68%. Over the recent 5-year period, the dividend has grown at a CAGR of 7.3%. In order to support the dividend, the company has a fairly high payout ratio of about 80% over the last three years. The cash flow story is rather more complex, but over the last three years the company has generated an increasing stream of free cash flow, which would suggest that the dividend is quite safe.

Table One: Westpac Banking Key Financial Data

2014-09

2013-09

2012-09

2011-09

2010-09

Net Revenue Au$ Mi

19,937

18,639

17,983

16,913

16,910

Operating Income Au$ Mi

11,390

9,865

8,862

8,514

8,038

Operating Margin %

57.1

52.9

49.3

50.3

47.5

Net Income Au$ Mi

7,561

6,816

5,970

6,991

6,346

Diluted Earnings per Share Au$

2.39

2.16

1.91

2.24

2.07

Dividends Au$

1.75

1.74

1.66

1.53

1.23

Payout Ratio %

79.9

82.7

83.5

69.6

57.3

Shares Mi

3,237

3,238

3,043

3,183

2,960

Book Value per Share US$

13.22

13.52

14.53

13.47

12.44

Operating Cash Flow Au$ Mi

28,371

25,580

18,484

-12,014

468

Capital Spending Au$ Mi

-1,179

-1,042

-855

-1,144

-874

Free Cash Flow Au$ Mi

27,192

24,538

17,629

-13,158

-406

Free Cash Flow per Share US$

10.12

3.51

0.69

-4.04

-0.13

Source: This data is publicly available on morningstar.com: Note the use of both Australian and US currencies in the original data source. As of 3 September 2015, I.0 US$ = 1.42 AU$, and 1 AU$ = .70 US$.

Table Two gives key profitability measures. Net Margins have been strong, increasing over the last three years from 33.2% to current levels over 37%. Return on Assets has remained fairly constant at around 1%, with financial leverage also fairly constant at around 16%. Finally, the bank has a Return on Equity consistently around 15%, suggesting that, indeed, Westpac Banking does have a strong business, with a wide economic moat, and should be able to generate a Return on Equity well above its Cost of Capital well into the future.

Table Two: Westpac Banking Profitability Measures

2014-09

2013-09

2012-09

2011-09

2010-09

Net Margin %

37.92

36.57

33.20

41.34

37.53

Return on Assets %

1.03

0.99

0.89

1.09

1.05

Financial Leverage (Average)

15.91

14.94

15.25

16.02

16.19

Return on Equity %

15.91

15.00

13.87

17.47

17.43

Source: This data is publicly available on morningstar.com.

In terms of ongoing operations, the bank seems in good shape, and given the wide economic moat, and the regulated oligopoly, there seems to be every reason to expect that to continue. But what about the balance sheet? It looks healthy, with total assets as of September 2014 of AU$770,842 million, liabilities of AU$722,386 million, and shareholders equity of AU$48,456 million. The question is, how safe are those assets? The first consideration is the need for the bank to maintain a common equity tier-1, or CET1, ratio closer to 10%, based on the Australia Prudential Regulation Authority's recent decision to increase the ration to nearer 10%. To meet this requirement, Westpac will probably have to increase its equity. Morningstar, in the report previously referred to, estimates that they will have to increase equity by AU$3 billion before 1 July 2016 and by AU$6 billion before the end of fiscal 2018. This additional capital will strengthen the bank considerably, and it should be possible to raise this easily from future retained earnings, or by selling assets.

Given the fact that mortgage lending accounts for 67% of total loans, the risk that seems likely to concern most US investors is a fall in the value of Australian housing. There is no doubt that property prices are high, and have been for a while, but there are several reasons why this may not be a concern. Underwriting standards appear quite tight, a large proportion of loans are covered by lender's mortgage insurance (paid by the borrower), there tend to be low loan/valuation ratios, high levels of loan repayments, and full recourse lending. Further, there are a high proportion of variable rate loans, and in the case of difficulties, interest rate cuts by the Reserve Bank of Australia could take off some of the pressure. While there is no guarantee that property prices will stay high, if they do fall, this should not cause serious problems for the bank. The residential real estate market market in Australia is quite different from that in the US.

Valuation

However good a company may be, it is not a good investment unless it can be bought at a fair price. There are two ways we can look at valuation, on a relative basis and on a fundamental basis.

Relative Valuation

We can compare current valuation metrics with past valuations of Westpac Banking, or we can compare valuation metrics with those of industry peers.

Westpac Banking Corp ADR (WBK) is currently (3 Sept. 2015) trading at US$21.39. The price has fallen considerably over the last year, with a 52-week range of US$20.12 to US$33.00, with the 52-week low coming quite recently on 19 August, 2015. Why the price has fallen is not entirely clear to me, but the price of all four Australian banks have similarly fallen, which is what first alerted me to a possible investment opportunity. It seems to me that there are three obvious reasons for these ADRs to fall in price: firstly, the general drop in commodity prices seems likely to have a considerable impact on the Australian economy, and Australian share prices have indeed dropped, with the S&P/ASX 50 dropping from 6133 in early March 2015 to 5136 on 3 September (www.marketindex.com.au). Secondly, recent worries about the Chinese economy seem to have had a greater impact on East Asian and Pacific markets. Finally, the US dollar is very strong, providing the opportunity to buy foreign assets at lower prices. The Australian dollar is currently at 1.42 to the US dollar, whereas in one year ago it was at at 1.09.

Currently the stock has a TTM P/E of 13.3, and a Price/Book of 1.9. Compared to the industry average of global banks (technically Westpac is a global bank, although I tend to regard it as a regional Australia/New Zealand bank) of P/E 13.2, and Price/Book of 1.0, these figures do not suggest a screaming buy, but considering the TTM ROE of 15.6 and TTM ROA of 1.0 compared to the industry average ROE of 7.3% and ROA of .5, the stock does look undervalued. Considering also WBK's 3-year revenue growth of 5.6% compared to the industry average of -3.7%, again it looks relatively undervalued compared to its peers.

Comparing these metrics to the past, Westpac's P/E was 14.1 in 2014, 15.5 in 2013, and 13.5 in 2012, so the current P/E at 13.3 is slightly less than previous levels. Price/Book is currently 2.0 compared to 2.1 2014, 2.2 in 2013, and 1.8 in 2012. Again, this suggests that the current price is somewhat lower than in the recent past.

Of course, for many of those seeking dividend income, the strongest indication of relative value is the dividend yield. Westpac's dividend yield is currently very high at 6.7%, which is significantly higher than most alternative investments of this type, and the dividend has grown at 7.3% over the last five years. This is very healthy for a large bank. From the perspective of an investor looking for a long-term income stream, the bank does seem relatively undervalued.

Absolute Valuation

Relative valuations can only tell us whether the stock is cheaper or more expensive compared to something else. It doesn't tell us what the stock is really worth. The standard definition of intrinsic value of a stock is that it is worth the present value of all future cash flows. This is a simple idea, at least in theory, and one I find very persuasive. However, figuring out the actual value requires predicting the future, and is fraught with obvious complications. The problem is firstly how to estimate what future cash flows will be, essentially the rate at which they will grow, and secondly at what rate they should be discounted to present values.

The standard method is to use one of the Dividend Discount Models. For stable companies, with slow and constant growth, that pay out most of their earnings in dividends, the Gordon Growth Model (also known as the Constant Growth Model) is the standard model. The first requirement is determine the rate at which the company will grow. Westpac has been growing Revenues steadily at a CAGR of 3.85% for the last five years. Operating Income, Net Income and EPS have grown considerably faster, at 13.32%, 17.02% and 14.14% respectively over the same 5-year period. The dividend has grown at 7.3%. The fact that Operating Income, Net Income and EPS have grown faster than Revenues suggests that the company has become more efficient over that period, but we cannot expect bottom line growth, or dividend growth, to outpace revenue growth over the long-term. Therefore, it seems prudent to be conservative and use the 3.85% growth rate in our estimates. Further, this is probably fairly similar to the expected long-term growth of the Australian economy, and it is unreasonable to expect a large, stable bank to grow at a rate significantly different from the growth of the general economy over the long-term. As for the assumption that the company should be paying out most or all of its revenues as dividends, Westpac has a dividend payout ratio of approximately 80%. All this suggests that the Gordon Growth Model is the appropriate model to use to estimate the intrinsic value of Westpac Banking.

Having decided on a growth rate, the second issue we need to consider is the discount rate we will use. In other words, what do investors expect in terms of reasonable rate of return? One way to calculate that is to use the Capital Asset Pricing Model. Briefly, this estimates an appropriate rate of return by adding the risk free rate (what investors can get with no risk) to the equity risk premium multiplied by the stock's beta (the extra return they expect for the risks of investing in the stock market, adjusted to take account of the stock's volatility). If we assume that 10-year treasuries are at 2.2%, that the historical equity risk premium for Australian equities is 5.75% (according to Damadoran) and the stock has a beta of 1.18, we get an expected rate of return of 2.2 + (1.18 * 5.75) = 8.99%. This seems a reasonable rate of return for such a stock.

The formula for the Gordon Growth model is:

Value year 0 = Dividend year 0 * (1 + g) / (r - g)

where g is the growth rate

r is the discount rate

Dividend year 0 (i.e. 2014) is US$1.57

If we plug these figures into the Gordon Growth model:

Value at the present time = 1.57 * (1 + .0385) / (.0899 - .0385) = US$31.7. Given the present price of the stock at US$21.39, Westpac's stock would appear to be priced at about 67% of its fair value.

Another way to look at valuation is to consider the price and the dividend as given, and based on those, determine what the resulting rate of return would be. The formula to do this is a simple re-arrangement of the Gordon Growth model. The rate of return is equal to the current dividend yield plus the growth rate. We can be conservative and use the low 5-year Revenue growth rate of 3.85%: thus, the implied rat of return is 6.68% + 3.85% = 10.53%. Or we can be overly optimistic and use the 5-year dividend growth rate of 7.3% (often referred to as the Chowder Rule among DGI investors): thus 6.68% + 7.3% = 14.0%. Of the two, it seems better to more conservative and plan for 10.5%, and be pleasantly surprised if it is higher.

Of course, such a valuation is entirely dependent on the inputs into the model, and it is prudent to test those against other valuations. Morningstar also values this stock, and we can compare our valuation with theirs. They use a far more complex Discounted Cash Flow model, intended to model cash flows rather than dividends. They are not entirely open about the nature of their model, nor about the exact inputs into the model, but in their Stock Analysts Report of 08/17/2015 they do assume a 9% cost of capital, which is essentially the same as ours. They also state that they expect per share revenue growth would be 7% in 2015, with "medium term" EPS growth of 5%. Their resulting valuation is US$28.00, somewhat less than ours, but still considerably higher than the current price.Thus the rpice is 76% of Morningstar's Fair Value.

Although we cannot replicate their model, the inputs seem reasonable and we can plug them into a Dividend Discount model to cross validate our valuation. Morningstar do not clearly explain their growth expectations. It is not clear what they mean by growth in the "medium term", but a period of five years seems reasonable. Nor do they explain what long-term growth they assumed at the end of that medium term. It is common among analysts to use the nominal growth rate of the Gross Domestic Product as the long-term growth rate, since a mature company in a mature economy is unlikely to grow much faster for a long period, and it is logically impossible for a company to grow at a rate higher than the economy for an indefinite period of time (since eventually it would eventually become larger than the economy of which it is a part). We cannot predict the future, especially the long-term future, but a long-term nominal GDP growth rate of 3.5% does not seem unreasonable, and we will use that.

The question then is how we model this growth, in order to determine the intrinsic value of the company. Using Morningstar's numbers, and applying a little common sense, it seems fair to assume that the growth rate will slowly decline from the high of 7% in 2015, through 5% in the medium term, to a stable rate of 3.5%. Let us also assume that the process of declining growth takes seven years. We can plug these into a Dividend Discount model. Since we have two stages of growth, an initial period of declining growth and then long-term stable growth, we have to use a different, more complex, model, called the H-Model. If we plug in the numbers, we get a fair value estimate of US$33.04, which is just a little more than our US$31.7 value using the Gordon Growth Model.

While it is clear that the estimates of fair value are just that, estimates, and as such are subject to considerable error, the three estimates of US$32, US$28 and US$33 are all fairly similar, and suggest the likelihood that WBK is trading with a current price at something 65% to 75% of its intrinsic value. At the current price, there appears to be a significant margin of safety, if things don't turn out as well as we hope.

Risk

Westpac Banking Corporation is a bank, and as such is exposed to the risks that all banks face. It is a leveraged company, deeply involved in the Australian economy and subject to considerable government regulation. Significant changes in the economy, or to government regulatory requirements do pose risk. However, Westpac is well placed with regard to all these. It is part of an established, long-term oligopoly, and as such has a wide moat; it is a crucial part of the Australian economy, with a strong market position and a loyal customer base. It is well placed to deal with current and future regulatory requirements. Further, customer deposits are growing faster than loans, and loans tend to be high quality, and the less secure mortgage loans are covered by insurance. Finally, Westpac is in a strong financial position, with an S&P AA credit rating (according to Morningstar). While risk obviously exists, I feel it is significantly less than most other large banks.

The is also the currency risk of course. Currency fluctuations could cause considerable changes to the value of American Depository Receipts. On the other hand, some may consider currency diversification as an advantage, and is one of the reasons I am attracted to international stocks.

Conclusion

By now my conclusion should be fairly obvious. Despite some risk, I believe that there are strong indications that Westpac Banking Corporation is a high-quality, high-yielding, dividend-growth company, which can be purchased at significantly below its fair value.

The biggest risk in investment, of course, is believing others. I am new to this. Please do your own due diligence.

Long WBK

Disclosure: I am/we are long WBK.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Editor's Note: This article discusses one or more securities that do not trade on a major U.S. exchange. Please be aware of the risks associated with these stocks.

About this article:

Expand
Author payment: $35 + $0.01/page view. Authors of PRO articles receive a minimum guaranteed payment of $150-500.
Tagged: , , , Foreign Money Center Banks, Australia
Want to share your opinion on this article? Add a comment.
Disagree with this article? .
To report a factual error in this article, click here