Westpac Banking Corp. (NYSE:WBK), Australia's second largest bank by market capitalization, has a fully franked dividend yield of about 5.8% and is likely to continue increasing its dividend in the near future. It may be worth noting that I expect the rate of dividend increases to slow down which may discourage some dividend growth investors. This article forms part of the series I am currently writing on Australian banks and should ideally be read in conjunction with my article on CBA and the discussion of the Australian mortgage market contained therein (including the comments section).
Readers should take note thereof that all figures are referenced in AUD unless reference is made to the US ticker symbol or the contrary is indicated. It should further be noted that all comparisons made between the majors are based on Full Year 2016 earnings, which ended on the 30th of September 2016 for all but CBA whose FY ended on the 30th of June 2016, unless the contrary is indicated.
Asset Quality and Capital
The dairy industry in New-Zealand, to which a number of banks has significant exposure, has performed poorly in an environment where demand from China has slowed. Westpac's exposure to the NZ dairy industry is currently at NZ$5.9 billion of which 0.34% is impaired compared to the 0.13% impaired in 2015. The risk of further impairments in this loan book is also highly probable as 25.29% of this loan book is considered stressed. This risk may, however, become less severe as milk prices have trended upwards over the course of the past few months.
The banks' exposure to residential apartment developments is currently at $5.1 billion while its total mortgage loan portfolio for inner city apartments is at $13 billion. The level of exposure to inner city apartments is an important consideration in light of the concerns raised around the increasing supply of apartments coming to the market in Melbourne and Brisbane over the course of the next few years. These apartments are also most likely to come under stress if there should be a large housing market collapse in Australia, which I do not foresee.
The bank has also given mortgages for inner city apartments at very low loan to valuation ratios (LVR), with the average inner city apartment mortgage at a LVR of 69% at the time of origination. The current weighted LVR of the banks residential apartment development portfolio is also at a low 54% the same as the banks current average LVR ratio in its portfolio of inner city apartment mortgages. The low LVRs will partially insulate the bank from any substantial correction in the property market.
The bank is also well capitalized with a CET1 capital ratio of 9.5% on an APRA basis and 14.43% on an internationally comparable basis. It may, however, be worth noting that the banks CET1 ratio (on an APRA basis) was the lowest of the four major Australian banks. The banks level of impaired loans at 0.32% is the lowest level of impaired loans amongst the four major Australian banks and the increase in its level of impaired loans this year was about 6 basis points lower than the average increase in impaired loans at the four majors as a group.
Earnings and the safety of the dividend
Westpac was the only one of the four major Australian banks that reported an increase in its net interest margin (NIM). The bank reported a 5 basis point increase in its NIM compared to an average decline of 0.8 basis points for the four majors combined. The banks cash profit after tax was essentially flat YoY compared to an average decline of 2.5% in cash profit after tax for the majors as a group.
The bank also managed to maintain its cost to income ratio at 42%, the same level as the previous year, whilst the average cost to income ratio at the majors increased by 116 basis points. The bank is currently targeting a cost to income ratio of below 40%. The banks ROE did, however, decline by 180 basis points which is below the average decline in ROE of 194 basis points for the majors as a group.
The bank has a targeted ROE of 13-14%, which I believe is a reasonable midterm target. I am, however, of the view that the banks ROE is likely to decline further in 2017 but will likely remain within managements targeted range. The banks payout ratio of 80% is at the higher end of the scale which along with lower earnings growth reduces the potential for significant future dividend increases. I do, however, consider the current dividend safe with the safety of the dividend enhanced by the banks strong history of generating free cash flow and strong capital position.
Valuation and Conclusion
The stock is currently trading at about 1.9 times book value which is slightly below its 5-year average of 1.99. The lower price to book value is in my view, like in the case of CBA, the natural consequence of a lower ROE. The stock is trading at a p/e ratio of 14.91 which is above its 5-year average p/e ratio of 13.84.
I do not currently consider the stock attractive from a valuation point. The stock is, however, likely to continue offering income investors a good dividend yield and I see no compelling reason for existing holders of the stock to sell at this time.
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Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
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.