Friday, May 5, 2017

An AIM Intl Fund holding: Westpac Banking (WBK) by Nicholas Christman. “Watch this holding closely, mate"

WBK (Westpac Banking Corporation) (WBK, $26.66): “Housing Risks May Dampen Recent Strength in Australian Banking”
By: Nicholas Christman, AIM Student at Marquette University

Disclosure: The AIM Equity Fund currently holds this position. This article was written by myself, and it expresses my own opinions. I am not receiving compensation for it and I have no business relationship with any company whose stock is mentioned in this article.

Westpac Banking Corp (NYSE:WBK) is one of the “big four” banks in Australia offering a range of financial services primarily through secured mortgage lending and a secondary focus on business lending and institutional banking. It was founded in 1817 and is headquartered in Sydney Australia.

• Westpac’s stock price has appreciated over the last 6 months by 15.21% and has paid out a dividend of A$.94 (~3% return on currency conversion differences). The performance was helped by improving asset trends (Distressed asset ratio: 17Q1 1.15% vs. 16Q4 1.20% - DB Research).

• The Australian banking industry has been driven by an explosion of housing debt, driving housing debt to income levels up to 133.84% (12/31/16 RBA data). Aussie household indebtedness ranks 2nd behind only the Swiss, causing for concern about the future of Australian consumer mortgage growth.

• The APRA (Australian Prudential Regulation Authority) has introduced regulations to lower IO (Interest-Only) loans from 40% to 30% of banks total mortgage portfolio. According to analysts, WBK’s portfolio is currently over the limit (~40%); therefore, the bank will be challenged to sell more expensive principal and interest mortgages, while simultaneously raising the cost for new IO mortgages.

• Rising housing debt costs could potentially lower discretionary income by billions of $A, and the risks associated with debt are enough to keep a RBA rate hike off the table.  

Key points: WBK has been a strong contributor to AIM international equity portfolio returns, as Australian stocks have rode the tide of rising commodity prices and robust lending reaching near 2015’s post financial crisis highs. WBK share prices have also been supported through unique Australian dividend taxation rules, which remove the double-taxation of dividend income and credit the investor the difference between personal and corporate tax rates. Prolonged low interest rate policy by the RBA (Royal Bank of Australia) has continued to support demand for defensive income generating stocks such as WBK.

WBK consensus estimates for FY17 EPS and BVPS by analysts are $1.82 (FY16 1.81 ex. extraordinary items) and $13.68 (FY16 $13.33), respectively. WBK looks expensive relative to 5-year historical averages comparing the P/E ex. extraordinary items (14.72x vs. 12.74x) and P/B (2.00x vs. 1.90x) to historical ranges. Given the limited EPS and book value upside and expensive valuation multiples, WBK’s risk reward profile become much less attractive.

While the stock performance has lessened WBK upside, the downside risks are now much more apparent. Loan Loss Reserves as a % of total loans are near 10 year lows (.50%), showing management’s confidence continued asset quality strength. However, one immediate risk is the A$2B projected reduction in household cash flow from conversion of IO mortgages to higher costing principal and interest mortgages. An additional A$3B of household cash flow decrease is projected based on new APRA regulations to lower share of IO mortgages. The RBA flagged housing credit growth as a concern at the most recent meeting; two possible outcomes could be slower loan growth or rising mortgage payments in arrears.

Given the indebtedness of Australian consumers, the RBA must now be very careful in determining interest rate policy. Bank stocks generally perform well during rising interest rates, but the RBA has indicated the stability risks surrounding higher interest rates. WBK’s NIM of 2.10% has decreased 6bps in the last five years and may continue to see pressure if rates remain low. The RBA on hold would also disappoint hawkish bets on rates, which would weaken the Aussie dollar. WBK’s ADR shares are vulnerable to these fluctuations; A$ depreciation presents another major risk for the stock.

What has the stock done lately?
Westpac’s US ADR shares have returned 9.24% in the last three months, as the FY17 Q1 update showed positive capital trends (CET1 ratio of 9.26%) and improved asset quality. Following a strong February, WBK has traded sideways as investors wait for 1H FY17 earnings. Mixed economic data has added to the lack of direction in the Australian stock market and currency.

Past Year Performance:
WBK’s share price has increased 16.37% in the past year, and paid a $1.37 dividend per share (5.98% yield). WBK benefitted from higher operating profits and improving asset quality driven by mortgage lending growth and stable commodity prices. The AUD fell 1.00% against the USD (currently .7545) over the past year; however, currency weakness was overshadowed by strong stock returns.

Source: FactSet

My Takeaway
Westpac’s stock was driven higher by a number of positive investment catalysts over the past year, achieving 20%+ total return. Operating income rose 4.31%(in A$), net loans grew 6.19%, and the CET1 ratio of 9.26% in Q1 17 impressed analysts. However, the good news is now reflected in the current stock price, meanwhile downside risks may not be reflected. Debt levels in the Australian property market are too high to ignore at this point. 

APRA regulation should begin to slow loan growth as new mortgage rates rise. Further regulation may be introduced as the RBA’s focus on financial stability could signal the end of the Australian debt bonanza. It would be wise to sell WBK to capture unrealized upside and protect from stock and currency downside.


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