How tax benefits from Westpac's St George acquisition have helped it pay out a bigger portion of profit in dividends than its rivals

By Gareth Vaughan

Australia's Westpac Banking Corporation, parent of Westpac New Zealand, needs to draw a line in the sand at its current return on equity (RoE) of 15% to be able to continue paying out more of its profits in dividends than its major rivals, analysts at JP Morgan say.

In a research report entitled Walk the Line: Is 15% the RoE 'line in the Sand'? JP Morgan's Sydney-based analysts Scott Manning, James Nicholias and Bharat Anand point out that with its RoE is down almost nine percentage points over the last five years to 15% from 24%, this is a bigger fall than any of Westpac's main competitors being ANZ Banking Group, owner of New Zealand's ANZ and National banks, BNZ's parent National Australia Bank (NAB), or ASB's parent Commonwealth Bank of Australia (CBA).

"Westpac needs to draw a line in the sand at the current 15% RoE to be able to afford the current dividend trajectory of a two cents per share per half increase," the JP Morgan analysts argue.

They forecast Westpac's September year (2012 financial year) RoE at 15.1% versus NAB's 15.3%, ANZ's 15.4%, and CBA's 18.8%. Since 2007 Westpac's is down 8.8%, ANZ's 4.2%, and both NAB and CBA's is down 2.4%.

Westpac's forecast 2013 financial year dividend payout ratio is put at 83% of profit versus CBA's 75%, NAB's 73%, and ANZ's 67%. Westpac's dividend policy, targeting an increase of two cents per share per half-year, gives an outcome in terms of "absolute cents per share" in contrast to the other banks who generally set a target payout ratio or range.

Manning, Nicholias and Anand say what has "gone wrong"  for Westpac, in terms of its declining RoE, has been an insufficient response to new regulatory capital allocations, and earnings dropping with Westpac's return on assets down 10 basis points, which is in line with its rivals, since 2007, despite the group "banking" A$469 million of cost savings from its A$18.5 billion acquisition of St George Bank in 2008.

"Our forecasts for (Westpac's) net capital generation in the years ahead provide no margin for error, versus somewhat of a buffer across our major bank coverage, and demand the RoE to not fall below the current 15% being generated. This will require flawless execution on the current strategic investment programme and ongoing pricing discipline on mortgages where Westpac (in Australia) are currently 10 basis points above peers," the JP Morgan analysts argue.

Westpac Banking Group CEO Gail Kelly has said the bank is making "seismic changes" to the way it operates in preparation for a decade of low economic growth, rather than merely cost cutting, as it strives to improve productivity.

Funding picture improved but at a cost

The analysts point out Westpac's biggest earnings drag since 2007 has been its rectification of "above peer" reliance on short-term wholesale funding with its funding profile before the St George takeover weaker than rivals.

"Disclosures for the 2008 first half-year period highlight that only 62% of Westpac's funding would meet today's definition of stable funding (customer deposits, long-term wholesale with residual maturity greater than one year, and equity) compared to a peer average 5% higher."

Since 2008 Westpac has improved its funding profile, with 79% of funding now meeting the stable funding criteria, more than any of its main three rivals. The JP Morgan analysts note Westpac's reliance on short-term wholesale funding has reduced by 15 percentage points, from 36% to 21%, over the last four years.

"However, this funding re-calibration has not come cheaply. Rotating this funding into customer deposits and long-term wholesale funding has cost in the order of an additional 100 basis points, which we estimate to have created an A$350 million drag on net interest income," the JP Morgan analysts add.

'Profit drag' should be over

Manning, Nicholias and Anand suggest Westpac's profit drag, relative to peers, ought to now be over given the group's funding profile has caught up and it has also "de-risked" both its commercial real estate portfolio and its St George mortgage portfolio, with the St George merger integration now over.

"Therefore, Westpac's profitability should no longer be inhibited by these issues and should be 'no worse off' than peers in the period ahead, but we remain cautious on the execution of the current strategic investment programme."

"The key question is whether that will be sufficient to fund the current dividend trajectory?"

St George tax benefits

Here, they point out Westpac's dividend has increased by two cents per share per half-year on 16 of 26 occasions since 2000. However, over recent years this has been helped by nearly A$1.8 billion worth of tax benefits stemming from Westpac's tax consolidation of St George. With this being applied from 2010 until 2014, the JP Morgan analysts estimate this tax benefit translates to a boost of nine cents per share annually to Westpac's capital ratio, and a 4% lift in the bank's payout ratio between 2011 and 2014.

Hence, they question what will happen to Westpac's dividends in 2015 when the St George tax benefit ends.

"Our current forecasts have the dividend continuing to increase at the current rate of two cents per share per half, resulting in a reported payout ratio being sustained close to 85%, which requires the JP Morgan pro-forma payout ratio lifting by 4% in 2015 to 'catch up' to the reported pay out ratio."

Their pro-forma ratio had Westpac at 71% in 2011. The forecast of 85% for Westpac in 2015 compares with 79% for CBA, 76% for NAB, and 68% for ANZ. However, the challenge for Westpac in continuing to deliver the two cents per share dividend increase per half comes with JP Morgan estimating the bank is delivering A$740 million less in pre-tax earnings than expected post the St George takeover.

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