I don’t think I’ve ever seen such a bad result by a major bank. Volumes contracting, margin down, fee income down, expenses up, dividend down and a bearish outlook statement. That was the story that new Westpac CEO Peter King delivered two weeks’ ago when presenting the bank’s full year result, and explains why Westpac’s shares have massively underperformed since then.

With underperformance comes opportunity, and I suggest you might want to consider Westpac in preference to the other major banks. Maybe buy Westpac, sell NAB?

For the record, I have been wrong on Westpac over the last 12 months. I argued that as the cheapest bank in a group where there is limited differentiation, Westpac offered investors the most upside. I had favoured a CBA/Westpac investment pairing – the best and the worst. By now, Westpac should have been doing a lot better and caught up to the other “tier 2” major banks, ANZ and NAB. Instead, the gap has widened and Westpac is even cheaper.

So, is it time to “bet” on Westpac again? Let’s start by looking more closely at the result.

A closer look at the Westpac result

Cash earnings of $2.6bn for the full year were, in Peter King’s words, a “disappointing result”, which he blamed on the “environment and our own issues”. Although cash earnings of $1,615m in the second half were up from $993m in the first half, core earnings, which excludes impairment charges and “one-offs” such as the AUSTRAC penalty, fell by 12% in the second half.

The net interest margin declined by 13 basis points in the second half, reflecting a huge build up in liquid assets, increasing customer deposits, and a fall in loans. The mortgage book went backwards by a net $4.7bn in the second half and $8.2bn over the year to close at $441bn. (By comparison, market leader CBA went up by $5.6bn in the September quarter alone)

Among the excuses was that Westpac’s offshore loan processing division was impacted by Covid-19 and couldn’t meet customer demands, with turnaround times for mortgage applications allegedly blowing out to almost a month.

Adding to its performance woes was its performance on expenses, which increased by 7% in the second half. The major drivers were increased spending on risk and compliance, increased investment plus additional Covid-19 related costs, offset to a limited extent by  productivity savings. But for a Bank whose strategy is “Fix, simplify, perform”, there is a long way to go on productivity.

Positives in the result related to balance sheet, capital and credit provisioning. Covid-19 related home loan and business loan deferrals were down almost 75% from their peak of $64.8bn to just $17.6bn as of 31 October. Credit provisioning was near the top of the major bank range with total provisions as a percentage of credit risk weighted assets being 1.71%, while the Bank’s CET1 capital ratio of 11.13% (11.21% proforma) was better than expected and is well above APRA’s “unquestionably strong” benchmark of 10.5%. Further, with the DRP being fully underwritten, the potential of a further capital issue is now unlikely.

Looking ahead, King was downbeat on volumes, saying that he expected business lending to decline, and that in regard to mortgages, Westpac’s aim was to “be in line with the major banks by the second half of FY21. The net interest margin was expected to remain under pressure, due to competition in the mortgage market and low interest rates impacting deposit spreads and earnings on hedged balances. Expenses would also remain pressured, with elevated investment in risk management. He was a little more upbeat on asset and credit quality.

A closer look at the NAB result

NAB’s reported cash earnings of $4,733m for the full year, with the second half of $2,258 down 8.8% on the first half. Unlike Westpac, underlying profit (which is before loan impairment charges) was 5.8% higher in the second half. NAB actually reported an increase in revenue in the second half, mainly due to a very material increase in markets and treasury income. In regard to this income, analysts generally consider this to be “lower quality” income as it may not be repeatable in the next period.,

On margins, NAB’s overall margin decline was limited to just 1bp, (3bp excluding markets and treasury). Volumes were essentially flat, with a small increase in business loans offset by a fall in mortgages. In the latter, NAB lost $1.3bn over the half year to $260.3bn.

Operating expenses in the second half rose by 4.9% compared to the first half, led by increased spending on technology and restructuring costs, offset by productivity savings.

Capital is strong with a CET1 ratio of 11.47% (11.82% on a proforma basis) while provisioning has been increased such that total provisions as a percentage of credit risk weighted assets are 1.80%. Loan repayment deferrals eased to $19bn at the end of October, down from a peak of  over $60bn.

CEO Ross McEwan was more upbeat in his outlook commentary. While noting further net interest margins headwinds of 6bp and subdued demand for credit (very low single digit growth in both business  and home lending), the NAB was “Investing in target segments to achieve growth while managing pricing and risk disciplines”. On the expense side, the bank is expecting growth in FY21 (excluding large notable items) “of approximately 0 – 2%”.

What do the brokers say

The following tables show the recommendations, target prices and forecasts by the major brokers for the four major banks (as of 13 November, source FN Arena). In summary:

• The brokers are most bullish on the ANZ, with each of the brokers recording a “buy” recommendation;
• In terms of price upside, they see the greatest potential gain on Westpac of 8.4%, with a consensus target price of  $19.89 (last market price $18.34);
• The brokers are negative on the CBA (0 buy , 4 neutral and 3 sell recommendations), and see 7.5% downside. This position is not new – it has been the case for many, many months;
• Consensus target prices for NAB and Westpac are quite close – $20.40 and $19.89 respectively;
• On forecast price/earnings multiples (which are determined using the current market price and forecast earnings), CBA trades at a very material premium to the others. About a 21% premium to the NAB, and around 40% to both ANZ and Westpac. NAB is also trading at quite a material premium to each of ANZ and Westpac.

Major Broker Price Targets and Recommendations

Major Broker Forecasts – PE and Dividend Yield

My view

Over the last five years, the margin between Westpac and NAB shares has never been greater. On Friday, NAB closed $2.86 higher in price at $21.20 compared to Westpac’s $18.34. As the chart below shows, Westpac has underperformed the NAB by almost 17%.

Westpac (blue) vs NAB (light green) – last 5 years

Of course, that doesn’t mean that the price differential cannot widen further, but I reckon at a difference of around $3.00, Westpac looks good value compared to the NAB. In particular:

• The underlying strategies are similar. Potentially due to AUSTRAC, NAB is further advanced in execution;
• The underlying businesses are now very similar. NAB has a stronger focus on business customers, Westpac has a stronger focus on personal customers;
• Westpac has a stronger set of brands – Westpac, St George, Bank of Melbourne, Bank SA compared to NAB’s National and UBank;
• In technology, while both are investing heavily in digital, they each have considerable legacy systems and issues and are some years way from the leader, Commonwealth Bank
• In home loans, both went backwards in the September half, highlighting the challenges of growing volumes;
• Both are well capitalised and appear to be adequately provisioned;
• Both have new CEOs in place. Ross McEwan is an experienced Bank CEO, whereas Westpac’s Peter King is a former CFO;
• The AUSTRAC debacle is behind Westpac and while there are ongoing costs with additional compliance and risk staff, Management should be able to shift attention back to the business; and
• On consensus, the brokers see 8.4% upside for Westpac and 3.8% downside for NAB.

At around $3, I think the trade is to buy Westpac and sell NAB. If that doesn’t suit and you want to increase your exposure in the banks, I think Westpac (over the next 2 to 3 years) is the preferred exposure.

Important: This content has been prepared without taking account of the objectives, financial situation or needs of any particular individual. It does not constitute formal advice. Consider the appropriateness of the information in regard to your circumstances.