Comparative Analysis of Westpac and BHP Company - Case Study Example

Name: Tutor: Title: A Research of Corporate Course: Institution: Date: Executive Summary The degree of profitability is one of the most controversial and debated topic in the banking industry. The main aim of this report is to give a comparative analysis between the bank and other institutions. The study examines the notion that banks make excessive profits compared to other economic industries or sectors. To achieve the set objectives, the study has mainly employed the use of secondary data; an extensive review of relevant literature and other related empirical data. This study finds that Westpac which represents banking institutions have high profits compared to BHP which represents the mining sector. Just like any other banks, Westpac is faced with various risks ranging from credit, liquidity risks, operational and compliance risks. However it is able to counter some of these risks by the use of an integrated approach for instance engaging in comprehensive risk identification, analysis and monitoring. In part, this explains why banks continue to accumulate large profits. Apart from this, the banking sector enjoys several privileges. They are under taxed or sometimes not taxed at all. Many a times they have been bailed out by states during financial crisis. They have accrued big profits $14 billion as per the latest results. The study also highlighted the importance of covered bonds in funding banks. The paper is outlined in six sections. Part one provides an overview of the topic. Section 2 gives brief background of Westpac and BHP which form the focus of analysis while part three Section gives a comparative analysis of the two sectors and also describes their leverage risks Section 4 discuses the notion that banks makes excess profits profitability, giving reasons and evidence Section 5 explains the role of bonds in funding of financial institutions or banking sector. Finally, Section 6 relates to conclusion as drawn from the key findings. Table of Contents Table of Contents 3 Introduction 4 Background information 5 Comparative Analysis of Westpac, BHP and Dominos Company 6 Leverage risks levels 13 Westpac’s risk measures 13 Banks’ Profitability 15 Conclusion 21 Reference 22 Introduction Profit maximization in the financial institutions has been the subject of importance and ongoing debate in the corporate world. There are mixed opinion as to whether banks are making excessive profits. There are those who believe this is quite true while still others like Narev, chief executive of Commonwealth Bank discard the Labor's conviction banks in Australia are amongst the most successful institutions globally (The Australian, Feb 15 2012). However, the RBA warns on pursuing unrealistic profits. Michael Handa reports that “…lending growth has been terrible over the past year (2011), the worst since the Second World War. And that's putting pressure on bank profitability. They have managed to keep their profits up with improvement in their interest income and their net interest margins over the last year, even though there was some pressure on those at the end of last year”. The Reserve Bank warned Australia's banks not to chase unrealistic profit expectations by taking on more risk. It identified lower credit standards, rapid overseas expansions and excessive cost cutting by cutting risk management staff as three of the key areas to watch for Australia's banks (Michael Janda, Wednesday, March 28, 2012, the World Today). Banks are more heavily regulated than any other industry sector. Despite this they are considered one of the most profitable sectors listed on the ASX with the main four banks reporting profits in excess of $5 billion each over the 2010-2011 year. This paper seeks to explore the general performance of the Westpac Bank (representative of the banking sector) and compares and contrast its results to BHP (representative of the mining and manufacturing sector) and Domino’s Pizza (representative of the food and hospitality sector). Background information Westpac Bank was established in the year 1817. It is one of the oldest financial institutions in Australia initially referred as the Bank of New South Wales. The banks expanded particularly during the gold rush of the 1850s, from just a single unit and by the time of Great Depression, there were about 37 branches. The banks acquired a commercial status in 1982. By this time it was known as the Westpac Banking Corporation. It continued to expand throughout Australia and New Zealand. Some of its branches comprised of Trust Bank of New Zealand, the Bank of Melbourne as well as the Challenge Bank Limited. BHP Billiton Company is a product of the 2001 amalgamation of three groups of company’s namely the giant BHP; Australia’s mining as well as the U.K.-based mining. The merger led to one of the most renowned company with operations in nearly 20 countries. BHP Billiton is one of the leading company’s in the industry sector. It accrued about $25 billion in 2004. Today, the firm maintains its operations as an independent entity; as BHP Billiton Company in both Australia and UK (web accessed 17 April, 2012). On the other hand, Dominos Pizza Enterprises Pty Ltd is public company which opened its first store in 1983 Queensland. The company has expanded to other areas like Brisbane, Sydney and Perth. Today, Domino’s Pizza Enterprises has more than 859 stores across its 5 Markets and operates as the National Franchisor of the Dominos Pizza worldwide Quick Service Restaurant (QSR) system with a high volume and low margin operation and wide range of products. Comparative Analysis of Westpac, BHP and Dominos Company Westpac results (in $millions unless otherwise indicated) 2011 Income statements for the years ended 30 September2 Net interest income 11,996 Non-interest income 4,917 Net operating income before operating expenses and impairment charges 16,913 Operating expenses -7,406 Impairment charges on loans -993 Profit before income tax expense 8,514 Income tax expense -1,455 Profit attributable to non-controlling interests -68 Net profit attributable to owners of Westpac Banking Corporation 6,991 Balance sheet as at 30 September2 Loans 496,609 Other assets 173,619 Total assets 670,228 Deposits 370,278 Debt issues and acceptances 165,931 Loan capital 8,173 Other liabilities 82,038 Total liabilities 626,420 Total shareholders’ equity and non-controlling interests 43,808 Key financial ratios Shareholder value Dividends per ordinary share (cents) 156 Dividend payout ratio (%) 67 Return on average ordinary equity (%) 17.8 Basic earnings per share (cents) 23.3 Net tangible assets per ordinary share ($) 9.96 Share price ($): High 25.6 Low 17.84 Close 20.34 Business performance   Operating expenses to operating income ratio 43.8 Net interest margin 2.19 Capital adequacy Total equity to total assets % 6.5 Total equity to total average assets % 7 Tier 1 ratio 9.7 Total capital ratio 11 Credit quality Net impaired assets to equity and collectively assessed provisions (%) 6.3 Total provisions5 for impairment on loans and credit commitments to total 88.2 loans (basis points) Other information Core full-time equivalent staff (number at financial year end) 33,898 Source: Westpac Group Annual Report 2011 Profit Ratios BHP results 2011 Consolidated Income Statement (US$M except per share data) Revenue 71,739 Profit from operations 31,816 Profit attributable to members of BHP Billiton Group 23,648 Dividends per ordinary share – paid during the period (US cents) 91 Dividends per ordinary share – declared in respect of the period (US cents) 101 Earnings per ordinary share (basic) (US cents) (b) 429.1 Earnings per ordinary share (diluted) (US cents) (b) 426.9 Number of ordinary shares (millions) – At period end 5,350 – Weighted average 5,511 – Diluted 5,540 Consolidated Balance Sheet (US$M)   Total assets 102,891 Share capital (including share premium) 2,771 Total equity attributable to members of BHP Billiton Group 56,762 Other financial information Underlying EBIT (US$M) (c) 31,980 Underlying EBIT margin (c)(d)(e) 47.0% Return on capital employed (e) 38.5% Net operating cash flow (US$M) (f) 30,080 Project investment (US$M) (e) 24,517 Gearing (e) 9.2% Source: BHP Billiton Annual Report 2011 Profit Ratios Liquidity risk Current assets = 23,648,000,000 =22.98% Total Assets 102,891,000,000 Dominos results Fiscal year ended (5 (dollars in millions, except per share data) December 30, 2007 (4) December 28, 2008 January 3, 2010 January 2, 2011 January 1, 2012 Income statement data: Revenues: Domestic Company-owned stores $ 394.6 $ 357.7 $ 335.8 $ 345.6 $ 336.3 Domestic franchise 158.1 153.9 157.8 173.3 187.0 Domestic stores 552.6 511.6 493.6 519.0 523.4 Domestic supply chain 783.3 771.1 763.7 875.5 927.9 International 126.9 142.4 146.8 176.4 200.9 Total revenues 1,462.9 1,425.1 1,404.1 1,570.9 1,652.2 Cost of sales 1,084.0 1,061.9 1,017.1 1,132.3 1,181.7 Operating margin 378.9 363.3 387.0 438.6 470.5 General and administrative expense 184.9 168.2 197.5 210.9 211.4 Income from operations 193.9 195.0 189.5 227.7 259.1 Interest income. 5.3 2.7 0.7 0.2 0.3 Interest expense (130.4) (114.9) (110.9) (96.8) (91.6) Other (1) (13.3) - 56.3 7.8 - Income before provision for income taxes 55.6 82.9 135.5 138.9 167.8 Provision for income taxes 17.7 28.9 55.8 51.0 62.4 Net income $ 37.9 $ 54.0 $ 79.7 $ 87.9 $ 105.4 Earnings per share: Common stock – basic $ 0.61 $ 0.93 $ 1.39 $ 1.50 $ 1.79 Common stock – diluted 0.59 0.93 1.38 1.45 1.71 Dividends declared per share $ 13.50 $ - $ - $ - $ - Balance sheet data (at end of period): Cash and cash equivalents $ 11.3 $ 45.4 $ 42.4 $ 47.9 $ 50.3 Restricted cash and cash equivalents 81.0 78.9 91.1 85.5 92.6 Working capital (2) (29.6) 25.8 (31.9) 33.4 37.1 Total assets 473.2 463.8 453.8 460.8 480.5 Total long-term debt 1,704.8 1,704.4 1,522.5 1,451.3 1,450.4 Total debt 1,720.1 1,704.8 1,572.8 1,452.2 1,451.3 Total stockholders’ deficit (1,450.1) (1,424.6) (1,321.0) (1,210.7) (1,209.7) Source: Global Momentum Domino’s Pizza 2011 Annual Report Total current assets-305,038(ibid, 47) Profit Ratios Liquidity risk Current assets = 305,038 =6.62% Total Assets 460,800,000 From the profit analysis of the two sectors in the economy, it is apparent that the banking sector, represented by Westpac bank is comparable to the mining sector and Domino’s. Westpac has low asset utilization and return on asset compared to both BHP and Domino’s Company however, the higher leverage multiplier make the bank equally competitive. Leverage risks levels Leverage risks is taken to mean all debts obligations. From the tables in the previous sections, Westpac has the highest leverage risk considering its total debts obligation of $165,931million. It is closely followed by BHP which has $2,683 million and finally Domino’s Pizza Company which has the least, $ 1,720.1million. Therefore, it is advisable to buy shares from Domino’s Pizza Company which has the lowest leverage risk. Although the prices of shares might be high compared to Westpac which is most likely to sell their shares at lowest price due to their debt burden, Domino’s has a promise for a good return in terms of shares. Westpac’s risk measures The Westpac guiding vision is leadership in the financial sector in all its major branches within Australia and New Zealand. Appropriate risk measures are very vital in realizing this goal. Risk from the financial point of view can be understood to mean the likelihood of variability between the actual and expected return (Rifki, 2010). A risk is very significant in any banking business and the banks main goals revolve around offering superior shareholder value by considering a suitable trade-off between risk and returns. Bank’s risk management practice is based on the principle of a clear understanding the types of risks, regular risk assessment, measurement protocols as well as continuous monitoring. Westpac is faced with various risks and consequently adopts an integrated strategy in controlling them. These risks comprise the following: credit risk which takes place when a client fails to meet his or her financial commitments. There is also liquidity risks brought about by bank’s inability to effectively funds assets and meet other obligations, without experiencing unnecessary losses. Still, there are market based risks as a result of variables like changes in foreign exchange rates, equity prices, interest rates as well as commodity prices. Other challenges relates to operational and compliance risk. Operational risks are brought about by ineffective internal systems, misconduct, or even as a result of external factors. They are also associated with technological risk, outsourcing challenges among others. On the other hand, compliance risk is about regulatory approvals, economic loss and others emanating from failures to abide by the compliance rules. As already indicated, Westpac prefer the integrated approach in its risk management. Like other financial institutions, Westpac bank is involved in a number of activities including risks identification, assessment and monitoring. To this end, the bank has formulated suitable risk management strategies and policies through a well set risk objectives and methods of the institution as well as adopting internal control systems to handle the different potential risk. In addition, Westpac also encourage accountability and comparability of banks via appropriate disclosures of details like capital quality and adequacy, potential risks as well as accounting standards. Westpac also uses Leverage as a tool for measure risk factor sensitivity and the level of “bucketized risk “There is also risk analysis in the evaluation of the bank’s performance in order to find out how the depositors’ and shareholders’ funds are used. For instance, the profitability measures show the direction of the bank’s market valuation as well as its ability to get funded in the deposit and equity markets. The bank also adopts a Transaction-managed strategy in dealing with its risks, like credit risks. In case there are many clients, the company evaluates its credit requests through a comprehensive risk analysis. This is where credit are approved by credit officers and categorized appropriately. In addition, it employs a Program based strategy where high-volume retail homogenous credit risks are managed on a statistical level and in line with a set objective criterion. Sometimes scorecards are utilized qualitatively in order to give both application and behavioural scores which in the end facilitate decision making in the company. The findings are generally monitored and validated against successive client performance (The Westpac Group, 2011). Westpac is also faced with chain related risks. To this end, it has developed a strategic approach which is implemented in six major stages. The first stage involves establishment of a chain policy, followed by data collection on the performance of current suppliers; screening of potential new suppliers; assessment of Compliance across the organization’s key departments to facilitate universal group procurement and supplier related activities; Supplier management and influencing; and lastly the reporting on supply chain impact in future social impact reports. The whole idea of this data gathering is to facilitate establishment of a clear business case to generate senior management support and which in turn, encourage internal commitment to the program (Keating et al, 2008). Banks’ Profitability Bank’s profits can be simply defined as the bank’s record or results revealed annually and derived at by subtracting expenses from income/revenue. Banks are making huge profits on various grounds. One of the reasons could be attributed to their levels of risk management as observed in the foregoing paragraph. Banks appears to be making excess profits since they are quite big entities for instance they are considered one of the largest business organization in Australia compared to other sectors like mining and manufacturing hence giving them large balance sheet which partly explains why they tend to make big profits. In addition, banks also act as the country’s money supply mechanism and seem to give their clients credit out of nothing; it doesn’t belong to anyone or exist. Furthermore, the banking sector has several privileges compared to other sectors in the economy thus able to make excess profits both in good times while cushioning them during crisis. They pay minimal and sometimes even zero tax and consequently able to save quite a lot in every financial year (Prieg, Greenham and Collins, 2011). The high profits can also be attributed to the stables economic growth which Australia continues to enjoys unlike other countries. In addition, Australia Banks are privileged by the banking acts, which literally, allow them to print money while the rest, three percent comprise of the notes and coins created by the government and sold to the banking system while an amount equal to their face value is deposited in the Treasury as a useful debt-free input to the public basket, traditionally referred as seignior age. Banks are often seen as backbone of the economy, offering capital for innovation, infrastructure, employment and the general development. These institutions also play significant role in society, ranging from individual spending to the growth of various industries. As intermediaries, they coordinate capital flow from investors to creditors or borrowers, a function quite significant in facilitating economic efficiency of a country. In other words, investors need not to spend a lot of time looking for borrowers. Consequently, banks are able to accumulate significant revenue from lending at a relatively higher interest rate compared to the borrowed ones (Prieg, Greenham and Collins, 2011: 44). Additional Evidence Many banks currently have limited high level risk securities, while many big banks have maintained their high credit ratings. The structure is also highly capitalized and the financial institutions have raised more equity at only few discounts to the general prices. Another case in point is the Australian Government Guarantee Scheme specifically for the Wholesale Funds as well as larger Deposits which have greatly enhanced banks’ access to funding thus have lengthen the maturity based profiles and liabilities. In addition, all the five biggest banks accrued huge profits after tax and marginal interests of about $8 billion over the period between Septembers to December equivalent of an annualized 15 percent post-tax return on equity (Financial stability review, 1999). Further, the commercial based loans and the assets share of most banks were 3.3 per cent for the period which ended in December, 2008, relative to only one and half per cent in beginning of 2008 (ibid, 1999). In 2010 alone, total bank incomes stood at $135 billion, approximately 10 percent of the country’s Gross Domestic Product (GDP) and as at September 2011, the total bank assets including loans, households and businesses was $2.3 trillion dollars which is almost a double of the total Australian GDP at the time. Most banks gained more profits during the time of financial liberalization up to the economic crisis of 2007/2008. A report by Washington (2010) revealed that how the big banks have hiked rates on a much higher levels compared to the funding expenses at the cost of their clients. The banks also charge their borrowers relatively more than the increase in their own costs, under the disguise of the global financial crisis, thus given the banks not only huge profits but also higher interest rates for their services. Reserve Bank statistics illustrates how for the first time many customers paid a monthly contribution to bank income during the financial crisis in 2007. For instance some of the customers gave an extra monthly contribution of between $75 and $125 to the bank’s mortgage bill as a result of increase in the interest rates charged for their services more than their own costs in the name of the financial crisis. In the latest results, most banks in Australia reported a year pre-taxed profits of $14 billion in the mid financial period thus exceeding pre-crisis profits (Web assessed April, 2012) Further, ANZ's revenue from mortgages and small businesses increased from 0.06 to 7.36percent and 9.12percent respectively while Westpac improved its home loan by 0..1 percent and the Commonwealth Bank increased by 0.09percent (Sutton, 2012 par.3 and 4). Similarly during the 2007/2008, incomes for many banks became highly volatile thus increasing the general risk within the financial industry. The Banking sector is often associated with uneven or uneven risk to the country during economic crises (Prieg, Greenham and Collins, 2011). A further illustration relates to the fact that many banks have larger premiums compared to other sectors. They have accrued equity related high returns even as their clients’ satisfaction levels continue to reduce. In addition, they have also benefited a lot in terms of financial support from the states. All these factors, bail out and premium in banking earnings is enough evidence for their excess profitability, especially through bonus expense compared to other industries in the economy. Covered Bonds and the banking Sector Covered bonds can be defined as secured debt instruments or tolls given by banks, as a single issuance or as part of a given program. Also, they are defined as bonds given by financial institutions or generated by interests from mortgages. They are different form other securities in that they appear on the balance sheet (Ergungor, 2008). They play significant role in providing funds as well as contributing to the cost of funds as outlined below: Covered Bonds are mainly associated with the economic role for many interested investors and organizations. They for instance not only offer secure and liquid assets to those who wish to invest but also used as instruments for liquidity management by various financial institutions. Today, bigger share of covered bonds is held by banks (Stocker 2011:33). The Bond offers revenue for the banks or any other institution having a number of cover pools or mortgage assets reflected on its balance sheet. Interest on the Covered Bond is paid to investors from the institution’s general cash flows and that of the mortgage serve as collateral. Just like securitization, covered bonds also have the ability to encourage mortgage lending by converting them into collateral which can then be used by the financial institutions. Further more, they also attract more investors as they are permitted in the form of collateral at the Federal Reserve’s banks (Ergungor, 2008). Covered bonds unique features also facilitate findings abilities. For instance, they are believed to be as dual-recourse instruments and thus less risky than other financial bodies’ securities and have proven themselves relatively more resilient during the market challenges (European Central Bank, 2008). They are also considers as another form of investment as they able to open other ways of investment for instance in super funds, providing high security and returns between government and banks bonds .Super funds in Australia is generally regarded as big investors in Government/Semi- Government issuance and supranational bonds. Covered bonds from Australia’s ADI’s tends to offer a bigger return relative to these other investment options and often put pressure on the yields of semi government securities. Covered bonds is basically an alternative source of funding at a lower price thus more likely the target of large super fund investors based in Australia, thus reducing the need to always seek wholesale funding in the offshore markets. It plays a significant role in the deposit market and reducing the margin currently being paid. Banks are currently willing (and able) to pay a premium for term funding via the retail deposit markets as they seek to diversify funding. Conclusion This is a corporate research and aimed at a comparative analysis of performance of banks with other sectors in the economy. The high profitability for most banks if not all in Australia in an undeniable fact. There are various reasons for this trend including the fact that banks have several advantages over other sectors, their size as well as their great role in the economy. Other factors could explain why banks make so high profits and therefore there is need to explore these factors. Despite the positive trend in terms of profits, banks also face several risks or challenges which call for effective risks management. In one way or another, their performance is also closely related to the extent of effective risk management. 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RBA warns banks on pursuing 'unrealistic profits' In The World Today retrieved from http://au.finance.yahoo.com/news/rba-warns-banks-not-chase-050901417.html , Wednesday, March 28, 2012 09:30:29 Otmar Stocker (2011) Covered bond models in Europe: fundamentals on legal structures in Housing Finance International The Quarterly Journal of the International Union for Housing Finance Winter 2011 Stuart Washington (2010) Banks' gouging brings in billions: Big banks gouging us on rates June 3, 2010 (online) http://www.smh.com.au/business/banks-gouging-brings-in-billions-20100602-wztf.html The Westpac Group (2011). Westpac Pillar 3 Report: Incorporating the requirements of Australian Prudential Standard APS 330, March Westpac Banking Corporation ABN 33 007 457141 Read More