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Why this top broker still rates Westpac a “buy” despite its $1.4bn profit warning

The Westpac Banking Corp (ASX: WBC) share price is under a cloud since the bank issued its profit warning yesterday.

The WBC share price shed 1% to $16.10 ahead of the close after it warned that it will have to take a $1.4 billion hit to its first half result, which will be released early next month.

Investors are also kept on edge as the bank said it is yet to make a decision on its interim dividend. This is a point of contention as banks are being pressured by the banking regulator to suspend dividends or substantially cut the payout.

Bigger cut to dividends than earnings

What I suspect is that the bank will still pay a dividend, but the reduction in the payout will be much more severe than the earnings drop would normally warrant.

Dividends are the primary reason many investors buy shares of the big banks as they don’t offer much in the way of growth.

But with this gloomy outlook on dividends, is Westpac still worth backing in the face of the COVID-19 pandemic?

Is Westpac a buy?

The answer seems to be a resounding “yes” from JP Morgan. This is despite the fact that the broker holds one of the most bearish forecasts on Westpac’s dividends that I’ve seen.

The broker believes Westpac will only declare a 30 cents a share dividend in May, which would represent a 63% cut in what it paid in 2HFY19.

What’s worse, the bank is likely to follow Bank of Queensland Limited’s (ASX: BOQ) footsteps in declaring this belatedly, added JP Morgan.

If the broker is right, this will put Westpac’s FY20 dividend yield at just 4.7%, or 6.7% with franking.

The upside to falling dividends

On the bright side, that’s still not too shabby given where interest rates are at the moment, although it is a far cry from the 10%-odd yield that some investors had been counting on.

The interesting thing is that, as I’ve highlighted earlier, the dividend cut is well in excess of the expected drop in earnings for the bank.

What this means is that the payout ratio is about to improve substantially. This ratio stood at around 90% in FY19 but will drop to just 52% in the current financial year, based on JP Morgan’s estimates.

The payout ratio is the amount of profit that a company uses to pay a dividend. Anything above 80% looks unsustainable, in my view.

I’ve always been bothered by the high payout ratios among most of the big banks, including National Australia Bank Ltd. (ASX: NAB) and Australia and New Zealand Banking Group (ASX: ANZ).

Both of these banks will also be handing in their earnings report cards and declaring their dividends in a few weeks.

Foolish takeaway

The coronavirus emergency gives Westpac and the other big banks an opportunity to rebase this ratio at a more sustainable level while providing a yield that still looks relatively attractive.

Coming back to JP Morgan’s assessment of Westpac, the broker isn’t using dividends as a reason to recommend the stock as “overweight”.

Instead, it’s focusing on the bank’s compelling price-to-book ratio of just 0.8 times and the flattening of the coronavirus-curve as reasons to buy the stock.

JP Morgan’s price target on Westpac is $18 a share.

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Motley Fool contributor Brendon Lau owns shares of Australia & New Zealand Banking Group Limited, National Australia Bank Limited, and Westpac Banking. The Motley Fool Australia owns shares of National Australia Bank Limited. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. This article contains general investment advice only (under AFSL 400691). Authorised by Scott Phillips.

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