Monday, November 13th, 2017
Suddenly the banking sector is alive with the buzzwords of the digital age: digitisation, artificial intelligence, robotics, big data, digital marketing, machine learning, agile team delivery of technology upgrades, and pre-empting disruption from fintechs. No longer staid generators of dusty files of customer loan and deposit papers, banks are now some of the most prominent technology leaders. It’s imperative to enable customers to interface digitally with their bank when they want on the device they want, to maximise the marketing advantages from analysing customer data and to use technology to reduce the costs of banking processes or to eliminate them altogether.
Bank customers already benefit from the convenience and ease of the new technology but it is unlikely any one bank will emerge with a sustainable competitive advantage in digital banking. Most likely banks will settle into a game of variously catching up, leapfrogging and falling behind peers – all at substantial cost. After an 11 per cent rally from their September low of $29.83 National Australia Bank shares have corrected since the fiscal 2017 result – not over concerns with the result, which was solid and impressive, but with the surge in technology expenses in 2018 as management accelerates its digitisation strategy in response to the above imperatives. New expense growth guidance of five to eight per cent for 2018 was way above market expectations and is driving consensus earnings downgrades for 2018.
The digitisation costs outweigh the savings from the net 4,000 positions NAB plans to remove from the business by September 2020. NAB will make 6,000 positions redundant as traditional processes are automated or not needed anymore but will also hire 2,000 positions with skills to deliver the new digital age. There will be a once-off restructuring charge of $0.5-0.8 billion to fund the redundancies. NAB obviously decided it could no longer afford to lag peers on underlying costs and had to do something to offset the surge in digitisation expense. The lack of revenue growth in the subdued banking environment also would have focused management on reducing employment costs to support earnings. The guidance is for expenses to be flat over 2019-20 but we think NAB will spend an extra $1 billion in total over the next three years above previous forecasts.
The surge in digital expenses reduces earnings and therefore weighs on regulatory capital strength by elevating NAB’s dividend payout ratio. At around 80 per cent for successive years this ratio is too high and the consequence is NAB’s decision to discount the dividend reinvestment plan by 1.5 per cent for the final dividend. Although there is no current plan to do so we expect NAB will also discount at least the 2018 interim dividend as well. The discount will triple takeup of the DRP to 30 per cent or more and the equity issued will dilute equity and earnings per share. It would be simpler just to cut the dividend per share but the resulting negative publicity probably was seen as unbearable after the costs blowout.
Value investors will be asking what all this means for what they should pay for NAB and indeed if the jump in costs in 2018 means the bank is worth less than before. The answer is yes but not by much. The second half result for 2017 was sufficiently strong to have driven consensus earnings upgrades for 2018 had there been no disappointment on costs. All four divisions delivered pleasing earnings growth from previous revenue initiatives and interest margin gains from better pricing discipline were a pleasing surprise. Bad debts expense remains historically low. Management’s confidence was clear in the guidance for earnings growth in 2018 before restructuring charges.
We think NAB’s share price will converge to our $33.50 valuation because global equity markets will remain benign as world growth accelerates and inflation remains low, the Australian economy will accelerate marginally next year, banking interest margins will be steady and bad debts low, return on equity will trend higher and because a premium will enter the share price for reliable delivery of strategy. The six per cent fully franked dividend yield, which admittedly will not grow for at least another year, increases the stock’s appeal to investors seeking income with some growth. Below $31 NAB trades at an adequate discount to value.
ANZ reported its 2017 result two weeks ago. This bank is at an earlier stage in its turnaround, which so far has emphasised derisking, capital release, divestment of non-core businesses and cost reductions, so the result disappointed expectations due to a lack of revenue growth. A year from now ANZ’s results should look much like NAB just reported, with improving revenue and earnings growth across the business. We value ANZ at $32.80, making the stock interesting below $30.50.
The market expected a solid second-half result from Westpac but the headline result fell short of expectations due to lower markets/trading income and higher customer redress costs. Wider interest margins and historically low bad debts were more supportive and Westpac should benefit from improved trading income, further mortgage repricing and lower customer redress costs in the first half of 2018. Further out, mortgage lending growth will slow down further and Westpac is the major bank most exposed to lower interest margins as borrowers switch from interest-only (higher-margin) to principal & interest (lower-margin), so we downgraded our valuation to $35 after the result. Westpac is interesting below $32.
In 2017 Commonwealth Bank was the only ASX major bank to increase its dividend. The stock enjoyed substantial dividend-driven rallies ahead of the interim and final dividends. Then CBA’s first-quarter 2018 update this week beat expectations and triggered a bullish rally ahead of likely consensus earnings upgrades. Cash earnings grew six per cent, bad debts expense surprised on the downside, revenue grew faster than underlying costs and regulatory capital was very strong. The market will now expect a solid interim result and another increase in the interim dividend, so we expect CBA will rally to $85-87 ahead of the result in February 2018.
Originally published in The Australian on Saturday, 11th November 2017.