Friday, May 17th, 2019
Although the 16% cut to NAB’s interim dividend, down to 83 cents per share, reduces shareholders’ income now, shareholders should more than benefit from a higher share price because the cut derisks the stock by increasing the bank’s capital buffers. The negligible share price reaction means the cut was already priced in – it has been for over two years given NAB’s formerly excessive dividend payout ratio – and signals the market’s confidence the bank’s capital position is now stronger and the new dividend payout ratio is sustainable.
NAB had to act. The bank’s ratio of high-quality (common equity tier 1) capital to assets of 10.4% on 31 March was at the bottom of the peer range and subdued capital generation in the first half was partly offset by customer remediation costs of $325m. Now the dividend has been rebased lower, NAB can more easily reach APRA’s ‘unquestionably strong’ target ratio of 10.5% by the January 2020 deadline. Even so, NAB plans to raise around 45bp of new equity capital by discounting and partly underwriting the interim dividend reinvestment plan, which indicates how far short of the capital target it was. This DRP will be very dilutive.
Eventually, the dividend cut should reduce the need to rely on ongoing dilutive DRPs. We would expect the DRP to be first neutralised, by buying back shares on-market, before dividend growth resumes, probably in the FY21. Before this can happen NAB (and the other three major banks) need to navigate the Reserve Bank of New Zealand’s proposed major capital increases, where consultation is proceeding ahead of an expected phase-in period of several years. In short, the dividend cut derisks the stock during a period of flat earnings, elevated remediation costs, some uncertainty about whether cost cuts will accrue to the bottom line or be competed away in yet more mortgage discounting, and capital uncertainty.
Despite the remediation costs, difficult conditions in home lending, and with only two months of benefits from mortgage repricing, NAB was able to hold earnings flat half on half. In our view, the ability to do this in a tough trading environment is one quality of a ‘blue chip’ stock. NAB benefited from being underweight retail banking (~25% of earnings vs 40-55% for WBC, CBA), where its earnings slid 13%, and from solid performances in SME business banking (2% earnings growth), large corporate institutional banking (2%) and New Zealand (7%). SME lending grew an impressive 5% over the previous first half, reflecting NAB’s attractive business banking offer, and interest margins in business lending widened. Operating expenses of $4.1bn were in line with guidance for “broadly flat costs” in 2019, impressive given the scale and riskiness of the bank’s transformational, cost-cutting program.
Figure 1. Major bank divisional earnings contributions
Source: Macquarie Research
Figure 2. NAB’s business lending interest margin
The pressures on retail bank earnings are slowing volume growth in mortgages as investors desert the market and house prices fall, switching from interest-only loans to less profitable principal and interest loans, fee pressure and mortgage price competition.
Credit quality also deteriorated in this result. NAB’s loan impairment expense was up 11% to $449m or 0.15% of gross loans, due mainly to a small number of higher charges in the institutional banking business. There were also more provisions for loans to retailers as the retail downturn drags on. Mortgage arrears past 90 days due worsened nationally as some heavily geared customers struggled with the new need to make repayments after conversion from interest-only loans, while other customers are having difficulty refinancing in the weak housing market so are staying in arrears for longer. 90 days past due arrears rose to 0.53% of gross loans, which remains low though would rise further if unemployment worsened. However, this normalisation of bad debts expense from historically low levels is already factored into consensus earnings estimates in our view.
Last month we added to our NAB position in the Clime Direct Model Portfolio around $24.50 and are pleased the dividend cut sees the stock consolidating around a dollar above this level. There is a growing list of reasons to be more optimistic on bank valuations including lower short-term funding costs, the need to address excessively conservative regulatory mortgage underwriting criteria, early signs banks will lend a little more confidently and house prices will stabilise, the passage of the Royal Commission, peaking remediation costs, limited further downside to consensus earnings forecasts after four years of heavy cuts, and improving global growth. We see NAB as worth over $27 within 18 months. There will be a discount in the stock until the identity of the new CEO is known, though we expect a credible appointment who strengthens market confidence.
If you would like to hear more from the Clime Investment team explaining how we select companies for our investment portfolios, deliver insights into global and domestic markets and investing in uncertain times – you are welcome to attend our upcoming Mid-Year Investor Briefing. Click here to check locations, availability and book tickets.