NAB and Suncorp – dog starts wagging the tail

Chief Investment Officer and founder of Aitken Investment Management
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NAB and SUN remain core members of my high conviction buy list. Both stocks this week confirmed they are continuing along the road to market redemption, which I believe will translate to further P/E expansion and share price gains. My confidence in dividend growth is also enhanced and I think the total returns generated by both stocks from here will be pleasing.

National Australia Bank

A year is a long time in banking. It was less than 12 months ago that NAB shares were under $24.00 (while still cum the final dividend) after analysts downgraded the stock for the poor UK performance. I think we described NAB back then as “the best risk adjusted large cap buy since TLS at $2.60”.

Fast forward to today and the only comment worth focusing on from NAB’s trading update on Tuesday was the following:

“In the UK, we continue to deliver against the strategy we outlined in April 2012. Progress on simplification of our UK banking business has been pleasing, with efficiency benefits ahead of plan. We have also achieved further run-off in the UK Commercial Real Estate portfolio, with the current balance of £4.4 billion down £1.2 billion, since its transfer to National Australia Bank Limited in October 2012.”

I remember saying to NAB CEO Cameron Clyne at a Christmas drinks party last year, a day after the AFR named him in the “top 10 CEO’s likely to be sacked in 2013”, that if he got the UK business off the headlines, the P/E discount to the oligopoly peers would take care of itself and the financial press would move on to kick another corpse. We both agreed it “wasn’t rocket science”, had another beer, raising our glass to hopefully better times ahead in 2013.

For all the press and analyst criticism/corpse kicking of Clyne, he has succeeded in getting the UK business off the headlines, and NAB’s P/E discount to its peers is narrowing at pace, as it becomes more obvious to all that the UK noose is coming off NAB’s share price.

As far as I can tell, most research on banks simply extrapolates the present. If I look forward two years, I can see a scenario where no bank analyst even mentions the UK for NAB, or if they do it’s in passing.

That is a very important call, because the UK tail has been wagging the entire NAB share price dog for the best part of five years. Now I believe the domestic, 18% ROE, oligopoly bank will drive the share price, as the UK P/E discount to the domestic peers evaporates.

A new darling

Imagine this scenario: the UK becomes a non-issue for NAB, domestic business confidence picks up post the election, consumer and household confidence improves with ultra-low cash rates for an extended period, domestic bad and doubtful debts (BDD) remain benign and unemployment peaks below expectations. Under that scenario, NAB will be testing all-time highs around $44.00 in a few years’ time.

And I believe that is increasingly becoming a base case scenario, not a “what if” scenario. Today, I think we are only part way through the NAB re-rating. It has moved from wildly cheap to now cheap.

I really want to stay the course in NAB, until it achieves a domestic bank sector multiple. The dividend yield plus franking credits alone pays me adequately to take that risk. FY14 dividend lifts to 198c fully franked, putting NAB today on a prospective 6.3% yield.

NAB remains a high conviction buy. A price target of $35.91 is generated on 13.5 times FY14 EPS, while our slightly increased (+2%) FY14 dividend forecast, leads to the 5.00% fully-franked yield target on NAB being lifted to $39.60. On that basis, in the year ahead, it’s fair to predict NAB moving into a new higher trading range of $35.00 to $40.00, as the UK discount is shed.

Suncorp

Now to another member of our high conviction list, which has been there since inception. The total returns generated by Suncorp (SUN) continue to outpace the broader ASX200.

Our previous attraction to SUN was as a specialist, contrarian, deep value post “near death” GFC turnaround situation. That turnaround has now broadly occurred, yet the next leg of the SUN story is a growth plus yield story that sees SUN come back onto all investors radars. It’s easily forgotten that SUN is an ASX top 20 stock with a $16 billion market cap.

In terms of future P/E rating for SUN, the good news is, just like the NAB example, SUN is shedding the previous P/E noose around the group neck known as the “non-core bank”. The non-core bank will be all but gone by the end of FY14. This is important.

Why is this important? Because the core SUN bank has good assets that we think will continue to grow. In fact, they grew nicely in FY13 to $47.5 billion. What I like is the SUN core bank is basically a QLD and NSW residential mortgage exposure.

In the insurance side of the business, margins continue to increase. This is also good news, driving a $883m general insurance NPAT for FY13.

A yield play

What all this translates to, is all SUN business lines are experiencing top line growth, which is seeing shareholders rewarded in big, fat fully-franked dividends, from their excess franking credit pool.

SUN is currently cum the 20c fully-franked special dividend and 30c fully-franked final dividend. We forecast SUN to pay another 73c of fully-franked ordinary dividends in FY14, with the clear risk of another special dividend. That means if you buy SUN today, you will be entitled to 123c fully franked of dividends, with risk to the upside on that number. On Wednesday’s closing price of $12.60, that equates to a 13-month yield of 9.76%, or 13.9% grossed up.

I actually fully agree with SUN’s view of themselves, that they are now a yield plus growth stock. That is pretty much exactly the attributes all domestic investors should be seeking, in an ultra-low interest rate environment, where headline growth is hard to find.

I also think management, led by Patrick Snowball, has done a very admirable job turning this big ship around. I suspect some P/E will be added from this point for management execution.

SUN remains a high-conviction buy with the bottom up, top down and technicals all coming together. The $14.50 price target is also the 5.00% fully-franked FY yield target.

Go Australia, Charlie

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 regards to your circumstances.

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