Income investors will be heartened by NAB’s full year result released last Thursday. The laggard of Australian banking given its recent share price performance, NAB defied analysts’ predictions and maintained its final dividend at 99 cents per share. Moreover, it demonstrated:
- measured growth in key market segments;
- positive jaws;
- an improved capital ratio;
- steady ROE across the half year; and
- stabilization of the business lending interest margin.
Back to basics starting to work at NAB
NAB reported cash earnings for the year of $6.48bn, which was up $261m (or 4.2%) on 2015. Cash earnings in the second half of $3.26 bn were up $43m on the first half. This reflected a fall in operating expenses, offset by a higher charge for bad and doubtful debts.
Financial highlights included very marginally positive jaws (income grew at 2.5%, a higher rate than expenses growth of 2.2%), the banking cost to income ratio declining from 41.6% in the first half to 41.2% in the second half, and a steady ROE across both halves of 14.3%.
From a business perspective, highlights included a pick-up in mortgage lending, which is now growing ahead of system, stabilization of the lending margin in business banking, a 13% increase in earnings from NAB Wealth, and an increase in Net Promoter Score in what NAB calls its priority segments – Mortgage Customers, Debt Free (investors), Micro Business, Small Business and Medium Business. With risk weighted assets growing across the Group in the year at just 1.3%, NAB is in effect switching out of lower returning sectors such as institutional and major corporate.
On the credit side, NAB added an extra $100m overlay as a top up to its collective provision. It said that conditions were improving with NZ dairy, and addressing concerns about exposures to property developers, provided details of its residential development exposure of $6.6bn. Of this, almost 59% is concentrated in NSW and less than 20% is classified as being associated with higher risk inner city postcodes.
NAB’s capital ratio stood at 9.77%, well above its current operating target range of 8.75% to 9.25%, and in reasonable shape to cope with potential regulatory changes.
A negative in the result was an increase in the capitalized software balance of $312m to $2,344m ($217m in the second half). While investing is a positive (if it translates to lower operating costs), capitalizing software effectively punts the cost into later years.
Dividend doubts won’t go away
For NAB shareholders, NAB maintained its second half dividend at 99 cents per share, taking the full year dividend to $1.98 per share. This represents a payout ratio of 80.8% for the full year.
NAB justified its payout ratio being above the target ratio of 70% to 75% on the grounds that with risk weighted asset growth being low at 1.3%, ROE steady at 14.3% and a capital ratio above its target range, it could afford to pay the dividend. Further, it also has excess franking credits of $548m.
I think you can read three things into this statement. Firstly, the Board and Management are very keen to maintain the current dividend. Next, as an “ex growth” Australasian retail and business bank, if risk weighted asset growth remains low and ROE holds steady (which NAB could achieve from business mix changes by prioritizing higher return segments and ongoing cost discipline), it will keep the dividend steady. And thirdly, it is really going to be a year-to-year proposition.
While the odds of the dividend remaining at $1.98 in FY17 have improved, the dividend doubters, which include most broker analysts, won’t go away. They will point to the payout ratio being unsustainable, and the inevitable higher capital ratios that banks will require post the implementation of Basel IV.
Following the experience of Basel I, II and III, I have always believed that the full implementation of Basel IV will take a lot longer than first feared and that once national regulators get involved, will be considerably watered down. So far, Basel IV is following these same footsteps. So, while some of the banking analysts will feed the “scare game” to the media, it still has a long, long way to play out. Yes, the banks will need to increases their capital levels, but I am betting they will be able to do most if not all of it organically (as NAB has demonstrated), rather than rush out with a new issue or slash dividend payments.
What the brokers think
None of the major brokers changed their recommendation following NAB’s result. While in the main the commentary was positive, particularly in regards to the capital ratio, and a couple of brokers upgraded their target share price, doubts still remain about the sustainability of the dividend.
NAB is viewed as a pure play Australasian banking operation in a low growth market, facing headwinds on margin, credit and capital. Most analysts forecast zero growth in earnings per share, with the consensus forecast expecting a dividend of 186.1c in FY17 (down from 198c in FY16), and 184.0c in FY18. They have NAB trading on a multiple of 11.8 times FY17 and 11.7 times FY18 earnings.
According to FN Arena, individual recommendations and target prices are as follows:
The consensus target price is $28.70, a 2.8% premium to Friday’s closing price.
Bottom line
On a multiple basis, NAB is now trading back on par with the ANZ, but at a marginal discount to Westpac’s 12.5 times or CBA’s 13.2 times FY17 earnings. While this discount has narrowed over the last 18 months or so, it is also the case that differences between major banks in terms of strategy, capital ratios, return on equity, technology or business execution are less pronounced.
If NAB can continue to pay a dividend of $1.98 per share, it is yielding a staggering 7.1% plus franking credits. If the dividend drops to $1.80 per share, which would be consistent with no growth in earnings per share and a payout ratio dropping back to midrange of the target, the yield is 6.45% plus franking credits.
For income seekers, NAB is a buy. It is unlikely that the market is going to materially re-rate NAB in the short term, so buyers can afford to be a little patient. Buy up to $28.00.
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.