ASX code: NAB
Share price: $26.34
Industry: Banking & Investment Services
Forecast FY2017 Dividend: 198.0 cents fully franked
National Australia Bank is our preferred major bank because it has the highest dividend yield and the most leverage to business lending of the four majors. We forecast a 7.5 per cent fully franked yield for 2017 and at $26.34 the stock trades at a 17 per cent discount to our 2017 valuation of $31.75.
The undervaluation demands attention because our valuation is deliberately conservative. That’s a safe place to be at this difficult time in the banking cycle, when bad debts expense is gradually rising from post-GFC lows and interest margins are under pressure from price competition in mortgages and deposits.
To be conservative our valuation uses earnings forecasts five to 10 per cent below market consensus depending on the year and we assume a one-for-30 rights issue at $24 next year. The Basel Process issues its next guidance on bank regulatory capital levels late in 2016 and we predict Australia’s bank regulator APRA will then require banks to raise more capital sooner, through entitlement offers and rights issues, rather than gradually through dividend reinvestment plans. So valuations should allow for this.
Some might say NAB trades on the highest dividend yield of the majors because it is the most likely to cut its ordinary dividend now ANZ has already moved. We agree NAB’s dividend payout ratio is too high at 80 per cent and capital accumulation via retained earnings is too slow but think this bank, and others, will hold ordinary dividends steady unless earnings fall sharply. The pressure on bank boards from income investors to sustain ordinary dividends at current levels is overwhelming and banks can inexpensively top up regulatory capital by issuing more hybrids. Last week NAB launched its latest hybrid offer, the Capital Notes 2. If Westpac’s recent Capital Notes 4 offer is any guide – the offer was increased in response to strong demand – NAB’s new hybrids will fly out the door.
We also observe a close, matey relationship between banks and their investment bankers/brokers in which bank boards are succumbing to pressure to issue more hybrids through the brokers – which then earn fees – rather than cut ordinary dividends.
We’ve consistently argued business lending would outperform home mortgage lending, and the data support our view. In April, according to Reserve Bank data, growth in bank lending to businesses surged to 7.4 per cent, its fastest rate for seven years. Housing credit growth was a respectable 7.0 per cent but was off its recent 7.5 per cent peak. This makes NAB more attractive to investors because the bank has the highest exposure to business lending, 38 per cent of total loans, of the three domestically oriented major banks. In the recent first half 2016 result, bad and doubtful debt charges in NAB’s business lending book remained very low at 0.18% of total loans despite impairments against large single names, and leading indicators of business asset quality were benign.
NAB also now has a clean, settled exposure to Australian and New Zealand banking after exiting the UK. There is no more turnaround work to do and management can concentrate on optimising financial performance in the core businesses. NAB trades on 1.4 times book value, which is cheaper than Commonwealth Bank on 2.2 times and Westpac on 1.7 times. ANZ is the cheapest on 1.2 times but a long workout/turnaround looms ahead. Given NAB’s superior dividend yield, the stock is relatively compelling.
Written by David Walker, Senior Analyst.
Clime Asset Management owns shares in NAB for and on behalf of various mandates for which it acts as investment manager. David Walker owns shares in NAB.