Jonathan Wilson

Written by Jonathan Wilson, Analyst, StocksInValue

Original article first published in StocksInValue

National Australia Bank, NAB.AX (See our valuation) delivered a messy but overall reasonable FY15 result highlighting strong progress on its strategy to divest its underperforming businesses which will help to close the profitability gap with the other majors.
Cash earnings of $6.7bn (excluding ‘specified items’, of which the majority is related to UK provisions) or $5.8bn (including specified items) were either side of consensus of $6.3bn. Underlying earnings increased 2.5%.
Net interest income grew 4.2% driven by asset growth of 6.5%, which was partially offset by 4bps reduction in the net interest margin (NIM) to 1.85% largely due to strong competition for business lending. Industry NIM’s should expand this half after the majors announced out-of-cycle increases in interest rates on loans this month.
Non-interest income grew 4.5% assisted by improved earnings from insurance businesses. Higher expenses (excluding specified items) reflected the increased technology spending and restructuring costs, while impairments down 5% to $823m reflected improved asset quality.
Our view is NAB is the best-placed major bank in the increasingly challenging Australian banking environment. The divestments will offset some of the pressure on ROE from increased regulatory capital requirements, slowing economic growth, peaking residential mortgage lending and ongoing pressure on interest margins.
As expected NAB announced the sale of its Life Insurance business, which involves splitting MLC into the Life business and Investment business and selling 80% of MLC to Nippon Life Insurance (Japan) for $3bn ($2.4bn after transaction and restructuring costs). As part of the deal NAB has agreed to a 20 year distribution agreement to sell products through the newly created Investments/Superannuation business.
The divestment is positive for value though NAB will incur a $1.1bn loss when the transaction settles in the second half of 2016. The $3bn price at 19 times FY15 normalised earnings of $160m was generous given the Life business was generating only single digit returns on capital. NAB will keep full ownership of the closer-to-customer and higher-returning superannuation, investments and wealth advice businesses within NAB Wealth, which is expected to increase NAB Wealth ROE from 6.9% to 9.4%. The sale proceeds will increase regulatory capital by ~50pbs.
NAB also announced the UK assets (CYBG PLC) will be spun-out in February next year, a slight extension on the end of year target. As per the March announcement approximately 75% of CYBG will be demerged to NAB shareholders, with the balance to be sold via IPO with a primary listing on the LSE and CDI listed on the ASX. A negative was the additional provisions for protection insurance (PPI) of $704m and interest Rate hedging products of $135m. The additional provisions were flagged at the quarterly trading update however quantum was not specified.
The CET1 ratio was 10.2% as at 30 September, up 137bps on 1H mainly due to the $5.5bn rights issue in March. Accounting for APRA’s mortgage risk weight increase (announced in July), the Life Insurance sale, and the CYBG demerger September 30 proforma CET1 is 9.4%, closer to NAB’s 8.75% to 9.25% target range. With APRA indicating the major banks would need to increase their risk-adjusted Tier 1 ratios above 10% to achieve a desired ‘strong’ capital assessment by S&P, and with the Basel Committee likely to recommend higher capital requirements after meeting in the first week of December, we expect NAB will need ~$2bn additional capital to meet requirements. We assume this will be funded via the dividend reinvestment plan.
NAB has now moved on all of the low-returning assets planned for demerger. After the UK demerger and IPO, sale of 80% of life insurance, Great Western Bank divestment, life reinsurance transaction, and the UK CRE and SGA portfolio reduction NAB will be a cleaner bank focused on its strong position in Australia and New Zealand. NAB expects the strategy will boost group ROE by at least 200bps, and group profitability will largely reflect the core Australian and New Zealand banking franchise, which generated 14.7% ROE in FY15.
Loan impairment expenses, which can be a large swing factor in bank earnings, are at historic lows across the sector due to strong credit quality supported by low interest rates. NAB’s FY15 impairment charges were down another 5bps to 0.16% of total loans, and provisions at 0.37% of total assets, are well below historical averages (since 1990), which are impairments as a % of loans of ~0.52% and provisions as a % of total assets of ~0.76% though this partly reflects a mix shift in asset type from business to residential loans.
The trend of declining provisions will likely reverse in coming results, which could dampen earnings, though we expect no more than a modest normalisation of loan impairment charges across the banking sector over the near term. Near term credit quality is supported by improved debt-servicing capacity from lower lending rates, low corporate gearing, and support for asset prices from global liquidity.
Over the medium term profitability is likely to come under pressure from higher bond yields leading to increased lending rates, slower credit growth, and higher impairments. Bond yields at low levels also support share prices of large-cap, high yielding stocks. A reversion in yields from currently low levels adds near term price risk, as these stocks will appear less attractive.
For now we think NAB should achieve mid-single digit earnings growth consistent with below-trend economic growth and benign credit quality conditions.

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