It was always going to be a weak result, and wide-moat-rated National Australia Bank (ASX: NAB) reported first-half cash profit down 24% to AUD 2.5 billion on second-half fiscal 2019. Profit was just AUD 1.5 billion if including the previously announced customer remediation and software capitalisation expenses. The fall in underlying profit was largely attributable to the AUD 691 million jump in loan impairment expenses to AUD 1.2 billion, which increases loan impairments to 0.38% of gross loans from 0.23% in first half fiscal 2019. While lower than our 0.5% forecast for the full year, we believe it is premature to lower our loss forecasts given the damage to the economy and certain sectors is far from certain. Loan impairments in the half includes a collective provision of AUD 828 million to reflect the potential coronavirus impacts.

Despite being down 64%, the bank's interim AUD 30 cent per share dividend was higher than we expected. The bank opted to pay AUD 850 million to shareholders after removing the uncertainty around capital through a AUD 3 billion institutional placement and AUD 500 million share purchase plan, or SPP. The bank's pro forma common equity Tier 1 ratio increases to 11.2% from 10.4% as at March 2020. With the additional shares already accounted for in our model, our AUD 25 per share fair value estimate is unchanged. We continue to believe the bank is materially undervalued, with the market overly focused on near-term earnings.

Given the raising price is at the lower of AUD 14.15 per share or a 2% discount to the five-day average share price to the SPP close date, and a substantial discount to our fair value, and we recommend shareholders participate. Investors should consider both their overall exposure to National Australia Bank and the sector more broadly though, with it looking increasingly likely other banks will offer discounted raisings.

It can be easy to overlook the positives given the headline numbers, but we liked the net interest margins were held flat at 1.78%, operating expenses ex-large notable items were only 0.4% higher, and loan balances increased by 2%. CEO Ross McEwan is not proposing a revolutionary new strategy, but wants the bank to be simpler, digital enabled, and relationship led. It all comes down to execution, and pleasingly he does not foresee an elevated annual investment to achieve his plans.

Last week we updated our forecasts and fair value estimate for National Australia Bank, Westpac, and ANZ Bank, assuming would each need to raise AUD 3.5 to AUD 4.0 billion of new equity in the next two years to maintain capital ratios close to the unquestionably strong benchmark over the next-three years. This in addition to lowering the dividend payout ratio to 50% of actual cash profit. We viewed this as necessary as higher credit losses and risk weighted asset increases are expected to weaken the bank’s capital position over the next 12 to 24 months. National Australia Bank today advised that based on its modelling of a severe downside scenario higher credit risk weights could detract 1.8% from the bank’s common equity Tier 1 ratio.

National Australia Bank’s common equity Tier 1 ratio was 10.4% as at March 30, 2020. While APRA has highlighted its comfort with the ratio falling below unquestionably strong, commentary from management today suggests it’s not comfortable with its capital position falling below 9.5%, hence the dividend cut and capital raise to restore a healthy buffer. We believe the capital raising today will be enough to get the bank through even its severe downside scenario. The bank's severe downside scenario assumes negative GDP growth of 3% and 2.5% in fiscal 2020 and 2021, and a cumulative fall in house prices of 30%. The increase in credit risk-weighted assets under this scenario would push the bank's common equity Tier 1 down to 9.5%, but this is before any organic capital generation. In this severe scenario, the bank estimates its excepted credit loss provisions would be around AUD 3.8 billion versus the AUD 0.8 billion taken today. And given these losses would be taken over a number of years, the bank would remain profitable over the period. Our assumption the bank would opt for underwritten dividend reinvestment plans over an equity raising was to allow the bank to gradually increase capital as required and as clarity on economic conditions emerged. Timing around the easing of restrictions and the potential for a second wave will likely have material implications for the economic outlook. The bank raising capital once the worst of the economic downturn was behind us, would likely mean capital could be raised at higher share prices compared with today.

Net interest margins fell 1 basis point from second-half fiscal 2019 to 1.78% in first-half fiscal 2020, with the full impact of lower cash rates guided to be a 5-basis point headwind in the second half. A sharp fall in wholesale borrowing costs, and mix shift between at-call deposits from term deposits should provide some margin relief, but we expect this to be offset by growth in lower margin institutional loans. We have increased our fiscal 2020 NIM forecast by 5 basis points to 1.75% but still expect a further fall into fiscal 2021 to around 1.65%.

The housing loan book increased less than 1% to AUD 346 billion in the first half, and with appetite for new loans currently stalled, we expect a similar second half result. Non-housing loans increased 5.1% to AUD 268 billion, with management guiding for business lending to grow 13% to 16% for the full year. Management expects the majority of loan growth will be drawdowns of existing loans, particularly from larger clients. With capital already held against these undrawn loans, our concern it would drive a sharp rise in risk weighted assets and hence capital requirements, is somewhat alleviated. Larger loan balances will support growth in net interest income, but over the short-term, rising loan losses are more than negating the benefit to the bottom-line.

Our full-year profit forecast of AUD 3 billion is largely unchanged and assumes a similar second-half performance. The AUD 1 billion software capitalisation expense will not reoccur, but we have allowed AUD 750 million for potential penalties from AUSTRAC and ASIC. Resolution of both matters may be delayed given priority has been given to coronavirus responses.

The bank paying an interim dividend has removed the fear of dividends being skipped for now, with the first half dividend on a payout ratio of 35% excluding one-off items, or a 61% payout ratio including. We have increased our dividend forecast for the full year to AUD 60 cents per share from AUD 45 cents per share previously, which assumes a payout ratio of 66% versus 50% previously. We are not confident this is the new rebased levels of dividends though, with higher penalties and loan losses capable of forcing the bank to lower dividends again. The additional AUD 15 cents per share in dividends amounts to AUD 400 million, over 10% of the funds being raised today.