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NAB fit enough to see out near-term ugliness

Emma Rapaport  |  28 Apr 2020Text size  Decrease  Increase  |  
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NAB remains undervalued despite a 51 per cent slump in half-year profits, a cut to its dividend and a $3.5 billion capital raising it hopes will insulate it against the downturn, says Morningstar analyst Nathan Zaia.

Zaia says even with the earnings slump and additional shares accounted for in his model, his $25 per share fair value is unchanged. At last close, the shares are trading at a 37 per cent discount to fair value.

"We continue to believe the bank is materially undervalued, with the market overly focused on near-term earnings," he says in a research note published yesterday in which he discusses whether investors should take up NAB's entitlement offer.

NAB (ASX: NAB) surprised the market on Monday morning announcing its half-year results almost a fortnight early. Cash profit fell 24 per cent to $2.5 billion. Profit was just $1.5 billion if including the previously announced customer remediations and software capitalisation expenses.

Zaia says the fall in underlying profit was largely due to the $691 million jump in loan impairment expenses to $1.2 billion. This increases loan impairments to 0.38 per cent of gross loans from 0.23 per cent in first half fiscal 2019. Loan impairments in the half include a collective provision of $828 million to reflect the potential coronavirus impacts.

The bank has also slashed its interim dividend to shareholders by 64 per cent to 30 cents, reflecting a payout ratio of 35 per cent.

"Our 1H20 result has been materially impacted by the COVID-19 pandemic, with cash earnings (ex large notable items) declining 24.6 per cent relative to 1H19, driven by higher credit impairment charges and mark-to-market losses on our high quality liquids portfolio within Markets and Treasury," the company said in statement to the ASX on Monday.

The dividend cut comes even after the prudential regulator APRA this month advised the banks to suspend their payments until there was more economic certainty. New NAB chief executive Ross McEwan said the decision to pay a dividend was a balancing act that recognised the bank's retail shareholders.

"(About) 48 per cent of shareholders do rely on a dividend ... at the time of a placement you don't want the share price dragged down," he said.

Zaia says the dividend was higher than he expected and he now forecasts a full-year dividend of 60 cents per share.

Fresh capital

NAB is now looking to remove uncertainty around its capital through a $3.5 billion capital raising and boost its pro forma common equity Tier 1 ratio from 10.4 per cent to 11.2 per cent. This is the amount the regulator APRA requires banks to hold in its reserves.

Zaia notes that while APRA has signalled its comfort with the ratio falling below unquestionably strong, commentary from NAB management suggests it is not comfortable with its capital position falling below 9.5 per cent—hence the dividend cut and capital raise. Zaia believes this capital raise will be enough to get the bank through even a severe downturn.

The raise includes a fully underwritten institutional placement of $3 billion. The placement will result in approximately 212 million new shares being issued, representing 7.1 per cent of NAB's existing ordinary shares on issue. Another $500 million will be sought via a non-underwritten share purchase plan.

McEwan said the bank was taking proactive steps to shore up its books as the nation faces a possible "prolonged and severe economic downturn".

"We entered this challenging period in a robust position, with capital, funding and liquidity significantly strengthened over recent years," the company said. "However, given the uncertain outlook, we have taken proactive steps to further strengthen our balance sheet."

MORE ON THIS TOPIC: Caution urged on corona capital raising

Zaia says there were some positives in the NAB result. "We liked that net interest were held flat at 1.78 per cent, operating expenses ex-large notable items were only 0.4 per cent higher, and loan balance increased by 2 per cent."

He is also pleased that management foresees no elevated annual investment to achieve its new long-term strategy.

NAB's share price closed up $15.76 when the market closed on Friday. Shares have been suspended from trading. Its rivals' losses worsened by Monday's close. ANZ (ASX: ANZ) dropped 2.3 per cent to $15.65 and Westpac (ASX: WBC) fell 4.4 per cent to $14.66. CBA (ASX: CBA) shares were flat at $58.88.

More banks to follow suit

Zaia reduced Morningstar's valuations across all the major banks by up to 7 per cent on Friday after factoring in higher loan losses and small equity raisings via dividend reinvestment plans.

He expects earnings and dividends to be under pressure in the near term and has increased the uncertainty ratings increase for all four traditional Australian banks to high from medium owing to the increased uncertainty around the economic outlook. 

Despite this, the banks still trade at substantial discounts to their fair value estimates.

"Uncertainty is elevated and unprecedented events are unfolding," he says. "But with Australian bank share prices down about 40 per cent since late February, those risks are in the price and bank shares are cheap in our view,” Zaia says.

"Our confidence in estimating loan losses and asset growth in the short term has reduced, with major implications for earnings, dividends, and capital adequacy. However, after revisiting our forecasts to incorporate a wider range of outcomes, and more near-term downside, we maintain our positive view."

banks table

Source: Monrningstar Direct. Data provided at April 27, 2020.

Zaia expects all banks will need to materially reduce their dividends, with payout ratios expected to average 50 per cent in fiscal 2020, with dividends falling by around 60 per cent to 70 per cent on last year. However, he expects earnings and payout ratios to improve by 2022, culminating in a solid rebound in dividends across the banks.

He says it’s likely the banks will postpone the payment of their interim dividends, instead declaring a single dividend in November. “This is dependent on how the next six months unfolds as social distancing restrictions are eased."

Even with materially lower dividends, the major banks, excluding Commonwealth Bank, will need to strengthen their capital positions, Zaia says

"Repayments of existing mortgages will slow, and commercial loans—which also require more capital be held against them—are expected to rise as businesses draw down on debt facilities," he says.

"Changes to expected credit losses will also mean an increase in capital required to be held against the loan exposure.

"Our base case assumes ANZ Bank and Westpac each raise $3.5 billion to $4 billion of new equity in the next two years to maintain capital ratios close to the unquestionably strong benchmark."

Read Nathan Zaia’s full report on the big four banks: Australian banks undervalued amid economic turmoil, 24 April 2020.

Read Nathan Zaia’s analyst note on the National Australia Bank, 27 April 2020: Corporate action: take-up NAB's entitlement offer, FVE unchanged despite earnings slump.

is an editor for Morningstar.com.au

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