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Morningstar | Chairman Elect and Interim CEO Starts the Remediation Process for NAB. FVE AUD 30 Unchanged. See Updated Analyst Note from 11 Mar 2019

Chairman elect and interim CEO Phil Chronican has started the remediation process for wide-moat National Australia Bank. Even though we have confidence in the commitment, skill and capabilities of the new Chairman, the lingering question is, can Chronican and the eventual permanent CEO, deliver on the goal for “NAB to earn trust and build a culture that puts the customer first.” Following the very negative publicity during the Banking Royal Commission, it will take a long time to regain the trust of retail customers and the broader business community. Another complication is the likely change of government at the federal level and a wide range of potentially proconsumer policies that could make business even more challenging over the longer term for National Australia Bank and major bank peers.

National Australia Bank will provide further details of progress made to restoring trust and instilling a culture of putting the customer first when it reports first-half fiscal 2019 results on May 2, 2019. But rebuilding culture, accountability and governance takes time and investors will need to be patient. No changes to our AUD 30 fair value estimate and at current prices, the stock is undervalued trading 15% below our valuation.

Chronican is well regarded and he will do a good job as Chairman, leveraging his banking experience and understanding of the challenges and opportunities facing the group. Chronican’s appointment was announced March 6, 2019 effective “later in 2019.” Previous CEO Andrew Thorburn finished end of February with Chronican taking over March 1, 2019. We are not surprised with Chronican’s appointment as Chairman and we think he will stay in the interim CEO role for most of calendar 2019, before current chief customer officer consumer banking, Mike Baird is promoted to CEO. We think Baird is the likely successor, with his key weakness being a lack of senior management experience at a large and complex commercial bank like National Australia Bank.

Notwithstanding questions around the sustainability of the bank’s high dividend payout ratio, we maintain our forecast fiscal 2019 fully franked dividend of AUD 1.98 per share based on an 86% payout. At current prices, the dividend equates to a high 7.8% yield, grossing to over 11%. We are forecasting a gradual decline in the payout over the next five years due to modest increases in EPS, but the new Chairman, eventual new CEO and refreshed Board may have a different view and a cut to the dividend could occur later this year.

The current high payout can be defended considering tepid loan growth, very benign bad debts and good organic capital generation. We see an orderly path to Australian Prudential Regulation Authority’s “unquestionably strong” 10.5% common equity Tier 1 capital ratio level by January 2020 from the bank’s common equity Tier 1 ratio of 10.0% at March 31, 2019. But longer term, the payout ratio must decline below 80% by either higher profits or lower dividends, or a combination of both. Our base case is for higher profitability to reduce the payout to 79% by end fiscal 2023.

Chronican needs to ensure the bank remedies the large gap between customer expectations and bank behaviour. Governance, ethics, culture, product suitability and service delivery need to improve to rebuild customer trust. Not surprisingly, National Australia Bank is focused on fixing the issues that caused its failures and “paying back customers who are owed compensation as soon as possible.” During the past nine months, the bank has returned more than AUD 110 million to more than 310,000 customers.

The board has established a special committee chaired by Director Ann Sherry to manage the selection of the Group CEO role. Interim CEO Chronican has moved quickly, communicating directly with shareholders and started the refresh of senior executives. Early indications suggest no major change in strategy, but the new CEO requires greater accountability and focus from the bank’s leaders. The proposed sell-off/demerger of the MLC wealth business will be an early test for the new Chairman and refreshed board of directors.