EUR 850.00 For Business Accounts Only

Morningstar | NAB Cuts Dividend More Than Expected, But a Good Long-Term Decision. FVE AUD 30 Unchanged. See Updated Analyst Note from 01 May 2019

Wide-moat National Australia Bank’s first half fiscal 2019 cash earnings of AUD 3 billion mildly disappointed, falling 5% below our forecast. The interim dividend was cut more than expected to AUD 83 cents per share. The 16% cut in dividend to a more sustainable payout is a good long-term initiative, providing greater flexibility to deal with potential future earnings volatility, regulatory changes and unexpected increases in customer remediation costs. Despite the profit miss, the bank is coping reasonably well with a wide range of challenges, including the departure of the CEO and announced retirement of the chairman. Business volume growth is good and bad debts remain around historical lows despite increasing modestly.

The process of restoring trust and building a culture of putting the customer first has started, but it is a long-term journey. Rebuilding culture, accountability and governance takes time. No changes to our AUD 30 fair value estimate and at current prices, the stock is undervalued trading 15% below our valuation.

The transformation project is on track and we expect a new CEO to be appointed before December. The proposed sell-off/demerger of the MLC wealth business in 2020 will be an early test for the new Chairman, refreshed board of directors and new CEO. We expect a period of stability under acting CEO Phil Chronican, who has broad-based experience across the Australian banking sector.

The interim cash profit from continuing operations includes an announced AUD 325 million of customer remediation charges. Excluding the provision, the adjusted cash profit is a more respectable AUD 3.3 billion. Our fiscal 2019 cash earnings forecast of AUD 6.2 billion is broadly unchanged, but we adjust for higher bad debts, lower net interest margins, and lower operating expenses. Our total dividend forecast is reduced to AUD 1.66 per share from AUD 1.80 previously. We expected a 9% cut to the interim dividend and were surprised with the 16% reduction.

The bank’s payout has been unsustainably high. The rebased interim dividend equates to an 80% payout of diluted cash earnings. Our total dividend forecast payout for fiscal 2019 is 78% and we expect the payout to gradually decline to 73% over the next five years. At current prices, the reduced fiscal 2019 dividend forecast equates to a still respectable 6.5% yield, grossing to over 9%.

As expected, balance sheet settings remain sound with good asset quality, and funding, leverage and liquidity levels comfortably above regulatory minimums. The common equity Tier 1 capital ratio of 10.4% is close to the regulator’s January 2020 benchmark of 10.5%, and the cut in dividend and partial underwrite of the dividend reinvestment plan, or DRP, will ensure an orderly transition to satisfy Australian Prudential Regulation Authority’s capital requirement by January. The DRP is expected to raise about AUD 1.8 billion or 0.45% in new common equity Tier 1 capital. All other things equal, the lower dividend payout will enable the bank to generate organic capital on a more sustainable basis--a good outcome for shareholders.

Key operating challenges to earnings growth include pressure on net interest margins and modest increases in loan losses. Despite slowing credit growth across the system, National Australia Bank’s loan growth continues at a reasonable pace with total loan balances up 5% year on year in the half. Home loan balances increased respectable 4% on the previous corresponding period, or pcp, but the growth comes at the cost of lower net interest margins.

Group margins declined to 1.79% for the six months to March 31, 2019, from 1.84% at September 2018, and 1.87% at March 2018. Lending margins accounted for the bulk of the decline as competition remains intense, the bank delayed variable home loan repricing three months to January 2019 and the ongoing switching from higher margin interest only home loans to principal and interest loans.

Despite the increase in home loan arrears rates, loan losses from home loans remain at historical lows around just 0.02%. Group loan losses of AUD 449 million increased 20% on pcp and 10% on the previous period, or pp, but with the loss rate at 0.15% of gross loans and acceptances remain at historically low levels. We increase our fiscal 2019 forecast loan loss rate to 0.16% from 0.15% previously to account for the modest deterioration. The bulk of the increase in group loan losses is due to a small number of SME and corporate exposures.

Excluding the AUD 464 million pretax remediation charge for continuing operations announced in April, expense growth was a modest 1.7% on pcp and declined 2% on pp with the bank confirming its broadly flat expense target for fiscal 2019 and fiscal 2020 compared with the adjusted baseline AUD 8.1 billion reported for fiscal 2018.

The transformation project delivered approximately AUD 122 million in productivity savings in first-half fiscal 2019 following AUD 320 million in fiscal 2018. Since the project commenced in September 2017, the bank has delivered savings of approximately AUD 512 million and is on track to achieve its target of at least AUD 1 billion in savings by the end of fiscal 2020. The path to the bank returning to sustainable and acceptable earnings growth is the expected reduction in operating expenses from the start of fiscal 2021.

Despite the challenges, there is good momentum in the business and private banking division with cash profits broadly stable, with margins up 6 basis points to 1.7% and good lending growth. New Zealand continues to impress on good volume growth, solid margins and tight cost control. The Australian consumer banking and wealth division disappointed with cash earnings down 20% on pcp with net interest margins down 22 basis points to 1.84% and wealth cash earnings down 29% to just AUD 96 million for the half.

The bank’s long-term target to get the return on equity to the top of peer group (currently around 14% for Commonwealth Bank of Australia), took a hit from the significant provision for customer remediation costs. But at 11.7%, including restructuring and remediation costs, the return on equity needs to substantially improve. Excluding the adjustments, the National Australia Bank’s return on equity was 13% at the end March 2019. We expect modest improvements in returns on equity during our five-year forecast period, reaching 13.5% by end fiscal 2023.

The program of customer remediation and reviews continues with the potential for further costs to be recognised in fiscal 2019 and or fiscal 2020, particularly for customer refunds and interest compensation for customers receiving financial advice through the bank’s aligned advisor, or self-employed advisor channel, between 2009 and 2018. During that period, approximately AUD 1.3 billion in fees were paid by customers to the financial advisors.