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Morningstar | NAB’s Customer Remediation Costs Continue to Mount. FVE AUD 30 Unchanged

Wide-moat National Australia Bank announced additional customer remediation costs of AUD 749 million pretax, or 525 million aftertax. The increased aftertax costs are split between continuing operations of AUD 325 million and AUD 200 million from discontinued operations. We expected an announcement on customer remediation costs before the early May interim results, but did not expect such a large amount. Despite the surprise, our AUD 30 fair value estimate is unchanged, with the stock undervalued, trading 15% below our valuation.

Prior to the remediation announcement, our fiscal 2019 payout ratio forecast was 86% declining to 82% in fiscal 2020. Normally, we would look through large one-off profit adjustments when assessing future dividends, but National Australia Bank currently has an unsustainably high payout and will have a new Chairman and a new CEO later this year. Consequently, we think the substantially higher remediation costs will likely prompt the refreshed board to reduce dividends, starting with the interim dividend for fiscal 2019.

Our full-year cash earnings forecast decreases to AUD 6.24 billion from AUD 6.56 billion previously. We cut our full-year forecast dividend to AUD 1.80 per share based on an 82% payout. We expect the interim dividend to be around AUD 90 cents per share. Despite the cut in our forecast, the fiscal 2019 fully franked dividend yield is still a high 7%. Prior to the announcement, consensus estimates for fiscal 2019 were AUD 6.5 billion for full-year fiscal 2019. First-half fiscal 2019 results are scheduled for release on May 2, 2019 and our earnings estimates decreases to AUD 2.95 billion from AUD 3.28 billion previously.

Dividend sustainability has long been a concern for National Australia Bank shareholders with the fiscal 2018 payout ratio a very high 90% based on cash earnings. Excluding fiscal 2018 restructuring and customer remediation costs, the payout was 83% and 74% after dividend reinvestment plan participation.

Despite the large first-half fiscal 2019 customer remediation provision, there is potential for additional provisions in fiscal 2020. We take the opportunity to reduce our fiscal 2020 cash earnings forecast by AUD 300 million after tax to allow for additional remediation costs. Our fiscal 2020 cash earnings forecast decreases to AUD 6.6 billion from AUD 6.9 billion previously. Earnings forecasts for outer years are broadly unchanged.

While interim CEO Phil Chronican has taken the opportunity to fully provide for potential costs, the underlying issues are complex, time consuming and very expensive to resolve. We therefore think more problems could surface and we have increased our forecast cost assumptions by AUD 300 million aftertax in fiscal 2020. The bank currently has around 350 people working on the remediation program and will soon increase the team to approximately 500 people. Approximately 91% of the AUD 749 million pretax provision is due to wealth-related issues with the remainder in banking.

The provision includes increased costs for customer related remediation for consumer credit insurance sales, non-compliant wealth advice, advisor service fees charged by salaried advisors and self-employed advisors and incorrectly charged fees on certain fee exempt banking transactions. The AUD 200 million in provisions for discontinued operations related to the group’s life insurance business sold to Nippon Life in fiscal 2016.

In addition to provisions raised in second half fiscal 2018, the latest provisions bring total unutilised remediation cost provisions to AUD 1.1 billion pretax. National Australia Bank’s announcement follows Westpac Banking Corporation’s AUD 260 million increase in provisions for customer payments and customer remediation provisions released in late March. To date, Westpac has provided a total of AUD 659 million in customer related provisions.

National Australia Bank confirmed guidance for broadly flat operating expenses in fiscal 2019 excluding the remediation provision.

The bank’s common equity Tier 1 ratio was 10% at Dec. 31, 2018 and we are confident the bank will achieve Australia Prudential Regulation Authority’s 10.5% benchmark by the January 2020 deadline. But a modest cut in the dividend would benefit the orderly progression to meeting the regulatory benchmark.