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Morningstar | No Major Surprises in NAB's 3Q18 Trading Update. AUD 32 FVE Unchanged

Wide-moat-rated National Australia Bank’s unaudited cash profit of AUD 1.65 billion for third-quarter fiscal 2018 was broadly in line with our expectations, coming in 1% lower than the average of the two previous quarters and 3% lower than a year ago. Profits fell due to higher operating expenses, softer net interest margins, or NIMs, and modestly higher bad debts. There was nothing in the update that would change our long-term positive and our AUD 32 fair value estimate is unchanged. Our fiscal 2018 cash profit forecast of AUD 6.45 billion and total fully franked dividend of AUD 1.98 per share is intact. At current levels, the stock is undervalued trading 12% below our valuation.

We exclude the previously announced AUD 755 million pretax restructuring charge from our cash NPAT forecast, but if included, our forecast declines to approximately AUD 5.9 billion, broadly in line with consensus estimates. Dividend consensus is AUD 1.98 per share. We cannot ignore the serious consequences and fallout from the Royal Commission, but fundamentally National Australia Bank, and major bank peers, remain in good shape and in the long term will produce solid profit growth broadly in line with growth in the economy. Earnings are expected to decline in fiscal 2018. The bank has moved ahead of likely Royal Commission recommendations with previously announced plans to dispose of the MLC wealth business before December 2019.

Our fiscal 2018 forecast dividend payout ratio is a high 85%, but strong asset quality, modest loan growth and a benign outlook support the high payout. We forecast the payout ratio to trend lower but remain above the bank's medium-term target of 70-75% of cash earnings. The stock is currently trading at an attractive dividend yield of 7%, or 10% on a grossed-up basis. Loan growth and NIMs were unspecified, but revenue increased 1% on the average of the two previous quarters on the back of good growth in SME lending within business and private banking.

A strong performance from New Zealand operations supported modest revenue growth. Credit risk weighted assets increased 2% in the three months ended June 30, 2018 to AUD 395 billion. Modest business momentum continues.

NIMs declined slightly due to elevated short-term wholesale funding costs and ongoing intense competition in the home lending segment, particularly for residential owner-occupier loans. Lower margins were expected considering elevated 90-day bank bill swap, or BBSW, rate to the overnight indexed swap rate, or OIS, spread during the past six months. Peer Commonwealth Bank of Australia reported a two-basis point decline in margins to 2.14% for the six months ended June 30, 2018. National Australia Bank's NIM for the six months ended March 31, 2018 was 1.87% and we maintain our full-year forecast at the same level.

As expected, expenses increased 3% due to higher compliance costs, investment spend, and increased depreciation and amortisation. We are forecasting negative "jaws" for fiscal 2018 with expenses expected to increase at a greater rate than income delivering an increase, or deterioration, in the forecast cost/income ratio to 45.5% from 42.7% in fiscal 2017.

Guidance for additional regulatory and compliance provisions in second-half fiscal 2018 come as no surprise; however, the quantum is uncertain at this stage. The bank confirmed the additional provisions will be excluded from expense growth guidance of 5%-8% for fiscal 2018. Our fiscal 2018 expense growth rate forecast of 7% is unchanged. Despite the sharp increase in fiscal 2018 expense, previous guidance calls for expense growth to be broadly flat during fiscal 2019 and 2020. Investment spend is expected to reach a cumulative AUD 1.5 billion by end fiscal 2020. The additional investment spend and the AUD 775 million in pretax restructuring charges are expected to deliver annual cost savings of more than AUD 1 billion by end fiscal 2020.

Balance sheet and asset quality remain strong. The quarterly loan loss charge increased 9% to a still very low AUD 203 million, including a AUD 25 million charge for additional collective provisions for forward-looking adjustments. The year-to-date annualised loan loss rate of 0.13% is in line with our full-year forecast and there's no need to adjust our AUD 767 million bad debt expense forecast. National Australia Bank continues to impress with historically low bad debts. The ratio of 90 plus days loan arrears and impaired assets, or nonperforming loan ratio, remains at a sector-low 0.71%, which is a steady improvement from 0.90% at Dec. 31, 2016. This is a very creditable outcome considering widespread concern of financially stressed households. Credit quality remained outstanding and a healthy Australian economy bodes well for fiscal 2019 and 2020. Furthermore, we believe the major banks have maintained reasonably strong lending standards in the current cycle--especially in consumer portfolios. Longer term, we forecast the loss rate to steadily increase to 0.21% by end fiscal 2022.

Despite the seasonal fall in the common equity Tier 1 ratio in the quarter, capital levels are sound. The common equity Tier 1 capital ratio decreased 50 basis points to 9.7% at June 30 due to the impact of the interim dividend of 0.63%, net of DRP, and seasonally stronger loan growth. The bank remains well placed to meet Australian Prudential Regulation Authority's, or APRA's "unquestionably strong" benchmark capital ratio of 10.5% by January 2020. A steady and orderly build up in capital is expected during the next 18 months at least. If needed, applying a DRP discount to one or two dividends should enable the bank to reach the APRA target. If needed, future dividends could be underwritten to raise the additional capital. Australia and New Zealand Banking Group reported a very strong common equity Tier 1 ratio of 11.1% at June 30, comfortably higher than Commonwealth Bank's pro forma 10.7%.

Longer term, we maintain our average annualised loan growth of approximately 4%, average loan losses around 0.18%, an average cost/income ratio approximately 43%, a solid return on equity about 14%, and a common equity Tier 1 ratio around 10.5%. Despite our forecast for negative EPS growth of 3.2% in fiscal 2018, we expect cost savings and good business momentum to boost future EPS growth to an annual average of 3.8% for fiscal 2019-2022. Our earnings forecasts are based on continued growth in the Australian and New Zealand economies and National Australia Bank leveraging its strong market position in business banking.

These expected outcomes, particularly the return on equity, underpin our long-term positive view. Going forward, we continue to forecast a resilient Australian economy with GDP growth in the 2.5%-3.0% range. Based on APRA's monthly banking statistics, National Australia Bank grew its Australian home loan book 5.3% for the 12 months to June 2018, in line with system growth. The bank's household deposits increased 5.5% for the same period modestly below system growth of 5.7%.