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Morningstar | No Surprises in NAB’s FY18 Profit, but Earnings Growth Under Pressure. FVE Reduced to AUD 30

The operating environment for all major banks is tough, with legal, regulatory, political and public scrutiny escalating at the same time earnings growth is slowing. The combined effects of a Royal Commission, increasing regulatory oversight, potential change of government, a weakening housing market, slowing credit growth, softer Chinese economic conditions, rising global interest rates, investment market jitters and the escalating debate around culture, governance and trust in the banking sector means the major banks' earnings power is under pressure.

Despite challenging conditions, we see longer-term upside for the major banks. Wide-moat National Australia Bank is at the early stages of major restructuring that will transform the bank into a more competitive and customer-focused business. Significant restructuring work is taking place in fiscal 2019 and fiscal 2020 and we will get a better idea of progress with the release of fiscal 2019 results. Increasing operating challenges results in a 6% cut to our fair value estimate to AUD 30. At current prices, the stock is undervalued, trading 15% below our valuation.

The fiscal 2018 result was messy, but with no nasty surprises. The adjusted AUD 6.2 billion cash profit declined 6% on fiscal 2017 and was broadly in line with our forecast. An unchanged total fully franked dividend of AUD 1.98 per share was in line. The statutory profit of AUD 5.6 billion was 5% higher than fiscal 2017. The dividend payout increased to a high 90% of adjusted cash EPS, and we see the ratio retreating to levels below 80% as EPS increases over time. The payout was 83% in fiscal 2017. Tough conditions in retail banking in Australia will limit revenue growth, however, the bank is well placed to leverage opportunities in its core business and private banking business. Our adjusted cash profit of AUD 6.2 billion includes the AUD 261 million in customer remediation costs but excludes the AUD 530 million in aftertax restructuring costs.

The cash profit of AUD 5.7 billion, including restructuring and customer remediation costs, was 14% down on fiscal 2017 and modestly below consensus estimates. The restructuring costs and customer remediation costs were previously flagged resulting in a large increase in operating expenses with the cost/income ratio increasing to 46% from 43% a year ago. Key earnings drivers and performance measures were soft, but this was expected. Modest growth in lending volumes was offset by a slowdown in customer deposit gathering. Fees and commissions declined 5%, expenses increased sharply and returns on equity declined. The sharp increase in investment spending, accelerated restructuring and customer remediation costs impacted overall performance, but should underpin good earnings growth in future years.

Credit quality again impressed with broadly no change in group loan arrears and a low loss rate of 0.13%, down from 0.14% a year ago. Capital increased modestly with the common equity Tier 1 capital ratio up 0.10% to 10.20%. The final dividend for fiscal 2018 is AUD 99 cents per share with a 1.5% discount offered on the dividend reinvestment plan expected to raise 0.24% in additional capital. The proceeds from the sale of the remaining stake in China Industrial International Trust is expected to generate a further 0.06% in capital in first-half fiscal 2019. The combination of these initiatives plus organic capital generation will see the bank comfortably meet the regulators 10.5% common equity Tier 1 ratio benchmark by the January 2020 deadline.

The MLC Wealth divestment is on track for completion before the end of calendar 2019 subject to market conditions, regulatory and other approvals. The divestment is progressing towards a public market exit via demerger and IPO. The bank retains flexibility to consider a trade sale. Commonwealth Bank of Australia was targeting a public market exit for its Colonial First State Global Asset Management business but instead accepted an attractive offer for the business from a Japanese bank, delivering price and timing certainty. National Australia Bank confirms good progress in work to separate MLC, but we see the process as very complicated and messy and delays will not surprise. An MLC investor briefing is planned prior to May 2019.

As expected net interest margins declined in the second half to 1.84% from 1.87% in the first half. Year-on-year margins were steady at 1.85% and in line with our forecast. This is a pretty good result considering the sharp increase in short-term wholesale funding costs. We disagree with the bank’s decision to not pass on higher funding costs to variable home loan rates, but it does not appear to be a big issue for National Australia Bank compared with major bank peers.

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 an adjusted expense growth of 6.4% in fiscal 2018 this was in line with the 5%-8% guidance range. There is no change to the bank’s target for expenses to be kept flat in fiscal 2019 and fiscal 2020 off an adjusted fiscal 2018 base line of AUD 8.1 billion. Guidance was confirmed for at least AUD 1 billion in annual savings from fiscal 2020. We forecast fiscal 2019 operating expenses to stabilise around fiscal 2018 adjusted levels in line with guidance.

The AUD 360 million in customer remediation costs, announced on Oct. 16, 2018, included refunds and compensation in the wealth business, costs for implanting remediation processes and other charges incurred in regulatory compliance investigations. Costs associated with responding to the Royal Commission are not included in the provision. Disappointingly, the program of customer remediation and reviews continues into 2019 with the potential for further costs to be recognised in fiscal 2019.

Our fiscal 2019 cash profit forecast declines to AUD 6.5 billion from AUD 6.7 billion with similar adjustments to later years. Going into the result consensus estimates from continuing operations for fiscal 2019 cash earnings were AUD 6.64 billion, and dividends of AUD 1.85 per share. Our fiscal 2019 dividend forecast remains at AUD 1.98. At current prices, the fiscal 2018 forecast dividend yield of 8%, grossed up to 11%, provides some valuation support, but negativity around the Royal Commission and an expected tougher regulatory environment continue to weigh on the stock price. The current one-year forward price/earnings ratio of 11 times remains below the five-year average of just under 12 times. Importantly for National Australia Bank shareholders, the balance sheet is strong, asset quality is pristine, net interest margins are stable, loan growth is solid, and execution of strategy is on track. Adjusted return on equity of 13.3% is respectable and we expect modest improvements during our five-year forecast period.