NAB: the Coles Myer of Australian banking

Whenever we see great brands and huge barriers to entry underperforming the market we get interested. Today we are going to explore why The National Australia Bank (NAB) is the Coles Myer of Australian Banking. Our analysis suggests NAB is worth significantly more in parts, with the current holding company model not reflecting the true market value of its asset base and earnings streams.

NAB vs. ASX200 last 5 years. Ouch

NAB’s underperformance versus the benchmark ASX200 index has been accelerating in recent years. This is significant because NAB represents 5.33% of the ASX200 and is the 3rd largest company in Australia. Despite its own huge weighting it has underperformed the index itself by 50% over 5 years. That underperformance has led to Australian institutional investors underweighting the stock to the point now where most domestic institutional investor reports specifically claim to be underweight NAB. Fair enough, that bet has worked, but will it work for the next 5 years with Michael Chaney in the Chairman’s seat?

NAB; could be nabbed

The government could consider allowing one major bank to be acquired and this bank is expected to come from the ranks of ANZ, NAB or WBC. We believe CBA will never be acquired because of its heritage and status as the “People’s Bank”. Of the other majors, NAB appears to have the greatest likelihood of being acquired or broken up. This is due to its various business segments that are considered attractive to a host of investors that include foreign banks and private equity interests. In this respect, we regard NAB as the “Coles Myer” of banking – an investment opportunity where greater value could be unlocked for shareholders by breaking up the bank.

We believe the catalyst for a NAB break up lies in its UK business. We continue to regard this as unsustainable and lacking in scale in a tough banking environment. Higher compliance costs in the EU as it transitions to a single payments environment should add further pressure on the bottom line. We feel the current reshaping of the UK business, including reinvestment in front-line infrastructure, is consistent with window-dressing to ultimately get a good sale price.

The recent ABN AMRO and Sallie Mae deals support the belief that quality banking assets in developed countries remain attractive investments. NAB has surplus capital and standalone offshore operations that are easy to integrate. It also has scale in Australasian banking and wealth management. We examine the attraction of NAB’s operating businesses below.

3,000,000 retail customers, a good place to start

Australian retail bank. The business services over 3m customers through 787 branches and has recently been reinvigorated by a new service and sales culture. Based on significant synergies to be realised from head office and other support functions, we consider the other majors and HBOS as the natural acquirers of NAB’s retail banking business. A merger involving HBOS should form the nucleus of a new major bank.

1,000,000 business and high net worth customers

Australian business bank. This provides deposit, lending and business transaction services to 1m business and high net worth customers. It has the largest share of business lending and deposits in the country, underpinned by a large network of business bankers and 186 centres. We believe this is one of NAB’s crown jewels and, in a break up situation, would be of substantial interest to the other majors, HBOS, Citigroup and GE. NAB’s significant agribusiness exposure (Figure 6) and the 110 rural outlets are considered particularly attractive to Rabobank. Transactional banking is also regarded as one of the more capital efficient segments. NAB’s leadership position in this area (Figure 7) would be a key attraction to banks wishing to capitalise on the new Basel II rules and improve Economic Return (Figure 1).

nabCapital. This involves debt financing, financial risk management and treasury services. We see this business as providing the necessary balance sheet leverage for the likes of MBL, BNB and even CBA.

NAB UK. As discussed earlier, this is considered a major distraction as it lacks scale in a very competitive market. Recent corporate activity in European banking suggests NAB’s UK business could provide substantial synergies to Santander / Abbey, Barclays, HBOS and RBS.

NAB NZ. As the most insignificant of the four major banks in New Zealand, the business unit could be the subject of a trade sale. We believe there are elements of NAB NZ that are potentially of interest to the local offshoots of the major Australian banks and possibly GE.

Wealth management. This incorporates MLC (2m customers and $102bn FUM) and would be primarily attractive to ANZ, the only major in Australia that lacks scale in wealth management.

NAB break up value as high as $53.50

The break up of NAB and realisation of synergies remind us of the implosion method of creating a nuclear explosion. Both seek to maximise yield through process efficiencies. In implosion, charges placed along the outer shell of a hollow plutonium sphere cause the plutonium to collapse to a smaller critical mass and generate a higher yielding explosion. This is sometimes compared to “crushing a can of beer without splattering the contents”. We consider breaking up NAB as a very efficient method to maximise synergies.

This valuation is shown in Table 1 below. We expect surplus capital and synergies to account for a significant proportion of total value. In this illustration, we have assumed a 20% takeover premium plus synergies as a percentage of cost bases as follows: Australian retail and business bank 30%; nabCapital 25%; NAB UK 25%; NAB NZ 30%; wealth management 15%. Including synergies, we expect the PE of the investment proposition to fall to around 15 times. This is considered a very reasonable outcome when compared with current market multiples. While our price target for NAB is $49.00, we feel there is value upside to $53.50 in any competitive tendering process.

As an example of acquiring the most capital efficient business segments in NAB (retail banking and wealth management), we have estimated the impact of the break up on the three majors. While the transaction should be EPS accretive for all the majors, Figure 8 highlights ANZ is best placed to withstand ROE dilution.

The impact on value appears to be the greatest for CBA (Figure 9), due to the scale of CBA’s retail business and scope to extract synergies in middle and back office operations. We expect the proposed transaction could add around $8.00 per share to CBA and $5.00 per share to ANZ following aggressive integration of overlapped operations.

So many options

Michael Chaney would be salivating at the chance to release value at NAB. Anyone who has been to “Wesfarmer’s University” would see the value creating opportunities in the current NAB holding company model. As we wrote on Monday, spin-offs and de-mergers have worked very, very well in Australia, and we see no reason why that won’t be the case going forward. If NAB doesn’t explore these options someone else will do it for them.

If you refer back to our valuation table 1. you can see that we value the NAB UK operations at $5.20 per NAB share using a multiple of 12x. We believe NAB is carrying excess capital of $1.90 per NAB share, while it also holds a massive pool for franking credits ($11.7bil) which equates to $7.10 per NAB share. Wealth Management we value at $5.30 per NAB share using a multiple of 22x for MLC.

It’s not hard to see ways of returning tax-effective capital to long-suffering NAB shareholders while concurrently releasing value from within the model. The UK operations should be sold to the highest bidder (then NAB can return to paying 100% fully franked dividends), MLC should be spun-off with NAB holding 51% and the surplus capital should be returned as a giant fully franked special dividend (forget the buyback route). Do all this and the stock will be above $50.00 organically and you will have defended yourself from predators.

$66bil and undervalued

It’s not often that you can write that a $66bil enterprise is undervalued, but there should be no doubt that the market is currently pricing NAB using the rear-vision mirror and no financial imagination. Interestingly it appears investors were looking at Dutch giant ABN Amro in a similar way before agitator funds turned up on the register and put the stock in play. ABN was trading 19.00 Euros and the bidding process went to 38.00 Euros. The corporate world believes ABN is worth 100% more than the market did.

It is not beyond the realms of possibility that an agitator fund, or a group of local institutions, moves onto the NAB register and starts demand a new, more dynamic, capital efficient model. That’s the short-term instant upside in NAB, and the “value release trade” is a good one particularly given who is now running this company.

In the interim NAB is a cheap stock on basic earnings based valuation techniques. On fy08 numbers you are paying 14x for an oligopoly with a great domestic brand and branch network, growing EPS by 11%, from an ROE of 20%, and yielding 5%. Today’s multiples more than justify investment in this stock, yet clearly there is huge value to be released via more aggressive structuring.

World-class short squeeze pending in NAB

All the ingredients for outperformance are in place, yet nobody seems to believe outperformance is possible. It’s the old “no catalyst” scenario, but as we always say “no catalyst is the biggest catalyst of all”. The same market didn’t believe Wesfarmers, Telstra, Qantas, or CC Amatil could outperform only a few months ago and their outperformance has been enormous. What did they all have in common? A great brand and heavy share price underperformance. What changed? Management and/or corporate strategy, and suddenly these stocks move from the bottom of the all-important quant ranking screens to the top. When that occurs the share price ramifications are large and instant.

Get in before the rush and make sure NAB is no less than 7% of your portfolio. Trust me; this will be one huge scramble when domestic institutions are given a “catalyst” to cover underweight bets. We recommend buying NAB anywhere under $45.00, taking the 5% yield, and holding on for the value release under Mr. Chaney et al.

Tomorrow we are going to look at another ASX20 stock the market is making a short-sighted mistake with; Brambles (BXB)