The Income First model portfolio will sell its interest in the demerged component of National Australia Bank at the open price on Tuesday February 9, 2016. The Clydesdale bank (CYB) demerger became effective on February 8, with ASX listed CDIs trading on a deferred settlement basis since February 4. While the operating metrics at CYB have been improving, the overall venture in to the UK has been problematic for NAB, and the demerged entity does not further the portfolio in terms of meeting dividend or capital objectives. It should be noted that there are both tax and cost base consequences for investors to consider when assessing their holding in NAB, and their own approach to the CYB demerger. So, while the portfolio has elected to sell its CYB, individuals should seek further advice if unsure as to the tax or personal implications of the demerger.
What is the demerger?
NAB has longed flagged an intention to exit from its UK exposure, and the demerger of Clydesdale (CYB) is a big step in this strategy. Investors who held NAB shares at the close of trade on February 2 will receive one CDI in the LSE listed CYBG (trading as CYB on the ASX) for every four NAB shares held. Effectively NAB is demerging 75 per cent of the business, and will sell the remaining 25 per cent via an institutional offer. The IPO price for the institutional offer was 180 pence, or around $3.68 per CYB share.
NAB has specified the rationale for the demerger as allowing the business to focus on its Australian and New Zealand operations while separating the capital structure from CYB in order to optimise capital and dividend policies.
Realistically, this is NAB exiting what has been a very unsuccessful attempt to expand geographically. Yes, this is disappointing to long term holders and has probably destroyed investor value when we consider the bigger picture, but it must be put behind us. The core NAB banking business remains healthy, and in our view is likely to be enhanced by this demerger.
Why we're selling CYB
CYB has never been the core reason to invest in NAB. The attraction of NAB is that the company has traded at a substantial discount to its peers as a result of the market pricing in risks associated with the poor operations in the UK. With UK operations now demerged from NAB, the company should have the ability to match peers more closely on financial metrics, meaning there is a chance that the earnings of the business will need to be repriced higher by the market.
Our intention when investing in NAB was to take on the risk of this demerger, but to benefit from any rerating that might occur in the core business when an exit strategy was executed. Given that this has occurred, and we are left with a holding in CYB, the only sensible option at hand for the portfolio is to sell.
On page 100 of the demerger scheme booklet, it is disclosed that the CYB Group’s directors are intending to pay an inaugural dividend for the period ending 30 September 2017, meaning that no dividends are expected between now and then. Even then, the expected payout ratio is to be 50 per cent of earnings, well below NAB’s standing 70-75 per cent payout ratio target range. Given our focus on yield, the holding of CYB is further deemed inappropriate for the income first model portfolio.
Impacts on the income first model: New NAB cost base, and CYB sale proceeds
The demerger has implications for the Income First model’s cost base, lowering the effective cost base when we first invested in NAB. At present, we are awaiting a tax ruling on the total amount that the NAB cost base will be reduced as a result of the demerger. For now, the NAB cost base will be left unchanged – this creates an artificial understatement of performance in terms of return on the NAB investment.
It should also be noted that there are likely some tax implications when considering what to do with CYB shares. This will become more concrete as the tax ruling is delivered by the ATO, but my initial understanding is that any sales of CYB will be subject to capital gains tax if sold within 12 months of the demerger date. Again, if you have any concerns or desire information on the tax implications of this demerger, consulting a tax specialist is recommended.
The cost base for the income first model portfolio’s NAB holdings will be adjusted once the ATO ruling becomes available.
Bank exposure going forward
The Income First model portfolio is well under market weight when it comes to banks, and we continue to believe that there is a good reason to ensure you control and limit your exposure to the Australian banking sector (in particular the big four). That said, we are comfortable carrying some exposure to the dividend yields at present. While we have opted to sell CYB and retain the proceeds in cash, there is otherwise no change to our exposure to NAB or ANZ.
Going forward, we continue to perceive that banks will play less of a role in income investing. Dividends are likely to come under pressure as interest rates rise, and regulatory requirements on capital deteriorate bank return on equity.
With this in mind, we are happy to continue to hold an underweight bank exposure.