Value Investor: What is NAB worth?

After years of restructuring in the UK operations, NAB appears to have turned a corner but much still depends on the outlook for domestic lending growth.

NAB’s long-suffering shareholders were finally rewarded this year with a meaningful share price rally but the stock is still only back to levels of early 2006 and the FY13 dividend was less than FY08. After a 34 per cent increase in FY13 earnings and a return to profitability in core UK banking, has NAB turned the corner? And are the shares still good buying?

NAB is the ASX’s fourth-largest bank by market capitalisation. The Australasian operations are relatively uncontroversial but the Yorkshire and Clydesdale banks exposed NAB to the UK recession and commercial real estate (CRE) downturn. There was also a $1.2bn portfolio of collateralised debt obligations (CDOs) “secured” by US sub-prime mortgages. Subsequently, NAB wrote off more than 90 per cent of the CDOs, triggering a class action alleging a breach of continuous disclosure rules, and incurred hundreds of millions of pounds of operating losses and loan writeoffs in the UK. The $16bn CRE book was hived off into a separate vehicle in runoff.

After years of restructuring, the UK bank finally made a profit in FY13 while the CRE bad and doubtful debt (BDD) charge fell below the FY12 peak with a solid decline in 2H13. The recovery in UK earnings is shown in the chart below. BDD charges fell in all but one business unit, reflecting generally improved asset quality. Total BDD expense in FY13 was $1.934bn, a reduction of $681m.


Graph for Value Investor: What is NAB worth?

Source: National Australia Bank

Apart from the decline in BDD expense, the healthy growth in FY13 earnings reflected momentum in lending volumes in Personal Banking and NZ Banking, and improved margins in Personal Banking. But despite 1 per cent revenue growth, experience losses and provision top-ups in Wealth detracted and pre-provision earnings were flat for the seventh quarter in a row.

This forced reliance on lower BDD for bottom-line profit growth – again, as BDD expense and provisioning have fallen for several consecutive years from GFC peaks. This has supported profits during weak revenue growth but the downtrend in provisioning is probably over or nearly over, meaning banking income must accelerate for shareholder expectations of rising dividends to be met.

The main downside risk to earnings in FY14 is renewed weakness in UK CRE prices, which would increase losses on the non-core portfolio in runoff. The key upside risk is a better economic outlook for the UK, which would improve earnings at the core UK businesses and support CRE values, reducing the risk of further losses. Our base case is the worst is over for NAB in the UK.

Assuming steady provisioning, stable interest margins and low to mid-single digit loan book growth, NAB can grow profits in FY14. This will require the absence of the large UK provisioning of 1H13 and a lower average cost of funding to offset drag from the end of out-of-cycle mortgage repricing. The maturity in FY14 of relatively expensive government-guaranteed funding will assist. Price competition in wholesale and institutional banking is a risk.

Business confidence is off its post-election peak but still higher than pre-election. General business conditions remain patchy, without consistency in forward orders. Confidence was scarred by the GFC and persistent Aussie dollar strength is causing uncertainty about structural change in the economy. NAB’s 2H13 domestic business lending volumes were flat and it remains to be seen whether the post-election improvement in confidence translates to higher lending volumes. System business lending growth has improved marginally but remains near historic lows.

Another year of slow system credit growth would increase pressure for further restructuring and cost savings.

In a bearish scenario, for example higher losses on the UK CRE portfolio and another year of slow system lending growth in Australia, we think NROE could fall to 17.5 per cent. In this case our valuation would be $30.69, 13 per cent below our $35.37 FY14 valuation. In a bullish scenario, for example faster lending growth in Australia and less price competition in domestic lending, NROE could rise to 20.5 per cent for a valuation of $38.11, 8 per cent above our FY14 valuation.

NAB shares have slipped 9 per cent from their late October high of $37.07 and are now trading at a 5 per cent discount to our valuation. The stock has become more interesting but is not yet trading at enough of a margin of safety to justify investment at current prices. Banks are leveraged, cyclical plays on the economy and should be purchased at meaningful discounts to valuation.


Graph for Value Investor: What is NAB worth?

NAB share price vs. intrinsic value

Source: www.StocksInValue.com.au

David Walker is Head of Equities Research at StocksInValue, a joint venture between Clime Investment Management, a value fund manager, and Eureka Report. StocksInValue provides valuations and quality ratings of 400 ASX-listed companies and equities research, insights and macro strategy. For an obligation free, FREE trial please visit www.stocksinvalue.com.au or call 1300 136 225.