NAB: Interim result 2016

After Westpac reported a doubling in its impairment charge last week, we wrote that 'bad debts are back'. ANZ followed the script, announcing that its impairment charge had done likewise – so it sticks out like a sore thumb that NAB's actually fell slightly in the first half.

The main difference was in specifically identified bad debts (aka 'individual provisions', which only increased 25% for NAB compared to the doubling at ANZ and the quadrupling at Westpac. This suggests either that NAB had lower exposures to the 'big name' recent defaulters, and/or that it had previously provided for more of these exposures, and/or that it is not now providing enough.

The truth is that it doesn't matter a lot in the long run; a few hundred million is about how much NAB's market capitalisation moves in a typical day. What matters more is what we can discern about the bank's overall credit quality and here the 'collective provisions' are probably more useful. These are the impairments which are anticipated due to the types of loans being made, but which have not yet been formally identified. As you can see from Table 1, while the other big four banks put money into their collective provision pool in the first half, NAB actually took some out.

It's surprising that NAB found reason to take from its collective provisions in the first half, while everyone, including itself, is reporting higher specific losses. In NAB's defence, though, it still has the largest pool of collective provisions among the big four, relative to its risk-adjusted loan book, at 0.98% (see Table 1). While it should have higher provisioning than the first two due to its higher business exposure, the difference between it and ANZ is surprising.

NAB also has the lowest resources exposure of the big four, at just 1% of its total. And, outside resources, as chief executive Andrew Thorburn put it: 'Business confidence in many parts of the economy is actually quite positive'. This is underlined by the fact that loans that are either impaired or more than 90 days in arrears are still just 0.78% of the total, barely changed from 0.77% a year ago (although up from 0.63% in the second half of 2015).

The lower specific provisioning now being reported may also indicate a more conservative approach to past lending decisions; and where management has reported a blow-out in the NZ Dairy sector, losses should be limited by the fact that most of the loans are fully secured.

Cyclical low

Taken together, the messages are reasonably reassuring. Even so, we agree with NAB's management that 'we're at a low point in the cycle, so we factor in an increase in [impairment charges] over time' from the current 0.14% of loans.

That said, our 'through the cycle' estimate of an impairment charge of 0.6% of loans is probably a bit conservative and we're going to nudge it down to 0.5% (we'll take CBA and Westpac down towards 0.4% and ANZ down from 0.7% to 0.6%).

Further up the profit and loss account, the 'out-of-cycle' mortgage rate increase helped the Australian Banking net interest margin increase from 1.61% to 1.67% over the half and the group margin to rise from 1.88% to 1.90%. This, in turn helped group net operating income rise by 3.3% compared to the first half of 2015 (on a pro forma basis to exclude the impact of the CYBG demerger).

Expenses rose 4.2%, due in part to extra staff working on the disposal of the Life Insurance business, so that the underlying profit before impairments was up only 2.7%. After the lower impairment charge, cash earnings increased by 6.5% to $3,310m, but cash earnings per share fell 4.1% to $1.21 due to the higher shares on issue following last year's rights issue. The cash return on equity was 14.1%.

Vulnerable dividend

NAB decided to cling onto its 99 cent dividend (ex date 17 May), but it looks vulnerable with the payout ratio for the interim dividend at 79%, compared to a target range of 70–75%. Apparently the board 'sees a path' to getting the payout ratio back to the target range within the medium term, and management 'would rather see [NAB's $600m of] franking credits in the hands of investors'.

Chief executive Andrew Thorburn, however, let slip the real reason the dividend was being maintained: 'When you've got 584,000 shareholders, who are normal folk, for whom that dividend is important. So you put that together, and that's why we're holding onto this position.'

We'd say that shareholders shouldn't be relying on dividends to the extent that a 20% cut caused them difficulty and that imprudent dividend policies don't help companies in the long run, least of all banks in need of additional capital.

The dividend is a sideshow, though, to what was an excellent result for NAB. Assuming the bank makes something similar in the second half, with a slightly higher impairment charge, it should earn about $2.42 per share for the full year. That puts the stock on a multiple of about 11.6 times earnings and 1.7 times tangible book value.

After making our 'through-the-cycle' adjustment to earnings, though, the price-earnings ratio rises to 14.3 and the ROE falls to 10.8% (see Table 3). That's still pretty attractive, though, and NAB's combination of being third among the big four in terms of quality (after CBA and Westpac) and second in terms of cheapness (after ANZ) make it third on our list overall, although there's not much in it. We're increasing our Buy price from $24 to $25 and, with the distraction of CYBG removed, the maximum portfolio weighting increases from 8% to 10%. HOLD.