NAB: Q1 update

After some nasty shocks in recent years, National Australia Bank is laying down some really boring results and that's just how we like it.

Lending growth and higher trading income meant that revenue for the first quarter (to December) rose 1% compared to the quarterly average for the September half. This was supported by a flat net interest margin, suggesting that mortgage repricing has been able to offset higher costs on term deposits.

The impairment charge dropped 23% as less additional ‘overlay' was deemed necessary for risks in the mining and agricultural sectors.

Expenses, however, rose 5% due to the timing of salary increases and redundancies. The overall result was a 1% fall in cash earnings (again, compared to the quarterly average for the September half) to $1.6bn.

The cash earnings figure was slightly below expectations due to the higher than expected increase in expenses, but this was offset by commentary reiterating the target of $200m in cost savings for the 2017 financial year, as well as for income growth exceeding cost growth.

The stock is up 9% since we wrote up its 2016 final result in October, and 26% since we upgraded to Buy in the aftermath of the Brexit vote back in June.

With full-year cash earnings per share likely to be little changed from last year's $2.45, the stock is on a low-looking price-earnings ratio of 12.5. And so it should be with impairments at unsustainably low levels and low single-digit growth the best we can realistically hope for over the next few years.

The stock does offer a fully franked dividend yield of 6.5%, but that's as likely to fall as it is to rise in the short to medium term, with the current payout ratio at 80% compared to a target of 70–75%. HOLD.

ANZ set the tone earlier in the week, with a result that pointed to a flat future, but for NAB yesterday, that future is already here. Its half-year result could hardly have been flatter, but still represented a decent performance in a low-growth environment.

As with ANZ, NAB's Markets and Treasury operations grew strongly, with income up 16% to $1,033m due to trading gains in interest rate markets following the US election, but that was about it.

Gross loans rose by 3.3% compared to a year ago, but just 0.8% over the first half, to $550bn, while the net interest margin edged down by 0.01% to 1.89% (excluding Markets and Treasury) to give net operating income up 1.8% at $8,869m.

In the results presentation, chief financial officer Gary Lennon explained that wholesale funding costs were beginning to reduce a little, but that this was being offset by the APRA requirement to increase average maturity dates.

A 0.8% rise in operating expenses to $3,785m over the year met the bank's target of ‘positive jaws' (lower cost growth than income growth). Over the half expenses rose by 2.8%, but this was affected by a seasonal increase in staff expenses.

Provisions

The impairment charge rose 5.1% to $394m, representing 0.14% of gross loans. That's in line with the first half of 2016, but was a arguably a stronger performance since it includes a $89m top-up to collective overlays (compared to none in the prior period).

These are unspecific provisions which the bank takes against its overall portfolio given the potential for a deterioration in the economic environment. In this case the overlays relate mainly to commercial real estate and, as chief executive Andrew Thorburn explained: ‘While we are not seeing any signs of stress at this time, given where we're at in the commercial property cycle, we believe this is a prudent step to take.'

Following the increase, overlays now stand at $291m and total collective provisions at $2,695m, which is 0.72% of risk-weighted assets – the same as in September, although down from 0.82% a year ago.

Given all that, it's hardly a surprise that cash earnings edged up just 2.3%.

At a divisional level, Business and Private Banking enjoyed a solid performance. Lending growth of 3.4% was met with a margin increase of 0.04% to 2.84% thanks to loan repricing combined with an improvement in the mix of deposits. That have a 4.0% rise in net operating income to $3,090m. However, the impairment charge doubled to $98m due to lower writebacks of collective provisions and that pegged the rise in cash earnings to 2.5%.

The Consumer Banking and Wealth division enjoyed lending growth of 5.7% – mainly from housing – but suffered a 0.09% fall in the net interest margin to 2.03% due to pressure on funding costs, particularly deposits. That left net operating income flat at $2,692m and cash earnings down 0.4%.   

As already noted, the Corporate and Institutional Banking division was supported by a strong performance from Markets and Treasury, with cash earnings up 17.9%, while the NZ business increased cash earnings by 10.4% thanks largely to reduced impairments in the dairy industry.

NAB's balance sheet also strengthened considerably, with retained earnings (boosted by the dividend reinvestment plan) and a reduction in risk weighted assets increasing the tier 1 capital ratio from 9.77% to 10.1%. That's well ahead of the target range of 8.75–9.25%, although this will depend on APRA's upcoming clarification on capital requirements.

With plenty of franking credits available, the board has maintained the dividend at 99 cents (fully franked, ex date 16 May). That keeps the payout range at 80%, compared to the target range of 70–75%, so question marks remain over the dividend – and again, much will depend on what APRA has to say on capital requirements.

NAB has returned about 37% since we upgraded it last June, which is not bad for a bank that's exhibiting precious little growth. The net result of that, however, is that the price-earnings ratio has expanded from about 11 to 13. If we triple the impairment charge from the current 0.14% of loans to get to our through-the-cycle estimate of around 0.5%, then the earnings fall by around 18% and the PER goes up to 16. That places the stock bang in the middle of our HOLD range.

*Please note our recommended maximum portfolio weightings of 10% for NAB individually and 20% for the banking sector as a whole. More conservative investors and those with other exposure to the property market should use lower limits