NAB: Result 2017

Fans of the classic television series Yes, Minister and Yes, Prime Minister would recall Sir Humphrey Appleby labelling politician Jim Hacker ‘courageous' if he proposed changing anything in the government or bureaucracy. It normally resulted in Hacker backing off.

Say what you will about NAB chief executive Andrew Thorburn but he's not in the Jim Hacker mould.

Since assuming the reins three years ago, Thorburn has wasted no time making the hard decisions to transform NAB. Gone are US-based Great Western Bank and British-based CYBG, along with 80% of its life insurance business, and NAB is now more focused on its Australian and New Zealand operations. 

As such, NAB is further along the restructuring road than its peer ANZ and, unlike ANZ, whose result was dominated by cost cuts and falling impairments, NAB's illustrated some, albeit modest, top-line growth (see Table 1).

Net interest income rose by 2% due to increases in housing and business loans, as well as the bank ‘repricing' (ie raising) its lending rates in both areas. This offset increased competition in the housing segment in the first half and a $94m hit from the new bank levy in the second.

Although net interest income rose, the net interest margin actually fell, from 1.88% in 2016 to 1.85%. Despite both the loan repricing and lower funding costs, the bank levy and, in particular, lower earnings in Markets and Treasury were the culprits.

Adding a 5% increase in 'other income', primarily due to rising trading income, NAB's net operating income rose a respectable 3%.

However, although headcount fell by more than 800, operating expenses rose by 3%. Increased software amortisation, legal and regulatory costs, including further ‘conduct' provisions in relation to CYBG, were the main reasons.

Nevertheless, NAB still managed positive ‘jaws' – income rising faster than expenses – albeit by a mere 0.1%.

Stable provisions

Impairments rose a smidgeon, to $810m, but at just 0.14% of gross loans and acceptances, they remain near historical lows. Despite NAB currently not seeing any signs of stress in its retail and mortgage portfolios, it acknowledges the ‘relatively subdued state of the Australian consumer'.

As such, the bank recorded $249m in collective overlays in its 2017 provisions, noting the potential effect of continuing slow wage growth, rising energy prices and increasing interest rates on its retail and mortgage portfolios.

All in all, cash earnings rose 2%, to $6.6bb, which is a good result given the headwinds facing all the big banks. The final and total dividends were maintainted at 99 cents and $1.98 respectively.

Yet despite NAB's best efforts over the past three years, the additional capital and liquidity requirements imposed by APRA that ANZ chief executive Shayne Elliott mentioned in his bank's 2017 result have led to NAB's return on equity (ROE) falling to 14.0%, from 15.0% in 2014.

Even so, the average ROE of NAB's big bank peers have fallen by more, from 16.8% to 14.0% over this period.

Still courageous

But this relative outperformance only seems to have whetted Thorburn's appetite for more.

Along with the result Thorburn announced what he admits are ‘aspirational' goals, including achieving the highest ROE of Australia's big banks and a cost-to-income ratio ‘towards' 35%. We'd label both goals as particularly ‘courageous' given CBA's ROE is materially higher, at 16%, and NAB's current cost-to-income ratio is 42.7% compared to Westpac and CBA's of 41.7% and 41.8% respectively. Both Westpac and CBA benefit from having greater exposure to retail customers, which are more profitable than the business customers that contribute much of NAB business.

Thorburn believes NAB can achieve these goals by further increasing investment in digitisation, automation and improving customer service. The bank will increase investment spending from $1.2bn in 2017 to an average of $1.5bn over the next three years.

The bank believes it can obtain over $1bn in cost savings by 2020 as a result of this investment. Unfortunately, around 12% of NAB's workforce or 6,000 employees will no longer be required, although an additional 2,000 jobs will be created via this investment.

With technology improving at a rapid clip and previously heavily-paper-based banking functions such as mortgage applications or bank account applications being digitised, we don't doubt that further digitisation and automation can occur.

And in support of his strategy, Thorburn noted that there were more than 30 people in a typical bank branch when he started his career. Thanks due to the automation of previously manual tasks, there are now five.   

On top of the cost cuts, NAB believes it can increase revenue through better customer retention and ‘targeted market share gains'.

Although we wouldn't be surprised to see the cost cuts achieved, we're more sceptical of the goal of increased revenue via market share gains. With credit growth slowing, particularly in mortgages, all the big banks will be competing fiercely for market share. If Thorburn is correct in his belief that rising demand for business loans will favour NAB given its business focus (along with ANZ), then it could indeed increase revenue enough to achieve its goals. But it's not going to be easy.

Maintaining dividends

At this stage, even with expenses rising by 5–8% in 2018, NAB intends to maintain its dividend in 2018, although this will likely push its payout ratio above 80%, materially higher than its target range of 70–75%.

And with its common equity tier one (CET1) ratio at 10.1%, the bank also believes it can achieve APRA's required minimum of 10.5% by 2020, helped by a 1.5% discount on its dividend reinvestment plan.

All in all, while we commend Thorburn for taking a long-term focus and making tough decisions, NAB has little room for error.

We'd prefer the bank to cut its dividend to give it more breathing space – and it may well be forced to do that if it doesn't achieve its goals, or if provisions start increasing from their current historical lows.

NAB trades on a price-earnings ratio of 13.8 but if we increase provisions from 0.14% to our through-the-cycle estimate of 0.5%, that PER rises to 17.6, which looks about right. HOLD.

*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.

Note: The Intelligent Investor Equity Income Portfolio owns shares in CBA and Westpac. You can find out about investing directly in Intelligent Investor and InvestSMART portfolios by clicking here.