NAB Fires The Warning Shot

This story features TELSTRA GROUP LIMITED, and other companies. For more info SHARE ANALYSIS: TLS

– NAB downgrades earnings due to provision top-ups
– UK an issue, but local mining weakness also cited
– NAB ratings downgraded
– Brokers discuss sector implications

By Greg Peel

Since the Australian stock market troughed in June and turned positive, the SPDR financials ETF ((XLF)), weighted to the big banks, has risen 19% in a relatively straight line. Over the same time period, the SPDR resources ETF ((OZR)) has stumbled and bumbled its way to an 8% gain.

Outside of Telstra ((TLS)), Australia's Big Four banks and resource sector majors make up the bulk of the weighting of the Australian stock market. To that end, offshore investors in particular often invest in “Australia” by investing in these big names alone. Prior to the GFC, both banks and resources rallied along together. Post GFC that relationship has changed somewhat, with the two sectors often at odds. If resources run a bit too hard, investors take profits and switch into banks, and vice versa. Alternatively, if one sector is suffering from a particular issue, say falling commodity prices for example, then the impetus is to switch into the other regardless.

One might argue this has been the case since June with respect to Australia's banks. One reason for outperformance.

The other reason for outperformance is the ongoing investor search for yield. Australian banks have offered after-tax dividend yields well above bank bill swap rates and have thus proven a red rag to the yield bulls. Hence despite analyst forecasts of low earnings growth, interest margin pressures and ongoing bad debt risk, bank shares have provided a solid return since the June bottom.

Too solid, perhaps?

FNArena has often alerted readers to a consistently reliable lead indicator of potential bank share price correction (See most recently Banks Now Overpriced – What Does That Mean?). When bank share prices for the most part exceed consensus analyst target prices, one of two things has to happen. Either the analysts have to lift their targets or the share prices have to correct from their overbought positions. Using last night's closing prices, the following table provides the current state of play.

As we can see from the “Upside to target” figures, three of the Big Four are sitting above target, with Westpac ((WBC)) suffering vertigo and ANZ Bank ((ANZ)) right on the line. It's thus not surprising that each of the three outside of ANZ can rustle up only one Buy rating each from the FNArena database. (What is surprising is the equivalent 1/5/2 Buy/Hold/Sell ratios for each. I've seen two the same before but I don't not recall three.)

Over the next couple of weeks, all of ANZ, National Bank ((NAB)) and Westpac will release their full-year (September year-end) earnings results with Commonwealth Bank ((CBA)) providing a first quarter update (June year-end). This will provide an opportunity for the bank prices-in-excess-of-targets rule to be tested. Will the results exceed analyst expectations, leading to target upgrades from analysts and perhaps ratings upgrades? Or will bank share prices correct? Well, we thought we would need to wait at least until the end of this week to begin finding out, until suddenly NAB provided a pre-result profit warning on Friday.

It is worth noting that the above table reflects targets and ratings since the NAB update, and that subsequent analyst response to the update has included two ratings downgrades (one to Neutral, one to Sell) and a target prices reduction to $22.06 from $25.91. NAB shares took a bit of a bath on Friday, and all the banks were sold off in sympathy.

We may thus have the answer to the question. But it depends on what the issues were which determined NAB's profit warning and how much of a “read-through” they have for the banking sector in general.

The answer is that NAB's warning of flat earnings growth for FY12 from FY11, and thus a flat 90c dividend, stemmed from issues both individually specific and arguably more sector-general in nature. A flat earnings result is 3-4% below previous guidance and analysts forecasts. Yet despite the need to trim forecasts for the upcoming official result release, no brokers were much surprised by NAB's warning. It was all to do with provisioning.

Because NAB operates in both Australia and the UK it is required to satisfy two jurisdictions with regard to provisioning requirements as well as globally accepted capital regulations. It's all a bit complicated, but suffice to say analysts long feared NAB had not provisioned sufficiently for bad and doubtful debts (BDD) in its mostly disastrous UK business. With the UK economy continuing to suffer from EU-wide pressure, NAB has already been forced to top up provisions. Initially management did so by raiding its more comfortable Australian-based provisions which, brokers suggested, left local provisioning below-peer and vulnerable to a weakening domestic economy.

That fear has proven justified, given Friday's earnings downgrade from management was the result of increased provisioning for both the UK and Australian businesses. Increased provisioning does not equate to a capital loss – funds are simply shifted into provisions from retained earnings thus reducing reported earnings for the period. So as far as profit warnings go, this one is not too dire. However, management's disclosed reasoning for the provision increases is what has analysts a bit concerned.

UK GDP growth has declined for three quarters now and the past three months have seen an acceleration of that trend. Yet management appears to have been slow to have acknowledged that trend given behind the curve provision top-ups. There is little sign of conditions easing in the UK, so analysts fear further provision top-ups may be required down the track. Credit Suisse, for one, would have liked to have seen a much larger and more “credible” UK increase, even if it meant an equity raising. This is a problem unique to NAB among the Big Four nevertheless, being alone in UK exposure. The irony is NAB tried not so long ago to sell out of the UK but couldn't find any willing buyers. Did management just close its eyes thereafter and hope the bad man would go away?

On the domestic front, NAB's loan book features a relatively high weighting to businesses (45%) and the largest market share among the Big Four of SME and middle market exposures. NAB has also been growing its market share faster than peers in the mining states of Western Australian and Queensland. In topping up local provisions, management cited the recent slowdown in the mining sector and mining-related services as the driving force. The economies of the mining states are very much tied to resource sector success, right down to consumer spending and house prices.

Not only do analysts fear further UK provision top-ups will be required, they note NAB's local provisioning remains below peer levels even after Friday's top-up and may yet need to be increased from a regulatory perspective. NAB has long been regarded as the “riskier” of the four, which is reflected in a more volatile share price. NAB shares had run solidly since June, yet brokers agree for the most part valuation still “looks cheap”. 

“We believe fundamentally NAB's return on equity should continue to improve from here,” declares Macquarie, “which should in the mid-term see valuation improve”. However if shorter term conditions continue to soften the risk is for more required provision top-ups, Macquarie notes, given Friday's “reasonably small overlay increase”. Macquarie has downgraded NAB to Neutral from Outperform, with a nod to recent outperformance.

BA-Merrill Lynch is of a similar mindset. “While we acknowledge NAB's relative valuation appeal,” declares Merrills, “an absolute PE of less than 10x is not cheap in our view. The uncertainty discount may return to the stock for further de-rating”. Merrills has downgraded NAB to Underperform from Neutral.

“Relative valuation” is an interesting concept if we look at the view of JP Morgan. JPM is unusual in that it rates stocks relatively within a sector rather than the full index. A low relative valuation for NAB might thus suggest a good rating but after Friday JPM is retaining Underweight, citing the risks of further provision top-ups creating a “peer-relative earnings drag”.

RBS Australia, on the other hand, is sticking by NAB with an unchanged Buy rating. RBS is now Robinson Crusoe in the FNArena database. “We continue to expect that NAB will deliver a superior return on total equity trajectory versus its peers over the next three years,” say the analysts, “and think its current PE discount to the sector will close”.

So that's NAB, but what about the “read-through”of NAB's profit warning for the rest of the banks? Well, on that issue, brokers are even more divided.

Citi believes NAB's problems do not reflect a broader sector problem. They are all about UK weakness and a shortfall in domestic provisioning relative to peers. Deutsche Bank notes NAB's trading update suggested weak trends in the core business, however the analysts believe this relates to higher UK bad debts than to underlying earnings. “As such we do not think there is a read-through for the sector,” says Deutsche.

UBS is hedging its bets. NAB's update provided a weaker outlook for the Australian economy, with softer mining activity, commodity prices and business conditions being the key issues, the analysts note. “This may have a sector read-through,” UBS suggests, “although NAB has a stronger SME market share”.

In acknowledging NAB's weaker outlook, Macquarie focused on the state divide. As noted above, NAB's greater exposure to the mining states was a factor in the broker's downgrade to Neutral. But hot on the heels of WA and Queensland exposure growth is Westpac, which was once the Bank of NSW and gained even more NSW exposure with its acquisition of St George. In a read-through of NAB's mining warning, Macquarie has downgraded Westpac to Underperform.

Morgan Stanley, on the other hand, has focused on “problem industries” as the core of NAB's exposure, and believes problem industries will remain challenging. NAB has the highest dollar value exposure to problem industries, the analysts point out, but not far off is ANZ. MS prefers retail banking over business banking and thus prefers Westpac and CBA.

Merrills is nevertheless left in little doubt. “With NAB the largest business bank we see a negative sector read across”, the analysts warn. Confidence remains fragile, Merrills notes, and some banks are reporting more downgrades than upgrades in their business portfolios – a shift the analysts think could extend, leading to gradually higher BDDs.

“The quarterly result suggests underlying growth remains tough,” says Merrills. “A key tenet of our negative Australian banks sector view is that the market is over-paying for this low revenue growth. It follows that a de-rating for an uninspiring structural [earnings per share] growth rate of 2-3%, and the potential for [dividend per share] growth to lag, remains a risk”.

If NAB's earnings pre-release does prove to be a warning shot for the sector as a whole, we won't have to wait too long for possible confirmation. ANZ will release its full-year on Thursday (Oct 25), CBA will provide a quarterly update at its AGM next week (Oct 30), NAB will officially report next week (Oct 31) and Westpac will follow suit the week after (Nov 5).

Despite Merrills coming across as perhaps the most negative of peers on Australia's banks, the analysts do admit any market de-rating to come will prove a “slow burn” given the ongoing attractiveness of the banks' relative yields in a yield hungry market. Once upon a time banks were considered “defensive”, but in the lead-up to the GFC they were anything but – a fact proven by the share price collapses and forced capital raisings of 2009-10. However in today's cautious world, the banks have begun to reclaim their defensive mantle. 

To that end, FNArena's oft reliable indicator, suggesting a coming share price correction, may this time work only on a relative basis – underperformance against other sectors due to yield support rather than an outright pullback.
 

Find out why FNArena subscribers like the service so much: "Your Feedback (Thank You)" – Warning this story contains unashamedly positive feedback on the service provided.

Click to view our Glossary of Financial Terms