NAB Ups Internal Investment But Will It Work?

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This story features NATIONAL AUSTRALIA BANK LIMITED.
For more info SHARE ANALYSIS: NAB
The company is included in ASX20, ASX50, ASX100, ASX200, ASX300 and ALL-ORDS

National Australia Bank will increase its investment in the business, targeting over $1bn in cost savings by FY20. Brokers welcome the strong FY17 result but remain more circumspect about the outlook.

-Accelerated expense growth should provide a more sustainable base
-Investors may have been underestimating the amount of reinvestment required
-Potential for business disruption and competitors gaining ground
 

By Eva Brocklehurst

National Australia Bank ((NAB)) has boldly set out a restructure plan, expected to generate cost savings and simplify its business and products. The bank's FY17 cash net profit of $6.64bn was near expectations. Overshadowing this was the decision to accelerate investment in FY18. While brokers gave the FY17 results a tick they are less united on the outlook.

NAB has announced increased investment expenditure, targeting over $1bn in cost savings by FY20. The bank intends to reduce its personnel by -12% over the next three years, which is expected to generate around $500m in annual cost savings. Management is guiding to elevated expenses growth of 5-8% for FY18 followed by flat expenses in FY19-20.

Macquarie suspects new expense growth guidance, as well as a restructuring charge of $500-800m, will put further pressure on capital and an already elevated pay-out ratio. On the other hand, the accelerated expense profile should translate into a more sustainable base and lead to an improved competitive position, assuming the strategy is well executed.

The broker believes the action on expenses is supported by both the desire to better position the bank for the future as well as the need to close the gap on expense recognition. All up, it implies that earnings quality will have improved materially by FY20 and Macquarie does not consider the valuation overly demanding. 

Morgan Stanley is Underweight believing, alongside slower housing loan growth, the re-emergence of margin pressure, higher loan losses and a rising share count that earnings per share will fall in FY18. The broker suggests investors have been underestimating the amount of reinvestment and restructuring required in the Australian franchise.

Moreover, the decision to accelerate investment means improvement in the CET1 ratio may take longer. NAB has reported an APRA CET1 capital ratio of 10.1% as of the end of September and expects to meet the "unquestionably strong" benchmark of 10.5% by January 2020.

Cost Growth

Ord Minnett considers the additional costs a necessary evil and a catch-up for past under-investment. That said, the broker was surprised by the quantum of the increase in expenses and suspects the impact in FY20 is negligible, with benefits eaten away by the expected increase in underlying costs in FY18, which remains the cost base.

The step-up in costs largely reflects accelerated investment expenditure, rising amortisation expenses and a move to a more conservative expense policy. While believing these are the correct moves to ensure the bank is fit for the challenges ahead, Ord Minnett suspects investment expenditure is likely to be well ahead of larger peers. In addition, with NAB taking such a big hit on costs amid little financial benefit, this is a clear disappointment to the market.

A restructuring may be "ambitious and necessary" as the bank described, but it reveals a starting point that is worse than UBS previously expected. The restructuring will result in, net, around 18% of the workforce leaving the bank as it is simplified and the revenue potential increased.

The broker is disappointed, as previous cost initiatives appear to have been ineffective and much of this new investment looks to be catch-up expenditure. The bank anticipates revenue synergies but UBS is sceptical, given the likelihood of business disruption, the weak starting point and the fact that competitors are also not standing still.

Moreover, UBS believes the new aspirational objectives of the bank are unrealistic. NAB is aiming to reduce its cost-to-income ratio towards 35% and to achieve this it will need to hold costs flat at FY18 levels and grow revenue by 30%. The broker also questions the expectation of "top quartile employee engagement", given a large slice of the workforce is being retrenched.

Morgans envisages little downside risk to the bank's plan although, besides the reduction in personnel, is less confident about the other cost savings being targeted.

Dividend Outlook

The broker continues to believe a discounted distribution reinvestment plan will operate in respect of the next two dividends. The bank hast stated it expects to maintain dividends at the FY17 level subject to no material change in the external environment in FY18.

UBS maintains a Sell rating, noting that the bank has a very good business arm but this represents just 18% of the book. The broker finds it hard to justify the rating given the challenging outlook and suspects that if there is any deterioration in the outlook for the Australian economy, which leads to a jump in bad debt charges, a cut to the dividend is likely.

Morgan Stanley is increasingly convinced that returns on equity will fall from current levels and the dividend will not rise before 2021. The broker believes, while the bank is now a lower risk and less complex because of its exit from non-core assets, the turnaround is largely complete and the benefits factored into estimates.

Furthermore, growth prospects for the business banking franchise are soft. Loan losses at around 15 basis points are also considered unsustainably low, given the challenges for the domestic economy and the bank's leading share in the small-medium enterprise market.

FNArena's database shows four Buy ratings, two Hold and two Sell. The consensus target is $31.87.

This stock is not covered in-house by Ord Minnett. Instead, the broker whitelabels research by JP Morgan.
 

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