NAB: Could Have Been Worse

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

By Greg Peel

National Australia Bank ((NAB)) has performed poorly compared to peers over the credit crunch period as analysts and the market have anticipated the bank might be particularly hard hit. Exposure to the UK goes a long way to providing caution. It was also a question of whether NAB would need to raise more capital.

Now that the half-year result is in, some fears have been allayed. As to whether this result exceeded or fell short of analyst expectations depended on their starting points. For the most part earnings forecasts have been lowered given the bank missed forecasts, but in some cases raised. JP Morgan – the most bearish of all bank analysts – needed to make quite significant upgrades for FY08 and FY09 forecast earnings per share of 6.8% and 11%.

A NAB result is always a messy one given the bank’s complexity, and this one was no different. However, one surprise was $214m of impairment provisions. It was not the provision that was a surprise, but the fact it was taken “below the line” and not allocated to divisions. It was neatly offset by $225m of Visa IPO profit (every bank’s been a winner on Visa) but had the effect of making the individual division results – all of which were positive – look better than they might have been.

Total provisions were a negative surprise at a 135% increase, being greater than expected. Apart from bad loans (of which three names dominate), the general impairment provision, and a general “economic conditions” provision, the real surprise was a $181m provision for conduits. This is basically set against US CDO exposure and equates to some of the massive write-downs US banks have been posting.

The very positive news was in the area of cost control. While the other banks struggled with costs up to 10% higher than last year, NAB managed to reduce its costs by 2-4% (depending which analyst’s numbers you use). This made the operational result look very good, as did the lack of specific division provisioning.

On the capital front, there were fears NAB might have to go to the market. However, the only capital rasing comes in the form of the dividend reinvestment plan, which is fully underwritten at a 2.5% discount. The bank has managed to hold its capital ratio at 6.73%, and this will look better when the banks move to Basel II accounting. The offset to the underwritten DRP is the fact the dividend was raised  – a trend emerging across the globe that has many analysts bemused – but although the capital ratio is at the top end of the bank’s target range it is still thinner than peers.

For those analysts leaning to the positive side, the bottom line is that NAB has been trading at a 10% discount to peers based on market perception it is the riskier of the bunch. As the result had no shocks, it is now questionable whether this discount is deserved. At least that’s the way ABN Amro, Credit Suisse, Deutsche Bank and GSJB Were see it, as they hang on to Buy ratings. However, the slew of Buys reflects more a sectoral weighting than an absolute return prediction. All analysts are cautious about bad loan charges and difficult economic conditions ahead.

Citi, for example, is among those looking for a slowing of credit growth. There is not yet any particular relief in sight on funding costs, barring a little bit of easing since Bear Stearns. There is clearly no relief in sight for the RBA’s cash rate, which is still a very good chance of being raised again, or at the very least remaining at 7.25% for quite some time. While all banks are enjoying a growth in assets as borrowers migrate away from stranded non-bank lenders, the general demand for loans is weakening. Citi today upgraded its rating on NAB from Sell to Hold, based on the result not being a disaster, but with due caution attached anecdotally.

Apart from slowing credit growth, the other effect of higher lending rates is the potential for an increase in bad loans. While the provisioning has been put in place, UBS (Neutral) notes the number of NAB’s non-performing loans increased by 24% in the half, equating to a 72 basis point risk. The peer average is 54bps, and even well-exposed ANZ ((ANZ)) is only showing 63bps. Macquarie (Neutral) sees the result as assuaging balance sheet fears, but suggests management will have to prove it can deliver on return on assets and earnings growth. No specific guidance was provided.

Merrill Lynch (Neutral) was not sold on the result, and points out that NAB has the highest exposure among peers to problem loans, the second-highest charge to non-housing, a number of “watch list loans” and a vulnerable looking conduit exposure. The analysts suggest that to be bullish on NAB, one must assume that both cost control continues and bad loans do not get worse. This is a big call, they suggest.

The UK division showed a surprisingly strong result, but once again it was a case of not being a disaster. UBS points out the UK has a trillion pounds of market cap trading at a forward PE of 6x, and that is telling us something. There is also downside risk to the Great Western acquisition in the US which, by comparison, was recently purchased on 19x.

JP Morgan (Underweight), while making those significant earnings forecast adjustments, will not be swayed on a general weak view of the banking sector. JPM expects flat dividends from here, negligible earnings growth to see out FY08 and declining earnings growth in FY09.

The FNArena database now shows a 5/4/1 B/H/S ratio for NAB. There were some positive adjustments in target price, resulting in an average price increase from $32.50 to $34.68. With the whole weekend to think about it, the market has decided to push NAB up by 5% today to over $34.00, leaving only 2% of upside on an average target basis.

With all the bank results now out of the way, it’s been a case of adjusting for the perceived oversold condition prevailing ahead of the Bear Stearns bail-out. The ASX Financials ex-Property Trust index fell 40% from its high, and has now rebounded by 24% as the market has reacted to low historical PEs and high yields. To return to the same high, a rise of 65% from the low would be needed.

Notwithstanding what may arise from the announced merger talks between St George ((SGB)) and Westpac ((WBC)), the road ahead into the second half and on to FY09 for the big banks is a case of dour upside earnings potential. Earnings are threatened not only by a slowing of demand brought about by tougher economic conditions in Australia, but from the very real potential for bad loans to blow out beyond what have been significant, but perhaps not sufficient, provisions. While capital appears sound for now, and dividends have been cemented, underwritten DRPs will provide for shareholder dilution and payout levels are unlikely  to improve in the near future.

Overall analysts remain cautious on the banking sector. The NAB result has seen a deal of relief from analysts and an improvement in favour, but mostly to bring the overly discounted bank into line with its peers. After that, it’s an uninspiring landscape.

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