To cut or not cut? That is the question facing the National Australia Bank (NAB) Board. Just over a week ago, NAB announced another customer remediation provision, this time a whopping $749 million before tax for 1H19. Unsurprisingly, NAB announced a review of its dividend settings. We wrote about the looming risk of a NAB dividend cut last June.
In recent weeks, there has been increasing pessimism and conjecture about NAB cutting its dividend. The ‘hate meter’ is rising, but like most aspects of investing, measuring sentiment is not an exact science. However, there are some key indicators. For example, short interest has ticked up in recent weeks and has been in an uptrend during the past 6 months. Broker commentary has become increasingly critical and expectations of a dividend cut are rising. Macquarie, UBS, Morgans, Bell Potter and Ord Minnett have all forecast the 1H19 dividend to be cut from $0.99 last year to between $0.80 and $0.90 per share.
NAB’s recent share price performance reflects the above sentiment. Its total return has underperformed the market significantly over the past 12 months, down 3% compared to the 13% rise for the S&P/ASX 200 Accumulation Index.
However, this makes it very interesting from a contrarian perspective. If most investors are positioned one way (that is, short / underweight NAB) then who is left to sell the stock? It might not take much for the stock to pop back up. Getting some bad news out of the way, a small piece of good news or even some ‘less bad news’ should do it.
Could NAB cutting its dividend be that piece of bad news that we need to get out of the way. Or maybe a cut by less than expected. Or no cut at all? These are all important questions.
However, the question we should be more interested in answering when it comes to NAB is: to buy or not to buy? And the risk around a dividend cut is just part of the puzzle. An important part, but not the starting point. First, we need to determine whether the stock is cheap.
NAB’s Valuation Versus Peers
A company’s valuation (post-gearing) is a function of three variables, return on equity (ROE), cost of equity and a long-term growth rate. In valuing the major banks, the cost of equity we use should be more or less the same. And despite the nuances among their short to medium term strategies, their long-term growth rates are likely to be very similar, driven by credit growth and the industry’s pricing environment.
The valuation driver that has a significant disparity among the banks is their ROE. This can be due to scale advantages, the composition of their book or gearing levels. All else being equal, a bank with a higher ROE should trade on a higher valuation multiple.
Chart 1: Major Bank ROE and PE forecasts for the next 12 months
Source: Vertium, FactSet
Upon examining the chart above, we see that the market appears to be efficiently pricing three of the four major banks. CBA has the highest ROE and, as expected, the highest PE ratio. WBC has a lower ROE than CBA and hence a lower PE ratio. ANZ has the lowest ROE and its PE ratio is lower than both CBA and ANZ.
But NAB stands out as an anomaly. Its ROE is almost an entire percentage point higher than ANZ (11.9% vs 11.0%) and is marginally higher than WBC (at 11.7%). Yet NAB trades on the lowest PE of the major banks at 11.3 times compared to 11.7 times for the next lowest, ANZ.
We also notice the wide PE gap between CBA and NAB, a disparity that is close to historical highs. On face value, CBA is the standout bank with by far the highest ROE at 13.2%. Could this justify its premium PE ratio of 14.4 times? We don’t think so. For starters, CBA’s ROE premium to NAB hasn’t been this narrow since the Global Financial Crisis. CBA’s PE is currently higher than pre Austrac and the Royal Commission (circa mid-2017), when the market was extrapolating much higher credit growth.
But in our view, the CBA-NAB PE dispersion isn’t just because CBA might be expensive. Similarly, ANZ’s and WBC’s low ROEs and high PEs relative to NAB aren’t because the former two are necessarily expensive. We think it’s more to do with NAB being cheap.
Why is NAB Cheap?
Once establishing that a stock is cheap, it’s important to understand why. If it is cheap for a good reason (e.g. earnings are cum a downgrade), then it could well turn out to be a value trap. But in NAB’s case, we think it’ shares are cheap because of a balance sheet issue.
NAB’s capital position, as measured by its Common Equity Tier 1 (CET1) ratio is under pressure. The Australian Prudential Regulatory Authority (APRA) has given the major banks until 1 January 2020 to meet its ‘unquestionably strong’ benchmark. To achieve this, banks are required to have a CET1 ratio of at least 10.5%. Our forecast CET1 ratios are depicted below.
Table 1: Major Bank CET1 Capital Positions
NAB is walking the tightrope as to whether it can achieve APRA’s ‘unquestionably strong’ CET1 benchmark. Given its high payout ratio, the company is simply not retaining enough earnings to bolster its balance sheet. From where we stand today, NAB is the only bank that is in danger of having a capital shortfall. And its share price is reflecting this risk, unlike the other three majors which are adequately capitalised.
How NAB’s CET1 Ratio can be Fixed
NAB’s Board and management need to address its capital position. It could raise capital, but at its current depressed share price, a capital raising would dilute existing shareholders. The simplest way to fix its balance sheet – a dividend cut.
You can see from table 1 that NAB’s dividend payout ratio is well above peers. What if the Board cut the dividend payout ratio to 75%?
Table 2: NAB pre and post dividend cut:
Now NAB has an additional $0.5 billion p.a. of breathing space. In effect, this adds 0.2% p.a. to the CET1 ratio, all else remaining equal. While its CET1 ratio is not quite as high as peers, we think it is adequate. Its share price should no longer trade with a valuation discount due to its balance sheet. Going forward, its valuation should reflect its superior ROE to that of ANZ and WBC. Moreover, its PE gap to CBA should narrow.
So now that we know why NAB is cheap and the impact of a dividend cut on its balance sheet, let’s go back to the question of whether NAB should cut its dividend.
The Fallacy of the Dividend Cut
There’s almost nothing that irks an investor like a dividend cut. Particularly investors in the decumulation phase of their lives, who rely on dividend income to fund their retirement. Should NAB’s Board cut, some investors may wish they’d sold their shares beforehand, while others may dump their shares in anger.
With a dividend cut on the cards, should you be fearful of NAB’s share price collapsing?
The first thing to consider is that stocks trade on earnings (or at least earnings as a proxy for cash flow). Stocks don’t trade on dividend yields. For example, ANZ’s low payout ratio results in the stock trading on a low dividend yield. It lowered its dividend in response to declining earnings in FY16 and the stock trades on a multiple of earnings. If stocks traded on dividend yields, then ANZ should have the highest yield of the major banks given its low ROE.
Table 3: Dividend Yields of the Major Banks
|ANZ||CBA||WBC||NAB||NAB post dividend cut|
Source: Vertium, FactSet
Reasons to Cut Dividends
The second thing to consider is the reason for the dividend cut. Many investors think a dividend cut is automatically a sign of things going horribly wrong with their investment. And let’s be honest, in most cases it is. Vertium has written in the past about the importance of avoiding yield traps, such as Telstra in 2017 or Asaleo Care in 2018. These dividend cuts occurred for negative reasons.
In Telstra’s case, structural headwinds from the NBN and a dividend payout ratio that was unsustainably high at 100% were the key drivers of the dividend cut. For Asaleo, a structurally weak competitive position (industry overcapacity and powerful customers eating away at margins) and stretched balance sheet led to the dividend being suspended indefinitely.
However, dividend cuts can be a positive. The most positive example would be a company lowering its payout ratio to retain capital so that it can fund a fantastic growth opportunity. Unfortunately, this isn’t the case for NAB. But on the flip side, we don’t think the driver of the potential dividend cut is because its earnings are collapsing under some sort of structural pressure. Rather, the objective of the dividend cut would be to repair its balance sheet and ensure the company is adequately capitalised. Once this occurs, a major overhang would be removed from the share price.
If the main reason many investors are short/underweight NAB is because of low capital, it stands to reason that investors should be long/overweight NAB if it becomes well capitalised. When everybody is on the same side of the boat it doesn’t take much for it to sway the other way when the consensus shifts.
We acknowledge that receiving a smaller dividend cheque than last year can be painful. But in our view, there are good reasons for NAB’s Board to cut the bank’s dividend. It won’t affect earnings and adequately capitalising the bank should result in a PE re-rating. A dividend cut won’t lead to a share price collapse if it’s for the right reason. In this instance, the outcome of the dividend cut could surprise on the upside.
Author: Daniel Mueller