Stock: National Australia Bank Ltd
Code: NAB
Market Cap: $42 bn
Recommendation: ‘None’

Every major market trend has a ‘leader’. In the case of the great bear market of 2008, the financials sector has been at the forefront. After being ‘whipping boys’ of choice for the last 18 months, our banks were looking fairly pink leading into their latest earnings results. Many times over recent months they had cried ‘pauper’ – reluctant to pass on any RBA interest rate reduction to consumers due to higher funding costs. Supposedly the financial crisis was threatening their bottom lines. So should our hearts be bleeding for them?

If Nab’s latest half year result is anything to go by, consumers may be forgiven for tuning out any sympathy cries. Nab’s result reveals that our banks have thus far weathered the financial crisis very well by international standards. Although their headline profit figures are down, a profit in this environment shouldn’t be shied at.

Nab reported a cash profit of just over $2bn, down 9.4% on the prior corresponding period (pcp). The highlight of the result was the solid performance of its core banking operations, which reported stronger revenues in all jurisdictions except for the UK. Apart from the domestic brand that we’re familiar with, NAB owns the Clydesdale Bank and Yorkshire Bank in Britain, and the Bank of New Zealand across the Tasman. Following the acquisition of Great Western Bank in late 2007, the bank has also established a small presence in the US. Overall group revenues increased 11.5% to $8.5bn. This is a sign of increasing market share as customers ‘flight to quality’ amid the financial crisis. The 18.7% increase in retail deposits over the period provides further evidence of this trend.    

So with more customers coming through their doors, why are profits down? The answer is simple – bad debts. Loan defaults – whether it be from large corporate failures such as Babcock and Brown or Allco Finance, small to medium size businesses, or mum and dad mortgagees – are on the rise. Losses on bad loans more than offset the increase in fees and interest generated from recent growth in Nab’s customer base. For the six months to March 31, Nab reported total provisions against bad debts of $4.9bn, which saw gross impaired assets as a % of gross loans rise from 0.49% to 0.89%. Management rhetoric suggested that the worst of the big corporate collapses has passed, but highlighted that signs of stress were increasing amongst small to medium size business and consumer loans.

The UK provided the biggest source of woe in terms of loan losses. Impaired assets reached 1.47% of total loans, much higher than Australia and NZ, where the ratio is below 0.8%. UK revenues were also down due to the more competitive nature of the UK banking industry, which saw Nab’s Clydesdale and Yorkshire Banks unable to pass on higher funding costs to customers. These two forces saw cash earnings from the UK fall 64% to $112m for the half year. Importantly the operations are still profitable, however this slump saw the UK become the biggest detractor from the Group’s overall cash earnings.

Nab’s exposure to the UK has seen investor sentiment favour its more domestic focused peers. Compared to CBA and Westpac, Nab is trading at 30-40% discount in terms of book value. Does this reflect the increased risks associated with Nab’s offshore exposures? Bad debts are rising at home and abroad. But absent of the strong market position commanded by its local operations, Nab’s UK banks have suffered from the double edged sword of rising loan losses and competitive pressures on pricing.

The bad debt cycle is having the most powerful impact on earnings, and until it abates, all of Nab’s banking operations are unlikely to see any bottom line relief. So how much further does the cycle have to run and what are the implications for our banks in the interim? Obviously the bad debt cycle is more advanced in the UK. A rival bluechip CEO from the building industry recently lamented that he was running out of superlatives to describe the dire state of the UK economy! So given such concerns, investors are left to wonder whether Nab’s book value discount relative to peers is warranted, or whether it offers a buying opportunity? On the other hand, should investors be considering the banking sector at all given its role in leading the current crisis?

None of our banks have been immune from the rising bad debt trends plaguing the sector. But when it comes to their failure to pass on RBA interest rate cuts, we suspect their show of empty palms may come down to a ‘slight of hand’. Hence their cupboards may not be are barren as their sympathy cries suggest.

Tim Morris is an analyst at, one of Australia’s leading independent stockmarket research houses. Click here for your complimentary report.


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