By Paul Rickard

When NAB CFO Craig Drummond's opening remarks at the briefing for analysts yesterday were “apologies for the messy nature of the results”, you knew that the results would be pretty messy. But they were also a little disappointing, and the market reacted by sending NAB’s shares 2.17% lower to close yesterday at $31.72.

The disappointment is probably because expectations (including mine) were too high, and serve as a salient reminder about how hard and how long it takes to turn around an institution like the NAB. And I am not talking about the legacy assets such as the UK banks - it’s the core Australian personal and business banking franchises. Low employee engagement, poor technology execution, declining customer advocacy and a confused message on market share vs pricing were hallmarks on the Cameron Clyne era.

New CEO Andrew Thorburn and his team are re-focusing the Bank on the Australian and New Zealand franchise, with three clear priorities: customer experience (advocacy, fixing pain points and digital enablement), a clear segment focus on SME business customers and mortgage customers, and developing a performance based culture where the people have a passion for customers. Together with the run off of low returning assets, this should translate for shareholders to improved returns as NAB closes the ROE (return on equity) gap on its peers.

Unfortunately, NAB hasn’t yet made a lot of progress in closing this gap.

The Result

Excluding specified items (largely charges relating to the UK), cash earnings for FY15 grew by a poor 2.4% on FY14. On an earnings per share basis, they fell by 2.8%, with ROE for FY15 falling by 1.2% to 13.8%. (Westpac reported a ROE of 15.8% for the same period, Commonwealth Bank reported 18.2% for the year ending 30 June).

Cash earnings for the second half were marginally better than the first half, rising by 2.8%. However, this was mainly due to a fall in bad and doubtful debts. Underlying profit (operating income less operating expenses) actually fell in the second half to $5,193 billion compared to $5,258 billion in the March half.

NAB’s result was impacted by a decline in net interest margin (NIM) from 1.89% in the March half to 1.85% in the September half. A decline of $150m in markets, treasury and trading income also hurt.  

But NIM was the big story, with NAB fighting hard to maintain share in its targeted market segments in business. The chart below horrified some analysts - an 18bp fall in the business lending margin over the half year. 

Within Australian banking (personal & business), the cost to income ratio deteriorated (or negative jaws), with a ratio of 42.3% in the September half compared to 40.8% in the corresponding half of 2014.

Positives? The CEO noted the 10-point improvement in employee engagement. On the numbers side, it was a little more difficult. Certainly, an improved result from NAB Wealth, with the ROE on this business improving from a well below the cost of capital level of 5.9% in the September 14 half to 6.7% in the March half to 7.1% in the September 15 half. NZ was sound (if you exclude the impact of dairy losses), and the Australian personal banking division grew revenue by 7.3% over the year as NAB maintained system growth rates in mortgages, cards and deposits.

Clearly, NAB is a “work in progress” - but at the moment, progress is slow. 

Sale of 80% of the Life Business

As had been well telegraphed in the media, NAB also announced the sale of 80% of its life insurance business to Nippon Life for a price of $2.4 billion. It will retain the remaining 20%.

After $440 million in one-off separation costs, mainly IT, (the life business needs to be separated from the superannuation funds business and platforms, which NAB is not selling), NAB will retain around $2.0 billion in sale proceeds. This will improve NAB’s common equity tier one (CET1) capital ratio by 50 basis points. NAB says that financially, the sale will ultimately improve its ROE by around 50 basis points, while reducing earnings per share by 2%. 

Shareholders to get shares in CYBG PLC

NAB shareholders will receive on a pro-rata basis shares in CYBG PLC, the new name for the entity that will own the Clydesdale and Yorkshire banks in the UK. 75% of shares will be distributed to NAB shareholders, with the remaining 25% to be sold to institutional investors by way of an IPO in February 2016. 

The new shares will be listed on the London Stock Exchange, with a secondary listing on the ASX of fully fungible CHESS Depositary Interests (CDIs). NAB says that the new bank should qualify for inclusion in the FTSE 250 Index and the ASX 100.

NAB shareholders will first need to approve the demerger, with scheme documents expected to be dispatched in mid-December and a shareholder vote in late January.

Capital and Dividends

After all the FY16 impacts have been taken into account (sale of the life insurance business, CYBG demerger and conduct indemnity, higher mortgage risk weights from 1 July), NAB’s CET1 ratio will be 9.4%. While this is higher than its target range of 8.75% to 9.25%, and competitors such as Westpac at 9.3%, NAB doesn’t have too many other hollow logs to fall back onto should APRA really push hard with their interpretation of what “unquestionably strong” means for bank capital ratios.

On the dividend front, NAB is paying a final (unchanged) dividend of 99 cents per share, taking it to 198 cents for the full year, fully franked. This level of payout puts the ratio at 75.9% for the full year and 76.3% for the second half - both above NAB’s target payout ratio of 70.0% to 75.0% of underlying earnings. With the sale of the life insurance business also expected to reduce EPS by around 2%, don’t count on any dividend increase in FY 16. While a small decrease is very unlikely, it can’t be categorically ruled out.

Disclosure: The author and his SMSF own shares in National Australia Bank