NABZY - National Australia Bank: Mismatch Between Prospects And Valuations (Rating Downgrade)

2023-09-25 10:58:16 ET

Summary

• Net interest margin compression and an increase in operating costs are expected to be a drag on NABZY's future earnings.
• National Australia Bank trades at a hefty premium to book value, which doesn't seem justified considering the difference in valuations and ROEs between NABZY and its peers.
• My rating for National Australia Bank is downgraded to a Sell, as I am of the view that the stock should trade at a lower P/B multiple.

Elevator Pitch

I have a Hold rating awarded to National Australia Bank Limited ( OTCPK:NABZY ) [NAB:AU] shares. Previously, I evaluated National Australia Bank's 1H FY 2023 (YE September 30) financial performance with my prior May 9, 2023 write-up .

In this latest update, I change my rating for National Australia Bank from a Hold earlier to a Sell now. NABZY's current valuation metrics aren't aligned with the company's financial prospects, which suggests that a valuation de-rating is on the cards. National Australia Bank's future earnings are expected to be hurt by higher operating expenses and lower net interest margin. But the market still values the bank at a demanding P/B ratio of 1.47 times.

Investors should pay attention to the fact that National Australia Bank has listings on both the Nasdaq Over-The-Counter or OTC market and the Australian Securities Exchange. In the past three months, the average daily trading value for the company's OTC shares were around $1.5 million (source: S&P Capital IQ ). As a comparison, National Australia Bank's Australia-listed shares boast a higher three-month mean daily trading value of roughly $85 million. Readers can deal in National Australia Bank's shares traded on the Australian Securities Exchange with stockbrokers offering foreign markets trading services such as Interactive Brokers.

Negative Outlook

The analysts have lowered their earnings forecasts for National Australia Bank recently. In the past month, the market's consensus headline FY 2024 (October 1, 2023 to September 30, 2024) earnings per share or EPS projection for NABZY was reduced from A$2.26 to A$2.21 as per S&P Capital IQ data. The sell side's consensus FY 2025 EPS estimate for National Australia Bank was also cut from A$2.36 to A$2.30 during the same time period.

In my view, the sell side has become more bearish about National Australia Bank's earnings growth prospects due to net interest margin compression and rising operating costs.

National Australia Bank's net interest margin declined from 1.79% in the first quarter of fiscal 2023 to 1.75% for Q2 FY 2023, as indicated in the company's 1H FY 2023 results presentation . As disclosed in its third quarter trading update , NABZY's net interest margin decreased by another -3 basis points QoQ to 1.72% for the period between April 1, 2023 to June 30, 2023.

NABZY attributed the lower net interest margin in the recent quarter to "home lending competition combined with higher deposit costs" in its Q3 trading update announcement. Separately, Commonwealth Bank of Australia ( OTCPK:CBAUF ) ( OTCPK:CMWAY ), a key peer and rival of National Bank Australia, noted at its most recent earnings call last month that it has witnessed net interest "margin pressure" due to "competition for deposits" and "home loans." It is clear that the net interest margin outlook for both National Australia Bank and its peers is unfavorable.

According to consensus financial data taken from S&P Capital IQ , National Australia Bank's net interest margin is expected to compress by -6 basis points from 1.75% for FY 2023 to 1.69% in FY 2024.

To make things worse, National Australia Bank's operating costs have been increasing recently. Operating expenses for NABZY went up by +2.6% HoH (Half-on-Half) from A$4,311 million for 2H FY 2022 to A$4,421 million in 1H FY 2023. The bank's Q3 FY 2023 operating costs turned out to be approximately +3% above its quarterly mean operating expenses for the first half of the current fiscal year.

The Australian Financial Review reported in July this year that NABZY "agreed to pay raises of up to 17.5 per cent over four years" in an agreement with the union. On the other hand, National Australia Bank stressed at its most recent interim results briefing that "we still need to put a lot of money into our technology." As such, it is reasonable to expect National Australia Bank's future operating margin to be negatively affected by higher salaries and technology-related investments.

Demanding Valuations

I am of the opinion that National Australia Bank's shares are overvalued.

Less than half of the sell-side analysts covering National Australia Bank stock aren't bullish on the name. Based on S&P Capital IQ data, there are 14 analysts covering National Australia Bank's Australia-listed shares with five and three of them having Hold and Sell ratings for the stock, respectively. This is in contrast with the majority of listed equities where most analysts' ratings are Buys. Looking at the analyst ratings, it is fair to say that the sell side doesn't think that National Australia Bank is undervalued.

Peer Valuation Comparison For National Australia Bank

Source: S&P Capital IQ

As per the peer comparison table presented above, Commonwealth Bank of Australia deserves to trade at a valuation premium to its peers because it boasts the highest ROE among the major Australia banks.

But I don't think that National Australia Bank is justified in being valued by the market at such a high P/B multiple. National Australia Bank is currently trading at a 47% premium over book value, while the market values both ANZ Group and Westpac Banking at close to book value. Considering the differences in expected ROE between these three banks, I take the view that National Australia Bank warrants a lower P/B valuation ratio at the 1.2-1.3 times level.

Concluding Thoughts

The financial outlook for National Australia Bank has become less favorable, but this has yet to be priced into the stock's valuations. This implies that there is a reasonably high probability of National Australia Bank suffering from valuation multiple compression sometime in the future. Therefore, I have chosen to assign a Sell rating to NABZY.

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