SCBFY - NatWest Group: Management Returns A Huge Amount To Shareholders

Summary

• Interest rate hikes in the UK means more income for the bank.
• In addition to a strong dividend, a large share buyback program is one item of the capital allocation program for shareholders.
• The strong capital allocation to shareholders is expected to continue for 2022 and 2023. This makes the stock worth buying.

Introduction

NatWest ( NWG ) is a retail, commercial, and private bank from the United Kingdom. With a total income of £10.5 billion in 2021, it is one of the UK's medium-sized banks. Return on tangible book value is strong at 9.4% and the bank has been returning a lot to shareholders since 2021. In addition to a strong dividend, a large share buyback program is one item of the capital allocation program for shareholders. The UK government owns approximately 47% of the outstanding shares and the stake is being reduced as NatWest is purchasing their shares.

Interest rate hikes in the UK means more income for the bank. This also carries a risk of a recession, in which case NatWest will have to adjust its ECL provisions. Still, I see a rosy outlook for the share price. NatWest paid out a special dividend this year with a special dividend yield of no less than 7%. The regular dividend yield will be around 4.5%. In addition to paying a high dividend, NatWest repurchases their own shares. In the first half year of 2022, the buyback yield was a solid 8%. The strong capital allocation to shareholders is expected to continue for 2022 and 2023. This makes the stock worth buying.

Bank of England Raises Interest Rates

Bank of England raised interest rates to 2.25% to curb high inflation. UK GDP fell -0.1% in the last quarter and the Bank expects a similar decline in the next quarter, triggering a recession. With higher energy and food prices, the Bank of England does not expect an inflation peak until October. In July inflation was over 10%, five times the Bank's target rate. Chancellor Kwarteng announced on Friday 30 measures to financially support households and stimulate the economy, such as tax cuts, new investment zones and acceleration of infrastructure projects.

Although an economic recession sounds bad, a drop of -0.1% doesn't seem that significant to me. I'm still cautious about that statement, a recession remains a risk for NatWest. The unemployment rate for the UK is still at an unprecedented low of 3.6%. For NatWest, this means it may need to adjust its ECL provisions in the coming quarter. SA contributor Discount Fountain showed that there are approximately equal numbers of ECL provisions for both the personal segment and the wholesale segment. Particularly in the leisure segment of the bank, high ECL provisions are on the books. This is an industry that will see volatility during recessionary periods. Over the past six months , the ECL provision ratio has been reduced from 0.98% to 0.93%. An ECL coverage ratio of 0.93% is generally very low, especially when compared to major US banks. Compared to British banks , NatWest's risk profile is moderate.

Management returns a huge amount to shareholders through dividends and share buybacks.

The payment of dividends and share buybacks are part of their shareholder distribution strategy.

In 2021 it bought back £1,125 million worth of shares through the UK government's stake and £676 million through the market buyback program. A total of £1,801 million worth of shares was repurchased. The market cap traded at £15.2 billion in early 2021, bringing the total repurchase yield to a solid 11.8%. The stock rose 47% excluding dividend payments. In addition to its robust share buyback program, it paid a dividend of 10.5 pence per share, which means a solid 6.6% dividend yield when investors bought the shares in early 2021.

In the second quarter 2022 earnings transcript , CEO Alison Rose describes the following:

Our common equity Tier 1 ratio is now 14.3%, and we have been clear about our intention to return excess capital to shareholders. We are declaring an interim dividend of [£0.035] per share which represents £366 million towards our distribution of at least £1 billion this year. We're also announcing today a proposed special dividend of £1.75 billion with a share consolidation. In addition to the directed buyback of £1.2 billion in March, this brings total distributions announced for the first half to £3.3 billion. And we have also recently completed the £750 million on-market buyback announced in February.

The shareholder distribution will continue in 2022. This year, NatWest has bought back £1.95bn of its own shares, of which £750m was on-market and £1.2bn from the UK government. The total buyback yield was a solid 8%, but the share price has barely changed. The large special dividend payment could have affected the share price. In addition to the regular dividend, NatWest paid a special dividend of 16.8 pence per share on September 16 (approximately 7% special dividend yield). On record date, the stock price adjusts for later dividend payment.

The regular dividend payment will be a minimum of £1 billion for both 2022 and 2023, representing a solid dividend yield of 4.5% at the current share price.

When interest rates rise, stocks generally fall. Investors can demand more dividend yield than interest. As the dividend yield is well above the UK interest rate of 2.25%, investors need not worry for the time being.

NatWest aims to close 2022 with a CET1 ratio of around 14%, with a target ratio of 13% to 14% by 2023. This will be done through share buybacks from the UK government and on-market buybacks. By repurchasing shares, fewer shares are available, which means that the dividend per share increases and investors receive a larger dividend. An associated benefit of a share repurchase program is that the demand is higher and the supply lower, which can cause the share price to rise. The expected recession may affect their CET1 ratio and capital allocation program to shareholders, but I consider this risk only moderate.

Valuation Metrics

Its competitors in the banking sector include Standard Chartered ( OTCPK:SCBFF ) and Barclays ( BCS ). NatWest is valued cheaper than Standard Chartered based on the PE ratio, but slightly more expensive than Barclays. Based on price to tangible book value, NatWest trades at a premium compared to the other banks, but this is because they allocate their capital to their shareholders in the form of share buyback programs and the payment of (high) dividends.

Key Takeaway

Pros:

• Higher interest rates fuel NatWest income.
• Major share repurchase program and dividend payments expected in the next 2 years.
• Favorable stock valuation compared to others in UK banking sector.

Cons:

• UK in an upcoming recession.
• At higher interest rates, investors could demand a higher dividend yield, which could put pressure on the stock price.

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