2024-01-17 11:11:14 ET
Summary
- NatWest Group offers a high dividend yield, but its weak operating performance justifies waiting for a lower price to enter a position.
- The bank's financial performance has improved due to rising interest rates, but its growth prospects are muted, and it faces competition in the UK banking market.
- NatWest's net interest income has been soft, and its fees and commissions have performed better. However, its outlook for 2024 is challenging, leading to a negative earnings momentum.
NatWest Group plc ( NWG ) offers a high dividend yield, but this seems to be justified by a weak operating performance rather than undervaluation, thus income investors should wait for a lower price to enter into a position.
As I've covered in a previous article , while NatWest offered at the time an interesting dividend yield above 5%, this was not much above the European banking sector average and its weak growth prospects were a major reason to avoid its shares.
Since then, NatWest's share price has been on a downtrend, underperforming the market by a good margin during this period, but raising its current dividend yield to about 7.3% due to a lower share price. This is now much more appealing to income investors, thus in this article I update the bank's investment case, to see if it's now a better income play within the European banking sector or not.
Financial Performance
NatWest is a bank highly geared to retail and commercial banking, being therefore clearly exposed to rising rates. Indeed, its two largest operating segments are Commercial & Institutional and Retail banking, accounting together for some 90% of its revenue, generated mainly in its domestic market.
Like other Western central banks, to combat inflation, the Bank of England has raised its official interest rate quite rapidly since the end of 2021, from about 0% to 5.25% since last August.
This rising interest rate environment is positive for banks, given that usually assets are much more rate-sensitive than liabilities, leading to wider margins for banks and higher levels of profitability.
NatWest is no exception, and over the past couple of years, its financial performance has improved markedly supported by the rising interest rate environment and resilient credit quality. This is not surprising, as the bank's strategy over the past few years has been to de-risk its balance sheet, increasing the weight of mortgages in its loan book, while not pursuing growth in risky areas, such as credit cards or other unsecured personal loans.
However, its large exposure to low-risk products in its domestic market means that NatWest's growth prospects are quite muted, especially considering that the U.K. banking market is quite competitive, with several challenger banks offering competitive products in the marketplace and putting pressure on larger established players' margins.
Despite that, during the first nine months of 2023, NatWest was able to report positive operating momentum, still benefiting from rising rates. However, given that most of its loan book is set at fixed rates, its net interest income was up by much less than other European banks, especially when compared to banks in Southern Europe which have much more loans linked to variable rates.
Indeed, NatWest's net interest income was close to £2.7 billion in Q3 2023 , up by just 1.7% YoY. While new loan production is done at higher rates and about 8% of its fixed book matured in 2023, its loan book did not increase much in the first nine months of 2023, and higher deposit costs led to a lower net interest margin ((NIM)) during this period.
Indeed, as shown in the next graph, its NIM declined by 19 basis points (bps) on a quarterly basis, not a good outcome during a period of rising interest rates.
This is explained by lower lending margins, but more importantly by higher deposit costs and a different deposit mix, as customers are gradually moving money into interest-income deposits or other investment alternatives, decreasing the weight of non-interest bearing deposits in its total deposits mix (from 40% in Q1 to 35% in Q3 2023).
Due to increased competition in the banking industry and other income alternatives offering higher returns, NatWest had to increase its deposit rates over the past few quarters, also explaining why its NII did not increase much despite a rising interest rate environment in the U.K. As shown in the next graph, NatWest's average interest-bearing deposit cost was 90 bps at the end of 2022, while at the end of Q3 2023 this had increased to 2.7%.
Additionally, the bank also performs structural hedges regarding its deposit base, which means that almost half of its deposits are invested at maturities up to five years, which at the end of the last quarter had a weighted average maturity of 2.5 years. This means that its structural hedge only fully re-prices every five years, which has been another headwind for NII growth in the past few quarters.
While NII was somewhat soft during the past few quarters and was not a major support for higher revenues like happened to other European banks, NatWest's fees and commissions performed better, up by 9.5% in Q3 2023, to £829 million. Its overall revenue in the quarter was about £3.5 billion, up by 3.4% YoY.
Regarding costs, despite the inflationary environment and pressure on wages, the bank was able to maintain strong cost control, reporting quarterly expenses of nearly £1.8 billion, representing an annual increase of just 1.2%. This led to a cost-to-income ratio, a key measure of efficiency in the banking sector, of 51.4% in Q3, which is an acceptable level for a bank that is highly exposed to retail and commercial banking.
Its asset quality was also quite good, given that loan loss provisions amounted to £229 million in the last quarter, still at a relatively low level and below the bank's historical loss provisions across the economic cycle. Its cost-of-risk ratio was 24 bps in Q3, slightly down from the previous quarter, showing that credit quality has remained strong despite higher rates and the cost of living crisis, which is to some extent a better result than expected at the beginning of 2023.
Due to the combination of higher revenues, good cost control, and asset quality, NatWest's operating profit increased to £1.3 billion in Q3 2023, up by 22% YoY. During the first nine months of 2023, its operating profit was £3.2 billion, and its return on tangible equity (RoTE) ratio was 17.1% (vs. 10% in 9M 2022).
For the full year, the bank revised downwards its expectation for revenue, due to lower NII and margins, expecting now to reach a total revenue of about £14.3 billion (vs. £14.8 billion previously) and its NIM should be above 3% (vs. 3.20% previously). This revised guidance was not well received by the market, explaining to a large extent its significant share price drop on earnings day, plus its miss both at the top and bottom lines in Q3, as shown in the next table.
While rising rates were an important tailwind for NII in 2022, this changed significantly in the past few quarters as customers were much more dynamic in searching for high-yielding alternatives to deposits, putting pressure on the bank's NIM and being a major reason for its weaker financial performance in Q3 compared to street expectations.
The fact that the Bank of England seems to have reached its peak rate some months ago, and may eventually start cutting rates in the coming months, leads to a challenging operating outlook for the bank. Moreover, the macroeconomic outlook in the U.K. is not particularly great, taking into account that analysts only expect GDP to grow by 0.3% in 2024 and the unemployment rate is projected to increase to 4.6% (vs. 3.7% in 2022 and 4.2% in 2023). This means that higher loan losses are likely in the coming quarters, which together with lower NII can lead to lower earnings ahead compared to 2023.
Indeed, current street estimates expect NatWest to report revenue of £13.8 billion in 2024, a decline of 4.3% YoY, and its net income is expected to be £3.2 billion, down by 17% YoY. This expected decline in its bottom line is mainly driven by higher loan loss provisions, which are expected to increase to nearly £1.3 billion in 2024, compared to about £690 million in 2023.
This combination of relatively weak earnings in the last quarter and a tough outlook for 2024 explain, in my opinion, why NatWest had a negative share price performance in recent months, which means it's justified and not particularly a sign of undervaluation.
Furthermore, while a lower share price has increased its dividend yield to more than 7%, based on its main listing in the U.K., I don't see it as a reason enough to buy its shares, given that its earnings momentum is likely negative in the next few quarters and this could lead to more share price weakness ahead.
Conclusion
NatWest has reported a somewhat weak financial performance in the last quarter, as the bank had to be more competitive in its deposit offering, leading to NIM pressure that is not likely to abate in the short term. Moreover, its operating outlook for 2024 seems to be challenging, thus I don't expect a share price rebound soon, and I see its current 0.6x book value valuation , in line with its historical average over the past five years, as being fair.
While the bank now offers a high dividend yield, I think income investors should wait to buy NatWest's shares, as quite likely they will have the opportunity to grab a lower price in the coming months.
For further details see:
NatWest: Challenging Operating Environment May Lead To A Lower Share Price