Huntleys' Stock of the Week

Recommendations: Accumulate

NAB's current stock prices

Quality and Special Purpose Entities issues

Investment Rating:

NAB is one of Australia's four major banks. The leadership qualities in years past fell short of what is expected from NAB's elevated corporate position. A series of disappointments made NAB the worst-performing Australian bank in the five years to September 2008. Controversial foreign exchange option trading losses in 2004 trigged an overdue and complete overhaul of top operational management. New management appeared to turn the situation around. Management embraced certain strategic pillars to deliver above system revenue growth, a sustainable cost base and a focus on ROE with disciplined capital management. The recent exposure to offshore credit problems via conduit vehicles was a blow to management credibility and once again NAB faces the future under new management.

Event:

• There were no real operational surprises in NAB's results report for the six months to 31 March. That in itself is a positive.

• Cash earnings from ongoing operations fell 9.4% to $2,027m from 1H08 but were 20.7% higher than the impairment swollen 2H08 and slightly below consensus. Reflecting the increased equity base, diluted EPS fell 22% from 137.2c in 1H08 to 107.4c.

• As previously telegraphed interim dividend was cut 24.7% from 97c to 73c fully franked.

Impact:

• As expected the Australia banking franchise performed well reflecting increased market share and effective margin management. This highlights a sound and stable banking sector assisted by government guarantees and the withdrawal of some overseas banks from the domestic market.

• What was annoying was the scant attention paid to widening gap between asset/book value and fair value of investments held in Special Purpose Entities (SPE). Last year the market was shocked with the revelation of exposure to these entities. Supplementary information contained in the presentation reveals the total asset value of SPE other purchased assets and NAB client originated assets is $18.11bn against a fair value of $14.24bn - a yawning gap of $3.87bn. More disturbing is the fact the gap widened by $1.8bn in the six months from 30 September 2008 to 31 March 2009. Management obviously decided to hold these securities to maturity as they were not marked-to-market and no impairment charge was made. This is a prime example of getting caught playing pass the parcel. A trading operation becomes an 'investment' because the loss is too great to realise. Will the credit agencies downgrade NAB's rating?

• We reduce our FY09 cash earnings estimate from $4.35bn to $4.02bn. A modest lift in weighted average ordinary shares to 1,905m sees EPS at 211.0c. FY10 earnings are also reduced from $4.68bn to $4.25bn with EPS of 217.4c. Fair value reduces from $29.25 to $26.80 and price triggers adjust accordingly.

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