? Presale Report: NAB Capital Notes 2 (NABPD) The Price is Right Recommendation: Subscribe Morningstar Research 31 May 2016 John Likos, CFA Head of Credit Research, Australia +612 9276 4513 john.likos@morningstar.com Michael Murphy Associate Analyst +61 2 9276 4406 michael.murphy@morningstar.com Executive Summary National Australia Bank, or NAB, will raise AUD 750 million - with the ability to raise more or less - via a new hybrid issue, to be listed on the Australian Securities Exchange, or ASX, called NAB Capital Notes 2 (ASX Ticker: NABPD). NAB Capital Notes 2, or NABPD, will provide Additional Tier 1 regulatory capital for National Australia Bank, and its features are compliant with the Australian Prudential Regulation Authority's, or APRA's, latest capital adequacy standards (Basel III requirements). NABPD is a fully paid, noncumulative, convertible, transferrable, redeemable, subordinated, perpetual, unsecured note with a AUD 100 face value and scheduled conversion date of 8 July 2024. Scheduled conversion on that date is subject to conversion conditions. NABPD may be converted earlier as a result of a trigger event or National Australia Bank exercising an option to redeem, transfer or convert the security two years early on 7 July 2022. Distributions are discretionary, noncumulative and fully franked with a dividend stopper. Distributions will be paid quarterly in arrears, based on the 90-day bank bill swap, or BBSW, rate plus a margin in the indicative range of 4.95% to 5.10% per annum. Using the current 90-day BBSW rate of 1.99%, this equates to a total estimated gross running yield range of 6.94% to 7.09% per annum. Key Takeaways We recommend investors subscribe to the offer. We believe the indicative issue margin range of 4.95% to 5.10% and yield range of 6.94% to 7.09% is attractive on an absolute and relative basis. We are comfortable for investors to apply via the primary market considering the transaction costs and illiquidity risks of purchasing via the secondary market. We have seen hybrid trading margins tighten since the issuance of Commonwealth Bank s PERLS VIII and we expect continued price support in the near to medium term. The recent Australian Tax Office ruling that allows banks to issue Tier 1 hybrids without having to attach franking credits could limit issuance of these securities in Australia in the medium to long term which could provide further price support. Hybrid securities should not be viewed as traditional fixed-income products, nor should they be considered a substitute for low-risk investments such as term deposits. of Morningstar, Inc, without reference to your objectives, financial situation or needs. Refer to our Financial Services Guide (FSG) for more information at www.morningstar.com.au/s/fsg.pdf. You should consider the advice in light of these matters and if applicable, the relevant Product does not necessarily indicate a financial product's future performance. To obtain advice tailored to your situation, contact a professional financial adviser. Some material is copyright and published under licence from ASX Operations Pty Ltd ACN 004 523 782 ("ASXO").
Page 2 of 14 Recommendation We recommend investors subscribe to the offer for NABPD. We believe the indicative issue margin range of 4.95%-5.10% is attractive on an absolute and relative basis. We expect investor demand to be strong, driving our expectation of final pricing at 4.95%. We assign NABPD a medium investment risk rating, the same as other Basel III compliant Tier 1 major bank hybrids in our coverage list. The terms and conditions, such as nonviability and capital conversion triggers, in this new breed of hybrid securities, make them more equity like and, consequently, riskier than the "old-style" issues. Nevertheless, for investors willing to take a position on the lower end of a company's capital structure, hybrid securities can represent an attractive yield investment. Exhibit 1 highlights not only the higher returns investors continue to demand on their hybrid investments in the last 18 months, but the strong support they have found since the recent CommBank PERLS VIII Capital Notes issue (ASX Code: CBAPE). CBAPE has rallied from an issue margin of 5.20% to about 4.70% at the time of writing, supporting our Subscribe recommendation at the time. Exhibit 1 Trading Margins of Comparable Tier 1 Capital Securities 7.00% ANZPE CBAPE CBAPD NABPC WBCPE 6.00% 5.00% 4.00% 3.00% 2.00% 1.00% 0.00% May-2015 Jul-2015 Sep-2015 Nov-2015 Jan-2016 Mar-2016 May-2016 Source: Morningstar National Australia Bank's proposed issue margin range of 4.95% 5.10% on NABPD translates to the highest issue margin of all outstanding National Australia Bank Basel III Tier 1 major bank hybrids. This continues the recent trend of higher issue margins being offered, including the CommBank PERLS VIII Capital Notes at 5.20% and the Westpac Capital Notes 4 at 4.90%, as shown in Exhibit 2.
Page 3 of 14 Exhibit 2 Issue Margins of Major Banks Tier 1 Hybrid Securities 6.00% 5.00% CBAPE WBCPG NABPD WBCPF 4.00% ANZPF NABPC 3.00% 2.00% 1.00% 0.00% Jan-2015 Apr-2015 Jul-2015 Oct-2015 Jan-2016 Apr-2016 Jul-2016 Oct-2016 Source: Morningstar Investors should consider the risk/reward merits of alternative investment options relative to NABPD, such as bank deposits, bank equity or other hybrids. Exhibit 3 Differences Between NABPD and Other NAB Investments Source: Morningstar, NAB
Page 4 of 14 A NAB 5-year term deposit, which has the benefit of a guarantee under the Australian government financial claims scheme, yields approximately 390 basis points less than NABPD s yield to call, based on the low end of the indicative issue range, as shown in Exhibit 4. Morningstar forecasts indicate a gross yield of about 10% on NAB ordinary shares for fiscal year 2016, approximately 300 basis points higher than that of NABPD's yield to call, based on the low end of the indicative issue range. Although the equity dividend represents a material yield cushion over the hybrid yield, we believe the equity dividend risk remains to the downside. Exhibit 4 NAB Credit Securities Yield Curve, 30 May 2016 8.0% 7.0% Tier 1 Hybrid Securities Senior Unsecured Term Deposit NABPC NABPB NABPD NABPA 6.0% Yield to maturity 5.0% 4.0% 3.0% 2.0% 1.0% 0.0% 0 1 2 3 4 5 6 7 8 9 Years to Reset Source: Morningstar Hybrid securities should not be viewed as traditional fixed-income products, nor should they be considered a substitute for low-risk investments such as term deposits. Therefore, they should offer a yield premium over these lower-risk products. Furthermore, hybrid prices can become volatile in times of distress, similar to shares and unlike traditional senior bonds. In the event of a winding up, NABPD ranks ahead of ordinary shares, equally with equal-ranking capital securities such as NAB Capital Notes, behind senior creditors, and behind bank deposits and secured debt. Exhibit 5 provides a summary of NAB's capital structure ranking, highlighting the relatively low position of NABPD in the event of a winding up, an event we consider highly unlikely.
Page 5 of 14 Exhibit 5 Ranking of NABPD in the Event of a Winding Up of NAB Source: Morningstar, NAB Exhibit 6 highlights some comparable Basel III compliant major bank hybrids, as well as the NABPD that we have included for the purposes of comparison. These are all similar to NABPD in their Basel III compliant features, however, issuer risk profiles may vary slightly among the major banks.
Page 6 of 14 Exhibit 6 Comparable Major Bank Basel III Compliant Hybrids NABPD ANZPE CBAPE NABPB WBCPE Name NAB Capital Notes 2 ANZ Capital Notes 2 CBA PERLS VIII NAB CPS II Westpac Capital Notes 2 Security Type Mandatory Conversion Mandatory Conversion Mandatory Conversion Mandatory Conversion Mandatory Conversion Issuer NAB ANZ CBA NAB WBC Issue Size ~AUD 750 million AUD 1,610 million AUD 1,450 million AUD 1,717 million AUD 1,310m Face Value AUD 100 AUD 100 AUD 100 AUD 100 AUD 100 Issue Date 7-Jul-16 31-Mar-14 30-Mar-16 17-Dec-13 24-Jun-14 Margin above Base Rate 4.95% - 5.10% 3.25% 5.20% 3.25% 3.05% Base Rate 90-Day BBSW 180-Day BBSW 90-Day BBSW 90-Day BBSW 90-Day BBSW First Call Date 7-Jul-22 24-Mar-22 15-Oct-21 17-Dec-20 23-Sep-22 Mandatory Exchange Date 8-Jul-24 24-Mar-24 15-Oct-23 19-Dec-22 23-Sep-24 Distributions Capital Trigger Event Discretionary, non-cumulative, fully franked distributions with a dividend stopper. Yes, if common equity tier-1 ratio is equal to or below 5.125%. Discretionary, non-cumulative, fully franked distributions with a dividend stopper. Yes, if common equity tier-1 ratio is equal to or below 5.125%. Discretionary, non-cumulative, fully franked distributions with a dividend stopper. Yes, if common equity tier-1 ratio is equal to or below 5.125%. Discretionary, non-cumulative, fully franked distributions with a dividend stopper. Yes, if common equity tier-1 ratio is equal to or below 5.125%. Discretionary, non-cumulative, fully franked distributions with a dividend stopper. Yes, if common equity tier-1 ratio is equal to or below 5.125%. Non-Viability Trigger Event Yes Yes Yes Yes Yes Conversion into ordinary shares Yes Yes Yes Yes Yes Ranking in windup Above NAB ordinary shares and equal to other preference shares. Above ANZ ordinary shares and equal to other preference shares. Above CBA ordinary shares and equal to other preference shares. Above NAB ordinary shares and equal to other preference shares. Above WBC ordinary shares and equal to other preference shares. Gross Running Yield * 6.94% - 7.09% 5.94% 7.22% 5.70% 5.68% Gross Yield to Reset * 6.94% - 7.09% 7.25% 6.84% 6.92% 7.06% Trading Margin * 4.95% - 5.10% 4.92% 4.70% 4.69% 4.84% * As at 30-May-16. NABPD yields at par value. Source: Morningstar We believe there is value emerging in many of the major bank hybrid issues for investors that are happy to hold until call and receive an attractive yield from a strong issuer. NABPD, in particular, offers compelling value relative to comparable securities for its attractive yield to call, high running yield and the backing of a wide-moat- rated issuer. The Offer The offer comprises: a broker firm offer for clients of eligible brokers an institutional offer to institutional investors a securityholder offer for eligible security holders. This includes a registered holder of NAB ordinary shares, NAB CPS, NAB CPS II, NAB Capital Notes and/or NAB Subordinated Notes on 26 May 2016 and shown on the register to have an address in Australia. Capital Conservation Buffer As of 1 January 2016, NAB, along with the other domestic major banks, is required to maintain a capital conservation buffer in the form of common equity Tier 1 capital of 3.5% of risk-weighted assets. On top of the Basel III requirement of maintaining a minimum common equity Tier 1 capital ratio of 4.5%, the total common equity Tier 1 capital requirement is now at least 8.0%. This is a positive for major bank hybrid investors as it increases the margin of safety above the 5.125% capital trigger level and reduces the risk of NAB being deemed "nonviable" by APRA. The potential downside is distributions may be affected if this new buffer is breached. NAB s common equity Tier
Page 7 of 14 1 ratio, on a Basel III basis, was 9.7% as at 31 March 2016, representing a healthy buffer above regulatory requirements. However, the proforma common equity Tier 1 ratio falls to about 9.3%, adjusting for APRA's 1 July 2016 increase in average mortgage risk weights and the sale of NAB Wealth s life insurance business. APRA maintains the discretion to apply an additional countercyclical buffer up to 2.5% of common equity Tier 1 capital. In December 2015, APRA confirmed the countercyclical buffer applicable to Australian exposures will be 0% from January. Further information regarding the Capital Conservation Buffer is available in Section 5.3.1 of the prospectus. Security Risks Capital Trigger Risk NABPD has a capital trigger event clause that requires immediate conversion of some, or all, securities into ordinary shares if NAB's common equity Tier 1 ratio equals or falls below 5.125%. NAB's common equity Tier 1 ratio, on a Basel III basis, was 9.7% as at 31 March 2016, representing a healthy buffer above the 5.125% minimum. However, the proforma common equity Tier 1 ratio falls to about 9.3% adjusting for APRA's 1 July 2016 increase in average mortgage risk weights and the sale of NAB Wealth s life insurance business. This still represents a significant capital cushion over the capital trigger of 5.125%. If a capital trigger event does occur, NAB must immediately convert such number of NABPD that is sufficient to return the common equity Tier 1 capital ratio back above 5.125%. Furthermore, if this ratio did fall below 5.125%, NABPD holders could suffer a capital loss as a result of the maximum conversion number of shares condition, where holders potentially receive ordinary shares worth less than the AUD 100 face value of NABPD securities. Exhibit 7 NAB Regulatory Capital Ratios 14.0% 12.0% 10.0% APRA Common Equity Tier 1 APRA Tier 1 Basel III Capital Trigger 10.4% 10.8% 8.4% 8.6% 10.2% 12.4% 9.7% 11.8% 8.0% 6.0% 4.0% 2.0% 0.0% Sep-2013 Sep-2014 Sep-2015 Mar-2016 Source: Morningstar, NAB.
Page 8 of 14 Nonviability Risk NABPD has a nonviability trigger, which is required by the prudential regulator, APRA, as part of the Basel III reforms. The nonviability trigger gives APRA the discretion to require some, or all, of NABPD to be converted into NAB ordinary shares, making NABPD more equitylike than the "old-style" issues issued under the previous, less stringent regulatory framework. Similar to conversion following a capital trigger event, holders could receive ordinary shares worth less than AUD 100. A nonviability trigger event occurs if APRA believes NAB would become nonviable without a conversion of some, or all, of NABPD, or a public-sector injection of capital or equivalent support is necessary because without it, NAB would become nonviable. It should be noted that whether a nonviability trigger event will occur is at the discretion of APRA and currently there are no precedents for this. APRA may exercise this discretion should it have a concern regarding NAB's capital, liquidity or funding levels. Capital Conservation Buffer Risk As a Domestic Systemically Important Bank, or D-SIB, if NAB's common equity Tier 1 capital ratio falls into the capital conservation buffer 1, distributions on NABPD may not be paid. This is because NAB will only be able to use a certain percentage of its earnings to make discretionary payments such as dividends, hybrid Tier 1 distributions and bonuses. Distributions that are not paid do not accrue and will not subsequently be paid. In the event NAB s common equity Tier 1 capital ratio falls below 8.0%, we believe management will prioritise coupon payments on AT1 instruments to prevent a dividend stopper on ordinary shares. Furthermore, management has a number of options available to them to strengthen capital including a discounted DRP, share issuance or reducing the dividend. Write-Off Risk If for any reason conversion of notes does not occur (for example, due to applicable laws, order of a court or action of any government authority) and the ordinary shares are not issued for any reason by 5.00pm on the fifth business day following a capital trigger event or nonviability trigger event, then: Those notes will not be converted in respect of such capital trigger event or nonviability trigger event (as the case may be) and will not be converted, redeemed or transferred on any subsequent date. All rights in relation to those notes will be terminated, and holders will lose all of the value of their investment and they will not receive any compensation or unpaid distributions. Scheduled Conversion Risk A fall in NAB s share price to below predetermined levels relative to the issue date volume weighted average price, or VWAP, required under the terms of scheduled conversion, would result in NABPD not being converted on the scheduled conversion date (8 July 2024) and remaining on 1 Which is at least 8% for the D-SIBs.
Page 9 of 14 issue until the next distribution payment date when the conversion conditions are satisfied. We discuss the relevant VWAPs required under scheduled conversion in the Key Terms section. Credit/Default Risk This is the risk of loss arising from NAB defaulting on its payments, whether in the form of distribution payments or principal repayment. This is largely offset by NAB's strong credit profile. Nevertheless, investors should be aware NABPD is an unsecured, subordinated investment, so in a wind-up scenario, investors will potentially lose all of their investment. Subordination Risk If NAB issues more equal or higher-ranking securities on the capital structure, NABPD may become further subordinated. Market Price Risk The market price of NABPD could decrease below face value, depending on various market-related factors, such as credit spreads, or NAB's underlying share price performance. Liquidity Risk Hybrids are generally less liquid than the shares in the same company. Low levels of liquidity can make it difficult to buy or sell a security, raising the risk of buying at an inflated price or selling at a capital loss. Extension Risk If NABPD is not called at the first call date (7 July 2022), it may trade like a perpetual security, acknowledging the potential conversion into ordinary shares at the scheduled conversion date. We encourage investors to refer to Section 6 of the prospectus for further detail on the risks associated with investing in NABPD. Key Dates for the Offer Bookbuild: 7 June 2016. Announcement of margin: 8 June 2016. Offer opens: 8 June 2016. Securityholder offer closes: 30 June 2016. Broker firm and institutional offers close: 6 July 2016. Issue date: 7 July 2016. Commencement of deferred settlement trading: 8 July 2016. First distribution payment date: 7 October 2016. Optional redemption, transfer or conversion date: 7 July 2022. Scheduled conversion date: 8 July 2024. Key Terms Face value: AUD 100 per security. Minimum subscription amount: AUD 5,000 (50 units). Additional amounts can be bought in increments of AUD 1,000 (10 units).
Page 10 of 14 Amount to be raised: NAB plans to raise AUD 750 million via the issue of 7.5 million securities with the ability to raise more or less. Cash distribution rate: (90-day BBSW rate + margin) x (1 corporate tax rate). This assumes the NABPD distribution is fully franked. Margin: The indicative margin range is 4.95% to 5.10% per annum. Frequency of distributions: Quarterly on 7 January, 7 April, 7 July and 7 October. Franking: Distributions are fully franked. If a distribution is not franked, the cash distribution amount will be increased to compensate for any franking shortfall. Distributions: Payment of distributions is discretionary and subject to payment conditions being satisfied, the most material being that payment does not cause NAB to breach its regulatory capital requirements or become insolvent and APRA not objecting. Distributions are not cumulative, so unpaid distributions do not accumulate. Dividend stopper: If a NABPD distribution is not paid in full for a distribution payment date, then, NAB cannot pay dividends on its ordinary shares, undertake a buyback or reduce capital on any ordinary shares until a distribution is paid in full on a subsequent distribution payment period. Term: Perpetual, with a scheduled conversion date of 8 July 2024, or any subsequent distribution payment date, subject to conversion conditions, or if the security is converted earlier as a result of a conversion event or NAB exercising an option to redeem, transfer or convert the security two years early on 7 July 2022. Capital classification: Additional Tier 1 regulatory capital. Scheduled Conversion date: If NABPD has not been converted, transferred or redeemed earlier, on 8 July 2024, NABPD will convert into a variable number of NAB ordinary shares worth approximately AUD 101 at a 1% discount to the 20 business-day VWAP of NAB ordinary shares. This is subject to conversion conditions. If these conditions are not satisfied, conversion will be deferred until the next distribution payment date upon which the conditions are met. The scheduled conversion conditions are: First condition: The VWAP of NAB ordinary shares on the 25th business day before (but not including) a potential scheduled conversion date is greater than 56% of the issue date VWAP of NAB ordinary shares; Second condition: The VWAP of NAB ordinary shares during the 20 business days before (but not including) a potential scheduled conversion date is greater than 50.51% of the issue date VWAP of NAB ordinary shares; For example, if the issue date VWAP is AUD 28.00, the relevant VWAP for the first scheduled conversion condition to be satisfied would need to be greater than AUD 15.68, and for the second scheduled conversion condition would need to be greater than AUD 14.14. Capital trigger event: If NAB determines, or APRA believes, NAB's common equity Tier 1 ratio is equal to or less than 5.125%, NAB must convert a sufficient number of NABPD securities into NAB ordinary shares to return this ratio above 5.125%. The number of shares on conversion would be based on the VWAP five business days following a capital trigger event. However, conversion following a capital trigger event is not subject to scheduled conversion conditions being satisfied. This means NABPD holders could receive NAB ordinary shares worth less than AUD 100. This is because the maximum conversion number of shares would apply based on 20% of the issue date VWAP. For example, if the issue date VWAP of NAB ordinary shares was AUD
Page 11 of 14 28.00, the maximum conversion number of shares would equal 17.85 NAB ordinary shares for each NABPD (AUD 100/(AUD 28.00 x 20%)). If the NAB share price on conversion was AUD 1.00, then NABPD holders would receive NAB shares worth approximately AUD 17.85 (17.85 x AUD 1.00) for each security. A nonviability trigger event occurs if APRA notifies NAB it believes that conversion of some, or all, NABPD (or some action in relation to other NAB capital instruments) is required, because without it, NAB would become nonviable; or a public-sector injection of capital is required because without it, NAB would become nonviable. Following such an event, NAB must immediately convert such number of NABPD securities specified by APRA or necessary to satisfy APRA that NAB will no longer be nonviable. Conversion following this event is not subject to schedule conversion conditions being satisfied. The consequence is similar to conversion following a capital trigger event where NABPD holders will potentially receive NAB ordinary shares worth less than AUD 100. Optional redemption, transfer or conversion: NAB has the option to redeem, transfer or convert some or all NABPD early on the 7 July 2022. NAB has the right to redeem all NABPD for tax or regulatory reasons at any time. It should be noted that redemption, transfer or conversion, as applicable, is subject to satisfaction of certain conditions and APRA's prior approval. NABPD holders have no right to request or require conversion, redemption or transfer of their Notes. We have presented a summary of the key terms. Investors should examine the prospectus in detail if they intend to invest in NABPD. Issuer Details Investment Thesis National Australia Bank is one of four major banks operating in oligopolistic Australia and New Zealand markets. It is Australia's biggest business bank, offering a full range of banking and financial services to the consumer, small-business and corporate sectors, with significant operations in New Zealand. Until recently NAB had exposures to the United Kingdom and the agricultural belt in the United States. We believe commercial banking licences in Australia are very valuable, as all four banks benefit from substantial competitive advantages, resulting from their oligopoly within the regulated industry, extensive pricing power, high barriers to entry, low-cost operations, high-profile brands, and very profitable operations hence our wide economic moat rating for the firm. National Australia Bank was Australia's leading bank in the 1990s, avoiding the commercial loan disasters that nearly brought down two of its current peers, but a series of slip-ups and disappointments during the decade to 2008 established a hard-to-dislodge reputation as a serial underachiever for the Melbourne-based bank. The ill-fated and expensive "blow-ups" caused top-line management changes on a far-too-regular basis. Disappointingly, the onset of the global financial crisis in 2007 found National Australia Bank wanting, with high exposures to off-balance-sheet special-purpose vehicles conduits involving structured "assets". Significant loan impairment charges were necessary.
Page 12 of 14 The bank's overriding strategic priority is to expand, develop, and leverage its core Australian and New Zealand businesses. The focus is squarely on the profitable Australian franchises, where earnings and return on equity, or ROE, are strong, and further long-term upside potential remains. The need to deliver on its strategy is just as important as transparency about it. Growth opportunities across business banking, retail banking and wealth management require the support of more favourable economic conditions, stronger equity markets and a rebound in consumer and business confidence. The powerful banking and wealth management franchise continues to deliver operating momentum, particularly from core retail and business banking operations. The combination of top-line revenue growth and tight cost control will drive better operational efficiency and underpin future profit growth. National Australia Bank currently generates more than 80% of its cash earnings from its Australia businesses, while accounting for 60% of the group's risk-weighted assets. The price-led, customer-focused retail strategy has been successful in capturing an increasing share of business, particularly at the expense of major bank competitors. The retail growth strategy is providing a larger and more diversified customer base, enabling wealth cross-selling and product-upselling opportunities. The extensive marketing campaign, existing distribution network and increasing reliance on third-party mortgage sales are leading to solid performance. A primary risk that concerns most investors is a potential fall in the Australian housing market. While Australian home prices have been undoubtedly strong for quite a few years, we're comforted by several crucial factors. A combination of factors mitigate potential losses from mortgage lending: tight underwriting standards, lenders' mortgage insurance, low average loan/valuation ratios, a high incidence of loan prepayment, full-recourse lending, a high proportion of variable rate home loans, and the scope for interest rate cuts if deemed necessary by the Reserve Bank of Australia. We certainly cannot rule out weak home prices, but investors that compare Australia to the United States and other markets are glossing over what are in fact fundamentally different residential real estate markets. National Australia Bank's mortgage book accounts for 60% of total group loans. We like the multiple growth options, focus on business efficiency, reinvigorated retail banking strategy, improving ROE and exposure to the positive long-term growth dynamics of the Australian superannuation system. Financial Health National Australia Bank is in good financial health, with a strong capital position. The common equity Tier 1 capital ratio as at March 2016 is 9.7% under the Australian Prudential Regulation Authority's, or APRA's, conservative interpretation of Basel III capital requirements. Common or core Tier 1 capital is ahead of the APRA domestically significantly important banks, or D-SIBs, Basel III capital minimum requirement of 8.0%, effective January. APRA is implementing tougher common equity Tier 1 rules, effective July 1 with the proforma common equity Tier 1 ratio falling to a still respectable 9.3%. The efficient capital structure and strong balance sheet provide room for comfort, and we consider concerns regarding wholesale funding, mortgage arrears and price competition within the sector to be overstated.
Page 13 of 14 CEO Andrew Thorburn took the opportunity to strengthen the balance sheet, raising AUD 5.5 billion in new capital via a prorata accelerated renounceable entitlement offer priced at AUD 28.50 per share, a significant 19% discount to the previous close, or a 16.7% discount to the dividend adjusted last trading price. The entitlement ratio was 2 for 25, issuing approximately 194 million shares, representing approximately 8% of issued capital. Economic Moat We assign a wide moat to National Australia Bank. The wide moat rating recognises the structural competitive advantages Australia's four major banks possess. The four major banks dominate a regulated and rational oligopoly, bestowing structural advantages that are strong and durable. We believe the economic moats surrounding the major banks are sufficiently wide to ensure global sector-leading returns on equity for the foreseeable future. In our opinion, cost advantage and switching costs are the main sources of the wide economic moats for Australia's four major banks. Intangible assets and efficient scale can provide important, but less prominent, moat sources. Banking in Australia is a highly profitable oligopoly, with the four major banks controlling more than 90% of the business and consumer lending markets, plus the vast majority of bank deposits. National Australia Bank is currently expanding its home loan book above the rate of system growth, with its share of the Australian bank home loan market currently 16%, compared with market heavyweights Commonwealth Bank of Australia at 26% and Westpac Banking Corporation at 25%. Household deposit market share is similar, with Commonwealth Bank leading at 29%, Westpac at 23%, Australia & New Zealand Banking Group at 14%, and National Australia Bank at 14%. Despite dominant market positions, competition is intense between the four major banks. Tight cost control and strong volume growth provide a solid platform for consistent earnings growth well in excess of our cost-of-equity estimate. We expect this to continue. National Australia Bank is a diversified financial services business, benefiting from economies of scale and a sticky customer base. The concentrated industry benefits from high barriers to entry across most segments, making it hard for new entrants to gain any sort of foothold, particularly in retail and business banking. National Australia Bank leverages its strong distribution network, large number of financial advisers, and high-profile MLC investment platform to further expand into the wealth sector. Customer inertia is high, as most customers view the major banks as providing similar levels of service. Most major bank customers have multiple product relationships with their bank, ensuring limited switching because of cost and time pressures. National Australia Bank's focus on deeper customer relationships promotes customer loyalty, reduces switching, and improves profitability. Regulation and highly profitable customer lending reduces risk taking in nonlending asset classes. The concentrated market ensures above-average risk-adjusted returns. Mortgage lending is consistently profitable and accounts for 59% of total loans and 36% of total assets, as at September 2015. Pricing is opaque, as higher advertised rates are discounted for customers, and mortgage interest rate changes tend to be matched by competitors. Standard loans require mortgage lenders' insurance if loan/value ratios, or LVRs, exceed 80%, limiting credit risk on a large portion of higher- LVR loans. Low-doc mortgage loans above 60% LVR require lenders' mortgage insurance, so
Page 14 of 14 mortgages resemble a fee-based business with significant operating leverage, and National Australia Bank benefits from its growing market share. Mortgage insurance is paid by borrowers but benefits the bank in the event of a mortgagee-in-possession property sale below the outstanding loan amount. National Australia Bank's Australian mortgage portfolio includes a lower proportion of first-time homebuyers and low-doc loans compared with its two bigger retail focused peers, Commonwealth Bank of Australia and Westpac Banking Corporation. Mortgage insurers in Australia are regulated by APRA, with the two dominant insurers currently rated AA- by S&P. Both insurers regularly stress test their mortgage insurance portfolios and are capitalised to withstand loss severity rates significantly higher than the worst previous experiences. Mortgage insurance covers 100% of the insured loan amount for the loan life. The major provider of mortgage insurance is Genworth Financial, with about 50% of the Australian and New Zealand market. Genworth Financial's Australian assets and capital are 'ring-fenced' from its US parent. Management & Stewardship We rate the company's stewardship of shareholder capital as Standard. In our view, CEO Andrew Thorburn was a smart appointment when promoted to CEO in August 2014. He is well-placed to lead the group following a successful six-year track record heading up the New Zealand operations. We consider the CEO to be an inspirational leader and a real people person, who is more than capable of running a large and complex major bank. Group strategy remains focused on Australia/New Zealand banking following the demerger of the troubled U.K. assets. K