While I use the Altman Z-Score and the Piotroski F-Score a lot to evaluate companies, I can’t use these so well for financials. For banks, the raw materials are money, the inventory is cash, the business is borrowing and lending. So we can’t use normal metrics to evaluate a bank.
For banks, I like to use the loan-to-deposit ratio. Loans are the core products of banks. Deposits are the core materials. Deposits are cheap forms of financing and are sticky compared to money markets (borrowing up to one year) and capital markets (borrowing over one year). As such, a loan-to-deposit ratio over one means the amount of loans exceed deposit funding and require more risky forms of funding. It means a risk of a possible asset liability mismatch should financial market conditions change.
A loan-to-deposit ratio of less than one means that loans are funded entirely by sticky deposits and loan growth is a possibility. It’s a sign of conservative management, high net interest margins and growth opportunity should the economies where the bank is exposed pick up.
I prefer banks with a loan-to-deposit of 90% or less to give that extra protection and financial flexibility. NatWest Group PLC’s (LSE:NWG, Financial) loan-to-deposit ratio was 89% in 2019 and 84% in 2020. Going forward, the bank should keep a conservative profile as with the U.K. government still the majority shareholder, management won’t be allowed to go to crazy. The boom-and-bust days of the Royal Bank of Scotland are well and truly over and the renaming to NatWest Group is supposed to draw a line in the sand and signal the more conservative style of the bank.
The U.K. government's ownership is a double-edged sword. Some analysts continue to see the government's stake in NatWest as an overhang that will depress the stock. The company has been buying back stock from the U.K. Treasury – 5% of share capital in the first quarter of this year and a further buyback of 75 million pounds ($1 billion) in the second quarter. Further buybacks in 2022 have also been signalled, which is positive. NatWest should also benefit from the U.K. government’s more populist policies and bigger role in the economy. As a result, it will be in a good position to fund all kinds of projects the U.K. government needs to undertake to fulfill its political promises, from greening the economy and reducing the North-South economic divide to generally building back better following the Covid-19 pandemic and supporting first-time homebuyers.
Since the global financial crisis, the company has been in a monumental restructuring phase to exit all the excessive businesses it entered as well as scale back and deleverage. These efforts are largely complete. After billions upon billions of write-downs and divestments, NatWest’s exit of Ulster Bank and restructuring of its Natwest Markets appear to be the some of the final major strategic changes needed.
By my calculations, the shares trade an earnings multiple of 7.2 for 2023 expectations, which seems very reasonable to me. In the RBS days, the bank was global but far too highly leveraged and too big to fail, hence its U.K. government bailout in the global financial crisis. Now as NatWest, the bank is far more simple with just three core businesses: U.K. Retail division, Commercial and International and Private Banking.
NatWest is significantly geared to the U.K. economy through its exposure to mortgages and commercial real estate. The group is likely to target further absolute cost reduction of in the region of 4% annually over the next few years, though increased expenditure on IT and digitalization are helping the bank to future-proof itself.
The bank is, obviously, exposed to interest rates, and higher interest rates and steeper yield curves will prove beneficial to margins. Any taper tantrum will increase volatility in fixed-income markets, which will be good for trading conditions (more customer flows) benefiting the commercial banking unit where its fixed-income customer business sits.
Finally, the U.K. economy is recovering and, as mentioned, a hawkish rate environment and steepening yield curve, which seem likely in the U.K., are certainly upside risks. In addition, this improving outlook aids the bank’s asset quality with potential write-backs benefiting the bank’s surplus capital position.
If the valuation overhang persists, then management guidance of a minimum of 1.0 billion pounds of dividend distributions per annum, combined with likely further share buybacks, would give a total yield of about 9% to 10% over the next couple of years, which I can happily live with in a low-80% loan-to-deposit ratio.
