Since the global financial crisis (GFC), confidence in U.S banks has fallen dramatically, with many investors shying away from the sector as the law suits, losses and risk management failures continue to mount up. This has seen many U.S banks reduce their dividends as they struggle to rebuild balance sheets and boost their financial performance. However, I and fellow Seeking Alpha contributor Colin Lea believe that financial stocks, and in particular banks, form an important part of any income portfolio. Typically this is because banks are dividend machines that reward investors with a consistently growing, high yielding income stream.
Some of the better dividend yielding banks are to be found outside of the U.S., namely in Australia and Canada. In this article, I have analyzed Canada's third-largest bank Scotia Bank (BNS), while Colin in his article has analyzed Australia's third-largest bank ANZ (ANZBY.PK) to determine whether they represent solid investment opportunities. We have done this by analyzing their shareholder remuneration, key risks, performance and valuation metrics to the four major U.S. commercial banks; Citigroup (C), Bank of America (BAC), JP Morgan (JPM) and Wells Fargo (WFC).
Consistently delivering a solid financial performance
Scotia Bank continues to deliver strong financial results, and for the third quarter 2012 exceeded its consensus earnings per share (EPS) target of $1.20, reporting EPS $1.23. It achieved this on the back of continuing strong revenue growth over the last year, as the chart below illustrates.
NB: Canada's 3Q12 Quarterly GDP growth rate is an estimate only.
This saw Scotia bank report revenue of $5.5 billion, which is a 17% increase in comparison to the second quarter (QoQ) and a 28% increase in comparison to same quarter in the previous year (YoY). It also reported net income of $2 billion for the third quarter, which represents a massive 41% increase QoQ and 57% YoY. This is a very impressive financial performance, particularly when the current operating environment and global headwinds stirred up by the European financial crisis and China's slowing economy are considered.
However, investors should note the financial results for the third quarter include a one-off gain of $614 million or 53 cents per share, resulting from the sale of Scotia Plaza. When this is accounted for, net income falls to $1.4 billion, which is a 2% fall in net income QoQ and a 10% increase YoY.
Another compelling aspect of Scotia Bank is its particularly strong balance sheet, with the bank having considerably lower leverage and dependence on volatile wholesale funding than either ANZ or the big four U.S. banks. Currently Scotia Bank has a long-term debt-to-equity ratio of 25% which, as the chart below illustrates, is substantially lower than the four major U.S. commercial banks and ANZ.
Such a low long-term debt-to-equity ratio indicates a superior and less volatile funding mix, which conveys the benefits of a lower cost base than the other banks. This is because Scotia Bank relies upon its deposit base, rather than wholesale credit markets, to fund the majority of its loan portfolio. In addition, it leaves the bank less vulnerable to the impact of short-term interest rate movements and rising interest expense for long-term wholesale credit. A significant impact of the GFC and the European financial crisis, has been an overall tightening of global credit markets, making wholesale funding more difficult and expensive to procure.
This lower dependence on wholesale funding is also evidenced by the bank's conservative loan-to-deposit ratio, which at the end of the third quarter was 77.3%. This, as the chart below shows, is commensurate to the four U.S. majors but is significantly better than ANZ, which has a loan-to-deposit ratio of 130%.
While this is significantly lower than what is considered to be the optimal range for a loan-to-deposit ratio of 95% to 105%, it indicates that Scotia Bank, like the four U.S. majors, is maintaining a high level of liquidity. This is in stark contrast to ANZ, which by virtue of its reliance upon wholesale funding has a loan-to-deposit ratio well outside the optimal range.
At this time I believe that a high level of liquidity is essential for banks when the current operating environment is taken into consideration. This is because there is still the heightened risk of further financial shocks and a slowing global economy, caused by the dual effects of Europe's financial crisis and China's slowing economy.
In addition to which, the level of regulatory risk has increased sharply in light of the lower global risk appetite for leverage that has seen new regulatory requirements governing the operations of banks, in the form of Basel III, introduced. All of which makes a low dependence on wholesale funding and high levels of liquidity a valuable commodity in global banking. Scotia Bank's low level of long-term debt, combined with its high liquidity not only leaves it well positioned to weather any further financial shocks, but also to take advantage of any uptick in economic activity in its core markets, to grow its loans and deposit business.
The strength of the bank's financial position can also be seen with its high level of capital adequacy, which is another good indicator of the degree of risk within a bank. For the third quarter 2012, Scotia Bank reported a tier one capital ratio of 12.6% as the chart below illustrates.
This indicates that Scotia Bank is well capitalized, showing that it has a low-risk balance sheet and is well positioned to meet the upcoming Basel III requirements. Interestingly, of the U.S. majors, it is only Citigroup and Bank of America that have higher tier one capital ratios, and this can be partly attributed to those banks seeking to rebuild confidence with regulators, investors and the markets since the GFC.
Finally, the other key indicator that measures the strength and the level of risk associated with a bank's balance sheet is the quality of its assets. For a commercial bank like Scotia Bank, ANZ and the four U.S. majors the primary assets are their loan portfolios. The quality of the loan portfolio is measured by way of a bank's non-performing loan (NPL) ratio, which as the chart below illustrates, is particularly low for Scotia Bank at 0.6%.
This ratio, like ANZ's NPL ratio, is substantially lower than the major U.S. banks and demonstrates that both ANZ and Scotia Bank have higher quality, lower risk loan portfolios. In contrast, both Citigroup and Bank of America, unlike Scotia Bank or ANZ, have particularly large portfolios of substandard legacy assets as a result of the subprime crisis and GFC. It is these portfolios that contribute to their higher NPL ratio, lower efficiency and ultimately lower profitability.
Typically, a higher NPL ratio is also associated with higher loan-loss provisions and higher risk, which the bank will seek to reduce by maintaining a high NPL coverage ratio. This in itself also significantly impacts on profitability, because the higher the level of provisions the greater the economic and accounting costs associated with them.
Despite the low NPL ratio, Scotia Bank during the third quarter chose to increase its loan loss provisions by 52% to $402 million because of growing concerns of an even deeper global economic weakness. This saw the bank's NPL coverage ratio a key measure of risk increase by 8% to an impressive 142%, leaving its NPL exposure well covered, yet still leaving the bank with a low provision to total loans ratio of 0.44%, which is a 14bps QoQ increase.
This particularly strong low balance sheet indicates that not only is Scotia Bank managing risk well, but that it is well positioned to continue growing its business and deliver value for shareholders.
Future Outlook and Evaluation
One of the compelling reasons for investing in Scotia Bank is its high level of profitability, with the bank regularly reporting a double digit return-on-equity. For the third quarter, it reported a return on equity of almost 25%, which as the chart illustrates is higher than any of the four U.S. majors and ANZ.
However, when the third quarter return-on-equity is adjusted to reflect the bank's financial performance by excluding the one off gain from the sale of Scotia Plaza, it falls to 17%.
Even more significant is that Scotia Bank has consistently reported a double digit return-on-equity over the last five quarters, while having a lower degree of leverage than either the U.S. majors or ANZ, as the chart below illustrates.
This, I believe, in combination with its low-risk loan portfolio and high levels of liquidity, indicates that the bank is well positioned to continue driving revenue growth and delivering strong profitability for investors.
Scotia Bank's strong profitability can, in part, be attributed to the bank's strong cost control and high level of efficiency, which saw it report an efficiency ratio of 47% for the second quarter 2012, as the chart below illustrates.
This efficiency ratio is superior to all of the major U.S. banks, but inferior to ANZ, which reported an efficiency ratio of 45% for the last quarter. This solid efficiency ratio is one of the reasons that Scotia Bank has been able to operate extremely profitably, as evidenced by its consistently high return-on-equity.
Scotia Bank has a generous shareholder remuneration program in place and has been paying a dividend to shareholders since 1 July 1833 with an initial yield of 3%. Since that time, the dividend has grown steadily in value, and at the time of writing the last dividend paid totaling just fewer than 58 cents, with an ex-dividend date of 28 September 2012. This gives the bank a healthy trailing-twelve-month (TTM) dividend yield of just over 4%.
This yield is superior to the major U.S. banks, including Citigroup at 0.1%, Bank of America at 0.4%, and both JP Morgan and Wells Fargo with yields of 3%. Furthermore, as the twenty-year dividend chart below illustrates, Scotia Bank has a strong record of dividend growth paying a steadily increasing dividend over that period.
I believe the bank's consistent dividend growth, with a compound annual growth rate of 3.5%, combined with a solid yield of over 4% makes Scotia Bank an ideal candidate for dividend growth investors.
However, foreign investors in Canadian companies need to be aware that withholding tax of 25% is payable on dividends. But this can be reduced depending on the nationality of the investor, and whether there is a tax treaty in place between Canada and the country in which the investor is domiciled. For U.S. investors the tax treaty between Canada and the U.S. reduces the withholding tax payable to 15%. Furthermore, there is no withholding tax payable for dividends paid to an approved pension or retirement plan, provided they are generally exempt from tax in the country of residence.
An aspect of Scotia Bank that I particularly like is the bank's strong international emerging market exposure, with operations in a number of emerging economies. This has seen the bank well positioned to enhance its performance by being able to gain exposure to the higher rates of economic growth in those economies as set out by the chart below.
A key plank of Scotia Bank's growth strategy has been to expand its franchise in Latin America, which now gives it a strong presence in one of the world's fastest growing regions. In 2011 Latin America and the Caribbean's regional GDP grew by 4.5%, which was more than double the 1.7% for the U.S. and almost double the 2.4% for Canada. It is also estimated that in 2012, the region's GDP will grow by 3.4% and then by 4.2% in 2013, which is almost double the growth estimates for the U.S. and Canada as the table below illustrates.
This also provides another significant growth opportunity for Scotia Bank, because the majority of countries in Latin America are significantly under-banked. Yet, because of their strong economic growth, they are seeing greater demand for traditional banking products and consumer credit.
As the chart below illustrates, all of the countries in the region have ratios of private sector credit to the domestic sector as a percentage of GDP that are significantly lower than advanced economies like the U.S. or Canada. Further, with the exception of Brazil and Chile, this ratio for those countries is less than 50%.
As these economies grow and mature there is also considerable opportunity for demand in higher value credit products such as mortgages, with the entire mortgage to GDP ratio in Latin America being well under 20%, as illustrated by the chart below.
All of this bodes well for Scotia Bank's ability to grow its business and continue to perform strongly despite the 2013 economic outlook for Canada showing some weakness. This geographical diversification also allows investors to obtain exposure to the Latin American banking sector, while mitigating many of the risks that traditionally come with investing directly in this region. This is because they are investing in a Canadian domiciled bank that is subject to more coherent and in many cases stricter prudential regulation.
Overview of risks and other matters for consideration
The other advantage that comes from investing in a Canadian bank such as Scotia Bank is that it carries little to no additional country risk when compared to investing in a U.S. bank. In fact, given the recent issues being witnessed in the U.S. banking sector, particularly as a result of ongoing fallout from the subprime crisis, Canadian banks are, in my view, lower risk. The level of risk for investors is also further reduced by Canada's more heavily regulated banking sector and stricter prudential regulation. This saw Canada's banks like their Australian counterparts weather the GFC far better than their U.S. peers. But investors do need to keep in mind that there are still some risks that they should be aware of including:
- A slowing housing market, with the risk of sudden devaluation in house prices from a perceived housing bubble. This will impact mortgage revenue, but because of Canada's strict prudential regulation, I do not believe this would have a significant impact on non-performing loans or loan loss provisions.
- Canada's dependence on commodities, as a key driver of economic growth, makes it likely that any further fall in global demand for resources will trigger slower economic growth. This will have a flow on effect to the broader economy impacting consumer spending and domestic housing construction, which would see demand for credit fall.
- Increased regulatory risk with increased banking regulation that will negatively impact operating costs, and increase the economic costs associated with regulatory capital.
- Tightening of wholesale funding markets internationally, with a declining appetite for risk and leverage because of the European financial crisis.
However, many of the economic risks that have the potential to impact the bank are mitigated by the geographical diversification of Scotia Bank's operations across a number of emerging market economies. This, I believe, makes it a superior investment opportunity to a bank solely focused on the Canadian market.
Finding Scotia Bank's fair value
At the time of writing Scotia Bank is trading with a trailing twelve month price-to-earnings ratio of 10, which I believe makes the bank look cheap, particularly when its solid profitability and dividend is considered. As the table below indicates, Scotia Bank on the basis of its earnings appears to be relatively cheap in comparison to its peers with the exception of JP Morgan.
However, it does appear the most expensive of the banks compared on the basis of its price to book value, with Bank of America and Citigroup trading at significant discounts to their book values. But in the case of Scotia Bank, I believe this premium of just over 80% is justified because of its strong management, solid profitability and high asset quality.
Furthermore, I don't believe it is possible to accurately value a bank using ratios alone, primarily because of their simplistic and backward looking nature. Therefore, I have valued Scotia Bank using my preferred valuation methodology for banks, an excess return valuation. In order to conduct this valuation I have taken Scotia Bank's tangible book value as the starting point and then made the following assumptions:
- Profitability, and therefore Scotia Bank's return-on-equity, has been discounted over the valuation period, in order to reflect the predicted slowdown of the Canadian economy. It has also been adjusted to allow for the one off $614 million windfall associated with the sale of Scotia Plaza.
- A return-on-equity in perpetuity of 11% has been used to calculate the terminal value of retained earnings.
- A conservative rate of economic growth of 2.5% has been used, which is similar to the ten year Canadian historical average of 2.6%. In determining this rate I initially discounted the ten year historical average to allow for the forecast slowdown of the Canadian economy and the long-term impact of the current global headwinds. But I then increased it to reflect the bank's exposure to faster growing emerging market economies.
- I have applied a cost of equity of 8%, which was calculated using the capital asset pricing model (CAPM).
Using this data and the assumptions discussed, I have calculated an indicative fair value of $61 per share as set out in the chart below.
At the time of writing Scotia Bank is trading at around $53, which means this indicative fair value represents a 16% upside for investors. While this does not represent a considerable margin of safety, it indicates that the market has marginally unfairly valued the bank at its current price and there is some opportunity for capital appreciation.
Scotia Bank is a high performing, geographically diversified Canadian bank with a solid, low-risk balance sheet, high asset quality and outstanding profitability that pays a consistently appreciating dividend. This makes it an appealing alternative for U.S. investors seeking exposure to the banking sector, while seeking both capital growth and a regular income stream. Even more appealing is it gives investors exposure to higher growth emerging markets in Latin America, while mitigating the risks typically associated with investing in these markets. Finally, with Scotia Bank trading at around a 16% discount to its indicative fair value at the time of writing, it now presents as a compelling opportunity.