Bank Of Nova Scotia: Cheapest Among Canadian Banks Relative To Growth Potential

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 |  About: The Bank of Nova Scotia (BNS), Includes: BMO, CM, RY, TD
by: Kenny Yang

Summary

Bank of Nova Scotia reported strong q1/14 earnings and hiked its quarterly dividend by 3%.

The bank's emerging market exposure is manageable and other profitable divisions are overlooked by investors.

Calculated intrinsic value of US$68.17 or 18.2% higher than the current price.

Author sees attractive upside for the shares but also sees high price volatility in the short term.

The Bank of Nova Scotia (NYSE:BNS), commonly known as Scotiabank or Scotia, started off fiscal 2014 with a solid quarter. The bank reported Q1/14 earnings on Tuesday which matched analysts' estimates despite weakness in its international banking and capital markets divisions. The company's stock underperformed its domestic rivals due to worries about its emerging market exposure. Scotiabank has the largest international banking operations among its peers and has operations mainly in Latin and Central America.

In January, investors' confidence in emerging markets collapsed when Argentina devalued its currency and Turkey was forced to hike its overnight rate by an exorbitant amount in order to prevent capital outflows. Companies with emerging market exposures experienced large sell-offs regardless of the underlying fundamentals.

However, the panic selling in financial markets did not affect Scotiabank's fundamentals. For Q1/14, which ended on January 31, 2014, the bank earned $1.32/share vs. $1.24/share in Q1/13. Despite Q1/14 included the apex of the emerging market sell-off in January, Scotiabank was still able to generate a 6.5% earnings growth. The bank also hiked its quarterly dividend by 2 cents from $0.62 to $0.64.

Regarding its Q1/14 result, Scotiabank's CEO issued the following statement in the earnings press release:

"We are pleased to report good results to start the year. Strong top-line revenue growth reflects the success of the Bank's highly diversified business model. We continue to invest in all of our businesses with particular focus on optimizing customers' experience"

Brian Porter, Scotiabank's CEO

As Mr. Porter reminds investors, Scotiabank has a diversified business model despite the common misconception that it has a large exposure to emerging markets. Although its international banking operations was affected by the emerging market panic, Scotiabank possessed other divisions that generated stellar earnings growth to offset that negative. As shown in graph 1, the bank has delivered a 6.5% year-over-year (Y/Y) increase in earnings in Q1/14.

Graph 1: Quarterly Financial Trend

Source: Financial Supplement

Investment Thesis:

Scotiabank's stock is an excellent investment because its current valuation is cheap relative to the company's growth potential. As shown in graph 2, the 10-year average price to book (PB) ratio was 2.4 vs. the current 1.85. Scotiabank has historically traded at a premium of about 8% relative to the peer average, but it is now trading at a 4% discount to the peer average (see graph 3). I believe the multiple should revert towards the mean over time and the bank should trade at between 2-2.2 times book. The multiple will expand due to (1) earnings improvement in its international banking division as growth in emerging market economies pick up (2) strong growth in its wealth management business which is experiencing double digit growth in both assets under administration (AUA) and assets under management (AUM).

I believe the Scotiabank is trading at a discount vs. peers due to the slowdown in emerging market economies since 2012. The announcement of the tapering of quantitative easing by the US Federal Reserve also added pressure on emerging market economies. However, mean reversion is a common theme in financial markets that investors should not forget. The long-term outlook for emerging market is still attractive given they possess much higher GDP growth relative to developed economies and the growth of the middle class in those countries will increase demand for financial products. Also, the bank's emerging market exposure is heavily weighted towards healthier countries (Mexico, Peru, Chile and Columbia), which are more fiscally stable and possess better growth potential than weaker emerging market economies like the fragile five (India, Indonesia, Turkey, South Africa and Brazil).

In addition, Scotiabank is a well-diversified bank, which allows the bank to generate stable earnings growth despite weak results in one particular division. As shown in graph 4, international P&C banking represents only 26% of the bank's total earnings and its exposure to emerging markets is manageable. Its capital position improved significantly Y/Y and the dividend outlook is bright. The bank grew its dividend by approximately 10% annually on average over the last 30 years and will continue to reward shareholders in the future.

Graph 2: Scotiabank's Historical PB

Source: Financial Supplement

Graph 3: Scotiabank's Historical PB vs. Peers

Source: Financial Supplement. Peers include Royal Bank of Canada or RBC (NYSE:RY), Toronto Dominion Bank (NYSE:TD), Bank of Montreal (NYSE:BMO) and Canadian Imperial Bank of Commence or CIBC (NYSE:CM).

Graph 4: Earnings by Division (FY 2013 Figures)

Source: Financial Supplement

Dividend Outlook:

The bank also increased its quarterly dividend by 3% from $0.62/share to $0.64/share. This increase was widely expected and the timing of the dividend hike is in-line with its historical trend of increasing its dividend twice a year. Scotiabank usually hikes its dividend in March and September. Therefore, I expect another 3% ($0.02/share) dividend hike in September.

Scotiabank is not an aggressive dividend payer but it does target a payout ratio between 40-50%. In fiscal 2013 (year ending October 31, 2013), the bank's payout ratio was approximately 45.8% and I expect that ratio to remain relatively unchanged in fiscal 2014. I expect a modest increase in EPS, approximately 6% to $5.52, in fiscal 2014 and the payout ratio should increase slightly to 46.3%.

Dividend growth in the future will be similar to earnings growth. The bank targets medium term earnings between 5-10%. Although that is a wide range, I expect investors should see dividend growth of approximately 7.5% on average in the next 5 or 10 years, which represents the mid-point of the 5-10% targeted range.

Graph 5: EPS, Dividend per Share and the Payout Ratio

Source: Financial Supplement

Canadian P&C Banking:

Canadian banking is a major profit contributor to Scotiabank although its size is much smaller compared to its domestic peers. As shown in graph 4 above, Canadian P&C banking only contributes 34% of total earnings, compared to the average contribution of 50% for other domestic banks. However, this division is still important given its solid earnings growth and high ROE (in the mid-30% range).

In Q1/14, the bank reported net earnings of $575 million which represents a Y/Y increase of 6.7% and quarter-over-quarter (Q/Q) increase of 3.6%. The Y/Y increase was less than the previous quarter because the comparison was skewed by the purchase of ING Canada in 2012, which gave an immediate boost to earnings once the deal closed in 2013.

Excluding the ING Canada impact, core earnings growth slowed slightly but is still healthy given the challenging operating environment in Canada. Loan growth was 5.1% Y/Y, which is comparable to the growth rate reported by other Canadian banks.

However, deposit growth was weak at 0.4% Y/Y. The decrease in operating expenses allowed the bank to improve the efficiency ratio (non-interest income divided by total revenue), which decreased 130 bps to 50.2%. The improvement in expenses also allowed the bank to achieve positive operating leverage of 1.1%.

Looking ahead, this division should continue to deliver stable growth. Loan growth may remain in the mid-single digits while net interest margin may increase slightly from the current 2.07% due to a favorable change in the product mix. Management expects operating leverage to remain positive going forward, which should be positive for earnings growth. Earnings growth rate should be 6-8% for this division going forward.

Finally, I would like to address on the risk of the residential mortgages on Scotiabank's loan book. The loan books is slightly overweight residential mortgages (68% of loan book) vs. peers. However, Scotiabank's portfolio has a higher portion (55%) that is insured vs. peer average of 50%. The majority of the mortgage insurance (about 90%) is issued by CMHC, which is a crown corporation and is 100% backed by the Government of Canada. Therefore, the 55% insured portion of the portfolio should be safe even if the housing market suffers a major correction.

As shown in table 2 below, the average loan to value (LTV) for the uninsured Canadian residential mortgages is 63%, which is slightly lower than the peer average of near 70%. With an LTV ratio of 63%, housing prices would need to correct more than 37% before Scotiabank would suffer losses.

Also Scotiabank possess about $5 billion in excessive capital (above the minimum required 8% Tier 1 Common Equity Ratio) that can absorb further losses. Also, the bank generates about $1 billion in excessive capital per quarter. Hence, unless the housing prices in Canada declines over 50%, investors should be comfortable with their Scotiabank investment.

I agree Canada's housing market is overvalued and will likely experience a 20-30% correction during the next 2-3 years. However, the stricter underwriting and regulatory rules in Canada have positioned the banks to weather a large housing correction. Investors should pay attention to the Canadian housing market very closely in the upcoming quarters.

Table 1: Canadian P&C Banking Data

Source: Financial Supplement

Graph 6: Canadian Banking Loan Book

Source: Financial Supplement

Table 2: Residential Mortgage Book LTV Ratios

(click to enlarge)Click to enlarge

Source: Q1/14 Quarterly Report, Page 12

International P&C Banking:

As mentioned in the introductory paragraph, international P&C banking experienced further weakness due to concerns regarding the tapering of quantitative easing and the large capital flight out of emerging market economies. Despite the challenging operating environment for its international P&C business, net income only fell 2.4% Y/Y to $401 million. Loan growth was healthy and remained in the double digits. NIM decreased 25 bps Y/Y but is stabilizing around 3.90%. The efficiency ratio increased 180 bps as the weaker Canadian Dollar resulted in higher expenses for the division.

Looking ahead, the fundamentals of its international P&C business are solid but the division is facing a near-term headwind. Nonetheless, there are positives. Loan growth should continue at double digit rates for the foreseeable future. Mr. Porter is expecting loan growth to be at least 2 times the average GDP growth of the emerging market countries. Mr. Porter is also announcing a cost cutting initiative to consolidate operations and reduce back office jobs by increasing automation. The bank is targeting a positive operating leverage ratio for the full fiscal 2014. If that target can be achieved, then it would be a boon to earnings growth. Furthermore, Mr. Porter is expecting NIMs to stabilize and increase to the 4% level, which will benefit earnings growth as higher NIMs imply higher net interest income. Mr. Porter also emphasized that most Latin American countries that Scotiabank does business in are fiscally sound and possess a more stable political environment than the fragile five countries.

On the international P&C banking strategy, Mr. Porter had the following comment in the earnings release:

"Our operations in emerging markets are an important long-term growth story for Scotiabank. We have deliberately chosen to invest in stable Latin American economies such as Chile, Peru, Colombia, and Mexico. We believe that the likelihood of sustainable, higher growth in these selected emerging markets remains strong and our businesses are performing well"

Table 3: International P&C Banking Data

Source: Financial Supplement

Wealth and Insurance:

Wealth and insurance is a key area of growth for the company that is under-appreciated. Many investors buy Scotiabank because of its emerging market exposure but never consider the potential of its wealth management business. In Q1/14, earnings increased 14.7% Y/Y to $327 million. The results were driven by double digit growth in AUA and AUM, which increased fee revenue. Expenses decreased slightly with the efficiency ratio falling 20 bps Y/Y and 60 bps Q/Q. Lower expenses resulted in a positive operating leverage of 0.4%.

Improvements in financial markets and higher investor confidence should drive earnings growth in the future. AUA and AUM should both increase as the global economy improves. The bank has launched several new products during the quarter including 5 in Canada and 6 in the Latin American region. Mr. Porter also expressed interest in buying another wealth manager within its core emerging market countries (Mexico, Peru, Columbia and Chile). Another growth option is take full control of CI Financial in Canada, which the bank holds a minority 37% equity stake in.

Table 4: Wealth and Insurance Data

(click to enlarge)Click to enlarge

Source: Financial Supplement

Global Banking and Markets:

Global banking and markets, the wholesale banking arm of the bank, reported a 12.6% Y/Y drop in earnings. The drop was attributable to weak fixed income trading revenues and high expenses due to negative FX translation. The NIM on its corporate lending book also decreased Y/Y from 2.46% to 2.14%.

Going forward, this division will continue to experience weakness in the next 2 quarters or so but earnings should stabilize around current level. Despite the large 12.6% Y/Y decrease in earnings, the Q/Q comparison is actually positive. Given the lower base, earnings growth should improve due to expense cutting and higher fees from M&A and underwriting. Those two factors should help to mitigate the decline in trading revenues. Scotiabank was named as sole financial advisor of Fortis' (OTCPK:FRTSF) $4.3 billion acquisition of UNS Energy and acted as advisor for Talisman Energy (NYSE:TLM) on its $1.5 billion shale asset sale to Petronas. Looking ahead, M&A activities should pick up in the future and that will benefit Scotiabank's wholesale banking division.

Table 5: Global Banking and Markets Data

Source: Financial Supplement

Credit & Capital:

Credit quality remains strong at Scotiabank but provision for credit losses (PCL) increased 15% Y/Y due to product mix changes at the Canadian P&C banking operations. The higher focus on auto and credit card lending helped to boost NIMs for the Canadian P&C division but also had a cost. Those products experience higher loss rates so the provisioning is higher on a Y/Y basis. Nonetheless, the PCL Ratio (PCL to average loans) is within its historical 0.30-0.35% range. Gross impaired loans increased slightly by 5% Y/Y but its total loans was also up 7%. The impaired loans to total loans ratios remained stable at 89 bps. Net impaired loan formation increased 16.9% Y/Y for the same reason as the increase in PCL.

Table 6: Credit Related Data

Source: Financial Supplement

As shown in table 7, the bank's capital ratios, under Basel III rules, improved from Q1/13 to Q1/14. The Tier 1 common equity ratio rose 120 bps from 8.2% to 9.4%. Other capital ratios also experienced a similar increase. Scotiabank is able to generate $1 billion in excessive capital every quarter and the Tier 1 common equity ratio is likely to increase from the current 9.4%. It should increase approximately 0.3% per quarter without additional acquisitions or share buybacks.

Table 7: Capital Ratios (Under Basel III "All-in" Approach)

Source: Financial Supplement

Valuation:

My 12-18 month price target for the stock is US$68.17 (for its NYSE listed shares) or C$75.67 (for its TSX listed shares). The price target is calculated by multiplying a PB multiple of 2 by my estimated book value of US$34.08 (representing estimated book value at end of Q1/15) or C$37.83. The price target is 18.2% higher than the current price of US$57.68 or C$63.72. I believe a PB multiple of 2 is fair given the long term growth potential of its international banking division and strength of its wealth management business. The 10-year average PB multiple is 2.4, which is significantly lower than the assumed PB multiple of 2 in my valuation. Also, I believe Scotiabank should trade at least near the peer average PB, which is currently 2.

Table 8 below provides a sensitivity analysis of my PB valuation. If the sentiment around emerging markets improves, the multiple may expand to 2.2, but it is unlikely in the near term. Although the long term growth story is attractive, investors should be prepared for short term price volatility.

Table 8: Sensitivity Table of PB Valuation

Source: Author's calculation. Readers should note that the prices that are shaded light blue are below the current price of US$57.68 and prices that are shaded light green are above the current price of US$57.68.

The Bottom Line:

The title of my previous article on Scotiabank summarizes my viewpoint on this name very well: "Short Term Pain, Long Term Gain". Despite the short term price volatility, the long term growth potential of the company is attractive. Investors should welcome near-term price declines and add to their positions. Scotiabank investors will benefit from an improvement in its international P&C banking division and growth in its wealth management and Canadian P&C banking businesses.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Disclaimer: This article is for informational purposes only and does not constitute an offer to buy or sell any securities discussed in the article. The stock mentioned in this article does not represent financial advice. The target price presented in this article is based on current information and are subject to change without further notice. Investors are recommended to conduct further due diligence before committing capital to any investment.