Laurentian Bank: We Are Cautiously Optimistic

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About: Laurentian Bank of Canada (LRCDF), Includes: CM, LB, NTIOF
by: Ploutos Investing
Summary

Laurentian Bank is the 7th largest bank in Canada.

The bank faces the challenge of expanding its NIM and grows its total mortgage portfolio.

The bank should be able to overcome its challenge as it shifts from lower margin residential mortgages to higher margin commercial loans.

Shares of Laurentian Bank are significantly undervalued with an attractive 6.6%-yielding dividend.

Investment Thesis

Laurentian Bank (OTCPK:LRCDF) (TSX:LB) posted unimpressive Q4 2018 result with double digit decline in its diluted EPS and net income. The company appears to be facing the challenge of declining residential mortgage volume as well as uncertain macroeconomic conditions in Canada. However, we are optimistic about Laurentian Bank’s growth strategy as the company gradually shifts its focus from residential mortgages to higher margin commercial loans. In addition, its exposure to Quebec and Ontario will help it to resume growth in its residential mortgages in 2019. The bank’s shares are currently trading at a significant discount to its historical average. Hence, we believe the company is an attractive investment choice for value investors.

Source: Investor Presentation

Recent Developments: Q4 2018 Highlights

Laurentian Bank posted unimpressive Q4 2018 result with declining top and bottom lines. As can be seen from the table below, its net income of C$54.3 million was a decline of 18% year over year. Likewise, its diluted EPS of C$1.22 per share was also a decline of 25% year over year. The decline in net income was mostly due to its strategy to reduce lower margin loans coupled with higher liquid assets. In addition, its investment in technology also increased its expense and resulted in lower net income.

Source: Q4 2018 Investor Presentation

Laurentian Bank’s Challenges in 2019

Flat net interest margin

Since mid-2017, Canada has raised its benchmark interest rate five times. These rate hikes have helped improve Laurentian Bank’s net interest margin. Its NIM has improved from 1.68% in 2017 to 1.78% in 2018. However, its NIM in Q4 stayed flat sequentially due to the bank’s higher level of liquid assets. Looking forward, it may be challenging to expand its NIM in 2019. This is because Bank of Canada has recently switched from a more hawkish tone back in October to a much more dovish tone. In its latest announcement on January 9, 2019, the central bank kept its overnight rate at 1.75%. We believe unless there are signs of economic improvement from now, the bank will stay on the sideline. Hence, we continue to hold on to the view that there will be fewer rate hikes in 2019 than in 2018.

Source: Q4 2018 Investor Presentation

Slowdown in residential mortgage growth

The introduction of B-20 Guideline in Canada effective on January 1, 2018, has resulted in a mortgage growth slowdown and lower housing market activities. About 6 months ago, we held the view that there were signs of stabilization. However, as time progresses, we are beginning to see more signs of further slowdown. As can be seen from the chart below, Laurentian Bank’s residential mortgage portfolio of about C$17 billion in Q4 2018 was a decline of 8.1% year over year. We noted that this was much worse than its larger Canadian peers. For example, CIBC’s (CM) mortgage portfolio increased by 0.5% year over year. Even National Bank of Canada’s (OTCPK:NTIOF) mortgage portfolio increased by 3.5% in Q4 2018.

Source: Created by author; Company Reports

While the introduction of B-20 Guideline was one of the main contributors to the deceleration in mortgage balance growth rate, we need to also understand that Canadian household debt is also quite elevated. As the chart below shows, its debt-to-income ratio is expected to reach 173% by the end of 2018, the highest we have seen in many decades. We believe the elevated debt level coupled with 5-interest rate hikes since mid-2017 will continue to limit future mortgage growth in 2019. This means that it will be challenging for Laurentian Bank to grow its interest income at a fast rate.

Description: ousehold debt-to-income ratio in Canada

Source: RBC Economics

Reasons why we are cautiously optimistic

Although macroeconomic conditions appear to be uncertain, we are cautiously optimistic for the following reasons:

Shift towards higher margin commercial loans

Management indicated in its latest conference call that the decline in its residential mortgage portfolio was as expected. There are three reasons that contributed to the decline in its residential mortgages. The first reason was the introduction of B-20 Guideline, which we discussed earlier. The second reason was due to its decision in November 2017 to no longer accept referrals from the broker network into the branch network. Finally, management has made the choice to strategically shift its loans towards higher margin commercial loans. In fact, management expects its commercial loan to grow by double-digit in 2019. We believe Laurentian Bank’s strategy should help it maintain or increase its net interest margin.

High Quality residential mortgage loan portfolio

Laurentian Bank’s residential mortgage portfolio is also quite healthy. As can be seen from the chart below, 54% of its mortgages with a loan-to-value ratio above 75% are insured.

Description: Andy_SSD:private:var:folders:y4:_clxjt7n0s525kf60mgm4jhc0000gn:T:TemporaryItems:Screen Shot 2019-01-03 at 3.17.35 PM.png

Source: Q4 2018 Investor Presentation

In addition, we like Laurentian Bank’s higher exposure in Quebec. As can be seen from the pie chart below, nearly half of its residential mortgage loan portfolio is located in Quebec, Canada’s second largest province.

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Source: Q4 2018 Investor Presentation

As can be seen from the left chart below, Quebec’s real GDP growth is expected to top all other Canadian provinces in 2018. Although Quebec’s real GDP growth in 2019 is expected to moderate to 1.8% in 2019, this growth rate is still above the national average.

Description: escription: Andy_SSD:private:var:folders:y4:_clxjt7n0s525kf60mgm4jhc0000gn:T:TemporaryItems:Screen Shot 2018-12-25 at 9.47.50 AM.png

Source: RBC Economic Research

Quebec is near full employment as the province’s unemployment rate of 5.4% in 2018 (forecasted) is the lowest since 1976. This low unemployment rate is also the second lowest among all Canadian provinces.

Description: https://static.seekingalpha.com/uploads/2018/12/27/22895591-15459626502905438.png

Source: RBC Economic Research

Looking forward to 2019, Quebec’s projected unemployment rate of 5.5% will continue to be the second lowest among Canadian provinces (see table below). The province’s projected retail sales growth rate of 4% in 2019 will be second only to Ontario. For reader’s information, residential mortgage in Ontario represents 36% of Laurentian Bank’s residential mortgage loan portfolio. Therefore, we are cautiously optimistic that the bank will be able to regain growth in residential mortgages.

Description: escription: Andy_SSD:private:var:folders:y4:_clxjt7n0s525kf60mgm4jhc0000gn:T:TemporaryItems:Screen Shot 2018-12-25 at 9.58.49 AM.png

Source: RBC Economic Research

Valuation Analysis

Laurentian Bank is currently trading at trailing twelve-month and forward PE ratios of 7.6x and 7.5x respectively. Both ratios are significantly below its larger Canadian peers who are trading between 8.1x and 11.4x (see charts below).

We do not believe Laurentian Bank should be trading at P/E ratios similar to its Canadian peers due to its smaller scale, and less impressive growth outlook. However, we believe the gap is too wide. This is especially because its P/E ratios (both forward and TTM) are below its 5-year average TTM and forward P/E ratios of 11.6x and 8.6x respectively.

In terms of price to book ratio, Laurentian Bank is also trading at a significant discount. We have included in the chart below its P/B ratio in the past 10 years. As can be seen from the chart, Laurentian Bank’s current P/B ratio of 0.723 is so low that it is comparable to the P/B ratio during the Great Recession.

Source: YCharts

Laurentian Bank currently pays a quarterly dividend of C$0.64 per share. This is equivalent to a dividend yield of 6.6%. As can be seen from the chart below, its dividend yield of 6.6% has now surpassed the yield during the Great Recession, thanks to recent share price weakness. Hence, we believe its shares are currently very attractive.

Source: YCharts

Risks and Challenges

Laurentian Bank faces macroeconomic risks related to the credit and debt cycle. Canada’s mortgage debt levels have increased considerably in the past decade. As mentioned earlier in the article, its debt-to-income ratio is expected to reach 173% by the end of 2018, the highest we have seen in many decades. Similarly, its debt service ratio is expected to reach 14.5% by the end of 2018. This is the highest we have seen since the peak of 15% reached back in the Great Recession in 2008. Any further rate hike will increase its debt service ratio higher. This may result in higher consumer defaults especially when the economy heads into a recession.

Description: ebt Service Ratio in Canada

Source: RBC Economics

Investor Takeaway

Although Laurentian Bank faces several challenges in 2019, we are cautiously optimistic about Laurentian Bank’s growth strategy. Its share price appears to offer enough margin of safety and is attractively valued. For investors with a long-term investment horizon, Laurentian Bank is a good stock to own as it offers both capital appreciation and dividend growth.

Note: This is not financial advice and that all financial investments carry risks. Investors are expected to seek financial advice from professionals before making any investment.

Disclosure: I am/we are long CM, TD. 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.

Editor's Note: This article discusses one or more securities that do not trade on a major U.S. exchange. Please be aware of the risks associated with these stocks.