- Laurentian's dividend cut wasn't entirely expected but was necessary given the impact of COVID-19 on the bank's credit stance.
- The low capital flexibility poses sustainability concerns as evidenced with CET1 ratio of 8.8%.
- Its future dividend payout is at risk and struggles likely not to be over.
With COVID-19 in the spotlight, the earning season for Canadian banks was of particular interest this 2nd quarter. The attention revolved mostly around impairment loans, capital and pandemic-related provisions, which looked material in many instances. More specifically, the earning results of Laurentian Bank of Canada (OTCPK:LRCDF) drew my interest – and not necessarily for the good reasons. Exiting this quarter and with preceding operational issues, I believe that Laurentian could be forced to take additional measures to sustain its financial resilience. In my opinion, there is still value in investing in Canadian banks, not only for their dividend stability but also for their resilience through crisis cycles. Laurentian just doesn't seem to meet that strong enough risk-reward balance. The limited capital absorption capacity and introductory dividend cut look like a warning signal to me and I think investors should think carefully before investing.
Of note, the stock trades on the TSX under the ticker LB. It lost more than 10% of its value post-Q2 before recovering substantially. It was trading close to C$31 on June 3rd, 30% away from the 52-week high.
The dividend cut may have not been anticipated, I believe it was necessary and probably not the last step
Laurentian reported Q2 net profit of $8.9mios, down almost 80% compared to the same quarter a year earlier. This resulted in a return on equity of 1% against 7.3% the prior year. What really stroke me was Laurentian’s very rare move for a Canadian bank – slashing its dividend payout by 40% to $0.4 per share, way below its previous payout of $0.67 per share. Considering Canadian banks’ defensive and consistent payout policies, including that of Laurentian, this is a significant announcement. Looking at LB’s dividend history up from 1995, I wasn’t able to find the last time Laurentian cut its dividend, if it ever did.
This has naturally to do with the limited capital retention the bank has shown. It reported a CET1 ratio of 8.8%, down 20bps quarter on quarter placing the bank at the lower end of the spectrum compared with other Canadian banks. Of course, the bank is only required to maintain a7% minimum given its size/status (as per OSFI requirements), compared with 9% for major Canadian banks, but its capital leeway is shrinking. Laurentian also postponed the adoption of its advanced internal rating-based model 'AIRB' to at least 12 months as disclosed in the firm's supplementary notes. In other words, the expected capital relief associated with that approach won’t materialize before at least 2022 if not later on. As per Laurentian’s quarterly release, the bank expects its regulatory capital ratios to "remain below the level observed over the recent quarters."
The limited capital buffer highlights in my opinion the importance of such a dividend cut but also represents a worrying signal to investors, that in the presence of flat revenue growth further dividend cuts are expected.
Provisioning assumptions could be covering up for existing fragilities
As many of you know, the financial impact of COVID-19 is yet to be fully experienced. Measuring the financial impact of such a dynamic process entails time lags and considerable GDP output revisions, not to mention that the financial stress caused to customers is not yet fully visible. OSFI and the government had also undertaken considerable steps to protect banks in the early months of the pandemic, measures that won’t last forever.
With deferral payment rates averaging 13.3% on Laurentian’s loan book, above the 11% average that I have estimated from the Top 6 Canadian banks' releases, LB's asset quality looks a bit off. Not only the bank will see a proportion of these loans become impaired as per the IFRS 9 classification (Stage 1, 2, 3 breakdown), but the interest it earns on many of those loans might be foregone and compress the company’s stock earning ability, ultimately, its stock price. While the bank has minimal exposure to the energy sector, often viewed as a credit weakness, Laurentian exhibits some concentration risk in industries not fully immune to the pandemic crisis. Commercial loans, which includes inventory and equipment financing, represent 40% of the bank's loan book:
Laurentian Bank Q2 disclosure – Loan Portfolio Mix
As I see it, the bank will need to adjust further its dividend payout and potentially restructure/streamline operations to reduce existing costs. Laurentian has significantly increased its provisions ($55mios compared with $9.2mios in 2019) but its provision coverage of 67% underperforms those of Canadian banks. This leads me to think that Laurentian may have under-estimated its assumptions relative to COVID-19. In its quarterly release, Laurentian argued in its base-case scenario that “a new normal in activity brings back GDP to its pre-pandemic level in early 2021.”, a forecast that looks far-stretched in my opinion.
Investment summary - caution is warranted
From a fundamental point of view, Laurentian now trades at an attractive price to book ratio of 0.5 times after dropping more than 10% following the dividend cut. This brought the stock price in oversold territory despite the bank still paying a 5.6% yield. While this may look attractive for investors, I am questioning the sustainability of the bank’s dividend payout. Preserving capital as we move into quarters that will see higher impairment charges and adjustments on provisions will get more challenging. Q2 had only encompassed for the early days of COVID-19 and is only a first peek at how Laurentian is dealing with the impact.
Investors need to evaluate the impact of restructuring and cost-cutting measures along with a further slash in dividend – measures that seem likely unless the economic assumptions associated with COVID-19 turn more positive than initially presumed. This perception, combined with the bank’s weaker risk standards vs. Canadian peers, makes me question Laurentian’s future stock performance.
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