Tuesday, August 15, 2006

RBC CM Preview of Scotiabank Q3 2006 Earnings

  
RBC Capital Markets, 15 August 2006

Q3/06 Preview - Expected In-Line, But with Improved Quality

Bank of Nova Scotia reports third quarter earnings on August 29. We are looking for cash EPS of $0.87, which is 1¢ above the Thomson First Call mean estimate of $0.86. This implies a growth rate of 13% year over year and 1% quarter over quarter.
We are factoring revenue growth at 8% year over year, indicated up 10% excluding securities gains. This is higher than last quarters 6% revenue growth, which was in line with the bank peer average. Last quarter, revenue quality was less than ideal as net interest income was lower than anticipated, driven in particular by weakness in Scotia’s domestic retail spreads. Exceptionally strong net interest income in the international division was not sufficient to offset.

Q2 ‘Underlying EPS’ Was Disappointing. We stripped down last quarter’s 89¢ in reported EPS to ~80¢ underlying EPS, indicating ~5% sustainable growth YoY, well below the 17% reported EPS gain. Above-normal securities gains and both a very low loan loss and tax rate added an estimated 14¢ to more than offset the 5¢ foreign exchange translation EPS drag. The International division’s loan loss was NIL last quarter, and that too is likely to normalize this quarter (Mexico looks light on an underlying basis this quarter). Also, the wholesale division not only profited from very strong trading and securities gains, but also from $54 million in loan loss recoveries last quarter. In our view, the Q2/06 reported GAAP result of 89¢ sets the bar too high, and investors should compare Q3/06 against an estimated 80¢ run rate.

Key Themes This Quarter:

1. Domestic Banking Outlook Brightened by Higher Rates (1/3 of Earnings). We are estimating divisional earnings could rebound to $345 million this quarter, from a $315 million average in H1/06. This quarter, we are banking on the higher short-term interest rates helping Scotia’s variable-rate loan book. In Q2/06, Scotia’s weak domestic banking loan spread mitigated otherwise excellent loan growth and market share gains: both revenue and operating leverage lagged its domestic peers. This may also be in part related to Scotia’s below-average leverage to wealth assets managed. This may prove to be a less-obvious hindrance this quarter, which we perceived as a tough environment for customer flows and portfolio returns. Last quarter, divisional loan losses were also up, and we think these too may stabilize or improve again.

• Maple Trust Acquisition – Integrating Independent Distribution. Scotiabank announced the acquisition of the mortgage business of Maple Financial Group for $233 million in February and closed the deal on April 3, 2006, so this will be the first full quarter of inclusion. The deal is expected to be accretive to earnings by the end of year two, however slightly, in our estimation, roughly break-even in the early going, and contributing on the order of 2-4¢ by and during 2008. This deal moves Scotia firmly into the high-growth mortgage broker channel, and may ease Scotia into non-conforming mortgages as well. Scotia was attracted to Maple’s existing and prospective customer base, betting it can cross-sell home equity lines of credit and deposit products. We believe Scotia is the only bank to have been bringing mortgage-broker originated borrowers to its branches to close the mortgage, perhaps giving Scotia an edge over peer banks that allow the mortgage brokers to ‘close’ the mortgage in the field on the banks’ behalf.

2. Wholesale Bank Profit to Level Off (1/3 of Scotia Earnings). We are estimating H2/06 earnings will revert to $260 million per quarter from ~$270 million on average in H1/06. Last quarter, wholesale generated 35% ROE (there was a time when management dreamt of 15% for this division) as Scotia’s commodity and derivatives business was outstanding, boosting trading revenue. This quarter we look to Scotia’s burgeoning M&A practice for strength instead. The aforementioned loan loss recoveries of $54 million helped in Q2/06 and are very unlikely to repeat.

• Scotia Waterous Seen Helping Out Already. Scotia’s M&A advisory activity is up by a factor of nearly six-fold YoY, more than 2 1/2 times last quarter’s total. This could boost Scotia from a distant 5th rank among the 5 majors to 2nd overall this quarter. We think this reflects the timely acquisition of ‘Energy-Patch’ advisor Scotia Waterous.

3. International Should Be Strong Again (1/3 of Earnings). We are estimating Scotia’s H2/06 earnings from International will revert to $240 million per quarter from >$250 million on average in H1/06, partly as the zero loan loss normalizes, but offset by incremental acquisition benefits expected to materialize. Scotia Mexico looks like it will add another $25 million in incremental earnings this quarter, although gains-assisted.

• Scotia Mexico’s Q2 ‘Beat’ Our Estimate. Grupo Scotiabank (Mexico) reported Q2/06 earnings of P$1,487 million or P$993 million excluding a VAT tax recovery of P$494 million. This translates into ~C$148 million or ~C$99 million (excluding one-time items) at the Scotiabank level. We were expecting a C$125 million contribution to earnings. Strong loan growth continued in calendar Q2, as mortgage balances increased 30% YoY, personal and commercial loans grew 38% YoY.

• Mexico Political Risk Muted. We discount the financial impact of recent election delays and expect Mexican banking fundamentals, including loan growth, will remain strong. Typically, political instability would pose a risk to local financial markets, though economic and political progress in Mexico in recent years has reduced the risk.

Mexico could be described as the regional leader on the path to sustainable democratic capitalism. Regardless of whether the Left- or Right-leaning Presidential candidate wins in Mexico, the positive economic path is set. We believe the RBC Emerging Markets Team’s words are instructive: “Mexico’s prudent fiscal and debt management policies and economic convergence with the U.S. means the country is significantly less vulnerable to internal or external financial market shocks than it was in the 1990s."

• Costa Rican Interfin Acquisition - Another Smart LATAM Deal. Early in the quarter (on June 14), Scotiabank entered an agreement to buy Corporacion Interfin for $330 million (US$294 million). Corporacion Interfin owns Costa Rica’s largest private bank (non-government) – Banco Interfin. The transaction is expected to close by August 2006. BNS is poised to be the #1 (private) bank in Costa Rica with this deal, and continues to be a leading player in Latin American bank consolidation. In our view, Scotiabank has taken another smart and decisive step in its international build-out. The deal is expected to be accretive by $0.03/share in year 1, without the benefit of synergies, and $0.04/share in year 3 assuming earnings growth above 10%. This is the bank’s fifth acquisition in the Latin American (LATAM) region in the past 2 years.

4. Foreign Exchange Translation Drag Continues. Last quarter, Scotia’s earnings were hit by 5¢ for by the depreciating U.S. and Mexican dollars; however, in Q3/06, we believe the bank earnings could be hit by another incremental 1¢. Of the Big Six banks, the F/X translation issue is most pronounced for Scotiabank as its larger international base of business derives much of the earnings from currencies that swing in concert with the U.S. dollar.

Capital & Dividends

No Dividend Hike. This quarter, we are not looking for a change to the quarterly dividend of $0.39/share, which was just hiked from $0.36 last quarter. We expect the next increase to be announced in December with Q4 results.

Tier 1 Ratio Now Peer-Like. We forecast a tier 1 capital ratio of 10.3% this quarter. BNS’ Tier 1 capital ratio declined to 10.2% last quarter from 10.8% in Q1/06, and now sits in line with the peer group average. The majority of the decrease was due to strong asset growth and the resulting impact on risk-weighted assets.

Valuation

Our price target of $49 is set at 13x our 2007 cash EPS estimate of $3.77. Our target P/E is set at sector neutral to our sector target P/E to balance Scotia’s strong long-term growth prospects and disciplined, focused management team, with its above-average credit exposure and earnings reliance on securities gains. Scotia’s international operations are clearly outgrowing North American bank norms, though the overall earnings level is supported by a below-average loan loss accrual and tax rate. We also estimate Scotia’s excess capital position at ~$2 billion at the end of Q2/06, down from a superior position within the peer group in prior periods. Our price target is also indicated at ~2.65x our projected book value of $18.52 (as at Jul 31/07).

Price Target Impediments

Risks to our call include: (i) prospects for higher loan loss accruals (largely reflecting Scotia’s higher corporate loan portfolio); (ii) below average wealth management leverage (at about half the group average); and/or (iii) another round of protracted U.S. dollar weakness. Also a potential concern would the possibility that BNS overpays in a foreign acquisition or a domestic merger (if permitted). BNS could do better than anticipated if the U.S. dollar weakness reverses.
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