Wednesday, August 30, 2006

Scotiabank Q3 2006 Earnings

Kevin Frayer, CP File Photo
BMO Capital Markets, 30 August 2006

Details & Analysis

Scotiabank reported third quarter cash earnings of $934 million, or $0.93 per share, compared to $893 million, or $0.89 per share, last quarter, and $780 million, or $0.77 per share, in the same quarter of last year. This quarter included a $51 million VAT tax recovery that added $0.05 to EPS. As a result, the better comparison is $0.88 per share in this quarter, $0.89 per share last quarter and $0.77 per share in the same quarter of last year. Although results were slightly better that street estimates of $0.86, the source of earnings momentum was somewhat disappointing.

Domestic Banking reported earnings of $323 million, up from $301 million in the last quarter but roughly unchanged from $324 million in the same quarter of last year. It is particularly disappointing to see Domestic Banking (which includes Wealth Management) unable to produce growth year over year. Both revenues (excluding acquisitions) and earnings appear to be unchanged versus the third quarter of 2005. The causes of this relatively poor performance are spread compression (which offset volume growth) and incremental expenses associated with the acquisition of Maple Financial and various other new initiatives.

International Banking reported earnings of $286 million, up from $268 million in the last quarter and $234 million in the same quarter of last year. This quarter's earnings were inflated by a $51 VAT tax recovery. Excluding this item, earnings were down versus the unusually strong second quarter, and essentially flat compared to the third quarter which included large gains on Emerging Market bonds. We continue to believe that Scotia has a solid International Banking platform. Despite this, we have assumed that earnings growth slows dramatically in 2007 as Scotiabank Mexico faces the headwind from the elimination in tax losses. This will be offset by continued growth in the Caribbean and additional contribution from deals in Peru, Costa Rica and El Salvador.

Scotia Capital reported very strong results. Earnings of $279 million were a record and were higher than we had forecast. This reflected loan loss reversals, interest recovery, securities gains and the incremental contribution from the GMAC financing agreement. These are all very valid sources of earnings but there is some question about the sustainability on the first three. As the credit cycle matures and as the level of gross impaired loans declines, loan losses are likely to rise and interest recoveries will become less material. The Corporate segment produced a larger than expected contribution reflecting favourable fair-value marks to market on derivatives as well as funding profits. The latter of these could easily be allocated to the Domestic Banking segment. We believe that this level of contribution is somewhat above a normal run rate.

The bank's credit performance remains stellar. This quarter, with over $100 million drop in gross impaired loans, provisions were well-controlled and there was some interest recapture. Provisions of $74 million were in line with our expectations but will likely be quite a bit higher in 2007 as recoveries decline. We are forecasting provisions of $540 million for fiscal 2007, up from $284 million this year. Scotia continues to have excellent levels of reserves - general allowances are high at $1.3 billion and there is an unrealized security gain of $848 million - principally in emerging market bonds and the residual holding of Shinsei.

Scotiabank continues to have one of the best capital ratios in the industry, but with ongoing growth in risk-weighted assets, Tier 1 declined slightly to 10.0%. RWA growth reflected additional loans in the corporate book and the GMAC securities. The latter is, by all accounts, relatively low risk given their over-secured nature.

Projections & Valuation

We are downgrading Scotiabank to Market Perform from Outperform. Since our upgrade on May 30, 2006, BNS shares have beaten the bank index slightly. At the time of the upgrade we felt that international earnings would continue to offset the relatively weak domestic trends. In addition, with bank stocks having corrected meaningfully, we thought it prudent to recommend four bank equities. The recent quarter suggests, however, that the trends in Domestic Banking continue to be somewhat discouraging and the International Banking business will be facing the challenges of additional tax headwinds in Mexico. Bank stocks have also had an excellent run.

Scotiabank continues to trade at an average P/E multiple and at a slight premium on P/BV. This seems appropriate given the calibre of management, the growth potential of the International business and the strong balance sheet. Despite this, we cannot lose sight of the fact that the bank will be facing increasingly difficult trends into 2007 reflecting higher taxes in International, higher loan losses and a less robust domestic consumer.

At the current time, we recommend TD and CIBC shares. The former has good growth into 2007 on the back of deals completed over the past year, while the latter is relatively inexpensive. We believe that both banks have relatively low exposure to deterioration in the U.S. economy.
TD Newcrest, 30 August 2006


BNS reported operating EPS of $0.88, ahead of our estimate of $0.84 and consensus of $0.86. We believe the results reflect excellent asset growth, partially offset by higher expenses driven by investments in future growth and as yet assimilated acquisitions.


Neutral. We are increasing our 2006 EPS estimate marginally to $3.46 (from 3.45), and 2007 estimate to $3.80 from $3.78. Our 12-month target price of $54.00, and our Action List Buy recommendation remain unchanged.


Canadian retail results satisfactory. Cash net income was $323 million, up slightly from $303 million in Q1/06 and essentially flat versus a year ago.

• Asset (i.e. loan) growth of 12.1% year over year is the best of the group thus far. Strength was reported in both residential and commercial lending, led by a substantial increase in residential mortgages (16%) – mainly due to the Maple acquisition.

• Net interest margins, however, fell to 2.67%, down 7 bps sequentially and 21 bps from Q3/05, due entirely to the acquisition of Maple Trust and AcG-13 charges, which were up $13mln in quarter. Management commented that ex-Maple trust margins were flat, and that they were confident that margins would improve given the more disciplined pricing environment. The bank’s significant funding gap requires wholesale funding, which was relatively more expensive in Q3/06, explained management.

• Expenses increased with the efficiency ratio increasing to 62.3% versus 61.7% in Q2/06 and 60.8% a year ago, and reflected investment in numerous initiatives as well as acquisition expenditures (Maple and the Bank of Greece not yet fully integrated).

The international operations continue to grow at a rapid pace, but this growth was not reflected in net income, which was $235 million versus $268 million last quarter and $234 in Q3/05. We highlight that the appreciation of the CAD$ cost the division $31 mln year over year and $9 mln in quarter. Asset growth was strong, up 11% year or year (or 14% organic - excluding the negative impact of foreign currency translation and the Peru acquisition). Growth was driven by a 47% increase in credit card balances and a 27% rise in mortgages.

• Net interest margins rose to 4.19%, up 4 bps sequentially and 21 bps from Q3/05.

• Despite the currency headwinds, revenues rose to $844 million in Q3/06 versus $762 million in Q2/06 and $749 million in the same quarter last year. Stronger revenue generation was due to the combination of strong asset growth, higher margins, and solid other income.

• Expenses increased meaningfully in Q3/06, with the efficiency ratio increasing to 62.6% from 58.1% in Q2/06 and 59.7% in Q3/05.

• We note that management indicated that as of Q1/07, tax loss carry-forwards will be exhausted and the effective tax rate in Mexico will be 15%-20%, which is reflected in our estimates.

Wholesale banking results beat our estimates this quarter, primarily due to controlled expenses and stable revenues in a seasonally slow period. Reported adjusted cash net income was $279 million, up from $277 million in Q2/06 and $202 million in Q3/05.

• Despite weaker trading, revenues of $613 million were up 18.3% year over year, driven primarily by growth in BNS’s loan portfolio, and from loan loss and interest recoveries and securities gains.

• Trading revenues were $187 million in Q3/06 versus $259 million in Q2/06 and $213 million in the same quarter a year ago. Management commented that Q1 & Q4 are normally better quarters, and Q3 was disappointing.

• Credit recoveries were $19 million, versus $54 million in Q2/06 and a charge of $2 million a year ago, with recoveries being realized in the U.S. and Europe

• The efficiency ratio was very low decreasing to 37.8% from 43.6% in Q2/06 and $41.3% in Q3/06.

Tier 1 capital was healthy at 10.0%, but down from 11.1% a year ago. We remind that the bank is growing its risk-weighted assets at the fastest pace of the group, up 16.2% year over year. Management repurchased 1.3 million shares during the quarter. Unrealized security gains remain at a very high $848 million.


Trading at 12.8 times 2007 earnings versus a peer group average 12.4 times 2007 earnings, we believe BNS should trade at a greater premium. At current prices, we believe this represents a buying opportunity.

Justification of Target Price

Our $54.00 BNS target price is a product of adding 50% of the $50.38 value derived from our 2007 P/E multiple of 13.5 times to 50% of the $48.43 value derived by our 2007 price-to-book of 2.49 times.

Key Risks to Target Price

We believe that the four key valuation risks include: a) a deterioration in the geopolitical situation in one of the bank’s international markets (most importantly Mexico); b) a tougher credit environment which could lead to credit losses, particularly with the bank’s more aggressive U.S. corporate lending strategy; c) the bank paying a significant premium for an acquisition; and d) the deterioration of the USD.

Investment Conclusion

The market didn’t seem impressed with BNS’s Q3/06 results, we suspect focused on their earnings beating consensus by less than what the Q3/06 peers have thus far reported. We think selling/not buying the bank at these levels is a mistake, as we believe management is priming the bank for sustainable, superior long-term growth, at the expense of short-term earnings out-performance. We do not have the disclosure available, but we believe the bank is spending more money than the others on initiatives. As well, we believe the six acquisitions the bank has completed in the last year have had a dilutive or marginal impact on 2006 earnings, but will add more than $0.08 to next year’s results. The bank’s operating businesses are generating leading ROEs, and with significant excess capital, BNS’s international operations provide multiple opportunities to deploy this balance. The bank is seeing strong growth in its US wholesale operation, a unique growth advantage the other Canadian banks will likely have little leverage to. Acquisitions and internal growth have generated the fastest risk-weighted asset growth of the group, which should produce above-average revenue growth in the future. Perhaps most importantly, we believe BNS enjoys the greatest financial flexibility of the Canadian banks, and shareholders stand to benefit. We reiterate our $54.00 target prices and our Action List Buy recommendation.
RBC Capital Markets, 30 August 2006

Investment Opinion

Underlying EPS up 14% YoY. BNS reported cash EPS of $0.93, which normalized to $0.88 (excluding 5¢ for a $51MM tax recovery) for 14% YoY growth. Wholesale drove YoY growth while the domestic division earnings were flat YoY. Scotia earned through a partial normalization in the loan loss this quarter and the tax rate was normal. The heavy expense growth may weigh on investor opinion this quarter, but we think there may be room for cuts in future quarters.

No Change in Outlook. We are increasing our 2006 cash EPS estimate by 1¢ to $3.47 to reflect the variance to the Q3/06 result. Our 2007 estimate remains unchanged at $3.77 for 8.6% growth and we are introducing a 2008 estimate of $4.10, indicating 8.8% growth. Our price target of $49 remains the same, set at 13x our 2007 estimate of $3.77.

BNS But Still the Cost Leader. On a constant currency basis and excluding acquisitions, revenue was up 11% and expenses were up 7% YoY. Reported expense growth reflected the acquisitions and strong reinvestment in the business, though we also noted much higher-than-usual incentive compensation relative to associated revenue. Bank-wide, cost/revenue was 57.4% (excluding the tax recovery), still the leader among the peers.

Wholesale Carried this Result. Scotia Capital reported cash earnings of $279MM, which beat our $260MM estimate for a 2¢ benefit. Domestic and International earnings were both level with year-ago results. In general, strong volume was mitigated by rising costs, which management has a knack for controlling well over the long-term.

Valuation. Our price target of $49 (unchanged) is set at 13x our 2007 cash EPS estimate of $3.77. Our target P/E is set 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. Our price target is also indicated at ~2.5x our projected book value of $19.77 (as at Oct 31/07).
Report on Business Television, 30 August 2006

Click here for the ROBTv video clip, of Luc Vanneste (CFO, Scotiabank) speaking about Scotiabanks's Q3 2006 Earnings.
The Globe and Mail, Paul Waldie, 30 August 2006

Bank of Nova Scotia is considering a range of potential acquisitions to bolster its already rapidly growing international operations.

"In the last 12 months, we've made six acquisitions, investing more than $1-billion. And there are a number of further acquisition possibilities," Rick Waugh, the bank's president and chief executive officer, told analysts yesterday during a conference call. "We have a strong pipeline and we are seriously looking at opportunities in all of our major markets."

Mr. Waugh's comments came as the bank reported a record third-quarter profit of $928-million or 93 cents a share on a fully diluted basis. That was 20 per cent higher than the same quarter a year earlier and surpassed most analysts' expectations.

The bank's far-flung international operations, which span roughly 45 countries across Latin America and the Caribbean, contributed much of the profit increase. The division reported a record profit of $285-million, up from $235-million a year ago. Revenue climbed 13 per cent to $844-million.

Mexico was the strongest player in the division, contributing $160-million in profit. Revenue at the Mexican unit, Inverlat, increased 10 per cent and the bank plans to open up to 100 new branches by the end of 2007.

Scotiabank has recently acquired banks in Peru, Costa Rica and the Dominican Republic and Inverlat has committed to increasing its market share from 6 per cent to 10 per cent. Over all, the bank expects to generate more than a quarter of its profit outside Canada this year, compared with 19 per cent in 2000.

Mr. Waugh said the bank will make most of its future acquisitions in countries where it already operates. "We're going to stay in the developing world or the emerging world," he said.

He added that the bank will also continue to look for innovative deals such as last year's agreement to purchase $20-billion (U.S.) worth of car loans from General Motors Corp.'s financing arm over the next five years. The bank has acquired about $8-billion (Canadian) worth of loans so far and they are performing well, he added.

On the domestic front, profit at Scotiabank's Canadian operations remained flat at $319-million while revenue increased to $1.41-billion from $1.36-billion.

The bank's brokerage arm, Scotia Capital Inc., reported a $278-million profit, up from $200-million last year. The firm benefited from a strong market for mergers and acquisitions, but its trading revenue fell in the quarter.

Like other Canadian banks, Scotiabank continues to enjoy a favourable credit environment. Its provision for credit losses was $74-million in the quarter, down from $85-million a year ago.

During the conference call, Mr. Waugh justified the bank's 7-per-cent increase in costs by saying it reflects a number of initiatives under way around the world to boost revenue and exposure. As an example, he cited the decision earlier this year to spend $20-million for a 15-year deal to rename Ottawa's Corel Centre "Scotiabank Place." Mr. Waugh said the bank had doubled its awareness in the marketplace since putting its name on the site.

The bank also said it expects to reach the upper end of its objectives for the fiscal year, which ends in October.

Those objectives included posting a return on equity of between 18 and 22 per cent and boosting earnings per share by as much as 10 per cent this year. To date, the bank said its return on equity is 22.5 per cent and its growth in earnings per share is 13 per cent.

The bank's shares closed down $1.30 at $47.63 yesterday on the Toronto Stock Exchange.
RBC Capital Markets, 29 August 2006

First Impression

Cash EPS Just Ahead of Expectations. BNS reported cash EPS of $0.93, which normalizes to $0.88 (excluding a 5¢ for a $51MM value added tax recovery in the International division) for 14% YoY growth. This compares to our $0.87 estimate and consensus of $0.86.

Domestic Retail & Wealth Earnings Flat YoY. The domestic bank reported flat earnings YoY, influenced by the acquisition of Maple and National Bank of Greece. With revenue growth of only 4% YoY, and acquisition-affected expense growth of 6.5%, the domestic bank recorded negative operating leverage of -2.5%. Net interest margins declined another 7bps QoQ and 21bps YoY. Market share in mortgages and term deposits were reported up 114bps YoY and up 68bps YoY, respectively, but this too was boosted by Maple and NBG.

International Earnings Reported Up 22% YoY. International earnings of $286MM (up 22% YoY) normalized to $235MM (flat YoY) excluding the VAT recovery. This is just shy of our estimate of $240MM. Solid revenue growth of 13% YoY was not enough to outpace normalized expense growth of 18% (for -5% operating leverage). The foreign exchange drag was 7¢ YoY this quarter (versus a 5¢ drag in Q2/06). Scotia Mexico revenue growth was 23% YoY (ex f/x impact) and noninterest expenses increased 16% (ex f/x impact and VAT recovery).

Scotia Capital Up 40% YoY. The wholesale division reported cash earnings of $279MM, which beat our $260MM estimate (for a 2¢ benefit). Trading revenue at $187MM and securities gains of $105MM totaled to $292MM, about in line with our forecast of $286MM. Strong net interest income growth (up 30% YoY) drove revenue growth of 18% YoY, which more than offset expense growth of 9%. The YoY results benefited from a $19MM loan loss recovery versus a $2MM provision in Q3/05, but was lower than the $54MM recovery in Q2/06.

Lower than Forecast Loan Losses. Loan loss provisions were slightly lower than expected at $74MM compared to our estimate of $77MM and consensus $83MM, but there was no significant EPS benefit. Impaired loans declined 6% QoQ and the reserve to impaired loan coverage ratio improved to 146% from 136% in Q2/06.

Dividend Left Unchanged. As anticipated, BNS did not increase its quarterly dividend, which was just hiked last quarter to $0.39/share. The tier 1 capital ratio declined to 10.0% from 10.2% last quarter.
Bloomberg, Sean B. Pasternak, 29 August 2006

Bank of Nova Scotia, Canada's third- largest bank by assets, said profit climbed for the 13th straight quarter to a record on higher earnings from Latin America.

Net income for the third-quarter ended July 31 rose 19 percent to C$936 million ($842 million), or 93 cents a share, from C$784 million, or 77 cents, a year earlier, the Toronto- based bank said today. Revenue climbed 11 percent to C$2.99 billion.

Profit from international banking rose 22 percent, led by Mexico, Peru and Central America. The bank has spent more than $1 billion since 2000 to buy banks, primarily in Latin America, to offset slower growth in Canada.

``I like their Caribbean and Latin American exposure,'' said David Cockfield, who helps manage $1.1 billion at Leon Frazer & Associates Inc. in Toronto, including Scotiabank shares. ``They're conservative and they know their way around there.''

Bank of Nova Scotia shares fell C$1.30, or 2.7 percent, to C$47.63 at 4:10 p.m. trading on the Toronto Stock Exchange, the biggest decline in three months as Canadian financial stocks fell. They've risen 3.2 percent this year, compared with a 4.8 percent gain for the 39-member S&P/TSX Financials Index.

The bank expects to generate more than a quarter of its net income from outside Canada this year, compared with 19 percent in 2000. There were 22,494 employees in the international business at the end of July, more than in the domestic consumer bank. The international bank's profit of C$285 million topped the investment bank's earnings for the second time in a year.

Earnings were bolstered by the purchase of two banks in Peru for C$390 million in March, making Scotiabank the third- largest bank in that country. Scotiabank also agreed in June to buy Corporacion Interfin SA, the owner of Costa Rica's largest private bank, for about C$330 million.

``Clearly the growth prospects internationally are much greater than they are in Canada,'' said Tom Kersting, an analyst at Edward Jones & Co. in Des Peres, Missouri. ``Scotia's international operations are in countries that are growing quite rapidly.''

Chief Executive Officer Richard Waugh, 58, told investors on a conference call today that the bank is ``seriously'' looking at additional acquisitions in international markets. He didn't elaborate. The bank also plans to open 100 new branches in Mexico next year.

Excluding a 5-cent-a-share recovery for taxes, profit was 88 cents a share, matching the estimate from Robert Wessel, an analyst at National Bank Financial in Toronto. The bank was expected to earn 87 cents a share before one-time items, according to the median estimate of eight analysts polled by Bloomberg News.

Earnings from the Scotia Capital investment bank climbed 39 percent to C$278 million because of higher lending volume and the sale of securities. Record mergers revenue helped offset a decline in trading income, which fell 14 percent to a two-year low of C$187 million. That contrasts with rivals Bank of Montreal and Toronto-Dominion Bank, which had higher trading revenue after stock prices rose and the number of mergers rose to a seven-year high.

Bank of Nova Scotia set aside C$74 million for bad loans, compared with C$85 million a year earlier as a 30-year-low jobless rate cut the number of bankruptcies in Canada. Expenses increased 6 percent to C$1.61 billion because of acquisitions and salaries.

Even with a 19 percent gain, Bank of Nova Scotia's profit growth was the slowest among the four Canadian banks that have reported third-quarter earnings. Consumer banking profit in Canada was unchanged at C$319 million, the third straight quarter in which profit failed to increase. Scotiabank's domestic bank was hurt by higher expenses and increased provisions for credit losses.

Bank of Montreal, the fourth-biggest bank by assets, said on Aug. 22 that profit rose 30 percent to a record C$710 million on higher trading income. Toronto-Dominion, the second-biggest, said Aug. 24 that profit almost doubled to C$796 million on higher trading fees and increased earnings from its U.S. discount brokerage.

Royal Bank, the country's biggest bank, said Aug. 25 that profit climbed 20 percent to a record C$1.18 billion because of its U.S. and international consumer bank.

Canadian Imperial Bank of Commerce and National Bank of Canada, the country's fifth- and sixth-biggest banks, are scheduled to report results Aug. 31.
Dow Jones Newswire, Monica Gutschi, 29 August 2006

Bank of Nova Scotia's forays into Latin America and Asia have powered the Canadian lender to record third-quarter earnings.

"I'm very impressed," said Theodore Kovaleff, an analyst with New York-based boutique investment bank Skye Capital. "The only thing that I see that really didn't grow as significantly was domestic banking. Everything else seems to be moving along beautifully."

And Tom Kersting at Edward Jones said the "international operations continue to be highlighted, you see that quarter after quarter. They continue to produce for Scotia."

Bank of Nova Scotia reported net income of C$936 million in the third quarter, 19% above C$784 million a year earlier.

On a cash basis, earnings were 93 Canadian cents a share compared to 77 Canadian cents a year earlier, easily beating the Thomson First Call forecast of 86 Canadian cents a share.

Revenue grew 11% in the period, return on equity rose to 22% from 18% the year before, and the bank's industry-leading capital ratio remained strong.

Provision for credit losses were C$74 million this quarter, an improvement from C$85 million a year earlier.

However, expenses rose due to the acquisitions and other growth initiatives.

And even though both the international division and wholesale bank Scotia Capital posted solid earnings growth, the domestic banking operations were flat.

In Toronto Tuesday, Bank of Nova Scotia shares are down C$1.04 to C$47.89 amid a 120-point decline in the key S&P/TSX Composite index. The shares had touched a year-to-date high of C$49.49 on Thursday.

"In our view, the earnings mix was disappointing," said BMO Capital Markets analyst Ian de Verteuil in a midday note. Canadian retail bank earnings were flat, the international division met expectations once a tax-related gain from Mexico is removed, and only Scotia Capital was strong, he noted.

"In our view, the only real good news in the quarter was that management suggested there is a strong pipeline for acquisitions," de Verteuil wrote.

Canadian retail bank earnings were C$319 million in the quarter, unchanged from a year ago, but up slightly from C$296 million in the second quarter. Provisions for credit losses edged up slightly, to C$69 million from C$63 million, while asset growth rose in part due to the acquisition of a mortgage-financing company.

The international operations reported a 13% increase in revenue, with net income rising to C$285 million from C$234 million.

The bank's recent acquisitions, including two banks in Peru, bolstered this quarter's revenue by 5% compared to the same period last year.

Scotia Capital's earnings rose to C$278 million from C$200 million, helped mainly the bank's purchase of asset-backed securities from General Motors Acceptance Corp. Trading revenue fell.

Neither Kersting nor Kovaleff owns Scotia shares nor do their firms have an investment-banking relationship with the company. BMO Capital Markets has an investment-banking relationship but it wasn't immediately clear if de Verteuil owns shares.