Wednesday, August 29, 2007

Scotiabank Q3 2007 Earnings

Analysts' ratings and target prices for Scotiabank:

• Blackmont Capital maintains "buy,"

• CIBC World Markets 12 month target price reduced to $54.00 from $60.00

• Credit Suisse maintains "neutral," 12 month target price is $58.00

• RBC Capital Markets maintains "sector perform," 12 month target price raised to $55.00 from $54.00
RBC Capital Markets, 29 August 2007

Very strong quarter in domestic retail banking

• Domestic retail net income of $395 million was well ahead of our $361 million estimate, and up 23% versus Q3/06.

• Revenues were up 9% (7% in banking, 19% in wealth management), and expenses were only up 1%, a growth rate that would have been higher if not for lower pension and benefits costs.

• Average assets were up 12%, deposits were up 6% and margins were down 11 basis points on loan mix, competitive pressures and higher funding costs.

• Market share was up 18 basis points in residential mortgages and 21 basis points in term lending. Mortgages are the lowest yielding form of retail lending, while term lending is the most expensive form of retail funding (although high yield savings account are also high cost). We believe that these volume trends partly explain the margin pressure.

• The potential for rising short term interest rates in the near term has declined dramatically in the last month. Scotiabank's net interest income margins are usually most negatively impacted by rapid increases in short term rates given heavier reliance on wholesale funding than others.

• The multiple initiatives undertaken to improve the bank's mutual fund business appear to be paying off. Mutual fund fees were up 34% versus Q3/06 and the bank's asset management arm ranks fifth in Canadian industry net sales of long term funds so far this year.

International banking growth could slow in near term

• International banking income of $276 million was well up versus Q3/06 (17%), but below the profitability of the first half of the year.

• Foreign currency translation, the change in the fair value of trading securities, and lower trading revenues in Mexico led to a decline in revenues versus Q1/07 and Q2/07.

• The mark to market of trading securities could continue to be a drag on earnings growth if risk aversion leads to further expansion in risk spreads on emerging market debt, which had essentially been declining for five years until July.

• Management believes that, if it can complete the acquisition of Banco del Desarrollo in Chile, it could bring up its ROE in that country closer to industry levels. Scotiabank's loan market share in Chile is fairly small and profitability, although improved in recent years, is below average. The rumoured acquisition size ($1 billion if the acquired interest is 100%), indicates to us that management is not overly concerned by the various issues that could affect the liquidity positions of financial institutions around the world.

Management seems relatively optimistic on wholesale earnings

• Scotia Capital net income of $280 million was close to our estimate and in line with Q3/06. The 12% sequential drop in core net income was mainly due to lower interest and loan loss recoveries. Year-over year revenue growth of 5% was offset by 15% growth in expenses on higher performance-based compensation and technology costs.

• The business loan book continues to grow rapidly; up 19% in the last 12 months, with the "vast majority of the growth in investment grade loans".

• Scotia Capital was clearly well positioned in its trading portfolio to take advantage of widening risk spreads and interest moves seen in the quarter. Total trading revenues of $312 million were up just over 20% both sequentially and year-over-year. Management did not sound alarmed about a potential drop-off in trading revenues in the near term.

• Value at risk (VaR) of $15.6 million in Q3/07 compares to $11.3 million in Q2/07 and $9.2 million in Q3/06. The increased VaR is due to larger interest-related positions, increased M&A risk arbitrage and the impact of volatility in equity markets on reported VaR. The increased capital commitment probably helps explain why management is comfortable with the sustainability of trading revenues.

• The bank noted that (1) it has no direct exposure to U.S. sub-prime mortgages and that its indirect exposure is not significant, (2) it has no significant holdings of Canadian third-party asset backed commercial paper or liquidity backup exposure, and (3) LBO underwriting commitments represent only about $800 million (0.2% of total assets).

• The Canadian banks that have reported so far (including Scotiabank) appear to have manageable exposure to "hot" areas but, to the extent that news flow and negative surprises affect risk spreads across asset classes, Canadian banks' wholesale results are still at risk of weakening in a risk averse environment.

• We are concerned about news flow because there is still no or very little liquidity for many structured finance assets, most of which have not been marked to market, U.S. subprime mortgage delinquency rates are likely to increase as interest rate resets take effect, and there are still many LBO loans that are waiting to be distributed. We realize that those issues are not material by themselves for Canadian banks, but we doubt Canadian bank stocks will perform well if negative news flow leads to weaker share prices for financial institutions worldwide.

• Our outlook for the banks does not assume a recession, which is in line with our economists' outlook. If liquidity continues to be a concern and credit availability is restrained for an extended period, it would have a negative impact on the economy.

We agree with Scotiabank management's assessment that the current capital markets turbulence and expansion in credit risk spreads will likely create opportunities for trading businesses, it should be a positive for margins in commercial and corporate lending, it should help well-capitalized organizations get higher returns on capital as competition for investments becomes scarcer, and acquisition opportunities may arise. This period of opportunity does, however, typically come after a period of pain in which assets get marked to market. We do not believe that this adjustment period is over.

Other highlights

• Credit quality remains excellent by long-term standards, as is the case with other banks, but the trend is toward rising provisions. Specific provisions for credit losses of $92 million were well up versus $74 million in Q3/06 and $45 million in Q2/07, driven by lower recoveries and reversals.

• Securities gains of $134 million were higher than the $94 million average of the last four quarters. Unrealized securities gains dropped from $1.2 billion to $960 million as gains were realized and widening credit spreads affected the value of fixed income securities and emerging market debt.

• Currency negatively impacted EPS growth by $0.02 versus Q3/06 and $0.05 versus Q2/07. We expect a continued drag on year-over-year growth in upcoming quarters, based on current rates. About 45% of the bank's income comes from outside of Canada, with the next highest Canadian bank at approximately 30%.


Our 12-month price target of $55 is a combination of our sum of the parts and price to book methodologies. It implies an approximate forward multiple of 12.2x earnings, compared to the 5-year average forward multiple of 12.5x. Our P/B target of 2.7x in 12 months is slightly higher than our target average for the banks given a slightly higher ROE and strong capitalization.

Our sum of the parts target of 12.2x 2008E earnings is in line with our target average for the banks, as strong performance in the growing international division is offset by slower growth in domestic retail banking relative to other banks in recent years and lower exposure to wealth management.

Price Target Impediment

Risks to our price target include the health of the overall economy, sustained deterioration in the capital markets environment, the potential for non-accretive acquisitions and/or related execution risk, deterioration in the Latin American political and economic climate, a rising Canadian dollar and rising business loan losses.
Financial Post, David Pett, 29 August 2007

Bank of Nova Scotia's international group may have taken a back seat to its domestic cousin when the company reported stronger-than-expected third quarter results Tuesday, but it still proved there is plenty of money to make overseas.

Profits at Scotiabank rose 9% year-over-year to $1-billion in the quarter, as domestic operations rung in profits of $391-million, up 23% from last year.

The international group, for their part, turned in profits of $270-million, a 15% increase from the year previous, after Scotia CEO Richard Waugh said operations in Peru, the Caribbean, South America and Chile all reported strong results.

"We were encouraged by the continuiing strong revenue growth and return to positive operating leverage reported by the international segment," Blackmont analyst Brad Smith said in a note to clients. "These two factors have allowed the international division to grow despite headwinds in the form of a rising effective tax rate and a rising Canadian dollar."

Mr. Smith added that with the effective tax rate rise poised to declerate and the rising Canadian dollar on pause, the profit growth outlook for Scotia's international operations appears solid.

He maintained his "buy" rating on the stock and left his $61 price target unchanged.

Meanwhile, RBC Capital analyst Andre-Phillipe Hardy reiterated his "sector perform" rating and increased his price target from $54 to $55 following Scotia's third quarter results.

However, he wrote that he remains concerned that Canadian banks could trade sideways or down if more negative news flows as a result of the ongoing credit crunch crisis.

As for Scotia's international segment, he told clients that banking growth could slow in the near term, as rising risk aversion could affect the multiple paid on earnings from emerging markets.

Mr. Hardy also said he believes net income for Scotiabank's key Mexican division may disappoint in the near term.
The Globe and Mail, Andrew Willis, 29 August 2007

It's fascinating to watch bank chief executive officers successfully turn their backs on their corporate roots.

Rick Waugh started his career at Bank of Nova Scotia in a Winnipeg branch. He came of age as the head of Scotiabank's U.S. commercial banking operations. One of his early achievements as CEO was the expansion of the bank's South American operations.

The hole in Mr. Waugh's résumé when he took the top job was in wealth management. He hadn't spent time swapping stories with stockbrokers, or running portfolios. Human nature would tell you that as CEO, Mr. Waugh would play to his strengths, and devote the bank's resources to the business lines he knows, while conceding wealth management to rivals.

Nothing could be further from the truth.

Over the past two years, Mr. Waugh and head of domestic personal banking, Chris Hodgson, made mutual funds a priority. The fact that Mr. Hodgson is in this position speaks volumes about Scotiabank's priorities. The head of the branch network is not a retail banker by training, but rather a former stockbroker at Scotia McLeod, who left to run Altamira Investments, then returned to the fold when the mutual fund manager was taken over by National Bank.

What did Scotiabank do to catch up with competitors? It hired new managers and pushed training programs on staff, then rejigged the commissions they earn from selling funds. The bank ensured that it had a full inventory of products, launching monthly income funds, for example. Mr. Hodgson also ensured that the funds he sold were top performers. And, gasp, he lowered customer fees.

What was the result? Year over year, Canadian mutual fund assets are growing at a 17-per-cent clip, according to the Investment Funds Institute of Canada.

Scotiabank's fees from selling mutual funds are rising at twice this clip, up 34 per cent from last year.

The bank, the No. 10 player in this sector with $20.7-billion of assets under management, is grabbing market share from rivals.

It's not just fund management that's growing at a torrid pace. Revenue from Scotiabank's retail brokerage was up 15 per cent, and the private client division, a hidden jewel when it comes to estate planning and caring for wealthy individuals' portfolios, saw revenue jump 12 per cent.

This from a CEO who said in a recent interview that he still has far to go on wealth management. All this growth helped boost Scotiabank's quarterly profit from domestic banking by 22 per cent, year over year, to $391-million.

Mr. Waugh is far from unique in moving to a shareholder-friendly strategy on taking the top job.

Royal Bank's Gordon Nixon has done much the same by investing heavily in systems and people at his market-leading retail bank, while challenging former colleagues at investment bank RBC Dominion Securities to do more with less capital.

High-margin retail banking, and wealth management, get far more respect from investors, in the form of premium stock market multiples. The same focus can be seen at Toronto-Dominion Bank, where Ed Clark betrays his roots as a Merrill Lynch financier by making the retail bank a top priority.

The meltdown in commercial paper this month took the market by surprise, and left many smart folks wondering where the next financial land mines may explode.

Bank of Nova Scotia's earnings call yesterday signalled where the country's most global bank sees possible problems.

Chief risk officer Brian Porter took analysts through Scotiabank's exposure to third-party asset-backed commercial paper, which is minimal, and U.S. subprime mortgages, also insignificant.

Then Mr. Porter, without prompting, pointed out that Scotiabank has relatively small commitments to financing leveraged buyouts. Analysts are still trying to get a handle on what loans promised to private equity funds in recent months are going to end up costing U.S. banks.

Scotiabank also went out of its way to say that while it deals extensively with hedge funds, it takes steps to minimize the risks associated with this trading and has no credit issues with these clients.

On a separate front, analysts fear the new problem child in European banking circles will be a creation known as SIV-lites, which combine traditional structured investment vehicles (SIV) with collateralized debt obligations (CDOs), the instruments that have already been the source of much woe in the asset-backed paper market.
The Globe and Mail, Andrew Willis, 29 August 2007

Canada's most global bank, Bank of Nova Scotia, rode a strong showing from its domestic branch network to a 10-per-cent profit rise over all, earning more than $1-billion in the most recent quarter.

Improved performance from its bank tellers, mutual fund arm and stockbrokers helped boost Scotiabank's retail banking profits by 22 per cent year over year, to $391-million. That rise made up for slightly weaker results from the bank's international operations.

"The domestic banking division led the way," said a report yesterday from analyst Andre-Philippe Hardy of RBC Dominion Securities. Scotiabank posted quarterly profit of $1.02 a share, beating analysts' forecast of $1 a share. Quarter-over-quarter, the bank's profit dropped slightly, to $1.032-billion from $1.039-billion, owing to unfavourable currency moves that hurt international earnings, and lower interest rates and loan-loss recoveries.

Over the past two years, Scotiabank reworked its $20.7-billion lineup of mutual funds, launching new funds and improving performance at others in a push to rise above its position as the No. 10 Canadian player in the fund sector.

"We were lagging rivals," said executive vice-president Chris Hodgson in an interview. "We were known as the lending bank, and we wanted to expand the focus of our branch system.

"One of our biggest efforts in domestic banking has been to improve our showing in mutual funds," said Mr. Hodgson, who used to run mutual fund manager Altamira Investments. Scotiabank has succeeded in that effort, with fee revenue from fund sales rising 34 per cent and overall wealth management revenues up 19 per cent compared with the previous year.

"Our third quarter saw continued contributions across all three of our platforms for growth," said Rick Waugh, Scotiabank's chief executive officer. He said recent turmoil in credit markets has not dampened Scotiabank's appetite for international acquisitions, and the bank is evaluating opportunities in countries such as Chile and China.

Despite this summer's credit crunch, Mr. Waugh said Scotiabank is on track to meet its annual performance benchmarks, which include 7-to-12-per-cent earnings growth and a 20-to-23-per-cent return on equity.

Scotiabank boosted domestic banking revenue by 9 per cent, while expenses crept up by just 1 per cent. The Toronto-based bank will be hard-pressed to keep producing this low-cost growth. Its industry-leading profit margins are expected to dip in coming months as Scotiabank opens 16 to 20 new domestic retail branches, and spruces up Caribbean and South American operations, according to analyst Mario Mendonca at Genuity Capital Markets. However, he has a "buy" recommendation on Scotiabank, in part because of the international operation's profit potential.

Return on equity at the bank continued to be strong at 22.7 per cent, compared with 22.8 per cent in the same quarter last year. The bank increased its share buybacks to $629-million through the first nine months of the year.

Scotiabank took pains yesterday to show it has minimal exposure to credit markets problems related to U.S. subprime mortgage loans.

Scotiabank is the fourth bank to report its third-quarter results. Earlier yesterday, Bank of Montreal posted a 7-per-cent fall in profit, to $660-million or $1.28 a share. The drop reflected commodity trading losses that the bank said are now the subject of a regulatory probe.

Toronto-Dominion Bank beat analysts' expectations with a $1.1-billion profit that was up 39 per cent from the previous year, while Royal Bank of Canada also did better than expected, with earnings that rose 19 per cent to $1.4-billion.
Financial Post, Duncan Mavin, 29 August 2007

For a change, it was Bank of Nova Scotia's domestic banking operations rather than its overseas business that stole the limelight when the bank reported its third-quarter earnings yesterday.

Scotiabank's Canadian retail bank turned in profits of $391-million, up $71-million or 23% from $319-million last year.

The improvement was "especially satisfying as we continued to make investments aimed at attracting and retaining customers," said Scotiabank chief Rick Waugh.

The bank has opened more branches, recruited more sales staff, and spent on marketing initiatives as it tries to grow market share at home.

The domestic banking unit turned in revenue of $1.5-billion, up 9% from last year, on the back of strong volume growth and higher wealth management fee income.

Assets were up 12%, while deposits rose 6%.

Overall, Scotiabank's profits of $1-billion were up 9% compared to $928-million last year.

Although the domestic bank stole much of the limelight, Scotiabank's international group also produced a strong set of results.

Overseas operations turned in profits of $270-million, up $36-million or 15% from last year after allowing for a one-off $51-million tax recovery in Mexico in 2006. "Solid results were reported by operations in Peru, the Caribbean and Central America, and Chile," Mr.Waugh said.

The bank also completed its purchase of 24.99% of Thailand's Thanachart Bank during the quarter.

Executives also confirmed Scotiabank is looking at buying Chile's Banco del Desarrollo, Inversiones Norte Sur. It already has a presence in Chile through its subsidiary, Scotiabank Sud Americano, S.A.

"For us, Chile's a strong investment grade country," said Rob Pitfield, Scotiabank's head of international banking.

"Our target is to achieve 10% or critical mass and we are looking to do that in Chile. Talks are continuing."

Scotia Capital's profits declined slightly from $278-million in 2006 to $276-million this year.
Bloomberg, Sean B. Pasternak, 28 August 2007

Bank of Nova Scotia, Canada's second-largest bank, said profit climbed for the 17th straight quarter, led by higher revenue from consumer banking and mutual fund sales.

Net income for the third quarter ended July 31 rose 10 percent to C$1.03 billion ($970 million), or C$1.02 a share, from C$936 million, or 93 cents, a year earlier, the Toronto- based bank said today in a statement. Revenue increased 11 percent to C$3.2 billion.

Domestic banking profit jumped 23 percent to C$395 million, as the company increased mutual fund sales by selling through its branch network. Higher brokerage and fund fees led to a 19 percent increase in asset-management revenue.

``I think it's a reflection on the Canadian economy,'' said Ian Nakamoto, director of research at MacDougall, MacDougall and MacTier Inc. in Toronto, which manages $4.3 billion of assets, including Scotiabank shares. ``The major battleground, going forward, is to grab more share of wallet from the Canadian consumer.''

The bank was expected to earn C$1 a share, according to the average estimate of four analysts surveyed by Bloomberg.

Scotiabank opened 16 branches in Canada this year and introduced debit and credit cards that offer rewards at movie theaters. The bank lags behind most of its main Canadian competitors for market share in deposits and credit cards, Dundee's Aiken said.

Scotiabank shares fell 62 cents to C$50.54 at 4:10 p.m. in trading on the Toronto Stock Exchange. They've fallen 3 percent this year.

International banking profit declined for the first time in more than two years, down 3.4 percent to C$276 million, mainly because of a year-earlier tax recovery at its Scotiabank Mexico unit.

Chief Executive Officer Richard Waugh has been pursuing more international acquisitions in recent months. In March, Scotiabank agreed to buy 25 percent of Thailand's Thanachart Bank Pcl, and on Aug. 10, the bank said it was in talks to buy a stake in Chile's Banco del Desarrollo. The bank yesterday completed its purchase of a 10 percent stake in Puerto Rico's First Bancorp for $94.8 million.

Profit from investment banking was unchanged at C$280 million. The Scotia Capital unit ranked second in the quarter for merger advice involving Canadian companies, advising on 12 completed deals valued at $8.49 billion, according to Bloomberg data.

The bank set aside C$92 million for bad loans, a 24 percent increase from the year-earlier period.