Wednesday, August 27, 2008

Scotiabank Q3 2008 Earnings


BMO Capital Markets, 27 August 2008

Scotiabank reported third-quarter cash earnings of $987 million, or $0.99 per share, compared to $966 million, or $0.97 per share, last quarter and $1.0 billion, or $1.03 per share, in the same quarter of last year. This was another clean quarter for Scotiabank. The bank earned over 20% ROE, side-stepped problems in structured credit markets and showed superior credit management skills. We are confident that it will outperform its peers over the course of this cycle.

One thing that does concern us is Scotiabank’s apparent lack of patience in building its domestic Wealth Management business. Over the past year, the bank has done two deals that in hindsight may indicate a degree of desperation: the decision to buy 20% of Dundee Wealth and the purchase of E*Trade Canada. The former resulted in an awkward period of uncertainty regarding a possible bid for Dundee overall, and the latter set the new high watermark on pricing of discount brokerage deals. Given management comments on the conference call, they appear to be prepared to give up control (or a clear path to control) of their mutual fund business for a non-controlling stake in a larger entity. We are not sure that short-term gain is sufficient pay-off for longer term complexity and cross ownership.

Domestic Banking earnings, which include wealth management, were $469 million, up a solid 10% from last quarter and 17% from the same quarter of last year. Year over year loan growth was a very strong 14%. Spreads remained stable versus the previous quarter. On the wealth side, fee revenues were strong and were only partially offset by the slowdown in new issuance and trading activity.

International Banking reported earnings of $337 million, flat with last quarter but up 22% over the same quarter of last year. This quarter’s results included a $40 million (pre-tax) gain on the IPO of the Mexican Stock Exchange, which was largely offset by a contingency liability and securities and trading losses in Latin America. Strong loan and deposit growth and higher contributions from recent acquisitions in South America account for the year-over-year growth.

Scotia Capital had a very strong quarter. Earnings of $298 million were up 16% from last quarter and 6% over the same quarter of last year due to a more attractive corporate lending environment and strong advisory and trading results. Trading revenues of $247 million were slightly above expectations due to strong derivative and fixed income activity. The segment posted a $4 million provision for credit losses this quarter. We expect earnings to trend lower into 2009. The Other segment reported a loss of $85 million, caused as much by transfer pricing as the widening spreads on bank funding. We assume that the loss will be more modest in 2009 as funding costs improve.

On the credit front, loan losses of $159 million came in lower than our expectations. Impaired loan formations continued to track up this quarter to $377 million. Net impaired loans (after general allowance) continued to decline but remained well in negative territory. Management indicated it expects provisions to move moderately higher in the medium term. We are assuming provisions of $1 billion next year.

Management provided further information about its GMAC auto lending program. Of the $7.1 billion exposure, 97% are auto loans and the remaining balance is leases. Credit enhancement is based on a discounted purchase price and is reset based on recent performance for each new pool purchased. Given the structure of the deal, management remains comfortable with this transaction.

Scotia’s capital position remained sound again this quarter. The bank’s Tier 1 ratio was 9.8%, up 20 bps from the second quarter as good internal capital generation and the issuance of $350 million of preferred shares more than offset growth in RWAs. Scotia was the only bank to participate in its share buyback program this quarter, indicating the confidence management has toward its balance sheet. Payout ratio is modest and the bank has the capacity to raise its dividend.

Projections and Valuation

We are leaving our 2008 and 2009 EPS estimates unchanged. Despite material headwinds, the bank has largely earned though the credit turmoil without significant “unusual” items. Scotiabank has a superior balance sheet and growth strategy, however the credit environment is deteriorating. We believe the next wave of problems will likely come from increased signs of pressure on Canadian loan books. Scotia is at least as well prepared as its peers to deal with this. We are maintaining our Outperform rating, and our target price of $52.50, which uses a 12.5x multiple on our forecast for 2009.
RBC Capital Markets, 27 August 2008

Scotiabank's core cash EPS of $0.99 were short of our estimate of $1.04 and consensus of $1.03.

• Net income in the Canadian and wholesale businesses was ahead of our expectations, which was offset by lower than expected income in the international and "Other" segments. Loan losses of $159 million were in line with our expectations and the prior quarter, but up 73% versus Q3/07. Capital remains strong, with the Tier 1 ratio at 9.8%.

We have lowered our 2008 EPS estimates from $4.15 to $4.00 and our 2009E EPS from $4.25 to $4.15. Our 12-month target price per share remains $49.

We maintain our Sector Perform rating on Scotiabank shares. (We currently rate half our Canadian bank universe as Sector Perform and half as Underperform).

• Near term, we believe that Scotiabank's share price should benefit relative to peers from (1) stronger asset growth in domestic banking, international banking and corporate lending; (2) less exposure to U.S. lending than some of its peers (the area most impacted by deteriorating credit for now); (3) less exposure to structured finance and off balance-sheet conduits than most; and (4) greater exposure to a Canadian dollar that has weakened against the U.S. dollar.

• We believe that BNS will maintain its industry high valuation (forward P/E of 11.2x versus 8.9x for Canadian peers, P/B of 2.4x versus 1.8x) as long as credit problems remain centered on U.S. exposures and visibility on structured finance exposures/off balance sheet vehicles remains clouded.

• We believe that BNS' relative valuation will be more at risk in 2009 as concerns spread from the above-mentioned issues to the impact of a slowdown in economies on loan growth and credit losses.

• Our 12-month target price of $49 is based on a P/BV multiple of 2.25x, and it implies a P/E on NTM EPS of 11.7x.
TD Securities, 27 August 2008


Yesterday, Scotia reported Q3/08 core cash FD-EPS of C$1.01 vs TD Newcrest at C$1.05 and consensus at C$1.03.


Reiterate BUY. EPS came in a few pennies shy of expectations on the back of some heavier expenses along with some funding pressures in Corporate. However, again we note several encouraging trends 1) Domestic P&C/Wealth continues to make solid progress 2) Credit is trending as expected and Scotia remains well reserved and 3) International remains on track despite headwinds. All told, Scotia is weathering the current environment well, and holds one of the best medium-term operating outlooks in the group in our view.


Credit worries manageable. Concerns have been building around potential credit risks in Scotia's corporate loan book, International segment and exposure to the auto sector. Management again expressed confidence in its management of credit risk, including these specific exposures, and we note that many of the bank's coverage ratios remain comfortably ahead of their peers. We do expect rising credit costs (reflected in our estimates), but the trends appear well managed at this point.

International prospects on track. International delivered 18% bottomline growth despite higher credit costs, higher operating spend and currency impacts. With strong volume growth, ongoing integration benefits and future acquisition prospects this segment continues to display strong potential to deliver superior medium-term growth in our view even with the headwinds of today's more challenging environment.

Domestic delivering. One of the most encouraging developments for Scotia over the past year in our view has been the acceleration of its Domestic business helped by concentrated efforts and some smart acquisitions. As a result, Scotia is evolving from a notable laggard, to posting some of the strongest operating trends in the group we expect to see this quarter.

Solid story deserving of premium. No bank is without issue in this environment, and Scotia is no exception. However, the bank is faring better than most and is exceptionally well positioned to capitalize on the eventual recovery with good operating momentum, strong capital position and competent management. We expect the stock to continue to trade at a premium valuation.

Q3/08 Conference Highlights

Credit exposure. A key focus on the call, management stressed that it is very comfortable in its overall credit exposure. Specifically it reiterated that its auto loan exposure is diversified and manageable. The GMAC program is performing inline with expectations and is well structured with credit enhancements to Scotia's benefit. Management expects moderate PCL growth over the coming year.

Mutual Fund deal. In our view, management clearly left the door open to a range of possible deal structures around its Mutual Fund business. Management remains focused on getting scale and growing the earnings contribution.

U.S. banking market. Conversely, in our view, management significantly downplayed any interest they would have in acquiring a U.S. P&C banking platform.

Domestic competition. The mortgage market is becoming very competitive, but Scotia is still gaining share. Deposits also remain hotly contested and Scotia has been able to gain market share (helped by Dundee Bank acquisition), but has not been 'buying' deposits with aggressive rates. Q3/08 Segment Highlights

Domestic. Another encouraging quarter in our view. Good volume growth in key products (mortgages +15%) and continued deposit growth (+13%). NIM improved +3bp quarter over quarter. Overall, revenue growth of 9% and NI growth of 17% should compare favorably with the best in the industry this quarter.

International. International continues to manage well despite some challenges. The group reported 25% revenue growth and 18% NI growth including the negative impact of FX (C$17M) and 20% NIX growth, reflecting recent acquisitions and strong organic growth. Credit costs are also on the rise reflecting largely portfolio growth and mix.

Capital Markets. The quarter was soft as expected with just 1% revenue growth, but good cost control (NIX - 5%) helped to deliver NI +6%.

Corporate. Typically volatile, corporate was a key source of the lower EPS on the quarter. The segment reported a NI loss of C$79 million compared to a gain of C$81 million in Q2/07. Higher liquidity, funding costs (run through Treasury) and hedging costs weighed materially on NII, while lower gains in non-trading securities hit Other Income. Ex corporate, NI was up 12%.


We updated our 2008 estimate to reflect Q3/08 actual results and no change has been made to our 2009 estimate. We continue to see encouraging trends in Domestic, while International continues to progress as expected and credit costs remained in line.

Justification of Target Price

We expect Scotiabank to hold its premium valuation relative to the Big-Five Canadian banks, reflecting superior growth prospects, strong return on equity and healthy excess capital. We base our target price on 12.50x forward earnings, a premium to our outlook for the group.

Key Risks to Target Price

These include: 1) the continued weakening of the U.S. dollar, 2) country and political risk in its international markets such as Mexico, 3) integration challenges associated with its recent and future acquisitions and 4) adverse changes in the credit markets, interest rates, economic growth or the competitive landscape.

Investment Conclusion

Scotia’s Q3 results provided some encouraging core operating trends and good volume growth. We continue to view the bank as having one of the best medium term operating outlooks and reiterate Buy.
Financial Post, John Greenwood, 27 August 2008

Given the ongoing economic turmoil and rising level of regulation, the United States is no place for a Canadian bank to be making acquisitions, Rick Waugh, Bank of Nova Scotia chief executive, said yesterday.

Speaking on a conference call with analysts, Mr. Waugh said that despite the collapse in share prices across the financial sector, banks there still face "a lot of issues" that could end up hurting potential buyers.

"We are aware of the significant change in valuations that we have seen over the past year," he said, adding that prices are still high.

"And the regulatory environment is getting worse rather than better. The U. S. has been through a major upheaval," he said.

In the wake of the collapse of former giants such as Bear Stearns Cos. Inc., regulators have launched a string of lawsuits, forcing players to pay out billions of dollars in fines and settlements.

"The legal system down there is reacting in many ways, creating problems for participants," Mr. Waugh said.

The bottom line for Mr. Waugh is that the United States is a hostile place for doing business and things will likely get worse. The bank, which has significant operations in the Caribbean, Mexico and Latin America, says it will continue to look elsewhere for acquisitions.

Contrast that with the view expressed by Bill Downe, Bank of Montreal chief executive, in a similar conference call. BMO yesterday surprised the Street with higher-than-expected loss provisions and a steep decline in third-quarter earnings, largely due to its substantial U. S. operations.

Analysts were particularly concerned by the bank's exposure to off-balance sheet investments that hold large amounts of credit derivatives linked to sinking U. S. real-estate loans such as the BMO-sponsored Parklands structured investment vehicle. But Mr. Downe dismissed such concerns.

"It is good news that U. S. housing starts are at the low level they are, [because] at some point people are going to come out of rental housing and move back into purchased housing," Mr. Downe said.

The major hurdle in the way of a recovery is the situation at mortgage giants Freddie Macand Fannie Mae, but they will be restructured, Mr. Downe predicted, and when that happens, "I think the U. S. housing market will become a much more orderly place."

Mr. Downe and Mr. Waugh may disagree about the state of the U. S. economy and the market for Canadian banks looking to expand there, but the fact that the rift is so big is illustrative of a general shift in perception in corporate Canada.

For years the United States was regarded as the place to be for business, especially banks, and only lofty valuations would keep them from expanding into world's most lucrative market.
Financial Post, John Greenwood, 27 August 2008

While still quite strong, Bank of Nova Scotia reported a drop in profit for the third quarter in the face of higher credit provisions and languishing capital markets.

For the three months ended July 31, Scotia posted net earnings of $1.01-billion, or 98¢ a share, down 2% from last year.

"It looks like a good quarter," said Mario Mendonca, an analyst with Genuity Capital Markets. "It was pretty much in line with what we were expecting."

The numbers came in slightly below analysts' consensus estimate of $1.02 a share.

In the context of the bloodletting going on in the sector globally, Scotia's performance is regarded by many analysts as proof that prudence and strong management can enable a bank to avoid the credit turmoil that has claimed so many victims in the United States and Europe.

"Scotiabank's strategy of diversifying across business lines and geographies has enabled the bank to continue to perform well during a challenging period for the global financial services industry," said chief executive Rick Waugh.

One of the few ominous notes in the results was a warning by Mr. Waugh that the bank is "unlikely" to hit its earnings targets set at the end of last year. While Scotiabank's main businesses continued to make strides in the quarter, slow global growth is expected to weigh down future results, he said.

Nevertheless, Mr. Waugh stressed that the bank remains on the lookout for acquisitions, noting that its recent US$442-million purchase of E-Trade Canada will double Scotiabank's footprint in the online investing market.

The bank is also rumoured to be mulling over the potential acquisition of a large equity stake in fund manager CI Investments Inc.

Total revenue grew by 5% during the quarter over the period, while assets swelled by $54-billion, or 13%, thanks to healthy performance in domestic and international banking operations along with investment banking.

Despite signs of a slowing Canadian economy, Scotiabank's domestic banking revenue grew by 9% in the quarter, helped by increased mortgage activity and rising consumer deposits.

"Scotia Capital had a strong quarter, benefiting from its diversified portfolio of businesses," Mr Waugh said in a statement.
Dow Jones Newswires, Monica Gutschi, 26 August 2008

Bank of Nova Scotia was expected to do reasonably well in the third quarter, and delivered.

Buffered by its international operations, the Toronto-based bank escaped any fallout from the U.S. subprime crisis. In contrast to Bank of Montreal, which also reported its third-quarter earnings Tuesday, its credit provisions rose by a less significant amount. And it missed analyst forecasts by only a few pennies.

Bank of Nova Scotia earned C$1.01 billion or 98 Canadian cents a share in the latest quarter versus C$1.03 billion or C$1.02 a year earlier. On a cash basis, earnings came in at 99 Canadian cents a share.

Bank analysts expected third-quarter cash earnings of C$1.03 a share.

"Things being what they are, holding your own is pretty good, I think," said David Baskin, principal at Baskin Financial Services, who counts Scotiabank as his favorite among Canadian banks.

Still, the bank's shares are being battered in afternoon trading in Toronto. Bank of Nova Scotia is down C$1.18 or 2.5% to C$46.45.

By contrast, Bank of Montreal is off 40 Canadian shares or 0.9% to C$43.66. And Canadian Imperial Bank of Commerce, which is widely expected to announce another huge writedown on its U.S. structured credit portfolio, is down only 36 Canadian cents or 0.6% to C$57.55.

Baskin said it was a "mystery" to him why the shares were under pressure, although he noted Scotiabank's stock has not fallen as far this year as many of the others.

John Aiken of Dundee Securities said the earnings were a "very positive comparison" to BMO, with manageable credit losses. Scotiabank's loan-loss provisions for the third quarter were C$159 million, above the C$92 million reported a year earlier and in line with analyst estimates. Bank of Montreal's provision for credit losses soared to C$484 million in the latest quarter from C$91 million a year earlier. Analysts had only expected an increase to C$195 million.

But Brad Smith at Blackmont Capital noted Scotiabank's loan portfolio had deteriorated over the quarter, while provisioning rose only slightly. That could imply, he said, that Scotiabank may fall behind in credit-loss provisions and have to make up for it later.

As well, he said, Scotiabank's earnings include a 3-Canadian cent gain from the initial public offering of Mexican Stock Exchange shares. Excluding that gain, he said, puts the bank 7 Canadian cents short of forecasts.

Blackmont has no investment-banking conflicts with Scotiabank nor does the analyst own the bank's shares. Dundee has an investment-banking relationship with Scotiabank and the analyst or a member of his household owns its shares.

There was more mixed news in Scotia's results. Return on equity, a measure of profitability, was 21.0%, down only marginally from 21.7% a year earlier.

Expenses rose 8% in the quarter, mainly on acquisitions and a big marketing push. Net income from its key international division rose 19% from a year earlier, but fell 2% from the second quarter, foreshadowing slower growth ahead.

"The bloom seems to be coming off the rose in the emerging marketplace," said Ian Nakamoto, market strategist at Macdougall, Macdougall and MacTier. He noted the recent strengthening in the U.S. dollar may indicate concerns that "cracks" are beginning to show in other regions of the world.

Analysts expected the Canadian banks as a group to report lower quarterly earnings, with UBS Securities predicting a 9% overall decline year-over-year, as they contend with the ongoing fallout from the credit crunch, weak capital markets and a slowing economy.

Bank of Montreal kicked off the third-quarter earnings season for the big six Canadian banks earlier Tuesday, posting a 20% drop in earnings on sharply higher credit provisions and another charge for valuation adjustments in its capital-markets division.

Analysts have said that Canadian banks' domestic retail business is increasingly important due to declines in capital-markets businesses and rising risk in U.S. platforms.

Nonetheless, Scotia Capital, Bank of Nova Scotia's capital-markets business, had a strong quarter, the bank said, benefiting from record revenue in Scotia Waterous and fixed income, continued strong contributions from ScotiaMocatta and foreign exchange operations and an increased contribution from its lending businesses.

The domestic-banking business, which includes wealth management, reported a record quarter, with mortgage growth recorded in all sales channels and a 12% increase in personal deposits.

Grupo Scotiabank, the bank's Mexican arm, contributed about C$104 million to earnings, including a C$40 million gain recognized in relation to the IPO of the Mexican Stock Exchange.

The second half of 2008 is showing improvement compared to the first two quarters of the fiscal year, the bank said, with continued asset growth in all three business lines and a rebound in capital markets activity. Nonetheless, the bank reiterated that it isn't likely to meet its fiscal 2008 earnings growth target set at the end of the last year.
Dow Jones Newswires, Ben Dummett, 26 August 2008

Bank of Nova Scotia declined Tuesday to comment specifically on rumors it's in talks to sell its mutual fund business to CI Financial Income Fund in exchange for a significant equity holding in the big Toronto mutual fund company.

However, bank officials didn't rule out this type of transaction as a possible way of growing its relatively small mutual fund arm.

"One formula doesn't fit all," Rick Waugh, Bank of Nova Scotia's president and chief executive, said during the bank's fiscal third-quarter earnings conference call. Waugh made the comment in response to questions about the bank's strategy to grow its wealth management business.

Behind the question is market speculation that Bank of Nova Scotia is in talks to sell its mutual fund business to CI, a much bigger mutual fund operator, in exchange for a significant equity stake in CI. Late last week, CI confirmed it has held talks with a number of undisclosed parties about possible strategic combinations, but said there was no certainty a deal would be completed.

Bank of Nova Scotia has declined to comment on the rumors.

On the conference call Tuesday, Bank of Nova Scotia's Waugh reiterated the bank's strategy of growing its wealth management business. While the bank is pleased with the division's organic growth rate, Waugh also said the bank doesn't necessarily need to own 100% of the business to achieve this goal. It would consider owning a minority stake as long as the resulting transaction contributed to the bank's long-term strategic goal and made financial sense.

Waugh noted his firm initially expanded its banking operations in Mexico, Peru and Chile by taking minority stakes in the countries' local banks and then over time increasing these holdings to control positions.

If it sold its mutual fund business to CI under the rumored transaction, Bank of Nova Scotia would gain a meaningful equity stake in a larger mutual fund business that would further benefit by allowing CI to tap Bank of Nova Scotia's distibution network to grow sales.

Mutual fund companies seek scale in order to expand their sources of fee income while cutting costs.

In turn, Bank of Nova Scotia would be in a better position to acquire CI if and when it came for sale. The bank is already in a good position to acquire money-management firm DundeeWealth Inc. if its controlling shareholder, the Goodman family, ever puts the business up for sale, because of its existing 18% stake.

Still, Bank of Nova Scotia could face a bidding war for CI if CI's existing major shareholder Sun Life Financial Inc. has a similar plan.

Some observers suggest this prospect, in addition to the bank giving up the immediate control and brandname of its mutual fund business, are reasons why a deal with CI is unlikely.

However, others argue the bank doesn't have much of choice under current circumstances. The number of independent mutual operators in Canada is dwindling, and those with any significant size such as AGF Management Ltd. have controlling shareholders that don't want to sell.

Still, many industry watchers believe the consolidation trend of Canada's mutual fund sector will continue because of the importance of scale. By holding minority positions in mutual fund companies now, Bank of Nova Scotia could gain an edge over rival bidders when particular assets come up for sale. In the meantime, the bank potentially lowers its ultimate transaction costs for any deals, if the value of potential targets rise as they become increasingly scarce.
The Globe and Mail, Tara Perkins, 22 August 2008s

CI Financial Inc. says it has been talking with a number of financial institutions about various strategic possibilities.

“Over the last several months, we have had discussions with a number of financial institutions about a number of combinations including CI and its subsidiaries,” chief executive Bill Holland said in an interview Friday as the company put out a similar statement.

There is no formal strategic process in the works, he said, adding “we're always talking to everybody. We have knocked on every single door in Canada. There's never been a door we haven't knocked on.”

Sources said Bank of Nova Scotia is among the companies CI has informally talked to, as a report said that CI was in talks to buy Scotiabank's mutual fund division in exchange for giving the bank an equity stake in CI.

CI said it would not comment further on speculation. Scotiabank spokesperson Frank Switzer declined to comment on the report.

Mr. Holland said that, over the last several months, the mutual fund giant has held discussions with several financial institutions about various different forms of combinations that might make sense. That is “very consistent with what we always do,” he added.

“Over the last eight years or something we've done 10 acquisitions, and for every acquisition [that] we do, we kind of lose five of them.”

Mr. Holland said there's no assurance that any of the informal talks that CI is holding with industry players will lead to a deal, but “we really believe it's important to take advantage of the scale that this business offers, and in a business that's dominated by a few big players you want to be big and bring down your costs.

“We believe that this is a bulge bracket game,” he said, and bulk will be key to success over the next decade.

CI's largest shareholder is Toronto-based insurer Sun Life Financial. A spokesman for the insurer, Michel Leduc, also declined comment on any talks. He did say “I can confirm that Sun Life is very committed to its strategic position in terms of its stake in CI.”

Sun Life holds roughly a 37 per cent stake in CI. One source familiar with the situation said the insurer would be actively involved in any major strategic process involving the fund company. Significant transactions often require approval from two-third's of a company's shareholders.

In a note to clients Friday, BMO Capital Markets analyst Ian de Verteuil said he believes the odds of Scotiabank selling its mutual fund operation in exchange for an equity stake in CI “are very low.”

“CI would certainly benefit from owning and managing Scotia's mutual fund business [which has about $19 billion in assets under management],” he wrote. “Improved access to a bank's distribution network would be desirable for any mutual fund company.”

But the potential deal would be far less attractive for Sun Life and Scotiabank, Mr. de Verteuil added. “Both are well capitalized, want to be bigger in wealth management and generally want to control their core businesses,” he wrote.

“Simply put, Canada's larger financial institutions typically don't share their ‘toys' well with others,” he wrote.

Last fall, CI attempted a run at DundeeWealth Inc., which sold an 18 per cent stake to Scotiabank, which has put a major emphasis on beefing up its wealth management capabilities. This summer, it announced a $444-million takeover of E*Trade Canada.

CI Financial Income Fund is the third largest investment fund company in Canada, and had fee-earning assets of $102.2-billion at June 30, down 5 per cent from $108-billion a year earlier.