29 November 2006

National Bank's Quebec Discount

The Globe and Mail, Derek DeCloet, 29 November 2006

This is a tale of two banks. For the moment, let's call them Company A and Company B.

Company A is one of best-run banks in Canada, though it wasn't always so. Along with one other player, it dominates the financial services market in one region of the country. Its earnings are diversified and, though its Bay Street securities arm has struggled, the company stands to make a 20-per-cent return on equity this year.

Company B is also a well-managed, regional player with a profitable niche. The CEO is credible, the track record excellent, the growth rate superb. But, unlike most other Canadian banks, it is heavily reliant on the health of the business sector -- only 12 per cent of its loans are to individual customers. It has no presence in some of the biggest growth areas in finance, like mutual funds. Its return on equity, at 14 per cent, lags its larger peers.

Which one would you rather buy? A smart investor would probably answer, "It depends on the price." Company A is Montreal's National Bank, which is getting its usual lack of respect and trading at about 12 times next year's earnings (using BMO Nesbitt Burns estimates). Company B is Edmonton-based Canadian Western Bank, which sells for 17 times. The better bank gets a Quebec discount; the inferior one, an Alberta premium.

That fact alone does not make National a good buy, but the investment case is worth looking at. The knock on the bank is that it's hemmed into Quebec and lacks a solid growth plan for English Canada, particularly since the performance of National Bank Financial is uneven. The skeptics have been winning the argument lately. Despite a great run for big bank stocks, National has been by far the worst one to own over the past year, returning 5.1 per cent, including dividends.

But to focus too much on the recent past is often a mistake with the Canadian banks, which have a habit of rebounding from their problems. Investors who walked away from Toronto-Dominion in 2002, when the bank took billions in loan write-offs, regretted their decision. Ditto those who gave up on Royal Bank in its dark days of 2004. You thought CIBC was doomed after last year's infamous Enron write-off? Guess which bank is virtually tied for top spot this year among the Big Six.

National, which reports its year-end results tomorrow, hasn't stepped in it the way those other banks did. That's a credit to RĂ©al Raymond, the bank's 56-year-old chief executive officer. Yet the Quebec stigma still sticks. The question is, does it justify the discount to the other large banks?

Not if you turn it around and look at this way: National is one half of a Quebec duopoly. Together, the bank and the Caisse Centrale Desjardins own about 60 per cent of the provincial market in personal and commercial banking. None of the larger Canadian banks can claim any such market share, anywhere. In the U.S., where there are dozens of sizable regional banks, investors would see this as an advantage, worth paying extra for. But not here.

What can Mr. Raymond do about it? From a perception point of view, it would help to make an acquisition outside of Quebec, except that there's nothing much to buy, and the last two significant deals -- for mutual fund company Altamira and U.S. investment bank Putnam Lovell -- haven't been stellar.

Mergers among the biggest banks would also help since it would force the sale of branches, which National could be in the best position to buy. You could argue Ottawa's solution to the merger problem, in fact, is to make it a policy to build National into a truly national bank -- good for Quebec, good for competition. But mergers aren't about to happen soon (though, at 12 times earnings, investors aren't paying for the possibility; consider it a free option).

In the short-term, a better answer might to be to ratchet up the dividend. National is one of the best dividend growers in the large-cap S&P/TSX 60, yet its payout ratio is on the low side -- about 37 per cent so far in 2006. But after the income trust debacle, high dividends are something the market seems willing to pay for. If National decided to give back, say, half its earnings, you could see its dividend rise by one-third next year.

Maybe then Mr. Raymond's bank would get the respect it deserves.

P/E ratio on 2007 earnings*

• Canadian Western Bank 17.0
• Royal Bank 14.4
• Bank of Nova Scotia 13.8
• TD Bank 13.0
• Bank of Montreal 12.9
• CIBC 12.5
• National Bank 11.9

* Cash earnings for fiscal 2007, based on BMO Nesbitt Burns estimates