01 September 2009

Scotiabank Q3 2009 Earnings

BMO Capital Markets, 1 September 2009

For the quarter ended July, the Canadian bank sector reported operating earnings that were roughly unchanged from a year ago, compared to Street expectations of a double-digit percent decline. Much better-than-expected trading revenues, and to a lesser extent smaller-than-expected loan loss provisions, keyed the upside surprise. We are adding to our bank holdings in order to keep our sector weight at market.

As our positions in the TD, RBC, BMO and National are relatively full, we have added a new and small position in Scotiabank. Scotiabank was recently upgraded to Market Perform from Underperform, with Ian de Verteuil raising his earnings per share forecast to $3.28 for fiscal 2009 and $3.20 for fiscal 2010. Scotiabank is the only Canadian bank with material operations in emerging markets. While this is a solid positive over the long run, it appears that the credit cycle is still ahead of us in those markets.
TD Securities, 31 August 2009

Last Friday, the bank reported core cash FD-EPS of C$0.96 vs. TD Newcrest of C$0.82 and consensus at C$0.84.


Neutral. A good quarter, but it failed to meet the very high bar set by the group. Credit was the biggest concern with a sizeable PCL charge, although it was still below our 2010 run rate. In our view, management is being conservative, and credit issues appear fairly concentrated. Wholesale/Trading was a big help, but Domestic continues to impress. International should provide leverage in a recovery scenario. No change in estimates or Target Price. In our view, the stock offers decent upside on one of the best platforms in the group. Reiterate Buy.


Domestic momentum continues. The bank turned in solid Domestic P&C/Wealth results. Good volume growth, cost control and reported margin improvement delivered some of the best bottom-line growth on the quarter and accounted for over 50% of earnings. Recent minor acquisitions are just starting to feed into the numbers and help the outlook. We see additional potential in Scotia’s interests in CI and Dundee Wealth over time. Credit still manageable. PCLs came in nearly C$145 million ahead of our estimate, but the underlying trends are less ominous; gross formations on over 85% of book were down sequentially. The commercial book in International was the exception and we continue to expect it to get worse over the coming quarters. However, management sees no indication of a looming credit spike and they continue to build reserves (with specific reserves above the group average).

Earning through downturn; good leverage to a recovery. Albeit helped by favorable trading, the bank earned through a large PCL expense. Eventually credit concerns will pass and as the world recovers, we expect the market to become increasingly attracted to the favorable International positioning of the platform in a growth world. This should help the stock sustain/improve its relative multiple.

Conference Call Highlights

Credit outlook. One the whole, the bank suggested that credit conditions have largely begun to stabilize across their Canadian Retail book, Domestic Commercial book and Scotia Capital. International (which has lagged the cycle relative to Canada and the U.S.) will likely see additional credit pressure in the near term with delinquencies either stable or up slightly across all products and regions. However, management does not expect to see another large increase in credit costs for 2010.

Guidance. Management was confident in saying they will likely meet their 2009 target objectives (which included ROE of 16%-20%, EPS growth of 7% to 12% and a productivity ratio of less than 58%) given their performance to date and further expects Q4/09 to post substantially better results than Q4/08. On a reported basis, management’s EPS growth objective implies FD-cash EPS for Q4/09 of approximately C$0.81 to C$0.96.

International. Management expects International growth to see some challenges near term primarily on back of rising credit costs, working through recent acquisitions and the impact of a stronger Canadian dollar. However, the bank has been aggressively reducing expenses in International and is meeting its targets.

Acquisitions. The bank remains watchful and patient for opportunistic acquisitions that are in-line with their current strategy. Management does not believe a large transformational acquisition is a high probability for the bank and likely prefers smaller ad-hoc deals.

Quarterly Highlights (year-on-year unless noted)

Domestic – another solid quarter. Assets +9% and revenues +7% and NI +8%. Margins improved sequentially as the bank continues to work itself out of some of its funding/margin pressures from earlier this year.

International – working through higher PCLs. On an adjusted basis NI was down slightly at -2.9% as PCLs rose +220%. Volume trends still look decent with average residential mortgages +8%, personal loans +12% and business loans & acceptances +14%.

Wholesale – an exceptional performance. Driven by strong trading numbers, NI was up 56%. Outlook. We have made no changes to our estimates or Target Price. Our estimates assume a run rate below the Q3 pace largely on elevated PCLs in 1H10 and lower Trading revenues.

Segments. We expect Domestic P&C to see further progress with continued investment and management focus by the bank (which has done several recent ad-hoc acquisitions in Wealth). Scotia Capital is likely to trend lower as the current level of trading revenues is unlikely sustainable. International will reflect a challenging environment largely on back of credit.

Credit. We expect the bank to face further credit pressure in 1H/10 largely on back of International, with some easing in the back half of the year.

Capital. The bank remains comfortably capitalized with a Tier 1 ratio of 10.4%.

Justification of Target Price

In determining our Target Price we establish a Fair Value P/BVPS multiple based on our expectations regarding long-term sustainable ROE, growth and COE. Our expectations currently stand at 17.5%, 4.5% and 10.0% respectively implying a Fair Value P/BVPS multiple on the order of 2.60x.

Key Risks to Target Price

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

In our view, management is being conservative, and credit issues appear fairly concentrated. Wholesale/Trading was a big help, but Domestic continues to impress. International should provide leverage in a recovery scenario. In our view, the stock offers decent upside on one of the best platforms in the group. Reiterate Buy.
Globe and Mail, Tara Perkins, 29 August 2009

Rick Waugh is that rare breed of CEO with no desire to pull off a big deal.

Scoop up a major rival that's in distress and transform Bank of Nova Scotia into a much bigger player, or vault it into new markets? No thanks, not for him.

“I call it discipline,” he told analysts on a conference call yesterday.

It's a strategy that doesn't make the headlines, or a big impact on the bank's year-over-year profit growth, he acknowledged. But acquisitions are like a treadmill, and “I would rather take it a little slower on the treadmill.”

These days, the chief executive officer of Canada's most international bank is doing a lot of his walking at home.

When the subprime mortgage crisis began hammering the value of U.S. financial institutions, Mr. Waugh was one of the first executives to go shopping. He took a close look at Cleveland-based lender National City Corp. in early 2008. But he had trouble coming to terms with the unknowns on U.S. banks' balance sheets, and once the government started injecting equity into the banks, he lost his appetite to do a deal there.

So he focused on his top priority in Canada – building up a substantial wealth-management business. Compared to some other countries Scotiabank is in, where even basic financial products such as consumer loans are relatively new, opportunities for growth in Canada are few and far between. Having conquered the lending business here long ago, banks have been turning their sights to wealth management and insurance in an effort to retain control of baby boomers' retirement savings and cash in on them to the full extent possible.

With that in mind, Scotiabank has made a number of deals in recent years, including the acquisition of TradeFreedom Securities Inc., Dundee Corp.'s bank and a stake in its wealth-management operations, a chunk of CI Financial Corp., and all of E*Trade Canada. While each was notable, none were large enough to radically change the bank.

The acquisition spree petered out this year, and some opportunities went to its rivals. Just this month, Manulife Financial Corp. managed to scoop up AIC Ltd.'s mutual fund business for a song.

Chris Hodgson, the head of Scotiabank's Canadian operations, said it's true that good opportunities are still popping up in the wealth management space. But the bank is now “more than comfortable” that it can boost profits in the next few years with what it has already got.

Indeed, its acquisitions aren't contributing all that much to its earnings growth yet. And it is plowing additional money into people, technology and new products such as a flex-GIC (a guaranteed investment certificate that can be redeemed prior to maturity) to squeeze more growth from the business.

Importantly, it is also putting muscle into building a significant insurance business this year, and is now pitching a full lineup of home, auto and life insurance products. That's a significant new growth avenue for the bank, which lagged a couple of its rivals in this respect.

In the hunt for growth in the basic banking and deposit business – the most profitable and jealously guarded operations of the big banks – Mr. Waugh and Mr. Hodgson are looking to steal customers from the competition in the most Canadian way possible: by tugging on the heart strings of the country's hockey moms and dads. Scotiabank, now the official bank of the NHL, is calling itself “Canada's Hockey Bank,” making its support felt in rinks across the country, and has struck a deal with a hockey equipment chain to offer discounts to its customers.

It appears the bank's domestic strategy is paying off. Scotiabank said yesterday that it earned $500-million in Canada in its latest quarter, a new record, despite socking away $169-million for troubled loans. (In total, Scotia's profit was $931-million, down from $1.01-billion a year ago, on record revenue of $3.8-billion.)

In Canada, Scotiabank held $119.9-billion in mortgages, up from $112.3-billion a year ago. Personal loans rose 21 per cent to $35.8-billion.

Analysts are asking executives at the big banks what they intend to spend their excess capital on.

It's a good question, Mr. Waugh suggested. “The world is into a new norm. Repricing has taken place, so sellers' expectations and buyers' expectations may be starting to narrow in and that may create some opportunities.”

He has looked at some significant ones, and he'll continue to take a look at big deals in the future, he said.

But will he crank up the speed on his treadmill by actually following through on a major acquisition? “Never say never,” he said. “But I would put it at a low probability.”

• Company Performance

Like all the Canadian banks, Bank of Nova Scotia suffered a sharp decline in profits during the financial crisis. But it has rebounded in a big way. Key to its strong third-quarter result was a record quarterly profit of $500-million in its Canadian banking unit. Its international banking division, which includes large operations in Mexico and the Caribbean, hasn’t bounced back as swiftly.

• Stock Performance

After being crushed in the banking meltdown, Scotiabank shares have nearly doubled since late February, and closed at $46.40 yesterday – about $8 short of the all-time high. Some analysts wonder if they’ve gone too far, too fast. BMO Nesbitt Burns analyst Ian de Verteuil, pointing to growing credit problems in Scotiabank’s portfolio of international business loans, wrote: “The issue for investors is whether now is the right time to have exposure to emerging markets.” He has a $42 price target on the stock.

• Banking Sector

Canadian banks’ continue to expand their balance sheets, despite the recession. In fact, their assets are growing partly because of the recession. Competing lenders have disappeared and alternative sources of capital have dried up. One eyebrow-raising figure: Bank of Canada data show personal credit lines by chartered banks have increased 21 per cent in the past year