Scotiabank is Most Attractive on P/E Valuation, Adjusting for Excess Capital

Canaccord Genuity, 16 October 2017

In this report, we focus on Canadian banks P/E valuation analysis relative to the S&P/TSX Composite, bank stock 1-year return analysis under different P/E (NTM) multiple ranges, and looking at implied P/E taking into consideration each bank’s excess capital. Our main findings below are as follows: (1) group bank P/E (NTM) of 11.7x (vs. historical avg. of 10.9x) represents a 32% discount to the TSX Composite (vs. 30% historical avg.); (2) banks trade at P/E (NTM) between 11-13x over 50% of the time (since 2002) with price return over NTM lowest at 6% on average; (3) banks perform well historically when the group is trading above 13x; and (4) BNS’ relative P/E valuation is most attractive (vs. historical) taking into account their excess capital position (see Fig. 6). At Q3/F17, Scotiabank reported the highest CET 1 ratio at 11.3%.

Investment highlights

• Canadian banks trading slightly above historical average. YTD, banks stocks have outperformed the broad index with NA total returns leading at >15% (Fig. 7). The Canadian bank group (Big-6) average now trades a slight premium to its historical average (see Fig. 1). Currently, the group trades at a P/E (NTM) of 11.7x vs. its historical average of 10.9x (since 2002). During this time frame, group bank P/E’s have ranged from a low of 6.6x (during financial crisis) and high of 13.5x (prior to crisis). We believe the market is likely factoring in excess capital build, continued strong quarterly results (FQ4 upcoming), and potential future 2018 EPS upward revisions concurrent with year end results (i.e. stronger NIM and credit trends). Currently, market consensus calls for Big-6 bank EPS growth of 5% (similar to CG) in 2018E, below the S&P/TSX Composite EPS growth expectations of <10%.

• Relative group P/E valuation still trading at discount vs. broad index. In Fig. 1, we compare group bank P/E (NTM) multiples relative to the TSX Composite Index (NTM). On this basis, we find that bank stocks still look quite attractive. Currently, the forward group bank P/E of 11.7x compares to the TSX Composite of 17.3x. This represents a 32% discount, slightly favourable compared to the historical average of 30%. Based on historical trends, we note that investors should be underweight Bank stocks during crisis. Referring to Fig. 1, the three main periods during which Canadian banks traded at larger-than-average discounts related to the Tech bubble (2001-2002), financial crisis (2008-2009), and Oil price collapse (2015, 2016; WTI oil reached $26 in Feb/16).

• Canadian banks trade at P/E (NTM) between 11-13x more than half the time. Dating back to 2002, we looked at S&P/TSX Bank Index P/E (NTM) multiples that traded within four buckets or ranges. We found that the Index valuations traded within a P/E (NTM) range of 11-13x (see Fig. 3) for 54% of the time. Currently, the banks sit at the lower end of this range (11.7x). The group P/E between 9-11x, and 13-16x occurred 22%, and 21%, respectively. At the low-end (P/E of 6-9x) happened just 3% of the time, which was during the financial crisis.

• Looking at Bank performance during certain P/E trading ranges. After that, we took weekly P/E valuation data points and ran stock price returns over the next twelve months using the TSX Bank Index. Not surprisingly, we found that largest stock gains followed the financial crisis with average 1-year returns of 64%. The second highest return periods have come from when banks trade between 9-11x, compiling an average return of 13%. Using historical data, this suggests that it is best to overweight banks when the group trades below P/E (NTM) of 11x. From the group’s trading sweet spot of 11-13x; 54% of time), stock returns over the next year were lowest, averaging 6%. Interestingly, when Canadian banks trade above 13x, returns continued to be solid, averaging 11%. The historical analysis demonstrates that Canadian banks are momentum stocks and that higher valuations don’t necessarily indicate an underweight signal. By way of context, the TSX Bank Index has generated a ~8% CAGR (price return) since 2002 proving that the latter are solid long-term investments.

• Canadian banks improving capital position. Since the financial crisis, Canadian banks have continued to build excess capital. The group has increased their CET1 ratio (avg.) from 7.1% (2008) to 10.9% (F2017E). As of Q3/F17, Scotiabank enjoyed the strongest relative capital position with a CET 1 ratio of 11.3%, followed closely by NA, and BMO (11.2% each). At the low-end is now CM that accounted for the closing of PrivateBank last quarter. CM’s CET1 ratio dropped sequentially from 12.2% to 10.4%. Generally, we believe excess capital will be used for: (1) increased usage of NCIB (although still modest to overall shares outstanding); (2) dividends (we forecast group dividend growth of 5% in 2018E); (3) acquisitions (expect bolt-on acquisitions as global valuations remain high); and (4) organic growth.

• P/E implied valuation accounting for excess capital. Lastly, we take each Canadian bank's current P/E (2018E) and adjust it for the PV of excess capital. For the latter, we have assumed a CET1 floor of 10.5%, which is consistent with most bank’s comfort level. We note the regulatory minimum ratio is 8.0%. For the purpose of this analysis, we assume incremental capital will be depleted by 2020 (i.e. in 3 years) and we discount the excess capital by 10% (estimated cost of equity) to derive the PV of excess capital. The analysis is shown in Fig. 6. Our implied P/E (F2018E) for Canadian banks (adj. for excess capital) moves down on average 0.7x. This would place the group P/E at ~11x, in line (instead of slight premium) with its historical average. Under this exercise, we estimate Scotiabank's implied P/E valuation (adjusting for excess capital) trades at 10.5x (excess capital of 1.0x), a significant discount to its historical average of 11.5x (Fig. 6). We found that CM also trades at a discount, but more modest at -0.3x, while TD, BMO, NA, and RY adj. implied P/E multiples generally trade in line with their historical averages.

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Bank Stocks Are No Longer Cheap, but They’re Still Worth Owning

The Globe and Mail, David Berman, 16 October 2017

The great Canadian bank stock sale is over. But don't worry: There are more gains ahead.

After a five-week rally, bank stocks have jumped more than 8 per cent on average. They have now emerged as clear leaders within the S&P/TSX composite index, after briefly lagging the index earlier this year.

But valuations that were cheap by historical measures near the start of September, before the current rally kicked in, are now in line with the long-term average. While that doesn't mean that bank stocks are overpriced, it does suggest that they're no longer a steal.

If you recall, Canadian banks were going nowhere for the four-month period between May and August (inclusive), marking a curious departure from what looked to be an upbeat operating backdrop at the time.

I wrote about this apparent mismatch on Sept. 5. The Canadian economy was humming, the price of crude oil was moving up and banks had reported strong third-quarter profits that were, on average, 11 per cent higher than last year. Best of all, the Bank of Canada was raising its key interest rate, which generally increases bank profits on their loans.

Add an average dividend yield of 4.1 per cent, and – barring a housing market catastrophe – Canadian bank stocks looked hard to pass up.

Yet, share prices were going nowhere. At their low point, on Sept. 7, stocks were trading at levels seen in early December.

Investors appear to have recognized the big opportunity here and, five weeks later, bank stocks are no longer looking unloved.

The S&P/TSX composite commercial banks index, which consists of the Big Six banks, Laurentian Bank of Canada and Canadian Western Bank, has rallied 8.3 per cent from its September lows. The sector has outpaced the 5.6-per-cent gain in the broader Canadian market – itself an impressive feat – and demonstrated that when things are good for Canada, they're very good for the banks.

Royal Bank of Canada, Toronto-Dominion Bank and National Bank of Canada, in particular, have hit record highs within the past week.

Bank stock valuations are now in line with 10-year historical averages. According to data from RBC Dominion Securities, the Big Six bank stocks trade at 11.6-times estimated 2018 profit, which is above the historical average of 10.9-times estimated profit.

Bank stocks also trade at their average historical price-to-book value of 1.8. And that 4.1-per-cent dividend yield before the rally has retreated to 3.8 per cent, attributable to rising share prices.

A nice buying opportunity has passed, but there is no need to fret: If you're inclined to make bets on individual stocks, rather than own the entire sector (I own units in the BMO Equal Weight Banks exchange-traded fund, which gives me exposure to the Big Six), good deals can still be found.

Among the biggest banks, Canadian Imperial Bank of Commerce stands out with price-to-book and price-to-earnings multiples that are below the peer average. The stock also comes with a sector-leading 4.6-per-cent dividend yield.

CIBC has another thing going for it: The stock lagged the returns of its big bank peers in 2016. As I've pointed out in previous articles, lagging bank stocks have a tendency to close the gap with their peers, meaning that last year's underperformer tends to be this year's outperformer.

So far in 2017, CIBC has bucked this trend with a year-to-date gain of just 2.5 per cent – compared with a group average gain of 6.8 per cent. Perhaps this stock-picking strategy won't work this year. Or perhaps CIBC remains an outstanding buying opportunity.

But there's another reason to stick with bank stocks following the group's impressive rally. While valuations have risen from bargain levels, they're not excessive today. That means there is room for stocks to rise further with profit growth, dividend hikes and interest-rate increases – all of which seem likely.

There are good times to buy Canadian bank stocks; there are not bad times to own them.

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Scotiabank’s AT1 Security A Hit; Other Banks Expected to Follow Suit

The Globe and Mail, Christina Pellegrini and Niall McGee, 10 October 2017

More Canadian banks and possibly life insurers are expected to follow Bank of Nova Scotia's lead and take advantage of a novel source of funding that has proven to be a hit with investors, bankers and analysts say.

Last week, Scotiabank raised $1.25-billion (U.S.) from institutional investors mostly in the United States, Europe and Asia through the sale of a new hybrid security that has many attributes of preferred shares, but is legally debt. The notes were crafted in such a way that the money raised qualifies as additional tier 1 (AT1) capital, which is part of a cash reserve that Canada's top banking regulator expects banks to hold to maintain a minimum level of financial stability.

The Canadian banks have primarily raised this type of capital by issuing preferred shares into the domestic market, which is heavily dependent on retail demand. But preferred shares have been a tough sell for banks to export beyond Canada because Canada Revenue Agency puts a tax of 25 per cent on any passive income generated by investors who are not residents of Canada.

Scotiabank's hybrid note was well-received partly because it was structured in such a way that avoids this tax on foreigners. It also offers investors a yearly interest rate of 4.65 per cent in the first five years and a floating rate after that. It has no scheduled maturity, and converts into equity during times of distress, satisfying the banking regulator's requirements.

Scotiabank lined up 330 interested institutional buyers and amassed an order book that was about seven times oversubscribed, Vivek Selot, an analyst at RBC Dominion Securities Inc., said this week in a research note. The deal was led by UBS AG and featured Scotia Capital Inc., Merrill Lynch, and Citigroup Global Markets Inc. as joint bookrunners.

Scotiabank declined comment on the offering.

Greg McDonald, the director of debt capital markets at TD Securities Inc., called the AT1 issuance "an important step" in Canadian banks' bid to gain access to additional U.S. dollar funding avenues. "Any time you can open up a new market for either funding or capital … it's definitely a plus," he said.

He expects many of the Canadian banks to consider it as a new potential future source of funding, and weigh it against existing options such as preferred shares.

BMO Nesbitt Burns Inc. analyst Kris Somers called Scotiabank's note a "gamechanger," adding in a report that the new structure has the potential to result in reduced supply of preferred shares sold by financials.

This type of offering is being billed as a solution to a problem that Canada's largest financial institutions have been wrestling with for years: The country's market for preferred shares has become a less reliable and more costly way of sourcing AT1 capital.

In 2015, it became clear that the preferred-share market in Canada was encountering stumbling blocks.

After the financial crisis, banks sold preferred shares with a built-in feature that would see the dividend rates reset after a certain period of time. This was done so that when interest rates eventually rose as the economy recovered, so, too, would the income generated by the shares. Except, by 2015, interest rates were not rising – they were still falling. The dividends were resetting lower and investors were earning a lot less, spurring mass selling and pushing preferred-share prices lower.

Opportunistic institutional investors stepped up to fill the void, demanding hefty dividend yields. Banks had little choice but to pony up and swallow the costs. The episode spurred banks and their lawyers to look for another way of sourcing these funds. Two years later, Scotiabank has done just that.

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