The yellow flag has come down and the pacer car has left the track. It's time for the Canadian banking industry to put the pedal to the metal.
For two long years, the Office of the Superintendent of Financial Institutions (OSFI) had banned the banks from undertaking major capital deployments until there was greater clarity over reserve requirements from global regulators. Then in September, the Basel III rules came out not as harsh as feared and the OSFI gave the green light to dividend hikes, share buybacks and acquisitions.
First out of the gate with dividend hikes were National Bank and Laurentian Bank .
And the larger banks lost little time laying down rubber on the acquisitions track, highlights of which include Royal Bank of Canada's October takeover of BlueBay Asset Management PLC, Bank of Nova Scotia's November purchase of DundeeWealth Inc. and Toronto-Dominion Bank's December bid for Chrysler Financial.
The Canadian banking industry is at an historic juncture. It has emerged from the global financial wreck in better shape than foreign rivals and is now deemed the soundest in the world by the World Economic Forum. Competitors in other countries are still far from having the same capacity for snapping up bargain-priced assets. Their balance sheets are nowhere near as charged up. Nor do most get quite the same mileage in making foreign acquisitions as Canadian banks do from domestic currency strength.
Bank of Nova Scotia, top performer
The strongest of the strong, arguably, is Bank of Nova Scotia -- even though it is only third largest by assets in Canada. The two largest, Royal Bank of Canada and Toronto-Dominion Bank, are struggling with large exposures to sluggish capital markets and ailing U.S. housing markets. On the other hand, the Bank of Nova Scotia - also known as Scotiabank - just finished its second-best year on record thanks to a focus on retail banking and expansion into emerging markets.
Fourth-quarter financial results reported in early December were well received. "In an earnings season for the sector that has been particularly messy, [Scotiabank]delivered what we believed to be a very clean quarter in which earnings quality was also high," noted Macquarie Research Equities' Sumit Malhotra, a top-ranked banking analyst in the Thomson Reuters StarMine ratings.
For the fiscal year ended Oct. 31, growth in earnings per share came in at 10 per cent, return on equity finished at 18.5 per cent and book value per share climbed 10 per cent. The bank's Tier 1 capital ratio ended up close to 12 per cent, well above the Basel III requirement of 7 per cent plus a 2.5-per-cent conservation buffer.
Metrics like these prompted Mr. Malhotra to upgrade Scotiabank's stock from "neutral" to "outperform." He also hiked his 12-month target for the share price to $62. "At a time at which the outlook for … Royal and TD remains mixed at best," he wrote in a Dec. 6 research report, "we believe the 4Q/10 print for Scotia's International Banking franchise indicates that earnings growth for the business is set to accelerate in 2011."
Growth strategy: International division
Another analyst highly rated in the StarMine survey, Jason Bilodeau at TD Newcrest, has a similar message. "International is starting to come on a bit … we now have for the second quarter in a row, a pretty good bottom-line contribution … we feel more comfortable that International can be a driver of superior growth and returns for Scotia," he observed in his Dec. 6 note.
Several factors are boosting the contribution from the international division, which currently accounts for one-third of total earnings. First, operations are concentrated in fast-growing regions such as South America that are in the early stages of a cyclical rebound.
Second, currency headwinds appear ready to ease with the Canadian dollar closing in on what historically has been an upper boundary in valuation. "It is important to note that year-over-year comparisons for the Canadian dollar are going to ease significantly beginning in 2011 … as such, currency translation should be much less of a drag on the segment performance in the coming year," reasons Mr. Malhotra.
Third, Scotiabank has the wherewithal for financing acquisitions. In recent months, purchases included R-G Premier Bank in Puerto Rico, Nuevo Banco Comercial in Uruguay and the South America banking operations of Commerzbank AG and Royal Bank of Scotland.
During a conference call after the release of fourth-quarter results, bank executives confirmed their commitment to acquisitions. "In 2011, we intend to remain acquisitive on a selective basis, particularly where there are opportunities to increase our footprint in high-growth markets," remarked Brian Porter, head of the international banking group.
John Aiken, vice president at Barclays Capital's research unit in Canada, believes the bank "can bring sophisticated management systems such as treasury, risk and front-line [customer relationship management] applications developed in the domestic market to these regions." Furthermore, "with its footprint, these and other overhead costs can be spread over a significant footprint against stand-alone operations in a single country."
Growth strategy: Wealth-management division
Scotiabank has opened up another front for growth. In September, a corporate reorganization created a separate division for its global wealth-management businesses, under group head Chris Hodgson. Since then, it has been built out with several acquisitions, including BNP Paribas' wealth-management assets in the Caribbean and two Canadian money managers: WaterStreet Group and DundeeWealth.
Scotiabank had been lagging in this segment but the DundeeWealth acquisition vaulted the bank into 5th spot, with a 7.8-per-cent share of the Canadian market. Scotiabank also owns 36 per cent of CI Financial Corp., Canada's third-largest asset manager. The bank is expected to either buy the rest of the company at some point, or sell the stake and reinvest the capital elsewhere.
"On the wealth-management front, profitability is directly correlated with scale," says Mr. Aiken. "The moves that Scotia has taken to date both organically and through its minority interests provides it with access to greater scale and ultimately higher profitability as costs and distribution can be spread over a larger amount of assets."
There is stronger growth potential than retail banking. Demand should rise on a cyclical basis as economies regain momentum and on a secular basis as an aging population deals with retirement needs while emerging nations capture higher levels of affluence. As well, wealth-management businesses don't require setting aside much in the way of capital reserves since they don't have a great deal of capital assets.
Dividends and valuation
During the conference call in early December, Scotiabank signaled that its growth initiatives would not come at the expense of dividends. Chief executive officer Rick Waugh told the audience that the target range for the dividend payout ratio was going to be raised to 40 and 50 per cent (actual payout is 49 per cent, currently).
The stock market is aware of Scotiabank's relatively better outlook and has accorded a higher valuation to the shares. But the analysts don't think it is excessive. As Mr. Bilodeau declares: "The stock does trade at a premium multiple, but we believe it is justified and should be increasingly well supported as the model demonstrates superior medium-term growth potential."
|LB-T Laurentian Bank of Canada||47.21||
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|RY-T Royal Bank of Canada||69.39||
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|TD-T TD Bank||96.19||
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|BNS-T Bank of Nova Scotia||63.84||
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|NA-T National Bank of Canada||89.47||
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