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Western Financial's struggles bring opportunity Add to ...

Starting a bank in Canada is no easy feat. Many have tried to do so, a few have succeeded and others have failed. The jury is still out on Western Financial Group . And that might be good news for investors. Unloved, neglected and therefore cheap, Western might be a hidden gem.

This little company, based in High River, Alta., started life in 1996. In its early days, it focused on consolidating insurance brokerages in the rural areas of Western Canada. Selling property and casualty insurance is still the core of Western's business, and it's a stable and valuable franchise. Ignoring the effect of acquisitions, Western's brokerage operation is growing at about 4.7 per cent a year, twice the industry rate. Return on equity is a very healthy 14 per cent and the segment makes up about two-thirds of Western's total operating earnings.

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Over the years Western has added a life insurance company and a property and casualty insurer. These businesses, while small, also make money and good returns.

The company's prevailing strategy has always been to sell more products to the half million customers of its brokerage business. By and large that has been a profitable tactic and will continue to be one.

The drawback to the business, which explains why this growing enterprise can be had for a mere 10 times earnings, is the firm's Bank West subsidiary. Western started the bank in 2003 and while the assets have grown, making money has proven challenging.

"Banking," chief executive officer Scott Tannas explains, "is totally counter to the entrepreneur's experience. Getting money for a bank is easy. Lending it is hard."

Bank West lends mostly to farmers, businesses and to consumers buying recreational vehicles. Its credit experience was not particularly bad over the credit crunch - loan losses were in line with that of other banks. It's just that banking works best if you have economies of scale and some diversity in product lines. Bank West lacks those benefits of size, so small loan hits are more painful.

Turning the Bank Around

The bank breaks even, more or less, but that's not enough for investors, who aren't crazy about loan books these days, especially small, niche loan books. Bank West has hardly any debt on its balance sheet and is probably the best capitalized bank, in terms of Tier 1 capital, in the country - meaning it has a big margin of safety - but still the market is punishing Western for its foothold in the banking business. Once upon a time, when investors loved banking, Western traded at 20 times earnings thanks in part to Bank West. Today Western trades a discount because of its foray into the lending field.

Mr. Tannas, who owns a lot of stock in this business, has a plan to turn the bank around. He's bringing in a strategic partner to provide expertise and perhaps capital. He won't offer the slightest detail of who that partner is, because "if I do you'll figure out who it is" - but is optimistic that the new alliance will help kick-start Bank West.

History suggests that the right partnership can be a smart move. In 1990, Canadian Western Bank was about the same size as Bank West and had the same problems. It partnered for a period with a Japanese bank and today has a market capitalization of $1.7-billion. Investors multiplied their money 30-fold.

Mr. Tannas thinks Bank West can earn about 10 per cent on equity. Achieving that target would boost Western's earnings by a third. It would also most likely lift the multiple that investors would apply to those earnings. Let's say the price-to-earnings ratio rises to 12 times from 10. The stock goes up 60 per cent on a turnaround at the bank alone.

Mr. Tannas vows that if he doesn't see signs of improvement by year-end he'll either close or sell the bank, which would free up about $65-million of equity for investment in existing businesses. That would likely improve earnings, and the multiple, too, although it would take longer.

In essence then, an investment in Western Financial is an investment in a good business at a good price with an option on a bank. The risk-reward equation seems to favour an investment.

Fabrice Taylor is a Chartered Financial Analyst.

The Financials

Western Financial share price: $2.42

Earnings per share (past 12 months): 23 cents (versus zero last year)

Book value/common share: $3.03

Insurance brokerage same-store sales growth: 4.70%

Increase in total operating profit: 88%

Bank West operating profit: $1.73-million (versus loss last year)

Income and book value data as of June 30, 2010

 
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