Scotiabank's Balanced Model Continues To Deliver

By Stephen D. Simpson, CFA | May 28, 2013 AAA

Each of the Canadian Big Five banks has its own strategy to diversify its growth outside of the Canadian banking market. In the case of Bank Of Nova Scotia (“Scotiabank”) (NYSE:BNS), that strategy revolves around building its high-growth Latin American banking business and it's less appreciated (but still lucrative) wealth management operations. Although investors should not underestimate the risk of a banking slowdown in Canada nor the inherent risks of emerging market banking, Scotiabank looks as though it may be a relative bargain in the banking sector.

SEE: The Industry Handbook: The Banking Industry

Solid Growth, But With A Few Concerns
Scotiabank delivered another solid quarterly result, albeit one with a few spots that may concern some investors.

Operating revenue rose 11% from last year on a reported basis, with acquisitions kicking in about one-third of the growth (7% organic growth). Growth was less impressive on a sequential basis, though, at about 1%. Net interest income rose 12% from the year-ago period but was slightly positive sequentially, as the company saw just a bit of net interest margin expansion. Non-interest income rose 10% from the year ago period and more than 1% from the prior quarter.

There were some issues in the quarter, though, and they come in the form of expenses. Operating expenses rose 11% and 1%, respectively, which was a little higher than expected and sufficient to keep the efficiency ratio basically flat. Elsewhere, the company's provisioning expenses were up a surprising 30%, and up 11% on a sequential basis.

SEE: Understanding The Income Statement

Is Canada Softening?
Scotiabank still relies upon its Canadian banking operations for a significant portion of its revenue and net income. To that end, the 1% sequential declines in revenue and net interest income and the 5% sequential decline in net income were not fantastic (albeit not unexpected). Keep in mind, though, that these results were boosted by the acquisition of ING Bank of Canada.

Like Bank of Montreal (NYSE:BMO) and CIBC (NYSE:CM), Scotiabank is seeing an ongoing weakening of the Canadian retail banking environment. While there has been ample back and forth as to whether Canada is in a housing bubble, consumer debt has been increasing and the Canadian government has implemented various rules and regulations to slow down the growth of lending. While Canada still seems on pace for a soft landing (certainly softer than in the U.S.), those rising provisioning expenses merit further watching.

SEE: Government Regulations: Do They Help Businesses?

Scotiabank Needs To Get Bigger To Be Better
Scotiabank has an interesting set of international banking assets. The company's operations in the Caribbean, Central America, and Thailand are nice, but the real crown jewels are the Andean banking assets (Chile, Peru, Colombia) and the company's position in Mexico.

Overall international banking revenue rose 11% this quarter (and 5% sequentially), with Latin American revenue up 15%. Provisioning was quite a bit higher though (up 34%), and combined with higher operating expenses allowed for just 5% net income growth.

The ongoing question for Scotiabank is scale. Scotiabank has the 3rd largest bank in Peru, but elsewhere it tends to fall between #5 and #10 in terms of assets, deposits, and loan share. Thus far, that seems to be limiting the bank's expense/profit leverage, and the company's international operations haven't contributed as much to stronger returns on equity.

Over time, I believe this can change if the bank is willing to make the investments and commitments and absorb the incremental risk. Other banks like Citigroup (NYSE:N), Creditcorp (NYSE:BAP), and Santander (NYSE:SAN) won't be pushovers, but so many people in Latin America are under-banked and the markets are growing at rates meaningfully greater than in Canada that I believe there's room for profitable growth. What's more, I like Scotiabank's strategy of balanced growth, acquiring wealth management operations and expanding into microfinance while also building up its conventional commercial banking assets.

SEE: Is Growth Always A Good Thing?

The Bottom Line
The general expectation for Scotiabank is that weaker net interest margins and slower loan growth in Canada will compress returns for the next couple of years, and I basically share that belief. Likewise, I believe it will take a little more time for the bank's overseas operations to really start seeing better profit and return leverage. Over the long term, though, I do believe that return leverage will appear and I believe these shares are undervalued on that basis.

I currently model a long-term return on equity of 17% for Scotiabank, and that's below the bank's historical return experience. With that estimate, the resulting fair value for the stock is about $71 per share. While I do see risks that Canada's banking situation isn't as stable as some want to believe (and banking in Latin America is never a safe bet), I think investors can expect pretty good compensation for those risks today.

At the time of writing, Stephen D. Simpson did not own shares in any of the companies mentioned in this article.

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