Monday, April 30, 2007

RBC CM Initiates Coverage of Scotiabank at Sector Perform

  
RBC Capital Markets, 30 April 2007

Event

We are initiating coverage of Scotiabank with a Sector Perform, Average Risk rating on its shares.

Investment Opinion

• Scotiabank's stock trades at 13.7x 2007E earnings, above its Canadian and U.S. peers (12.9x and 12.6x, respectively).

• Scotiabank holds the most excess capital of the Canadian group and has, in our mind, superior medium- and long-term growth prospects compared to its peers due to its presence in Latin America and the Caribbean. It also stands to benefit more than its peers from a flat to down Canadian dollar.

• However, domestic retail momentum is weaker than average, the bank is more exposed to normalizing business loan losses and Mexican operations are likely to be taxed at a higher rate and see higher loan losses in 2007 than in 2006. We also believe that the valuations of emerging markets assets have benefited from a worldwide decline in risk aversion, a phenomenon that is unlikely to be permanent.

• Valuation. Our 12-month price target of $57 is a combination of our sum of the parts and price to book methodologies. It implies a multiple of 13.3x 2008E cash EPS, compared to the current 13.7x multiple on 2007E earnings and a 5-year average forward multiple of 12.3x. Our P/B target of 2.7x in 12 months is higher than our target average for the banks given a higher ROE and strong capitalization. Greater exposure to emerging markets partly offsets those positives. Our sum of the parts target of 12.8x 2008E earnings is in line with our target average for the banks, as strong performance in the rapidly growing international division is offset by challenges in domestic retail banking relative to other banks and lower exposure to wealth management.
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TD Newcrest, 30 April 2007

Event

We are downgrading the stock from an Action List Buy to a Hold, and reducing the target price on the stock from $60 to $57.

Impact

Negative. Although our estimates remain unchanged, weakness this quarter in the earnings from the Mexican operation is concerning us and we are lowering our valuation multiples applied to the international division’s earnings. Furthermore, we find that explanations regarding increases in credit losses under Mexican GAAP unsatisfying. We believe greater upside exists in lower risk stocks in the group.

Details

On June 6, 2006, we increased our rating on BNS from Hold to Action List Buy, joining Royal Bank on the Action List. Our rationale at the time was “the banks that will experience the best share price appreciation are those presently willing to take on additional risk to sustain growth”. As can be seen in Exhibit 1, these two banks have performed well over the last 11 months.

We are becoming increasingly nervous about BNS’s growth in lesser developed countries. While country risk premiums are presently at the lowest we’ve ever seen, at some point, we believe an event will eventually materialize that could put into question the valuation the market is placing on the bank’s international earnings. We are anticipating BNS’s international operation to earn 32% of consolidated earnings in 2007.

We believe that the growth that BNS has demonstrated in the international markets has been remarkable, a product of both strong-performing acquisitions and excellent organic growth. The issue we have is that the growth looks too good, and in areas that could be at the front end of the next credit cycle, like Mexican credit card and auto loan exposure. We believe BNS is one of the top providers of credit cards and auto loans in the market today, having ramped up sales efforts materially in the last two years. While the net interest margins earned are spectacular, it generally takes about 18 months for card portfolios to mature sufficiently to gain a good understanding of underlying loss trends.

We are not implying that BNS hasn’t been credit diligent in the Mexican markets. Rather, that present credit loss experience likely doesn’t necessarily reflect “normal” losses because the book is so new. And, if a credit event causes a rush to quality, investor reaction on BNS’s shares could be even more impacted.

Provisions for credit losses (PCL) under Mexican GAAP have increased materially in the last two quarters (Exhibit 2). Management has explained that Mexican GAAP provisions for credit losses can be recorded without an increase in impaired loan formations; that generally speaking, PCLs should increase in line with the growth of the loan book. We don’t quite understand, though, why these PCLs spiked so quickly last quarter, and continued to increase in the most recent period.

In Q1/07, despite increased credit losses under Mexican GAAP, BNS’s Mexican operation reported record earnings of $141mln under Canadian GAAP. On Friday, however, BNS announced that the Q2/07 contribution from the Mexican operations fell to $114million, also down from the year earlier period result of $124 million (see Exhibit 3). Little explanation for the variance has been provided, and we certainly are curious as to the level of credit losses under CGAAP. Acquisitions in Peru and Costa Rica and organic growth in other regions could partially offset the weaker numbers emanating from Mexico this quarter, but we view Mexico as being the key operation.

Competition does seem to be increasing in the Caribbean and Central America, which appears to be attracting more suitors for acquisition targets than before. Management’s decision to invest in Thailand recently, albeit not requiring a lot of capital, was troublesome for us to rationalize. Competitive interest in Asia is significant, BNS holds no advantage of scale, and we believe the challenges of different languages, regulations and systems are significant.

On a side note, BNS is the Canadian bank most exposed to currency translation earnings pressure (40% of BNS’s earnings are denominated in USD and USD correlated currencies).

Justification of Target Price

Our $57.00 BNS target price is a product of adding 50% of the $58.01 value derived from our 2008 P/E multiple of 13.4 times to 50% of the $56.79 value derived by our 2008 price-to-book of 3.06 times.

Key Risks to Target Price

We believe that the four key valuation risks include: a) a deterioration in the geopolitical situation in one of the bank’s international markets (most importantly Mexico); b) a tougher credit environment which could lead to credit losses due to the bank’s more aggressive U.S. corporate lending strategy; c) the bank paying a significant premium for an acquisition; d) the deterioration of the USD and e) a significant increase in interest rates.

Investment Conclusion

The two “over-weights” in our bank portfolio over the last year have been the two that we regard as taking on the greatest risk; RY equity risk, and BNS credit risk. It’s been a good run, but now we feel is the opportune time to begin moving into lower risk investments.

BNS has developed impressive scale and profitability in the Caribbean and Central American markets. Last quarter’s reported 23% ROE, despite holding roughly $4 billion in excess capital, reflects the strong profitability of the international operations.

While BNS management is taking multiple steps to improve their domestic retail and wealth operations, they are clearly second tier in our opinion. We believe the bull markets in equities and credit are long-in-the-tooth, and expect that investors will gradually begin to place greater value in the stability and growth of domestic operations. As a result, we are downgrading BNS to Hold.
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Dow Jones Newswires, 27 April 2007

A 20% drop in earnings from Bank of Nova Scotia's Mexico unit "will produce some headwinds to growth" in the quarter, notes Dundee Securities. Although BNS's recent buying spree means Mexico losing ground in bank's overall earnings, it's still a material contributor. And with 1Q GAAP earnings not sustainable, Dundee says 2Q net likely to be 7% lower on sequential basis.
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