Friday, October 19, 2007

Scotiabank Investor Day

  
RBC Capital Markets, 19 October 2007

We expect management will continue to balance organic growth with acquisitions.

• International Banking's contribution to earnings grew from 27% in 2004 to 30% in 2006 (in spite of the stronger Canadian dollar, which appreciated 30% since the beginning of 2004) with 75% of the growth coming from organic initiatives. We estimate the contribution to earnings will grow to 34% in 2008E.

• Scotiabank has been successful in balancing local strategies with bank-wide resources. Management teams in each country focus on growing their business organically by implementing unique local strategies. The bank has also been able to leverage its presence in multiple markets via shared services and practices.

• From a distribution perspective, the bank adapts its strategies to local needs. For example, (1) 50 branches were built in Mexico last year and management expects 85 will be open this year with another 100 branches in each of the next few years for a total of 800+ branches by 2010. (2) In Peru, Scotiabank partnered with twenty retailers for 778 in-store locations, and is using low-cost correspondent tellers in high-traffic stores. (3) In the Dominican Republic, adding scale through branches is not required to maintain its top three market share position, so the bank is focused on reaching more clients through remote channels such as external sales forces, contact centres and the Internet.

• From a customer segmentation perspective, Mexico's management is targeting a consumer finance segment that will be new for the bank in Mexico but has the potential to reach 52 million people or 49% of the country's population. To start, it is launching a new low-limit credit card business via a 50/50 joint venture formed with a team of industry professionals to target this segment. Leveraging the expertise of the recently acquired bank in Peru will also help in the introduction of this new product in Mexico. In Peru, management sees opportunities in the Micro business segment with over 600,000 businesses to target its growth efforts. In the Bahamas, the bank hopes to target new segments such as small business, non-resident mortgages and wealth management.

• Each management team is also working with teams from other countries while implementing their own unique initiatives. Over thirty cross-platform teams have been organized to help and to learn from each other in their efforts. They implement best-of-breed ideas and share in global resources such as sales management systems, risk management processes and contact centres.

• The division should also benefit from acquisitions that were completed in the past few years and all successfully integrated within twelve months of the closing date. Since 2004, Scotiabank has spent $1.3 billion on acquisitions with another $1 billion committed for the announced purchase of Banco del Desarrollo in Chile. These acquisitions have provided good returns (for example, in Peru, the bank invested US$330 million at the beginning of 2006, and has earned US$86 million from January to July 2007), and at least doubled the bank's loan market share in Peru, Costa Rica, Dominican Republic, El Salvador and Chile. Through both branch builds and acquisitions, Scotiabank has grown its number of branches from 773 at Q4/04 to 1,154 at Q3/07.

• The bank is also making equity investments in banks that may grow, such as the 10% stake in FirstBank in Puerto Rico. Management also stated that it plans to increase the 25% ownership of Thanachart Bank in Thailand to 49% when legislation permits, which could be as early as next year.

• We believe management will continue to look for opportunities to deploy the bank's excess capital via acquisitions and investments, with a preference for targets in Latin America and the Caribbean, followed by Canada and Asia. Acquisitions in Central America are likely to be first on the bank's radar screen, as it views the region as less competitive given that it is too small to attract major international players.

Loan and deposit growth should continue to be faster than in Canada

• The International Banking segment has 5.2 million customers with 30% in both Mexico and the Caribbean. To grow, management is increasing its focus on new customer segments, channels and products within each country.

• Scotiabank intends to expand beyond its traditional mid market and commercial and corporate focus, by targeting three new client segments to help it reach its organic growth objectives: 1) Small Business, which has approximately two million prospects in Latin America; 2) Affluent, with over one million target households in its markets with over $250,000 in assets; 3) Consumer Finance, which management believes has over fifty million potential customers in Mexico alone.

• Scotiabank's management is focused on "earning their way through investments and acquisitions", with a focus on positive operating leverage. Leveraging the bank's shared services (such as contact centre activities, a new global Internet platform or its one data centre in the Caribbean) and operational support (such as the new sales management and finance MIS systems) is allowing the bank to realize scale economies.

• Loan growth has been strong at 11% CAGR from 2004 to 2006. We expect the rapid growth to continue based on rapid GDP growth, credit card growth and cross-sells of new products. Deposits have only grown at 4% CAGR during the same period, but we expect the rate of growth will increase as the bank is putting greater emphasis on the business. To further grow wealth management revenues, the bank has launched new mutual funds and is expanding its private client offering.

• We believe loan losses will rise as loan growth has been very strong and seasoning of recent growth should lead to higher losses. Retail loan delinquencies have been at cyclically low levels, and we are seeing a rise in the PCL ratio which grew from 1.0% at Q4/06 to 1.25% at Q3/07. Some businesses (in Peru for example) target higher-risk customers, and we expect growth efforts in certain business, such as credit cards and consumer finance, will lead to increased delinquencies and losses.

The macro environment in Scotiabank's International Banking footprint is favourable.

Emerging markets are healthier than the past. Fundamentals in key Latin American countries (Brazil, Chile, Colombia, Mexico and Peru) are in much better shape than the past. The improvement has been due to both cyclical and structural factors. The changes have allowed Latin American countries see ratings upgrades and rising stock markets (Exhibit 1), and the outlook for growth continue to look favourable.

Structural: Many Latin American countries undertook significant and painful reforms during the 1990s and the first half of this decade in the areas of fiscal/tax reform, banking reform (which has included opening up the banking system to foreign ownership, forced consolidation of banking systems that were fragmented, privatization of state-owned banks, etc.), energy reforms, labour reforms and political reform. These reforms have taken several years to fully implement and become entrenched into their economic systems. Latin countries over the past 5 years have begun to see the fruits of this painful labour as their economies have seen fiscal deficits dramatically shrink, banking system risk significantly reduced, and overall productivity and growth potential improve materially. Poverty levels have declined, and Scotiabank management estimates that by 2010, the majority of people in Latin America will join the working middle class. Today, the bank is adding almost 100,000 customers each month and the majority of them use only one service, so the opportunities for growth exist as the classes change.

Cyclical: There are a number of external forces which have been working together to bolster the performance of key Latin American countries. These forces are tied into the global business cycle including global growth, liquidity and commodities. The global economy has been growing at faster than a 5% pace for the past 3 years and is on track for another strong increase this year, stringing together the strongest run since the 1970s. Commodity prices have been rising well above historical averages and hitting all-time highs in some cases. This is particularly beneficial for Latin America given that many countries are commodity exporters. China and India's continued strong growth has been particularly beneficial given their large needs for commodities.

Latin American countries have in many cases undertaken deep and painful reforms to set their economies on the right track to ensure more stability and higher growth (including Brazil, Chile, Mexico and Peru). As a result, risk premiums have fallen dramatically for these countries as reflected in their sovereign debt spreads. The EMBI+ spread in Latin America has fallen to 180 bps from 1400 bps in a little over 5 years. In 1998, the spread was 400 bps before jumping to 1500 bps and then remaining within 600 and 1000 bps from 1999 to 2001 (Exhibit 2). Given the dramatic changes that have taken place in key countries where Scotiabank operates in Latin America, we believe the discount rate applied to cashflow from Scotiabank's Latin American operations should be reduced in line with other measures of risk premia such as the sovereign debt spread (mentioned above). This explains why we are not valuing Scotiabank's international business at a discount to its Canadian business anymore.

Valuation

Our 12-month price target of $55 is a combination of our sum of the parts and price to book methodologies. It implies an approximate forward multiple of 11.9x earnings, compared to the 5-year average forward multiple of 12.5x. Our P/B target of 2.7x in 12 months is slightly higher than our target average for the banks given a higher ROE and strong capitalization. Our sum of the parts target of 12.1x 2008E earnings is in line with our target average for the banks, as strong performance in the growing international division is offset by greater exposure to business lending and the rising Canadian dollar, while the domestic franchise lags the two leading banks', in our view.

Price Target Impediment

Risks to our price target include the health of the overall economy, sustained deterioration in the capital markets environment, the potential for non-accretive acquisitions and/or related execution risk, deterioration in the Latin American political and economic climate, a rising Canadian dollar and rising business loan losses.

Company Description

Scotiabank is Canada's most international bank and most active corporate lender. Notable for a long track record as the low-cost Canadian producer, Scotiabank currently ranks third by market cap and second by assets. Scotiabank operates 988 Canadian branches and 98 wealth management offices, as well as 1,154 branches and offices internationally. The domestic bank contributes about 40% to earnings, while international banking and wholesale banking each add around 30%.
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TD Securities, 19 October 2007

Event

On October 16-17, Scotiabank hosted an investor conference in Lima, Peru highlighting its international platform. We had the opportunity to meet with a large contingent of Scotiabank executives, business heads and line employees that were in attendance.

Impact

Overall, the event served to reinforce our constructive view on Scotiabank’s international platform based on 1) the prospect of higher growth and returns in a number of countries and 2) Scotiabank’s demonstrated ability to effectively deploy capital in these markets.

We are not making any changes to our estimates at this point, although the presentations provided helpful detail on some key segments and identified organic growth and acquisition initiatives going forward. All told, we continue to expect their international business to deliver superior growth over the medium-term.

Investment Conclusion

We continue to highlight Scotiabank as one of the best outlooks in the group with what we expect will be a strong growth driver in International and signs of improving domestic progress.

Details

We note the following highlights from the conference:

Management. Over the two days, we had the opportunity to meet with nearly two dozen Scotiabank executives, business managers and front-line personal. We were struck by the range and depth of experience across the team from a number of markets. Importantly, Scotiabank has had very good success in retaining top employees through acquisitions and attracting talent from competitors which speaks to their reputation in the market. We came away with comfort that Scotiabank has very capable talent to compete in the region.

Macro environment. We met with a number of economists and individuals with deep experience and understanding of LatAm’s political and economic development. Among them, there was a consensus that the region has made important structural progress. A number of countries now have more stable and diverse economies and a more effective political climate. This progress is reflected from 5-6 years of strong economic growth for the region, greatly reduced inflation rates and improved fiscal order with a number of countries moving toward or through investment grade ratings. There is still a tremendous amount of work to be done (for example, many of the countries have vastly under developed infrastructure), but overall we were encouraged by the outlook.

M&A prospects. Acquisitions in the Personal & Commercial space remain a key focus for Scotiabank in LatAm. In particular, we believe they would like to gain further scale in Chile, and a handful of countries in Central America. We also believe Scotiabank would like to enter Brazil in a material way, but the potential targets are larger and currently richly priced. In addition, the bank continues to look for a number of small niche opportunities that could compliment their existing retail banking presence.

We expect Scotiabank to continue making opportunistic moves in Asia, but do not expect the region to be a major driver of the investment case in the foreseeable future.

Integration success. Members of the bank’s M&A team and key participants in recent deals highlighted Scotiabank’s rigorous approach to due diligence and integration. With five meaningful deals successfully completed in the region over the past three years, the team is getting better and faster. Their track record and experience lends credibility to the acquisition strategy for the region in our view.

Organic growth. The platform should continue to offer superior organic prospects given the outlook for strong economic growth (nearly twice that of North America), the opportunity to increase penetration of banking services, and Scotiabank’s intention of continuing to consolidate market share.

Consumer finance. A number of growth initiatives were highlighted, but the most important was Scotiabank’s plan to expand into consumer finance. This market involves making small loans to consumers to finance purchases of things like appliances, furnishings or even clothing. We were given a tour of some of the in-store kiosks where customers apply for the loans and discussed at length the process and controls around managing credit risks: 1) they have 10 years of experience in this business in Peru 2) they apply a very fine filter (ie approximately 50% of applicants are rejected) using credit bureau reports, their own databases and in some cases personal home visits for verification 3) they use a graduated approach, extending very small loans with very short-terms initially 4) most importantly, they have wide flexibility in setting rates and as a result enjoy very strong returns (they suggest 15% ROA!).

They are currently building out this initiative in Peru, but expect to migrate to other regions (particularly Mexico) as they develop the business; targeting a market of over 70 million people.

Challenges. The event reinforced some important positives, but there are challenges. First, while greatly improved, the economies are still emerging and many of the larger ones remain tilted toward exports and commodities; clearly at risk should the current strength of global demand fade. Second, the distribution of improving conditions remain uneven and a source of potential social unrest. Finally, competition remains intense not only in day-to-day operations, but also in acquiring good assets at good prices.

Valuation and Justification of Target Price = $61.00

We expect Scotiabank to hold its premium valuation relative to the Big-Five banks, reflecting superior growth prospects, strong return on equity and healthy excess capital.

We base our target price on 12.75x forward earnings, a premium to our outlook for the group.

Key Risks to Target Price

The following are key risks that we have identified for Scotiabank and could prevent the stock from attaining our target price. These include: 1) the continued weakening of the U.S. dollar 2) country and political risk in its international markets such as Mexico 3) integration challenges associated with its recent and future acquisitions and 4) adverse changes in the credit markets, interest rates, economic growth or the competitive landscape.
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