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Bank of Nova Scotia research and analysis

Contributed by eResearch

By Bob Weir

Bank of Nova Scotia (BNS) reported cash EPS (fd) of $1.10, up 15%Y/Y. Excluding a small general loan loss reversal and a negative goodwill adjustment, adjusted cash EPS was $1.06, up 6% Y/Y but  down 5% from the adjusted earnings last quarter. Adjusted EPS this quarter came in $0.08 below our estimate and were $0.02 below the general consensus. The adjusted cash ROE in the quarter was 16.4% compared to 18.0% last quarter. The Tier 1 capital ratio decreased in the quarter to 12.2% from 12.3% last quarter.

The earnings were driven by solid Wealth Management earnings offset by a weaker performance from International and Capital Markets. The latter continued to be negatively impacted by lower fixed income trading revenue. Domestic banking reported a modestly better quarter with net income up 4% Y/Y. Wealth Management reported a 33% Y/Y increase in net income. International adjusted net income improved 2% Y/Y reflecting higher credit losses and lower interest margins. Scotia Capital reported an earnings decline of 28% Y/Y. The quarter also benefited from strong securitization income. Provision for Credit Losses (PCL) increased 3% Y/Y which was higher than expected.

For fiscal 2011, reported cash EPS was $4.72 per share, up 19% Y/Y. Adjusted cash operating EPS was $4.37, an increase of 8% from the $3.94 reported in fiscal 2010. Provision For Credit Loss (PCL) decreased by 15% to $1.1 billion during the period while Gross Impaired Loans (GIL) decreased by 7% to 4.1 billion. Adjusted ROE was 17.7% vs 18.0% in 2010. In 2011, the dividend was increased by 6% from $1.96 per share to $2.08 per share.

Looking forward, we remain concerned that Domestic earnings may remain under pressure for some time as the low interest rate environment combined with intense competition for both deposits and loans is keeping pressure on net interest margins. Credit losses are now expected to flatten out. That leaves the Bank more dependent on Wealth Management and International for earnings growth. International earnings should benefit from improved volume growth and further selective acquisitions.

For fiscal 2012, we have lowered our forecast to $4.90 from $5.10 largely driven by the lower interest rate margins we expect throughout the year. Our preliminary EPS forecast for fiscal 2013 has been set at $5.40, an increase of 11% over 2012. The dividend payout ratio, based on our fiscal 2012 and 2013 EPS outlook, approximates 42% and 39% respectively which is at the lower-end of management’s new targeted payout ratio of 40% to 50%. We expect investors could see a further dividend increase of 5% to 7% over the next 12 months.

We have lowered our target share price to $63.00 from $66.00. BNS remains a BUY.

Valuation – Premium Valuation Sustained

BNS is well diversified in its earnings with about 55% domestic and wealth management, 27% international and 18% capital markets. Our share price target supports a valuation of 12.8x our 2012 EPS forecast which represents a 5% premium to the other Canadian major banks.

Other Quarterly Highlights

- Reported Q4/11 cash net income of $1,269 million, up 12% Y/Y but down 3% sequentially. Excluding the reduction of the general loan loss allowance of $30 million and $27 million negative goodwill, adjusted cash net income would have been closer to $1,220 million, up 10% Y/Y. Net interest margins decreased Y/Y by 12 bps and 4 bps sequentially. The lower margins resulted from consumer preferences for lower margin variable rate products, the maturing of older higher-yield fixed rate mortgages into variable rate products and increased competition for deposits in Canada. Revenues increased 10% Y/Y while non-interest expenses increased 15% for negative leverage. Higher revenues and expenses resulted largely from acquisitions principally driven by the DundeeWealth acquisition. Management stressed that the Bank would return to positive operating leverage next year.

- Domestic banking net income was $460 million, an increase of 4% Y/Y but flat sequentially. Loan volume growth remained good, albeit somewhat slower. PCL declined 4% Y/Y but was flat sequentially. Margin compression was significant both Y/Y and sequentially. Net interest margins were lower Y/Y by 15 bps and higher by 7 bps sequentially. Revenue was flat Y/Y while expenses grew by 4% for a decrease in operating leverage of 4%. Expenses increased primarily due to annual salary increases, higher pension costs and volume growth. Commercial banking experienced lower spreads as the asset mix shifted to higher quality loans in the automotive portfolio.

- International cash net income increased 10% Y/Y to $373 million. Excluding a negative goodwill adjustment of $27 million, net income was up only 2% Y/Y and flat sequentially. Average assets increased 7% Y/Y driven by higher commercial lending activity. Net interest margin came under pressure in the quarter and decreased 9 bps Y/Y and sequentially. Revenues were up 11% Y/Y while expenses increased by 16% Y/Y. Revenue growth was helped by growth in Chile and Peru as well as the Uruguay acquisition. Expense growth was impacted largely by acquisitions and higher costs associated with additional support staff and branch expansion in Mexico, Chile and Peru. PCL increased by 19% Y/Y and sequentially to $152 million driven by higher losses in the Caribbean. GIL in the quarter was unchanged over the prior quarter at $2.8 billion. We expect the level of GIL to stay elevated throughout fiscal 2012.

- Global Wealth Management reported net income of $250 million up, 33% Y/Y. Sequentially, net income was flat. Results now include all of DundeeWealth. Total revenues increased 44% Y/Y. Expenses increased by 54% Y/Y. Assets Under Management (AUM) doubled to $103 billion, including DundeeWealth. Mutual fund revenues doubled Y/Y but were down 1% sequentially. Insurance revenues increased 16% Y/Y.

- Scotia Capital reported net income of $230 million, down 28% Y/Y and 20% sequentially. Trading revenues were weaker, down 28% Y/Y and 7% on a sequential basis. Fixed income trading was particularly weak while precious metal trading was stronger. Underwriting revenue were lower by about 16% Y/Y and sequentially. This quarter reported PCL of $14 million versus a net reversal of $8 million in the same quarter last year and a loss of $8 million last quarter. GIL increased to $267 million in the quarter from $242 million last quarter but was below $291 million reported in the same quarter last year. The decline in GIL on a Y/Y basis was driven by lower U.S. GIL offset in part by a jump in European GIL. GIL is expected to remain near the current level over the near-term. Capital markets revenue is expected to remain under pressure for some time particularly fixed income trading.

- Provision for Credit Losses increased 3% Y/Y to $302 million. PCL was 11% higher on a sequential basis. Overall, PCL was 15% above expectations. The increase was concentrated in the international portfolio while domestic losses were slightly lower in the quarter. We have increased our fiscal 2012 PCL estimate to $1.2 billion from $1.1 billion and project PCL to remain at $1.2 billion in fiscal 2013.

- Gross Impaired Loans (GIL) were lower at $4.1 billion last quarter and 7% Y/Y. GIL was 5% below expectations. Net new formations were slightly lower at $160 million versus $228 million in the prior quarter. The decrease in formations was largely concentrated in the domestic and international commercial portfolios. We have maintained our fiscal 2012 and 2013 forecasts for GIL at $4.0 billion at the end of each year.

- Securitization revenues were very strong at $107 million versus $38 million last quarter and $69 million in the same period last year.

- Security gains of $43 million this quarter or about $0.03 per share compared to the prior quarter gain of $81 million and gains of $40 million in the same period last year.

- Unrealized AFS security gains at the end of the quarter were $1,189 million compared to unrealized gains of $1,073 million as at the end of the prior quarter.

Credit Exposure to Euro Zone

Total exposure to non-PIIGS is $15.2 billion including sovereign, banks and corporate but excludes trading securities totaling $1.1 billion. Management disclosed the Bank’s credit exposure to the European PIIGS at $2.2 billion. Exposure to sovereign credits was limited to $114 million in Ireland. Credit exposure to banks totaled $1.2 billion with modest exposures to Portugal ($103mm), Ireland ($46mm), Italy ($976mm - mainly precious metal related) and Spain ($113mm). Corporate lending exposure was $0.8 billion comprising of Greece ($340mm – largely shipping related), Ireland ($25mm), Italy ($66mm), and Spain ($367mm).

Basel III Capital Rule Impact

Under the current Basel II capital rules, the Bank’s Tangible Common Ratio is 9.6% and its Tier 1 Capital Ratio is 12.2%. Management estimates that its Tier 1 Common Equity Ratio under Basel III (2019 rules) to be in the 7.0% to 7.5% range by the first quarter of 2013.

Recent Event

On October 20, 2011, Bank of Nova Scotia (BNS) announced the acquisition of 51% of Banco Colpatria in Colombia for a total consideration of US$1 billion in the form of US$500 million in cash and 10 million BNS common shares. Management expects the transaction to be accretive immediately on fiscal 2012 earnings by the mid-single digits (a few cents per share). This acquisition fits nicely into the Bank’s international strategy. Colombia supports one of the faster growth rates of the emerging market economies. This adds strategically to the Bank’s other regional investments in Mexico, El Salvador, Belize, Costa Rica, Peru and Chile.

This transaction is basically an acquisition of control of the fifth largest bank in Colombia.

- Banco Colpatria is a Personal & Commercial (P&C) franchise in the middle market with a 5% market share in total loans and deposits (19% and 9% market share of credit cards and mortgages respectively). It has 3,900 employees, 175 branches and 308 ATMs.

- The Pacheco Cortes family owns the balance of the Bank and has a put option to sell its 49% after 7 years at fair market value to be determined by a third party.

- Banco Colpatria had gross loans of US$4.95 billion (50% commercial, 21% in cards and 15% mortgages). This will add about 10% to the current BNS international loan book.

- ROE was 19% in prior five year history.

- Transaction is valued at 12x P/E based on 2011 estimated U.S. earnings of about $160 million or approximately 3x book value. BNS share of earnings would be $80 million versus total BNS international earnings of about $1.2 billion. The transaction includes the sale of Scotia Colombia (wholesale operations of BNS in Colombia) to Banco Colpatria at a book value of $30 million.

- BNS will have 4 of 7 board members and the right to appoint the deputy CEO, CFO, CRO and Chief Auditor.

- Capital Impact: Lowers the Basel III Common Equity Tier 1 Ratio by 15 to 20 bps partly offset by the common equity to be issued. Targeted 7% to 7.5% Basel III Common Equity Tier 1 ratio by Q1/2013 remains unchanged.

- Closing is expected in December 2011.