The Canadian banks have long been a personal favorite of mine as they were able to maintain their dividends during the last recession even as their U.S. peers were slashing theirs to the bone. Even the Covid-19 pandemic never truly threatened these companies’ ability to continue to pay and raise their dividends.
The Bank of Nova Scotia (BNS, Financial), often referred to as Scotiabank, reported earnings results last week that came in ahead of estimates. The stock has increased nearly 44% over the last year, but I feel that the market continues to undervalue the name. In this article, we will examine why I think shareholders of Scotiabank could see an additional 20% in total returns from the stock.
Earnings highlights
Scotiabank reported earnings results for its third quarter of fiscal year 2021 on Aug. 24. Revenue grew almost 5% to $6.16 billion, $21 million above Wall Street analysts’ estimates. Earnings per share of $1.60 were 9 cents higher than expected and far higher compared to EPS of 79 cents in the prior-year quarter.
Provisions for credit losses (PLCs) dropped 112 basis points to 0.24% from the previous year. The PCL ratio on impaired loans was 0.53%, coming in close to pre-pandemic levels of 0.49% that were seen in 2019. Both figures also improved from the second quarter of 2021.
The Canadian Banking segment had revenue growth of 12% from the prior year while net income was higher by 152%. This gain was due in large part to a 78 basis point improvement in PLCs. Non-interest income was higher by 34% while net interest income increased 5%. This segment’s loan portfolio grew 7%, driven by a 10% increase in residential mortgages. Deposits were higher by 12%, mostly due to a 26% gain in non-personal accounts.
Global Wealth Management had revenue growth of 18% and net income was up 21%. Higher mutual fund and brokerage fees drove much of the gains. Canadian wealth management grew 20%, the 10th straight quarter of at least double-digit year-over-year growth. Assets under management were up 17% from the prior year and 3.6% from the previous quarter. PCLs for the quarter were less than $1 million.
Global Banking & Markets had a decline of 19% for revenue, while net income was lower by 14%. Release of PCLs only partially offset performance in capital markets. Net interest income was down 3% with non-interest income falling 24%. On a sequential basis, average loans improved 1%. Average deposits climbed 5%.
International Banking net income and revenues were flat compared to the same period of 2020, but grew 17% and 2%, respectively, from the second quarter of 2021. Compared to this period, mortgages increased 2% while commercial was up 1%. Credit cards and personal loans fell 3%. PCLs declined 71% from the prior year as Scotiabank has seen a rebound from the pandemic.
Scotiabank's Common Equity Tier 1 ratio was a healthy 12.3% while adjusted return on equity improved 670 basis points to 14.9%.
Takeaways
Scotiabank did benefit from rather easy comparisons. Net income was higher by 95% from the prior year, which took place during some of the worst parts of the Covid-19 pandemic. That said, the company’s results were strong as net income improved 4% and earnings per share increased 6% on a sequential basis.
The international businesses were challenged, especially Global Banking & Markets, in the most recent quarter. However, this should subside some as the economies of the world recover from the pandemic. Scotiabank’s international presence is large as the company has operations in more than 50 countries worldwide. One piece of evidence that the recovery is already taking place is that Pacific Alliance loans grew 1% quarter-over-quarter. Every other segment within Scotiabank is already ahead of where it was at the same time in 2019. As international markets recover, so should these businesses.
The company has also showed a remarkable improvement in PCLs as the ratio has improved every quarter since the third quarter of 2020. The number of impaired loans has declined 83% from last year’s third quarter and 23% from second quarter of 2021 to $380 million.
Scotiabank, like many other financial institutions, set aside sizeable amounts of capital in anticipation of a significant increase in bad loans last year. Now that much of that overhang has decreased, even if the pandemic is still with us today, Scotiabank has been able to release much of the capital set aside.
Year-to-date earnings are better than even those for the same period of 2019. Earnings per share are up 16.5% while revenue is nearly 10% better than pre-Covid levels. Simply put, the company survived the worst of the pandemic and appears to have come out stronger than before.
And yet, this strength doesn’t appear to be reflected in the stock’s valuation. With a current share price of $62, Scotiabank has a forward price-earnings ratio of 10.2. The stock does have a very consistent valuation over the medium- and long-term. According to Value Line, Scotiabank has five- and 10-year average price-earnings ratios of 11.1 and 11.2, respectively.
I feel a valuation range of 10 to 12 times earnings is appropriate given the strength of the company’s business as well as its historical average price-earnings ratio. Reaching the top end of my valuation range would result in an additional 17.3% return from today’s share price.
This projected return doesn’t include the dividend either. Though the dividend was paused from 2009 to 2010, Scotiabank has raised its dividend every year since. U.S shareholders will receive $2.87 in dividends per share this year, equating to a yield of 4.6% at the most recent price. Combine this with possible multiple expansion and the total return could be in the low 20% range, a solid return considering the gains seen over the last year.
