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Bank Of Nova Scotia: Solid Growth Prospects For Canada's Most International Bank


Scotiabank has lagged its "Big Five" bank peers over the past two years, which represents an opportunity, as Canadian bank stocks tend to revert to the mean.

Scotiabank's current valuation does not reflect growth prospects for its International business. The bank's relative valuation will improve as the International segment improves its earnings power.

Total return potential of 14.4% over the next 12 to 18 months.

In the Canadian banking system, five banks stand above the rest in terms of assets, deposits and capitalization. These five banks are referred to colloquially as the "Big Five." All five are headquartered in Toronto and are classified as Schedule 1 domestic banks operating in Canada under government charter. Cumulatively, the Big Five banks account for close to 90% of the banking industry in Canada.

On March 31, I published an article for Seeking Alpha entitled, "A Good Time To Buy The 'Big 5' Canadian Bank Stocks". The "Big Five" has become an outdated moniker. The assets held by the Big Five Canadian banks have ballooned in size over the last decade, crossing the threshold into gargantuan territory. Toronto-Dominion Bank (NYSE:TD) and Royal Bank of Canada (NYSE:RY) became Canada's first trillion-dollar banks, measured by total assets, and the Bank of Nova Scotia (NYSE:BNS) is not far behind. Only four banks in the U.S., an economy 10 times the size of Canada, have crossed into trillion-dollar territory, reinforcing how massive these institutions are in relation to the overall Canadian economy.

However, Canadian bank stocks, including the Big Five banks, have fallen out of favor. The Bank of Nova Scotia, or Scotiabank, as it is commonly known in Canada, is down 5.2% on the NYSE and 1.2% on the TSX in the past 12 months. The Canadian oil patch and broader Canadian economy have struggled, taking the "loonie" down with them. Canadian government finances and the country's exports have deteriorated. Among G7 countries, Canada has experienced the largest increase in household debt relative to income since 2000. Canadian households are now more indebted than any other G7 country, leading to concerns about the vulnerability of households to economic shocks.

It is a testament to the quality of Canada's Big Five banks that, despite these significant challenges, they continue to enjoy a high degree of success. But despite their long record of success, the Big Five banks are among the most heavily shorted names on both the Toronto and New York Stock Exchanges.

Scotiabank is the second-largest holding in my investment portfolio, which is comprised exclusively of attractively valued, large- to mega-cap, dividend growth stocks. Scotiabank trades on the Toronto and New York Stock Exchanges under the symbol "BNS." The bank was incorporated by the Legislative Assembly of Nova Scotia on March 30, 1832, in Halifax, Nova Scotia.

Scotiabank has a team of more than 89,000 employees, a market cap of C$78.7 billion, assets of C$895 billion and 1.2 billion common shares outstanding. Scotiabank and its affiliates offer a broad range of advice, products and services, including personal and commercial banking, wealth management and private banking, corporate and investment banking, and capital markets.

The bank focuses on five overarching priorities:

  1. Customer experience
  2. Leadership
  3. Low cost by design
  4. Digital transformation
  5. Business mix

Investment Thesis

Scotiabank is a leading, globally diversified financial services provider and Canada's "most international bank." International banking accounted for 27% of the bank's annual earnings in fiscal 2015, versus 50% from Canadian banking and 23% from its Capital Markets unit. The lender has more than 23 million customers in over 55 countries around the world. In addition to North America, it has a meaningful and growing presence in Latin America, the Caribbean, Central America, and parts of Asia.

The populations in all of its geographies outside North America are growing at a healthy rate and there remains a large "unbanked" population in each region, providing good opportunity for Scotiabank to grow. Scotiabank is well positioned to continue to grow organically and has the balance sheet strength to selectively pursue accretive acquisitions.

In Latin America, Scotiabank is focusing on four key countries with the best growth opportunities - Mexico, Chile, Columbia and Peru - the so-called "Pacific Alliance nations." It is targeting to increase earnings in these countries by as much as 15% within three years by growing its customer base, leveraging new banking technologies and reducing costs.

Scotiabank CEO Brian Porter is positioning the bank to act on the anticipated bank consolidation in Mexico, its largest Latin American operations, as well as acquisition opportunities in Peru, Colombia and Chile. In its fiscal second quarter, ended April 30, 2016, Scotiabank completed acquisitions in Panama and Costa Rica, further strengthening its existing operations in these countries. I anticipate additional acquisition announcements across this region over the next 12 months.

I do not believe the current valuation for Scotiabank captures the growth prospects for its International banking business. I believe the bank's relative valuation will improve as the International segment improves its earnings power over time.

Applying a P/E multiple of 11.5 to analysts' consensus FY2017 EPS estimates yields a 12-month target price of C$72, which represents 10% upside to Friday's closing price of C$65.47 on the TSX. Adding the current yield of 4.4% delivers a total return of 14.4%. The target multiple is at the high-end of its peers, given Scotiabank's significant exposure to higher growth international markets. This business can deliver better earnings power once the bank has digested its international acquisitions and completed the restructuring. I believe average earnings growth of 8% to 10% is achievable for its International segment over the next two years.

Upside to this base-case...