Unlike its U.S. counterparts, the major Canadian banks did not slash dividends during the 2008 financial crisis. These companies did pause dividend growth in many cases, but they returned to growth rather quickly.
In addition, these companies have performed well over recent quarters, and each of the top players offers a dividend of at least 5% today. For these reasons, I have turned my eyes north for possible banking investment opportunities.
I’ve previously written about Canadian Imperial (CM, Financial) and Royal Bank of Canada (RY, Financial). In this article, we will examine the recent earnings, dividend history and valuation of The Bank of Nova Scotia (BNS, Financial).
Background and recent earnings
The Bank of Nova Scotia, commonly referred to as Scotiabank, is the third largest bank by assets in Canada. The company also has offices in the U.S. and more than 50 other international markets. In total, Scotiabank has more than 3,000 offices around the world. The company trades with a market capitalization of $43.7 billion as of the writing of this article.
Scotiabank reported earnings result for the first quarter of fiscal 2020 on Feb. 25. The company’s adjusted earnings-per-share increased 3.8% to $1.38, which was $0.06 higher than expected. Revenue improved 6.1% to $6.1 billion, beating estimates by $71 million.
The Canadian Banking segment grew 5% year-over-year, but net income was down 1%. Loans grew 6%, led by a 12% increase in business loans. Personal deposits grew 5%, while non-personal deposits were up 6%. Net interest margins decreased 3 basis points, primarily due to lower interest rates, but net interest income improved 4%.
The International Banking segment had a 2% decline in revenue and a 29% decrease in net income. The vast majority of this decrease was due to a combination of divested operations in Puerto Rico, the U.S. Virgin Islands and El Salvador and a tax benefit in Mexico in Q1 2019. Adjusting for this, revenue increased 4% and net income was lower by 4%. Shrinking margins in Mexico and Chile were more than offset by 10% loan growth in the Pacific region.
Global Wealth Management had a strong quarter, with revenue up 5% and net income climbing 12%. Driving these gains was a 6% increase in assets under management compared to the previous year. Trading activity also aided brokerage revenue growth.
Global Banking & Markets had a 9% improvement in revenue and 11% growth in net income. Trading related revenue was a source of strength in the quarter. Also aiding results was loan growth of 6% and a 21% increase in deposits.
Scotiabank added $155 million to its loan loss provision during the quarter. This shouldn’t be unexpected, as the financial sector is likely to take losses on small business loans and personal credit cards during the pandemic. Impaired loans at the end of the first quarter grew 14 basis points to 0.61%.
Overall, I think Scotiabank had a good first quarter. Only the International Banking segment had a decline on both revenue and net income, but much of this was due to a divesture and tax benefit in the prior year. The other segments showed growth.
Second quarter results will be announced May 26, in which we will see how much of an impact the ongoing pandemic has had on results. In particular, how high will provisions for credit losses move as consumer spending decreases and businesses begin to default on their loans? However, regardless of results, I am confident that the company’s dividend has strong ground to stand on.
Dividend and valuation analysis
For holders of the Canadian-listed stocks, Scotiabank didn’t cut its dividend during the last recession, though the dividend was paused in 2010. Since then, the bank has raised its dividend every year, including a 3.4% increase for the Oct. 29, 2019 payment.
Dividends paid to investors in the U.S.-listed stocks of the company have fluctuated over the years due to currency translation. From 2010 through 2019, Scotiabank’s dividend increased at a rate of 3.4% annually on average for U.S. investors. In Canadian dollars, the growth rate was nearly 6% per year.
While the average increase for U.S. investors may not be as exciting, the stock’s dividend has averaged a 4.1% yield over the last decade. This is a fairly generous dividend yield over a lengthy period of time. Based on the recent closing price and the company’s annualized dividend of $2.56 using currency exchange rates, Scotiabank yields 7.1%. Today’s yield is almost three-fourths higher than the average yield over the last 10 years.
It is true that an extremely high yield compared to the historical average can be a sign of a troubled company getting ready to cut its dividend, but I don’t believe that to be the case based on the payout ratios.
Using Wall Street estimates for earnings-per-share of $5.51 for the year, Scotiabank’s dividend payout ratio is just 46%, which is slightly below the 10-year average payout ratio of 48%. The company has had just one year (2015) where the payout ratio was above 50%.
As healthy as the earnings payout ratio looks, free cash flow is even better. Scotiabank distributed 4.5 billion Canadian Dollars ($3.2 billion) of dividends over the year while generating C$16.5 billion of free cash flow for a payout ratio of just 27%. This compares to the average free cash flow payout ratio of 63% covering the company’s fiscal years of 2016 to 2019. It should be noted that this calculation included one year of a loss of C$13 billion in terms of cash flow.
Shares of Scotiabank have been hit hard in 2020, losing more than 36% year-to-date. The S&P 500 is down almost 13% over the same period of time. Shares closed the most recent trading session at $36. Using analysts’ estimates for earnings-per-share, the stock trades with a forward price-earnings ratio of 6.5. The average multiple over the last 10 years is 11.8. This means that the stock trades at a 45% discount to its long-term historical average.
The difference in the current and the historical average valuation is most certainly due to the impact of the pandemic. Investors likely are fearful of impaired loans on Scotiabank’s results due to lower consumer spending and the possibility of loan defaults.
Eventually, consumers will spend again as the economies of the world recover from the pandemic. This could take more than a few quarters, but a conservative valuation range of eight to 10 times earnings seems reasonable to me given Scotiabank’s past success. Applying earnings estimates gives us a target price range of $44 to $55. Compared to the recent closing price, investors could be looking at a 22% to 53% gain.
Final thoughts
I find a lot to like about Scotiabank. The company’s most recent quarter was solid for the most part. I expect impaired loans to be higher in the second quarter, but that is to be expected due to the current situation.
Longer term, I believe that Scotiabank will return at least 22% from the current price, maybe even reaching about a 50% return. Add in the 7% dividend yield and Scotiabank looks like an excellent investment opportunity for long-term investors.
Author disclosure: the author has no position in any stocks mentioned in this article.
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