BANK OF NOVA SCOTIA $38 (Toronto symbol BNS; Conservative Growth Portfolio, Finance sector; Shares outstanding: 990.0 million; Market cap: $37.6 billion; SI Rating: Above average) is Canada’s third-largest bank after Royal Bank and Toronto-Dominion Bank, with total assets of $462.4 billion. It provides a wide variety of financial services through 2,560 branches and offices in Canada and over 50 other countries. The bank gets about a third of its revenue and earnings from its international operations. Unlike other Canadian banks, it has largely avoided expanding in the United States. That has helped it escape the big writedowns related to U.S. subprime mortgages. Instead, Bank of Nova Scotia prefers to focus on international regions such as Latin America, the Caribbean and Asia, where it can quickly expand its market share. Thanks to the spread of free trade and rising global prosperity, Bank of Nova Scotia’s revenue rose from $10.0 billion in 2003 (fiscal years end October 31) to $12.5 billion in 2007. Earnings grew from $2.34 a share (total $2.4 billion) in 2003 to $4.01 a share ($4.0 billion) in 2007.
Latin America has strong potential
Bank of Nova Scotia’s Latin American operations (mainly Mexico, Peru and Chile) provide 20% of its total revenue. The recent credit crisis has hurt Latin America more than other regions, as much of its economic activity depends on commodities such as oil and minerals. Lower resource prices could lead to a drop in exploration projects or new mine construction, and hurt demand for loans. As well, the Canadian dollar continues to rise compared with the Mexican and Chilean currencies. That hurts the earnings contribution from these countries. However, the long-term outlook for the region is still promising. Populations continue to expand rapidly, along with the size of the middle class. That should spur strong demand for banking services. Banks in these markets also face less competition than banks in North America. That gives Bank of Nova Scotia, which has a long history of operating in these regions, an advantage. The bank also has little exposure to Brazil and Argentina, so the recent economic turmoil in these countries will have only a minimal impact on its earnings.
Acquisitions will add to future growth
The bank is also taking advantage of the problems in the financial services industry to expand its domestic operations. For example, it recently paid $442 million U.S. for the Canadian operations of E*Trade. The purchase doubled the size of the bank’s online brokerage business. Another big purchase was its recent deal to pay $2.3 billion for Sun Life Financial’s 37% stake in CI Financial Income Fund, Canada’s third-largest mutual fund company. Following the purchase, Bank of Nova Scotia will become CI Financial’s largest shareholder with a 37.6% stake. Besides the CI Financial purchase, Bank of Nova Scotia recently increased its interest (mostly nonvoting) in DundeeWealth Inc., from 18% to 19.4%. DundeeWealth provides investment management, securities brokerage, financial planning and investment advisory services. It also operates the Dynamic family of mutual funds.
Controlling costs & loan losses
The bank continues to do a good job controlling costs. In its third fiscal quarter ended July 31, 2008, its productivity ratio (non-interest operating expenses divided by revenue — the lower, the better) weakened to 54.3% in the latest quarter, from 53.0% a year earlier. However, that was mainly due to the costs of building new branches in Canada, Mexico, Chile and Peru. Despite the increase, Bank of Nova Scotia is still the most efficient Canadian bank. The bank has set aside $2.5 billion for possible loan writedowns. In the most recent quarter, it added $159 million to these reserves. That’s 72.8% more than the $92 million it contributed in the year-earlier quarter. Most of that increase was due to an acquisition in Chile, plus general economic uncertainty in Asia and the Caribbean. At July 31, 2008, Bank of Nova Scotia had $1.0 billion in past due and other problem loans, up from $584 million a year earlier. Still, despite the rise, bad loans represented just 0.36% of its total loan portfolio, up from 0.25% a year earlier.
Enough capital to absorb loan losses
Bad loans will probably continue to move up as the economy weakens. However, Bank of Nova Scotia’s balance sheet is strong enough to absorb these losses. That cuts the risk that it will have to raise capital by issuing new common or preferred shares. Bank of Nova Scotia probably earned $3.87 a share in fiscal 2008, and the stock trades at 9.8 times that estimate. That’s cheap in light of the bank’s broad international reach and growing domestic operations. The strength of these underlying businesses should continue to let Bank of Nova Scotia increase its dividend. The current annual rate of $1.96 yields 5.2%. Bank of Nova Scotia is a buy.
