Slightly Lowering Fair Value Estimate for Scotiabank, Earnings Pressure Likely Over Medium Term

Strategist

Eric Compton

Bank of Nova Scotia is the third-largest Canadian-based bank by assets and one of six Canadian banks that collectively hold almost 90% of the nation's banking deposits. It is known as Canada’s most international bank as it derives a little over half of its revenue from Canada, over 40% from international operations (primarily Latin America, namely Mexico, Peru, and Chile), and a single-digit percentage from the United States. Its domestic operations are more concentrated in mortgages and auto lending, with leading market share in autos. The bank has been expanding its domestic wealth operations significantly with its acquisitions of MD Financial and Jarislowsky Fraser, making it the third-largest active manager in Canada. The bank has been reworking its Latin America footprint, making acquisitions in markets it likes (Chile, Colombia) while reducing exposure to businesses and geographies that are less favorable as it attempts to consolidate better share within the area. The international exposure gives the bank the potential for higher growth and return opportunities compared with peers, but it also exposes the bank to more risks, as we've seen during the pandemic. While theoretically beneficial, the bank's international exposure has tended to be more of a headwind than tailwind.

After numerous acquisitions, we think the bank has made substantial progress on rationalizing its many back-end systems and improving efficiency bankwide, although much work remains. The bank's original goal was to have an efficiency ratio of 50% by the end of 2021; however, this was delayed given the less positive economic backdrop caused by COVID-19, and we now forecast that the bank will struggle to break this barrier for the next several years. Further, new CEO Scott Thomson has begun to hint at what direction the bank will take under his leadership, and it appears that it will be a multiyear lift to improve performance.

As investment needs remain high and competition from peers also does not abate, we expect that expansion of the bank's returns on tangible equity will be limited for the time being. Increasing credit costs are also likely to pressure earnings for the time being.

Business Strategy & Outlook

We believe Bank of Nova Scotia is worthy of a Narrow Morningstar Economic Moat Rating. Although it has some of the best historical total bank operating efficiency, moaty nonbank businesses, and the ability to primarily operate in the favorable Canadian banking environment as its third-largest bank, we assign it a narrow moat rating instead of wide. The bank has significant, but not leading, market share in its domestic operations, and it has the lowest proportional exposure to Canada, at roughly 50% of revenue. Additionally, the bank's non-Canadian exposure is concentrated in Latin America, where we calculate the international segment has often struggled to earn returns on equity much above above the 11% average cost of equity we assign to that segment.

We argue that banks derive moats primarily from two sources: cost advantage and customer switching costs. We see a tightly regulated, oligopolistic market structure limiting excess competition within the Canadian system, therefore stabilizing product pricing and giving customers less incentive to switch banks. We see cost advantages stemming from three factors: a low-cost deposit base, excellent operating efficiency, and conservative underwriting; regulatory costs are also a factor we must consider. We view the Canadian banking environment as offering systemic cost advantages for the banks in its domain. These advantages manifest themselves in the form of lower operating costs, lower credit costs, lower regulatory costs, and lower absolute levels and better diversification of risk, all of which allow the banks to achieve greater risk-adjusted returns.

Bank of Nova Scotia has built up substantial market share within its Canadian retail operations and with large commercial clients. While the bank has number-one share within the fairly attractive auto and dealer floor lending space, the bank is usually not the number-one or number-two player for most products. The Canadian segment does earn returns on equity well in excess of the 9% cost of equity we assign to Canadian banking operations.

While its Canadian operations are strong, Scotiabank has the least proportional exposure to Canada among the Big Six banks, as nearly 50% of operations are outside Canada, primarily in Latin America. We believe these operations warrant a higher cost of equity of 11%, and at this point the bank earns roughly 14%-16% returns on equity in this segment. While we like the bank’s international exposure to higher-return and higher-growth markets, it tends to not be the dominant player in most of these markets, although its scale is improving. In these regions, the largest players with the most scale tend to earn the best returns and be the moatiest (such as Banco de Chile in Chile, Bancomer in Mexico, and Santander in multiple locations). 

Bank of Nova Scotia has built a decent-size wholesale banking and capital markets group. Based on deal credit, it tends to be a top 10 player within Canadian offerings, and it does a fair amount of business internationally. Also, while not historically a dominant asset manager among the Canadian banks, a series of acquisitions have improved the bank's standing here. Scotiabank is one of the larger asset managers among the banks and it should be seeing decent fee income from this segment. This gives the bank exposure to this higher-margin fee-based business that we don’t think will change in the near term as the banks still have the dominant branch and distribution networks.

We believe the Canadian banking environment offers systemic cost advantages that lead to returns above the cost of capital, allowing the main banks operating under its jurisdiction to possess moats. 

Barriers to entry are very high for the Canadian banking system. Existing regulations prevent foreign competition, as non-Canadian residents may not own more than 25% of the shares of a bank unless approved by the government, preventing foreign takeover. Foreign banks can operate in Canada only under certain restrictions, preventing significant direct foreign competition. The federal government also controls domestic competition, as Canada’s banking system historically developed to favor a few large banks controlling the majority of the domestic market, and this is actively enforced through the handling of chartering by the federal government exclusively. Additionally, the rejection of merger proposals in 1998 between Royal Bank of Canada and BMO, and between Toronto Dominion and Canadian Imperial Bank of Commerce, created a precedent where no further consolidation between the main Canadian banks will be accepted by the regulators. 

Having larger banks helps to spread out fixed costs across a larger operating base, increasing operating efficiency, as the four largest Canadian banks are all bigger than the largest U.S. regional bank. The Canadian banks arguably have some of the most powerful distribution networks within Canada because their branch networks are spread out through all of Canada. This offers cost advantages via lower customer acquisition costs. In addition, the banks are involved in nearly every major financial product, including asset management, wealth management, insurance, investment banking, and a variety of other consumer and commercial banking products and services. On a bigger scale, powerful distribution networks, a multitude of products, and diversification of business lines lead to economies of scope in addition to those already achieved.

We believe a more protective and efficient regulatory system also leads to cost advantages, primarily through risk reduction. Less fragmented and well-integrated banking systems like the Canadian system have tended to be more stable over time, reducing risk. Also, the Canadian regulators must only primarily monitor and develop relationships with the Big Six Canadian banks, which is much easier than trying to monitor the thousands of banks that exist in the U.S., for example. This leads to more collaboration and cooperation between regulators and banks as well as greater institutional memory and more coordinated and easily implemented responses if strains begin to appear in the system. Regulators also help to control pricing in the market at times, such as on mortgage products, helping to reduce the potential for pricing wars to gain market share at the expense of underwriting standards. In many ways, Canadian regulation makes it more difficult for banks to issue bad credit, including mandatory insurance and standards on riskier mortgage loans, not having a GSE like government subsidized mortgage securitization market, and forcing banks to hold more of the risk on their own balance sheets. These factors help contribute to better absolute risk reduction in the system as well as regulatory economies of scale.

The Canadian banks are also more geographically diversified on average than, for example, the majority of U.S. regional banks that often have concentrations within individual states or local economies. This diversifies credit risk, lowering the overall risk for each individual bank. Canada’s system of higher taxes, more social safety nets, and undoubtedly other complex factors have also led to a more robust and stable middle class that contributes to economic and political stability, further reducing systemic risk.

Combine all of these factors, along with explicit government subsidies on deposit insurance and mortgage insurance as well as the implicit subsidy of being too big to fail domestically (all Big Six Canadian banks are labeled as DSIBs), and we believe an environment exists where excess returns for banks are almost certain to exist in Canada.

Narrow

Economic Moat

Bank of Nova Scotia

SoctiaMocatta, is the precious metal and base metal banking division of The Bank of Nova Scotia. ScotiaMocatta is the oldest bullion dealer in the world, is one of the 10 market-making members of the London Bullion Market Association. Additionally it is one of five banks to participate in the London gold fixing. It has a history of 340 years, and is the only original member of the London Gold and Silver fixes to maintain its seats on both respectively.

SoctiaMocatta

Tangerine Bank, is a Canadian direct bank and a subsidiary of Scotiabank. It offers no-fee chequing and savings accounts, Guaranteed Investment Certificates, mortgages, and mutual funds. Many savings and investment products are eligible for registration under a Tax-Free Savings Account, Registered Retirement Savings Plan, or Registered Retirement Income Fund. Founded by ING Group in 1997 as ING Direct Canada, the bank was acquired by Scotiabank in 2012.

Tangerine Bank

The Bank of Nova Scotia engages in the provision of financial products and services including personal, commercial, corporate, and investment banking. It operates through the following segments: Canadian Banking, International Banking, Global Wealth Management, Global Banking and Markets, and Other. The Other segment includes group treasury and smaller operating segments. The company was founded on March 30, 1832 and is headquartered in Toronto, Canada.

Earnings data Q4 2023

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Bank of Nova Scotia is one of the largest Canadian banks with a strong presence in Latin America. BNS is among the leading Canadian banks in digital banking services. BNS offers a respectable dividend yield of 6.6%, higher than its Canadian peers. BNS liquidity risk is well managed, with a large portion of interest-bearing deposits and debt securities available for sale. The credit risk is distributed across a large pool of borrowers.

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Barb Mason, Group Head and Chief Human Resources Officer (CHRO) to retire at the end of 2023 Jenny Poulos appointed to Deputy CHRO, effective October 2, 2023, and CHRO, effective December 4, 2023 Aris Bogdaneris appointed to Group Head, Digital Transformation, Tangerine, Marketing and Analytics, effective September 1, 2023 Phil Thomas promoted to Group Head and Chief Risk Officer, effective September 1, 2023 Paul Baroni appointed to EVP, Finance & CFO, Canadian Banking, effective September 1, 2023 Maria Theofilaktidis appointed to EVP & Chief Auditor, effective September 1, 2023 Anique Asher, EVP, Finance and Strategy, expands her mandate to include Capital Management, effective September 1, 2023 Chris Manning appointed to EVP, Global Business Payments, effective September 1, 2023 TORONTO , Aug. 31, 2023 /PRNewswire/ - Scotiabank announced today that Barb Mason, Group Head and Chief Human Resources Officer (CHRO), has announced her intention to retire from Scotiabank at the end of 2023, after a 41-year career with the bank. "On behalf of all Scotiabankers, I would like to congratulate Barb on an impressive four-decade career with the Bank and thank her for her invaluable guidance and partnership as an integral part of our Senior Leadership Team," said Scott Thomson, President and CEO for Scotiabank.

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News for Bank of Nova Scotia Stock (BNS)