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Morningstar | Acquisition Integration Still In Progress, Credit Costs Shoot Higher for Scotiabank in 2Q

Narrow-moat Bank of Nova Scotia, or Scotiabank, reported fiscal second-quarter results which were again a bit weaker than most had expected. The bank’s revenue growth was 8%, on the surface a strong number, however, this was almost entirely due to recent acquisitions, and adjusted EPS growth of negative 1% could be the weakest number we see among the Canadian banks this quarter. Provisioning also shot up 63% year over year, to CAD 873 million. This was due to multiple factors, including the fact that Scotiabank made an international acquisition, which would naturally cause outsize growth in this metric. Management does expect this growth in provisioning to subside, and they say the bank is getting paid a proper return to take on this additional risk, but it does highlight that investors are going along with management’s bet on certain areas of South America and Mexico during a potentially tricky time for many parts of the continent. Further, Scotiabank remains in the middle of multiple acquisition integrations which will continue to dilute earnings over the medium term, and it will be squarely on the bank to prove that the higher prices paid for some of these acquisitions were justified as results play out, mostly in 2020. Management stated that they are seeing increases in market share from the BBVA Chile acquisition, and that customer retention rates have improved for their wealth-related acquisitions, although we would highlight the stories here are only just beginning to play out. Current results do not fundamentally alter our long-term outlook for the bank, and we do not plan any material changes to our fair value estimate of CAD 77 (USD 58) per share.

The Canadian banking segment saw positive operating leverage on revenue growth of 5%, although provisioning did shoot up 23%. Management highlighted that much of the movements were from the forward-looking macro projection inputs that go into the credit loss model under the IFRS 9 regime, which affect their auto and credit card portfolios the most. Delinquency rates were essentially steady for the Canadian portfolio, and management claim to be sticking with A and B level borrowers. If the underlying strength of the portfolios remain sound, we would expect much slower growth in PCLs for this unit as the macro inputs stay more constant. Delinquency rates actually have been improving for the international segment, and the adjusted PCL ratio was still generally with the range we have seen over the last year. Again, this will be an area to watch, as some of the volatility from acquisitions fades away. The global banking and markets segment recovered from a tough market environment in first quarter, however, year over revenue was still only flat. This unit has also seen elevated expense levels due primarily to regulatory and growth-related investments. We will be looking for this segment to produce the growth that management is investing for, as the productivity ratio is currently moving in the wrong direction. On the plus side, Scotiabank remains one of the least exposed among peers to the Canadian real estate market as well as slowing growth in Canada overall, trading that in for exposure to emerging markets instead. If management is indeed right about the futures of the countries they are targeting, it could be a positive as the housing market and slowing overall growth play out in Canada.