Earnings of The Bank of Nova Scotia (BNS) plunged to C$1.0 per share in the April-ending quarter, down 46% from the first quarter of 2020. A hike in provision expense amid the COVID-19 pandemic was the major cause for the earnings decline. Earnings will likely remain low in the remainder of the year because provision expense will most probably remain elevated. Moreover, the net interest margin will contract further in the July-ending quarter due to interest rate cuts in Canada and other countries of operation. On the other hand, continued loan growth will likely support earnings. Overall, I’m expecting BNS’s earnings to decline by 24% year-over-year to C$5.07 per share (US$3.76 per share) in 2020. The probability of an earnings surprise is high in the year ahead because the provision expense is difficult to predict in the current uncertain economic environment. The October 2020 target price suggests a high upside, but the stock price will likely remain subdued in the near-term until some of the uncertainty is cleared. Hence, I’m adopting a neutral rating on BNS.
Pandemic-Sensitive Industries, Oil and Gas, Credit Cards to Drive Provision Expense
BNS’s provision expense surged to C$1.8 billion in the second quarter ended July 2020, from C$0.9 billion in the first quarter. As mentioned in the second quarter’s conference call, the management expects the loan loss provisioning to remain above-normal for the rest of the year and the run rate of the second quarter to continue in the third quarter. I’m expecting BNS’s exposure to COVID-19 sensitive industries to drive provision expense in the last two quarters of the year. As mentioned in the second quarter’s investor presentation, high-impact industries, including office and retail real estate, air travel, and hospitality and leisure, made up around 3% of total loans as of April 30, 2020. Additionally, the oil and gas segment made up 1.7% of total loans. Moreover, credit cards made up 2.6% of total loans as of April 30, 2020. The high unemployment rates in Canada, the United States, and other countries of operation due to the lockdowns will deteriorate the credit quality of credit cards in the year ahead. Considering these factors and management’s guidance, I’m expecting the provision expense to increase to C$6.4 billion in 2020 from C$3.0 billion in 2019. The estimated provision expense for 2020 represents 98 basis points of total loans, versus 51 basis points of total loans in 2019.
Monetary Easing Across North and South America to Compress Margin
The 150 basis points interest rate cuts by the monetary authorities of Canada and the United States will likely compress net interest margin, NIM, in the third quarter. The policy rates in other operating countries, including Mexico, Peru, Chile, and Colombia, have also been slashed recently, as mentioned in the presentation. Further, the management expects high liquidity to suppress NIM in the year ahead, as mentioned in the conference call. Moreover, the management expects high competition to adversely affect NIM because all the peers will compete for the same business as the economy reopens.
However, hedges will offset some of the pressure on NIM from the interest rate decline. As mentioned in the conference call, the benefit from the hedges will get amortized over the next eight to ten quarters through the income statement. Due to the hedges, the sensitivity of the NIM is limited. The results of a simulation conducted by the management give an idea about NIM’s rate-sensitivity as of April 30, 2020. According to the results of the simulation, a 25 basis points interest rate cut can reduce net income by C$33 million. The following table from the second quarter’s shareholder’s report shows the sensitivity of the net income to interest rate changes.
Considering management’s guidance, I’m expecting NIM to decline by 11 basis points in the third quarter and by 18 basis points in the full year, as shown below.
BNS’s loans grew strongly in the second quarter, by 5.6% quarter-over-quarter, due to the high demand for relief loans. Loan growth will likely continue in the second half of the year due to the demand for relief loans and higher line utilization. I’m expecting the North American economies to start recovering in 2021; therefore, the demand for relief loans will likely remain high this year. Overall, I’m expecting the net loan balance to stand at C$641 billion on October 31, 2020, up 8.2% from the end of the fiscal year 2019. The following table shows my balance sheet estimates.
Expecting Earnings Decline of 24%
The expected surge in provision expense will be the chief contributor to an earnings decline this year. Moreover, the NIM compression will pressurize earnings in 2020. On the other hand, the demand for credit by cash-strapped corporations will likely support the bottom-line. Overall, I’m expecting earnings per share to decline by 24% year-over-year to C$5.07 in 2020 (US$ 3.76 using an exchange rate of C$1.35 per US$). The following table shows my income statement estimates.
The severity and duration of the COVID-19 pandemic are unknown, which makes forecasting of the provision expense difficult. Currently, I’m expecting economies in North and South America to start recovering in early to mid-2021 after a COVID-19 vaccine becomes widely available. If the impact of the pandemic exceeds my expectations, then provisions expense can surpass estimates. The risks and uncertainties will likely keep BNS’s stock price rangebound in the near-term of around three months.
Year-end Target Price Suggests 43% Upside
I’m using the historical price-to-book-value multiple, P/B, to value BNS. The stock has traded at an average P/B of 1.54 in the past, as shown below.
Multiplying the average P/B multiple with the forecast book value per share of US$39.7 gives a target price of US$61.1 for October 31, 2020. This price target gives an upside of 43% from BNS’s June 15 closing price. The following table shows the sensitivity of the target price to the P/B multiple.
Apart from the high upside, BNS is also offering a dividend yield of 6.3%. The dividend yield estimate is based on the expectation that the bank will maintain its quarterly dividend at C$0.90 per share in the remainder of the year, and that the exchange rate will remain at C$1.35 per US$. There is little threat to the dividend payout because the earnings and dividend estimates for the fiscal year 2020 suggest a payout ratio of 71%, which is manageable.
As discussed above, BNS currently has a high level of risk because the impact of COVID-19 on future provision expense is largely uncertain. The risks and uncertainties will likely keep the stock price rangebound in the near-term despite the attractive valuation and decent dividend yield. As a result, I’m adopting a neutral rating on BNS.
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Additional disclosure: Disclaimer: This article is not financial advice. Investors are expected to consider their investment objectives and constraints before investing in the stock(s) mentioned in the article.