Via SeekingAlpha.com

Introduction

The financial sector will undoubtedly be hit hard by the COVID-19 outbreak and I have been trying to look for banks that are trading cheap and could be added to a long-term portfolio. Canadian banks have had to deal with several problems that surfaced at the same time: COVID-19, an overheating residential real estate market and low oil prices that will see some banks have a tough time collecting loans in the energy sector. As the National Bank of Canada (OTCPK:NTIOF) (OTC:NTIFF) finished its Q2 at the end of April, its financial results offer a bit more insight as there was an additional month of data compared to other banks which reported their Q1 results.

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National Bank of Canada is a large Canadian bank with a current market capitalization of almost C$20B. The bank has an average daily volume of just over 15,000 shares on its OTC listing but its Canadian listing is obviously more liquid with an average daily volume exceeding 2.3M shares. As the company reports its financial results in CAD and is trading in CAD on its primary listing, I will use the Canadian Dollar as the base currency in this article.

The second quarter was tough for National Bank

In the second quarter of the year, National Bank saw its net interest income come in at C$1.1B, not because its gross interest income increased (it actually decreased by approximately 1.5M) but due to a sharp drop in the interest expenses, which fell by almost 15%. Although the amount of deposits increased to in excess of C$200B, the interest expenses dropped from C$831M to C$711M. Additionally, National Bank generated a much higher fee income: up to C$931M compared to C$828M in the second quarter of FY 2019.

Source: financial results

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This caused the total banking revenue to increase from C$1.77B to C$2.04B. Of course, the operating expenses also increased but even after deducting the C$1.12B in expenses, National Bank’s Q2 performance indicates a pre-impairment income of around C$915M, up from the C$744M generated in Q2 2019.

This allowed National Bank to record a substantial increase in the loan loss provisions (C$504M compared to just C$89M in the first quarter of this year and C$84M in Q2 FY 2019) while still writing black numbers with a net income of C$379M. C$29M was paid as dividends to preferred shareholders, leaving C$339M or C$1.01/share on the table for the common shareholders.

Source: financial statements

On a normalized basis (using a C$100M allowance for credit losses and a normalized tax rate of 18%, National Bank would have been able to report a net income of C$669M of which roughly C$640M would be attributable to the common shareholders for an EPS of C$1.9.

Source: company presentation

We shouldn’t be too worried about the CET1 ratio

As of the end of April, National Bank had a total CET1 ratio of 11.2% on an adjusted basis (the adjustment consists of not applying the transitional measure applicable to expected credit losses, including these transitional measures, the CET1 ratio would have been approximately 11.4%) based on a total CET1 capital of C$10.37B on a total amount of C$92.8M in risk-weighted assets.

Source: Financial report

If we would use the 11.2% as a base case, National Bank did lose approximately 0.5% of its CET1 ratio compared to the situation as of the end of its financial year in October 2019. The lower CET1 ratio was caused by a substantial increase of the RWA (up more than 10%) while the CET1 capital increased by just 7%.

Despite this, we shouldn’t be too worried about National Bank’s CET1 ratio as the bank still handsomely meets the minimum requirement of the Canadian Regulatory organ, the OSFI.

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Source: Financial report

As you can see in the image above, National Bank is required to maintain a CET1 ratio of 9% which requires a CET1 capital of approximately C$8.35B based on the C$92.76B in risk-weighted assets. The current CET1 capital of C$10.37B exceeds this by just over C$2B. In other words, National Bank will be able to absorb a one-time credit loss of C$2B before it no longer meets the CET1 criteria.

It will be important for National Bank to ensure the credit loss provisions will be in line with its pre-impairment income. That would indicate it can stabilize its CET1 ratio above 11% whereby the banking income absorbs loan losses without putting the balance sheet into jeopardy.

It is however interesting to see the North American banks continue to pay dividends. Whereas the European Central Bank has urged banks to suspend dividend payments until it becomes clear what the impact of the COVID-19 pandemic will be on the balance sheets, the North American banks are continuing to pay dividends.

Source: Company presentation

National Bank announced a C$0.71 quarterly dividend which brings the annualized dividend at C$2.84 for a dividend yield of almost exactly 5% based on a C$57 share price. That’s great for shareholders relying on the dividend income but let’s not forget that every quarterly dividend has a negative impact of 0.26% on the CET1 ratio. While there is currently no real need to skip a dividend, it would be the easiest option to quickly bolster the balance sheet. In National Bank’s case, offering shareholders the option to take their dividends in new stock (on top of the DRIP program which isn’t open to non-Canadian investors) could further help to boost the capital while issuing the new shares at a substantial premium to the book value.

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Source: Company presentation

Investment thesis

National Bank of Canada isn’t very attractive from a fundamental investor’s point of view as the share price is trading at in excess of 1.5 times the book value, the 5% dividend yield may be attractive enough for dividend-focused investors to gain and/or increase exposure to this bank. That being said, dividend investors may be even more interested in the preferred shares of National Bank, but that’s not the focus of this article.

It’s interesting to see the bank has rapidly reduced its exposure to the oil and gas sector which should help to protect the balance sheet and it’s interesting to see National Bank’s normalized EPS (applying a normal credit loss provision) would result in a full-year EPS of around C$7.5 indicating National Bank is trading at just 8 times its normalized underlying income. And that could be a good argument to overlook the 50% premium on the book value National Bank is currently trading at as the bank is hugely profitable in normal circumstances.

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Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.