Canadian Western Bank Stock Report

Canadian Western Bank Group

The Graph of revenue (the red line) for Canadian Western Bank shows impressive historical growth but with only modest growth in the past several.  Adjusted earnings per share (the purple line) have been flat to down in the past three fiscal years but turned positive in 2017. In the period shown, the adjusted earnings per share have risen a compounded average of 5.6% per year and the book value per share had increased at an average of 10.3% per year. The blue GAAP earnings line is distorted by a large special gain in 2015, the adjusted earnings line is more representative of the trend which has recently turned quite positive after a period of weaknesses due to loan losses in the energy sector. (Note that the apparent flat book value per share in 2017 is not correct and is due to the fact that we use the average number of shares, which is correct for earnings but which very occasionally distorts the book value per share which should use the end of period number of shares. Because CWB issued shares near the end of 2016 our book value per share for end of 2016 is biased high.)

Canadian Western Bank (CWB, Toronto)
RESEARCH SUMMARY
Report Author(s): InvestorsFriend Inc. Analyst(s)
Author(s)’ disclosure of share ownership:  Author(s) hold shares
Based on financials from: Oct. ’17 Y.E.
Last updated: 20-Jan-18
Share Price At Date of Last Update:  $                             40.55
Currency: $ Canadian
Generic Rating (This rating does not consider the circumstances of any individual investor and is therefore not specific advice for any individual): Buy at $40.55
SUMMARY AND RATING: This cell attempts to summarize information from other cells in this report and the graph. Based on the graph this has been a  “Great Company” (historically able to grow earnings and revenues per share reasonably steadily at attractive rates -although this has not been the case for earnings in the past three years). Importantly this is a company that can probably be safely predicted to grow its earnings per share in the long term. Its economics are good although, like all banks, they rely on high leverage. At a recent price of $40.55 the  value ratios  indicate it is a strong company and could be rated a Buy. The recent earnings growth is quite strong. The near-term outlook is for continued positive earnings growth assisted by higher interest rates and the recovering Alberta economy although loan losses could lead to an earnings decline. Longer term growth should continue. Management seems very strong. The industry structure is moderately attractive. CWB does not appear to have any very strong competitive advantage but may have some advantages in its chosen field of commercial lending. As a bank incumbent, it has the advantage of an established sticky customer base.  Liquidity is reasonable by bank standards but is still low on an absolute basis. (All banks are highly leveraged which means solvency can be threatened in adverse conditions, common equity can evaporate quickly due to losses in extreme situations.) The insider trading signal is somewhat negative. In general,  CWB would NOT be considered highly Speculative but its high leverage and the possibility of high loan losses arguably makes it somewhat speculative.  In summary this is a simple business with good long-term economics that is well managed and that is selling at what appears to be selling at a reasonable price but where there are risks. Overall, we rate CWB a  Buy.
DESCRIPTION OF BUSINESS:  Updated March 2017. A western Canada regional bank with 42 branches and with some associated lines of business. Mostly a commercial lender. A traditional “spread” lender, it simply takes in/ holds deposits and lends them out at a higher rate.   Total staff about 2000. The bank operation  has 42 branches in western Canada with. Related businesses include: Trust operations with two locations: A mutual fund advisor business and an employee investment management operation: A small-ticket leasing operation. 89% of revenues are from the net interest income on lending.  Loans are 36% Alberta, 35% BC, 16% Ontario, 6% Saskatchewan, 3% Manitoba and 4% other. The Bank loan book is only 19% personal mortgages and loans and much of that represents Alternative mortgages sourced through a broker network and there is no material exposure to unsecured personal loans such as credit cards, 25% general commercial loans, 19% commercial mortgages, 19% equipment financing, 19% real estate projects, 1% oil and gas production loans. Deposits are 37% sourced from in-branch regular accounts and 18% in-branch term deposits (total 55% in-branch) and 36% retail term deposits sourced from the (higher interest cost) third party broker network and 9% from deposit bonds sold to investors. Deposits are 63% personal and 37% commercial or investor. 55% of the deposits are term deposits meaning they can’t be withdrawn on short notice. Trust and Wealth management constitute only 4% of revenues but would be higher than that in terms of profit contribution.
ECONOMICS OF THE BUSINESS: (updated for fiscal 2016 and Q1 2017) Pure spread lending, and not counting associated fees,  constitutes about 89% of revenue. In this business the bank takes in deposits at a weighted average interest of 1.70% and lends out money at an average of 4.06% (2016). The net interest spread was most recently about 2.4%. This spread has fallen as market interest rates drop but 0% interest deposits cannot decline any further. The 2.4% gross profit is then reduced by the banks operating costs. The net interest after operating costs and income taxes is about 0.8% of assets. With such a thin margin it becomes very important to avoid defaulting loans and where defaults occur to have security so that at least some amount is recovered. CWB’s allowance for bad debt has run at about 20 basis points but was 38 basis points in 2016. The 0.8% net profit on assets is then leveraged up by the fact that the loan assets are financed with only about 8.5% common equity (they are mostly financed with deposits) This results in an ROE of about 10% (lower than recent years due to higher loan losses).  Banking is attractive when loan losses are low because customers tend to be quite sticky. Banks make money literally every day as interest accrues.
RISKS: Banks have very high total debt levels (including deposits) and there is a large potential for losses if poorly managed. Larger banks have technology and scale advantages. The high leverage means that a small decline in revenues or a small increase in bad debt can chew through earnings very fast. There is a major risk of loan losses if the economy turns unexpectedly bad and the value of equipment securing the loans may plummet in that environment.  As well, being (mostly) a regional bank CWB can not manage its risk as well as the larger banks through geographical diversification. There can be interest rate movement risks, although these are substantially (but not entirely) hedged against. However, the company has been profitable every quarter for some 28 years. The internet may make banking a more commodity product and lead to (permanently) lower returns on equity. See annual report for more risks.
INSIDER TRADING:  Checking “transactions in the public market” from August 1, 2017 to January 15, 2018: An insider exercised 1865 options in December and then sold only 500 of these at $37.91. Another exercised about 1500 options in September and December and sold essentially all of the shares in December at $38.13. A third exercised 513 options in September and sold 400 shares at $38.04 in December. A fourth insider did a similar action selling 1500 shares in December at $37.85. A fifth exercised options and sold 4358 shares in December at $39.11. A sixth had exercised 2156 options in September and mostly December and sold 759 in January at $39.73 and then another 750 at $40. A seventh bought 500 shares in September in his RRSP at $32.27. Notably the CEO and the CFO exercised options and did not sell, a couple of others did this as well. In addition a number of insiders were buying “under a plan” but that usually is done without regard to price and so offers no signal.  Overall, the insider trading signal is moderately negative. A few insiders own very significant amounts, which is positive.
WARREN BUFFETT’s CRITERIA: Buffett indicates that all investments must pass four key tests: the business is  simple to understand (Pass, it is a simple bank although loan losses can appear suddenly), has favorable long-term economics due to cost advantages or superior brand power (marginal pass, as a small bank unlikely to have cost advantage, product is a commodity, but bank customers tend to be sticky and does have expertise in equipment and asset-backed lending), apparently able and trustworthy management (pass, the management has a strong track record and reputation), a sensible price – below its intrinsic value (pass, appears to be under-priced), Other criteria that have been attributed to Buffett include: a low  debt ratio (unclear, while it has low debt as such, it has the high leverage characteristic of all banks), good recent profit history (pass) little chance of permanent loss of the investors capital (pass, could lose if loan losses were high but would likely recover in the long run) a low level of maintenance type capital spending required to maintain existing operations excluding growth (pass). Buffett looks for companies that can be counted on to grow over the long term. This bank appears to qualify.
MOST RECENT EARNINGS TREND: See graph for the longer term trend. The adjusted earnings per share growth in the last four quarters starting with the most recent, Q4, 2017, was positive 17%, positive 16%, positive 43% (due to high loan losses in prior year) and minus 12%.  Revenue per share growth in the most recent four quarters, starting with the most recent, was positive 15% (boosted by a sale of part of its Trust business) positive 3%, minus 3%, and plus 1%. 2017 overall had 13% adjusted earnings per share growth,  2016 overall had minus 15% “growth” in adjusted earnings per share.  2015 overall had about a 2% growth in adjusted earnings per share.   The calculation of the growth in earnings per share since 2013 is complicated by a divestiture as some analysts would take the divested business out of past years. Overall the most recent trend is quite positive.
INDUSTRY SPECIFIC STATISTICS: As of Q4 2017: Provisions for loan losses had increased very substantially in 2016 but improved in the latest four quarters. Provisions for loan losses in Q3 and Q4 2017 at 20 basis points have returned to low levels.  Loan growth was up only 4% in Q3 year over year but was up 6% year in fiscal 2017. Loan growth grew 13% in fiscal 2016. Branch-raised deposits up 12% in 2016. Net interest margin declined to 2.36% in Q4 2016 but improved to 2.64 as of Q4 2017. Year over year deposit growth as of Q4 was 3%.
Earnings Growth Scenario and Justifiable P/E: This company currently pays out about 37% of earnings as a dividend but targets 30%. If it grows at 8% per year, for ten years, and then slows to 4% with a 50% dividend, we calculate we can justify paying a P/E of 22. This assumes we target (or require based competing investments) to make 6.5% on our money. The recent P/E of about 15.7 requires relatively modest growth to justify itself.
VALUE AND GROWTH RATIOS: Based on a share price of $40.55.The price to book value ratio seems reasonable at 1.64 (Price to tangible book is also reasonable at 1.77). The trailing adjusted P/E is moderately attractive at 15.7. Compounded fiscal five year growth in adjusted earnings per fully diluted share is relatively low at 4.3% due to relatively unchanged earnings in ’14 and ’15 and the 15% decline in fiscal 2016. Five year fiscal growth in revenue per fully diluted share was relatively modest at 4.2%. The dividend yield is modest at 2.4% and this reflects a pay-out ratio of 37% of adjusted earnings. Adjusted ROE is good but not great at 10.7% for the latest four quarters. Intrinsic value per share is calculated as $35.85 assuming 5% average annual growth for 5 years  and a terminal P/E  of 13 and more optimistically calculated as $48.62 assuming 9% growth for 5 years and a terminal P/E of 15 . These ratios in isolation, focusing on the higher end of the growth scenario, would indicate a Buy rating.
SUPPORTING RESEARCH AND ANALYSIS  
Symbol and Exchange: CWB, Toronto
Currency: $ Canadian
Contact: investorrelations@cwbank.com
Web-site: www.cwbank.com
INCOME AND PRICE / EARNINGS RATIO ANALYSIS  
Latest four quarters annual sales $ millions: $726.6
Latest four quarters annual earnings $ millions: $214.3
P/E ratio based on latest four quarters earnings: 16.8
Latest four quarters annual earnings, adjusted, $ millions: $228.5
BASIS OR SOURCE OF ADJUSTED EARNINGS: We have adjusted for certain unusual items identified in the earnings reports. To be conservative we have deducted gains on sales of securities (and more recently added back losses on securities)
Quality of Earnings Measurement and Persistence: Earnings Measurement is not entirely reliable since it is based on estimates of loan losses. Earnings could go sharply lower in future if credit losses were to widen, such as due to low oil prices and recession.
P/E ratio based on latest four quarters earnings, adjusted 15.7
Latest fiscal year annual earnings: $214.3
P/E ratio based on latest fiscal year earnings: 16.8
Fiscal earnings adjusted: $228.5
P/E ratio for fiscal earnings adjusted: 15.7
Latest four quarters profit as percent of sales 31.4%
Dividend Yield: 2.4%
Price / Sales Ratio 4.94
BALANCE SHEET ITEMS  
Price to (diluted) book value ratio:                                         1.64
Balance Sheet: (Updated Q1, 2017 Canadian Western Bank’s balance sheet is highly leveraged, which is typical of banks. Assets are comprised as follows: Loans owed by customers 88%, securities 8% (largely debt issued by Canada, then debt issued by provinces and a modest amount of corporate bonds and corporate preferred shares) Other assets including receivables, goodwill and property total 2% and Cash 2%. On the liability and Equity side of the balance sheet these assets are funded as follows:  Customer deposits 83%, Debt 5%, Other 2%, Preferred equity 1%, Common Equity 8%. Overall, the balance sheet is typical for a “community” bank but could still be considered to be somewhat weak given the leverage. It also reflects an almost pure lending operation given the very high percentages for loans and deposits.
Quality of Net Assets and Book Value Measurement: The reported assets and liabilities should be quite reliable. Bank assets are mostly very liquid (i.e. compared to investments in fixed assets) and therefore should be close to market values. However, banks operate with exceedingly high leverage, therefore the reported book value could be eaten up very quickly if there were ever abnormally high  loan losses.
Number of Diluted common shares in millions:                                  88.8
Controlling Shareholder: No one can control more than 10% by law.
Market Equity Capitalization (Value) $ millions: $3,600.2
Percentage of assets supported by common equity: (remainder is debt or other liabilities) 8.3%
Interest-bearing debt as a percentage of common equity 67%
Current assets / current liabilities: not available
Liquidity and capital structure: Very high debt level (including deposits due to customers) which is typical for banks. This is off-set by the very liquid nature of the assets (easily converted to cash if needed). A low debt ratio if we exclude deposits from the debt calculation. Their common equity to asset ratio recently was rather low in absolute terms  at about 8.3%. However, this is actually reasonably good by bank standards. Tier 1 capital ratio – common equity plus preferred equity plus certain debt issues (Tier 1 is designed to protect depositors not common share holders) is reasonable and even high by banking industry standards  at 10.8% as of October 31, 2017.
RETURN ON EQUITY AND ON MARKET VALUE  
Latest four quarters adjusted (if applicable) net income return on average equity: 10.7%
Latest fiscal year adjusted (if applicable) net income return on average equity: 10.7%
Adjusted (if applicable) latest four quarters return on market capitalization: 6.3%
GROWTH RATIOS, OUTLOOK and CALCULATED INTRINSIC VALUE PER SHARE  
5 years compounded growth in sales/share 4.2%
Volatility of sales growth per share:  strong reasonably steady growth
5 years compounded growth in earnings/share 1.7%
5 years compounded growth in adjusted earnings per share 4.3%
Volatility of earnings growth:  strong reasonably steady growth
Projected current year earnings $millions: not available
Management projected price to earnings ratio: not available
Over the last ten years, has this been a truly excellent company exhibiting strong and steady growth in revenues per share and in earnings per share? Yes
Expected growth in EPS based on adjusted fiscal Return on equity times percent of earnings retained: 6.7%
More conservative estimate of compounded growth in earnings per share over the forecast period: 5.0%
More optimistic estimate of compounded growth in earnings per share over the forecast period: 9.0%
OUTLOOK FOR BUSINESS: The short-term could see increased earnings as Alberta recovers from its recent recession. Net interest margin has begun to improve as interest rates increase. Impaired loans may continue to show some increase in the short term and there is a risk these could be larger than expected leading to higher provisions for credit losses. Management expects actual loan write-offs to remain modest. The long term outlook for growth seems good.  Longer term, internet banking seems like a commodity business and could definitely erode profit margins. Products that lead to customer stickiness like chequing accounts, investment accounts, in-branch services are likely to remain high profit.
LONG TERM PREDICTABILITY: This bank does seem to offer long-term predictability. It has been growing for many years and it seems reasonable to predict that it will continue to do so and on a profitable basis. Beginning around fiscal 2019 it may increase profits though higher leverage when it is allowed to calculate its risk-weighted assets on a less conservative basis similar to the larger banks.
Estimated present value per share: $35.85 if earnings per diluted share grow for 5 years at the more conservative rate of 5% and the shares can be sold at a P/E of 13 after five years. And $48.63 if earnings per share grow at the more optimistic rate of 9% compounded for 5 years and the shares can then be sold at a P/E of 15. (This is not a share price prediction) Both estimates use a 6.5% required rate of return.
ADDITIONAL COMMENTS  
INDUSTRY ATTRACTIVENESS: (These comments reflect the industry and the company’s particular incumbent position within that industry segment.) Michael Porter of Harvard argues that attractive industries are those that are relatively protected from competition based on 5 key tests or forces. The banking industry has relatively strong barriers to entry in terms of regulations, scale, technology, brand and access to attractive locations. However this is less so as more of the business is handled by brokers and by internet business (marginal pass). Not subject to powerful customers or suppliers who could usurp industry profits (pass and pass). No substitute product (pass) and not usually prone to excessive levels of competition but again this is changing with increased role of brokers and pure internet banking (marginal pass) will likely grow faster than the economy in general. It can benefit from increased computerization. In this industry it is possible to leverage existing assets and grow without a proportional increase in fixed assets. Overall we rate this as a moderately attractive industry for an established incumbent.
COMPETITIVE ADVANTAGE: Strong conservative management with a focus on cost control, asset backed lending, and a focus on the core business of lending money at an interest spread above the cost of funds.  This regional bank has an appeal to a certain segment of the population and to a certain segment of corporations.  Overall in banking it is unlikely to have cost advantages due to its smaller size. Bank customers do tend to be “sticky” which is positive.
COMPETITIVE POSITION: This Bank had a net interest margin of 2.56% in 2017.  (And 2.64 in Q4, 2017) This is higher than the average spread for the big Canadian banks which were at 2.27% in 2015.   However it achieves this by charging a higher average interest rate and has a higher average deposit rate cost. It has had the advantage of operating primarily in the Western Canada economy which had been strong but which is now a disadvantage due to  the decline in oil and gas prices. Has targeted commercial real estate including mortgages and  equipment lending and probably has more expertise in those areas. Competes mostly as a traditional branch based bank and attracts a certain segment of the corporate and retail population that prefers a smaller regional bank. Seems to be well run but it’s not clear that is has any strong competitive advantage other than being well managed. Could be vulnerable to all-internet banks that have lower costs of operation. It is a cliché to claim that your employees are the best but CWB does appear to have excellent programs to attract and train good staff. They promote from within.
RECENT EVENTS: The bank continues to grow Ontario as a percentage of its loans (which were 16% at the end of fiscal 2016 and rose to 19% at the end of fiscal 2017). The proportion of deposits raised in branch is increasing which decreases the reliance on the deposit broker channel.  Impaired loans increased noticeably (32%) in the year ending October 2017. Continues with the implementation of a new banking computer system. It has recently gained more ability to securitise residential mortgages.
ACCOUNTING AND DISCLOSURE ISSUES: The disclosure detail is very good. The Banking industry standard reporting is much more comprehensive and standardized compared to reporting required by non-bank GAAP and the stock exchanges. Focuses on diluted earnings per share, which is more conservative than is the usual practice of looking at basic EPS. However by nature, banking industry profits are uncertain since they depend on estimating bad loan debt expenses and the estimate can be vastly under-stated when recession conditions arise suddenly. The Q3 2016 report noted the lower impaired loans without emphasising that this was due to write-off of based debt, that aspect of the disclosure seemed a bit weak. This was continued in Q1 2017 where loans that were likely written off were described as being “resolved”. Furthermore, in Q4 2017 they failed to deduct a gain on selling part of their Trust business in calculating adjusted earnings.
COMMON SHARE STRUCTURE USED: Normal common shares, 1 vote per share. Ownership currently limited to 10% but the company expects this restriction may be removed for smaller banks.
MANAGEMENT QUALITY:   Management has a reputation for being capable and conservative. Management seems quite strong to have achieved this performance despite the small size of the bank. Management seems to be focused on shareholder value.
Capital Allocation Skills: Management appears to have made reasonably good choices in investing its capital and in its financing. It has made a number of acquisitions over the years which have worked out well. It targets a dividend of about 30% of earnings which is reasonable although it may have been wiser, in theory, to have retained those earnings. The share count has increased by 38% in the ten years ended in October 2017. This was largely due to the use of convertible debt and other options and warrants but also a recent share issue at a low price. In retrospect it might have been better to avoid the increase in the share count. The bank has obtained approvals for share buybacks on occasion but it appears that they bought back few or no shares. (The difficulty perhaps being that times of very low share prices coincide with times of risk when capital must be preserved).
EXECUTIVE COMPENSATION: Compensation appears reasonable and not excessive. 2016 compensation was $2.3 million for the CEO, and just under $1 million for the other four named executives. By today’s standards this is not unreasonably high.
BOARD OF DIRECTORS: (updated from Winter 2017 proxy circular) 12 members with about half long standing and others quite recent. They are well qualified with extensive experience in banking and the investment management industry and some with experience in the heavy equipment business  and real estate business (both key customer groups for the bank). It is comforting to note that the majority of Board members have shown their personal confidence by holding a substantial number of shares. (however, this signal is diluted because the bank requires them to own shares).  Board compensation is not excessive at roughly $130k. Board members appear to be wealthy enough that they would not be overly beholden to the bank (they can act independently because the Board retainer is not a very “big deal” financially for them).
Basis and Limitations of Analysis: The following applies to all the companies rated. Conclusions are based largely on achieved earnings, balance sheet strength, earnings growth trend and industry attractiveness. We undertake a relatively detailed  analysis of the published financial statements including growth per share trends and our general view of the industry attractiveness and the company’s growth prospects. Despite this diligence our analysis is subject to limitations including the following examples. We have not met with management or discussed the long term earnings growth prospects with management. We have not reviewed all press releases. We typically have no special expertise or knowledge of the industry.
DISCLAIMER: All stock ratings presented are “generic” in nature and do not take into account the unique circumstances and risk tolerance and risk capacity of any individual. The information presented is not a recommendation for any individual to buy or sell any security. The authors are not registered investment advisors and the information presented is not to be considered investment advice to any individual. The reader should consult a registered investment advisor or registered dealer prior to making any investment decision. For ease of writing style the newsletter and articles are often written in the first person. But, legally speaking, all information and opinions are provided by InvestorsFriend Inc. and not by the authors as individuals. The author(s) of this report may have a position, as disclosed in each report. The authors’ positions may subsequently change without notice.
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