Canadian Western Bank Stock Report

Canadian Western Bank Group

 

The Graph of revenue (the red line) for Canadian Western Bank shows impressive historical growth with, however, only modest growth in 2015 and 2016 but a recovery in growth more recently.  Adjusted earnings per share (the purple line) had been flat to down in 2014, 2015 and 2016 but turned positive in 2017 and more so in the first half of 2018. In the period shown, the adjusted earnings per share have risen a compounded average of 6.3% per year and the book value per share had increased at an average of 10.0% 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. + Q2 ’18
Last updated: 09-Jun-18
Share Price At Date of Last Update:  $                             37.05
Currency: $ Canadian
Generic Rating (This rating does not consider the circumstances of any individual investor and is therefore not specific advice for any individual): (higher) Buy at $37.05
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 was not the case for earnings in 2014, 2015 or 2016). 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 $37.05 the  value ratios  indicate it is a strong company and could be rated a (higher) 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. This bank has decided to focus even more heavily on serving businesses and their owners and therefore could divest some retail operations (Alternative mortgages and online savings accounts) Longer term growth should continue. Management seems very strong. The industry structure is moderately attractive for this smaller incumbent. 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 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. Overall, we rate CWB a  (higher) Buy.
LONG TERM VALUE CREATIO: CWB has been a reliable creator of long term value for share owners. This demonstrated by retained earnings (after paying dividends) of $1568 million compared to common equity invested (after deducting the portion of dividends that were return of capita) of $741 million. The value creation is also reflected in the price to book value of 1.46. It is also demonstrated by the 650% or 11.#% annual compounded gain since InvestorsFriend first featured this stock rating it a Strong Buy in August of 1999.
DESCRIPTION OF BUSINESS:  Updated June 2018. A (still mostly) western Canada regional bank with 42 branches (plus a new virtual branch) and with some associated lines of business. It has always been mostly a commercial lender and recently has sharpened its focus on serving business owners but including their personal banking needs. A traditional “spread” lender, it simply takes in/ holds deposits and lends them out at a higher rate.  Total staff about 2100. Related businesses include: Trust operations with two locations: A mutual fund advisor business and a wealth management operation: A national small-ticket leasing operation and a national franchise lending operation . About 90% of revenues are from the net interest income on lending.  Loans are now 34% British Columbia, 32% Alberta, 21% Ontario, 5% Saskatchewan, 2% Manitoba and 2% 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 61% personal, 29% commercial/government and 9% investor deposit notes on the capital markets. 65% of the deposits are term deposits meaning they can’t be withdrawn on short notice. There are no “high interest savings account” deposits of the type that fled Home Capital in 2017. 36% of deposits are raised from deposit brokers. 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 2017 and Q2 2018) Pure spread lending, and not even counting associated fees,  constitutes about 90% of revenue. In this business the bank takes in deposits at a weighted average interest of 1.69% and lends out money at an average of 4.45% (2017). The net interest spread was most recently about 2.6%. The 2.6% gross profit is then reduced by the banks operating costs. The net profit after operating costs and income taxes is only about 0.9% 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 but has now returned to about 0.20%. The 0.9% net profit on assets is then leveraged up by the fact that the loan assets are financed with only about 8.0% common equity (they are mostly financed with deposits) This results in an ROE of about 11.5% recently.  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 December 1, 2017 to June 10, 2018: About a dozed insiders sold shares mostly in December and January at prices around $38 to $40. Often this was in association of exercising options. The Board chair bought 1250 at $33 in April. In addition most of these same insiders and others 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 although less so with the price at $37 as opposed to $40. 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, Q2, 2018, was 25%, 19%, 17%, and 16% (the increases partly due to due to higher loan losses in prior year).  Revenue per share growth in the most recent four quarters, starting with the most recent, was 13%, 9%, 15% (boosted by a sale of part of its Trust business that counts as revenue) and 3%. 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 has turned very positive.
INDUSTRY SPECIFIC STATISTICS: Provisions for loan losses had increased very substantially in 2016 but improved in the latest six quarters. Provisions for loan losses in at about 20 basis points in each of the past four quarters have returned to low levels.  Year over year loan growth was up 12% in Q2 ’18 and 11% in Q1. Loan growth was up only 4% in Q3 ’17 year over year but was up 6% year in fiscal 2017. Loan growth grew 13% in fiscal 2016. Net interest margin declined to 2.36% in Q4 2016 but improved to 2.64 as of Q4 2017 and was 2.61% as of Q2 ’18. Year over year deposit growth as of Q2 ’18 was 12%.
Earnings Growth Scenario and Justifiable P/E: This company currently pays out about 35% of earnings as a dividend but targets 30%. The recent P/E of about 13 requires relatively modest growth of under 5% annually to justify itself.
VALUE AND GROWTH RATIOS: Based on a share price of $37.05. The price to book value ratio seems attractive at 1.46 (Price to tangible book is also reasonable at 1.55). The trailing adjusted P/E is attractive at 13.0. 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. Earnings per share growth in the past 12 months is about 20%. 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 11.5% for the latest four quarters but has been improving and is targeted at 12 to 15%. Intrinsic value per share is calculated as $38.34 assuming modest 5% average annual growth for 5 years  and a terminal P/E  of 13 and more optimistically calculated as $52.05 assuming 9% growth for 5 years and a terminal P/E of 15 . These ratios in isolation would indicate a (higher) 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: $768.8
Latest four quarters annual earnings $ millions: $239.5
P/E ratio based on latest four quarters earnings: 13.7
Latest four quarters annual earnings, adjusted, $ millions: $252.6
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. However, in the absence of material loan losses, the earnings are extremely persistent and not volatile.
P/E ratio based on latest four quarters earnings, adjusted 13.0
Latest fiscal year annual earnings: $214.3
P/E ratio based on latest fiscal year earnings: 15.4
Fiscal earnings adjusted: $228.5
P/E ratio for fiscal earnings adjusted: 14.4
Latest four quarters profit as percent of sales 32.9%
Dividend Yield: 2.7%
Price / Sales Ratio 4.28
BALANCE SHEET ITEMS  
Price to (diluted) book value ratio:                                         1.46
Balance Sheet: (Updated Q4, 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 9% (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 1%. 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 that is typical of banks. 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:                                  89.2
Controlling Shareholder: No one can control more than 10% by law.
Market Equity Capitalization (Value) $ millions: $3,305.7
Percentage of assets supported by common equity: (remainder is debt or other liabilities) 8.0%
Interest-bearing debt as a percentage of common equity 11%
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 very 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 8.0%. 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 10.6% as of April 30, 2018.
RETURN ON EQUITY AND ON MARKET VALUE  
Latest four quarters adjusted (if applicable) net income return on average equity: 11.5%
Latest fiscal year adjusted (if applicable) net income return on average equity: 10.7%
Adjusted (if applicable) latest four quarters return on market capitalization: 7.6%
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: 6.9%
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 remainder of fiscal 2018 should see double digit growth based on recent trends. Given the new much sharper focus on serving business owners it would not be surprising if CWB disposed of its retail-focused business which are its alternative mortgage business (Optimum mortgage) and its retail online bank (Motive Financial) and even perhaps (but less likely) its wealth management business. Given its desire to meet the personal banking needs of its business owner clients and given the difficulty of doing so on a small customer base we would expect to see it provide more services through affiliations with larger banks which is how it currently offers credit cards. 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: $38.34 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 $52.05 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 7.0% 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 this established but smaller 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 an average 2.14% in 2017.   However it achieves this by charging a higher average interest rate and has a higher average deposit rate cost. 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 business owners 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 has recently decided that it will focus almost exclusively on serving business owners but including the personal banking needs of those business owners. The bank continues to very significantly 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 and (with a acquisition of a loan portfolio) to 21% as of Q2 2018). The proportion of deposits raised in branch is generally increasing most quarters which decreases the reliance on the deposit broker channel.  Impaired loans increased noticeably (32%) in the year ending October 2017 but has decreased modestly as of Q2 2018. Has implemented a new banking computer system. It has recently gained more ability to securitise residential mortgages. It created a virtual branch to remotely serve customers in areas where it does not have branches such as Ontario.
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. In general, accounting rules create a few oddities in the accounting such as the requirement to maintain on balance sheet securitised loans that have actually been sold but this does not have a material impact on the figures.
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. 2017 compensation was $2.8 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 2018 proxy circular) 12 members with about half long standing and others relatively 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 $150k. 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, achieved earnings per share 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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