The worst seems to be over for Canada in terms of COVID-19, but the economic impact is going to linger a while longer – there’s evidence of a recovery off the bottom, but indicators like the BMO Business Activity Index still show about a 20% gap from where the economy was prior to COVID-19. As a primarily commercial lender, the health of Canada’s economy is a direct concern for Canadian Western (OTCPK:CBWBF) (CWB.TO), and while economic activity should improve, I wouldn’t just assume the company is completely out of the woods with respect to credit.
I wasn’t excited about the prospects for Canadian Western back in December of 2019, but that was before COVID-19 whacked the entire sector. Canadian Western has done generally okay since then, and I like the recent progress on funding, but the valuation is not as appealing here as for many other banks around the world, and it’s still more of an “okay, I guess” idea for me than a compelling buy with the shares having nearly doubled from the late March lows.
Ongoing Growth Despite Economic Pressures
Unlike the experience of U.S. banks, where commercial lending demand has noticeably tailed off, demand has stayed stronger in Canada, with most banks generating mid-single-digit loan growth. That applies to Canadian Western as well, which posted 5% yoy and 2% qoq loan growth on a gross basis in the quarter. Loan growth was also balanced, with 12% yoy growth in general commercial, 6% growth in personal, 4% growth in equipment finance, and 9% growth in commercial mortgage. Real estate project lending, which declined 19%, was a notable exception, but it’s a relatively small part of the mix.
Underlying earning asset growth continued to support profit growth. Revenue rose about 4% yoy and 6% qoq, with about 1% yoy and 5% growth in net interest income. Net interest margin was stable qoq despite a 50bp rate cut back in March and I’ll talk about this more in a moment. Fee income jumped 10% qoq, helped by the acquisition of two wealth management businesses earlier in quarter. Wealth management is now close to half of non-interest income, though at less than 12%, non-interest income is still a relatively modest driver.
Management did pretty well on expenses, driving a 3% yoy and 6% qoq improvement in pre-provision profits. Tangible book rose 6% yoy, but fell 3% sequentially.
Can The Company Keep Up The Momentum In Branch Deposits?
I was excited to see the strong growth in branch-based deposits this quarter. Total deposits rose 7% yoy and less than 2% qoq, but branch deposits rose 22% yoy and 5%, with branch demand deposits up 34% and 6%, respectively.
At a time when many American banks are lamenting the excess liquidity they’re getting from deposit growth, and its negative impact on spreads, why am I celebrating this? Well, for some time Canadian Western has been skewed more than I’d like toward more expensive sources of funding like broker deposits. With the mix shift this quarter, though, deposit costs declined about 75bp from the year-ago level and 50bp sequentially, and that was a big help in offsetting weaker loan yields (down about 70bp and 30bp).
Whether or not this is sustainable remains to be seen. As a primarily business lender, Canadian Western has never enjoyed the advantages of a sticky, cheap low-cost deposit base, as most retail Canadian deposits are held at the Big Six (the six large, national Canadian banks). I expect the weighting of deposits to stay fairly volatile on a quarter to quarter basis, but better branch-based deposit-gathering was a big item on my “hope to see list”.
Credit Quality Looks Okay, And Perceptions Seem To Have Changed
Credit metrics looked alright this quarter. Provisioning expense rose 86% yoy, but declined 30% qoq and the overall PCL ratio is okay at 0.33 (vs. 0.19 last year and 0.49 in the prior quarter). Net impairment formation dropped by more than half from the prior quarter, and the gross impaired loan ratio was basically stable (0.95 vs. 0.51 last year and 0.93).
I said in my last piece that I thought credit had gotten about as good as it could get, and now we’re seeing the other side of the cycle. So far, though, I haven’t seen anything all that troubling in the credit numbers. Canadian Western has made a lot of progress on diversifying its lending business and improving its underwriting, and that finally seems to be understood. For quite a while Canadian Western carried the burden of being perceived as an energy lending-driven business, and while that was true at one point, perception lingered longer than the reality.
That’s not to say that Canadian Western is free and clear. Around 13% of loans were still on deferral for the quarter, though management reported that the number has since fallen further (10%) from a peak of 25%. I’d also note that there’s a meaningful hotel lending business here – about 75% of the Franchise Finance portfolio is loans to hotel operators. It’s not a huge weighting at around 3% of total loans, but it’s something to watch given the potential lingering effects of COVID-19.
From a long-term, top-down perspective, I like a lot of what Canadian Western has done. The company has diversified its business outside of Western Canada (though still not much east of Ontario) and has significantly expanded its lending operations, with meaningful positions in equipment finance, franchise finance, and a few other specialized commercial niches.
There’s also the Optimum Mortgage business which has, frankly, done better from a credit perspective than I would have modeled years ago. In addition, there’s the progress in diversifying the deposit base – Canadian Western doesn’t have the luxury that an American bank would to acquire some small incremental retail deposit bases, so it will take work to keep growing, but there has been progress.
I expect mid-single-digit long-term core earnings growth from Canadian Western. I believe rates are likely to be low for a while, but I do still see opportunities for the bank to lower its deposit costs even further, and while the wealth management isn’t large, it’s large enough to provide a little boost to earnings. Credit costs remain a big unknown, but I think the bank’s reserves are in good shape.
The Bottom Line
All of that said, I’m not overwhelmed by the valuation here, even though long-term core earnings and ROTCE-driven P/TBV both support a double-digit annualized return. There are a lot of regional and community banks in the U.S. and a lot of large national/international banks in Europe, Latin America, and Asia that offer a lot more upside. Obviously that’s not an apples-to-apples comparison, but if you want to look at this from a “returns are returns, wherever they come from” point of view, there are better options. Still, as its own thing, Canadian Western continues to execute on its plan to become a more diversified, more profitable national Canadian business lender, and I still see meaningful long-term upside to that model and double-digit upside from here.
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