Bank of Nova Scotia BNS

From RBC

[Al42]

August 12, 2024
The Bank of Nova Scotia
A surprising U.S. acquisition
Our view: We had thought that BNS’s longer-term goals in the U.S. were
more targeted. While the deal may take advantage of a capital-efficient
structure and hence may be viewed as a “high return” investment, if the
end game is full ownership, this may put BNS on the path to a larger dilutive
acquisition. In the meantime, we see a minority stake in KEY as unlikely
to materially help BNS’s North American businesses. We believe strategic
opportunities to work with KEY in the U.S. may be difficult to effect. We
maintain our $62 price target and Sector Perform rating.
Key points:
On August 12, 2024, BNS announced its intention to acquire a 14.9%
equity interest in KeyCorp (KEY; covered by RBC analyst Gerard Cassidy)
for US$2.8 billion (C$3.9 billion) in cash. KEY will issue common shares at
US$17.17 per share, an 11% premium to the last 20-day VWAP.
At BNS’s 2023 investor day, the bank identified the U.S. as a priority
market for growth, but we had envisioned a focus on its U.S. capital
markets business and activities such as product development for the North
American corridor. We are unsure whether a minority acquisition in KEY
truly furthers BNS’s North American growth strategy, as it is often difficult
to work with a minority partner in a substantive manner in markets where
they may compete. If the end game is to eventually acquire KEY, significant
synergies are not readily apparent to us.
BNS expects the transaction to be accretive to EPS in the first full year
following the additional investment and incremental earnings of ~C$300–
350 million in fiscal 2026, which would increase our 2026 core EPS estimate
by ~3%.
The investment will be completed in two stages: an initial investment of US
$0.8 billion for 4.9% of ownership (expected to close by the end of August),
followed by an additional investment of US$2.0 billion for an additional
~10% of ownership (expected to close in calendar Q1/25) upon approval of
the Federal Reserve, after which BNS will own 14.9%.
We view the discontinuation of the DRIP positively, as it clearly signals BNS’s
confidence in its capital and may also suggest it is confident that any near-
term dispositions are unlikely to dent its capital base.
BNS is trading at 9.2x our next-12-months core EPS estimate, below its long-
term historical average of 10.8x and the second-lowest among the large
Canadian banks. BNS is trading at the lowest P/B multiple among the group
at 1.07x, below its long-term historical average of 1.70x.
RBC Dominion Securities Inc.
Darko Mihelic, CFA (Analyst)
[phone], [e-mail]
Eunseo Namkung, CPA (Associate)
[phone], [e-mail]
Michelle Li, CPA, CA (Associate)
[phone], [e-mail]
Sector Perform
TSX: BNS; CAD 61.49; NYSE: BNS
Price Target CAD 62.00
WHAT'S INSIDE
Rating/Risk Change Price Target Change
In-Depth Report Est. Change
Preview News Analysis
Scenario Analysis*
Downside
Scenario
46.00
18%
Current
Price
61.49
Price
Target
62.00
8%
Upside
Scenario
74.00
27%
*Implied Total Returns
Key Statistics
Shares O/S (MM): 1,230.0
Dividend: 4.24
BVPS: 57.40
Tangible BVPS: 43.51
Market Cap (MM): 75,633
Yield: 6.9%
P/BVPS: 1.07x
Cash ROE: 11.3%
Avg. Daily Volume: 7,073,901
RBC Estimates
FY Oct 2023A 2024E 2025E 2026E
P/CEPS 9.5x 9.4x 8.5x 7.6x
EPS, Rpt Diluted 5.72 6.51 7.16 8.07
P/Rpt EPS 10.8x 9.4x 8.6x 7.6x
EPS, cash Diluted 6.48 6.56 7.22 8.14
Revenue 31.8 34.1 36.5 38.8
EPS, Rpt Diluted Q1 Q2 Q3 Q4
2023 1.35A 1.68A 1.70A 0.99A
2024 1.68A 1.57A 1.61E 1.65E
2025 1.70E 1.69E 1.86E 1.91E
EPS, cash Diluted
2023 1.84A 1.69A 1.72A 1.23A
2024 1.69A 1.58A 1.63E 1.66E
2025 1.72E 1.71E 1.88E 1.92E
All values in CAD unless otherwise noted.
Priced as of prior trading day's market close, EST (unless otherwise noted).
Disseminated: Aug 12, 2024 22:28EDT; Produced: Aug 12, 2024 22:28EDT
For Required Non-U.S. Analyst and Conflicts Disclosures, see page 9
BNS – A surprising acquisition; we are lukewarm on the deal
On August 12, 2024, BNS announced its intention to acquire a 14.9% equity interest in
KeyCorp (KEY) for US$2.8 billion (C$3.9 billion) in cash. KEY will issue common shares at
US$17.17 per share (an 11% premium to the last 20-day VWAP) to BNS. The investment will
be completed in two stages: an initial investment of US$0.8 billion for 4.9% of ownership
(expected to close by the end of August), followed by an additional investment of US$2.0
billion for an additional ~10% of ownership (expected to close in calendar Q1/25), upon
approval of the Federal Reserve, after which BNS will own 14.9%. OSFI approval was not
required for this transaction, but BNS suggested that it had positive discussions with the
Canadian regulator. BNS will be subject to a customary standstill agreement for five years,
whereby it has agreed to not increase its ownership in KEY above 19.9%.
BNS estimates that at closing of the initial investment, there will be a ~10 bps negative
impact on its CET 1 ratio. At the closing of the additional investment, BNS estimates a further
40–45 bps negative impact on its CET 1 ratio. BNS intends to suspend the discount on its
DRIP effective after the dividend expected to be declared on August 27, 2024.
We maintain our estimates, $62 price target, and Sector Perform rating.
Strategic rationale
At BNS’s 2023 investor day, the bank identified the U.S. market as a priority market for
growth, and with this deal, BNS is suggesting that it is allocating more capital to developed
markets.
We had walked away from the investor day with the impression that BNS was looking to,
over time, organically move capital into its U.S. capital markets business and more capital
into activities that would support the North American “corridor” strategy. We had envisioned
product development (cash management), hiring (in both capital markets and
commercial/corporate activities) and perhaps small tuck-in acquisitions. We are therefore
surprised by the size of the KEY acquisition and the kind of acquisition it is (minority stake),
and we also fail to see how it connects with BNS’s businesses in the U.S. or its North America
strategy.
A minority interest stake (that is eventually added to or perhaps sold) is a tactic that BNS has
employed in the past, and while some might suggest that this kind of approach to deploying
capital makes some sense (less financial risk), we believe that it has not succeeded enough
for BNS in the past and hence do not like it, all else equal. While a full committed purchase is
clearly a big financial commitment, it may be that the commitment itself (along with
synergies) results in better outcomes.
We also do not see many opportunities for BNS and KEY to “work together”. These types of
arrangements are difficult and unwieldy. We have seen TD struggle for years to have any
type of substantive arrangement with either Ameritrade or Schwab that would result in a
significant return for either party.
BNS suggests the deal is financially attractive
BNS suggested this investment would result in incremental earnings (equity accounted) of
~$300–350 million in fiscal 2026, which would increase our 2026 core EPS estimate by ~3%.
BNS further suggested that at the high end of that range, incremental earnings of $350
million on ~50 bps of invested capital suggests a return on regulatory capital of ~20%. The
$350 million of annual earnings suggest capital generation of 8–9 bps per year for anThe Bank of Nova Scotia
August 12, 2024 Darko Mihelic, CFA [phone]; [e-mail] 2
investment payback of approximately five years. BNS noted that a stock repurchase would be
accretive to core EPS by $0.20–0.22, versus the transaction’s ~$0.25 core EPS accretion in
2026.
We do not believe the availability of a regulatorily “efficient” capital treatment is the
proper lens through which we should judge the financial merits of this deal. If this deal is in
fact a precursor to a full acquisition of KEY, it would almost certainly require a lot of equity,
unless BNS were to have a windfall of capital over the next five years. Assume, for example,
that the next 85% of KEY (at the same price) would be financed entirely via equity—the ROE
on this transaction would be less than 11% ROE (using the same earnings power in 2026).
We like the discontinuation of the DRIP, and we believe BNS’s transformation may be
proceeding smoothly. We do not believe that BNS would engage in an acquisition of this
type and magnitude if its underlying transformation were not proceeding smoothly and/or if
there were significant negative developments around the corner with things such as credit
quality or the possible sale of an asset in Latin America.