National Bank looks to Rest of Canada

“We want to be the super-regional bank of choice,” says Vachon.

That means focusing on traditional retail and corporate banking in Quebec, against the ubiquitous caisses populaires, and on niche investment-management and advisory services in the Rest of Canada. With that in mind, Vachon has led an examination and reorganization of National Bank products, brands and distribution channels in the past few months.

“We need to put the right resources in the right place,” he says, “and offer a concerted, proactive approach, both in the branches and in commercial banking.”

As part of this more client-centric approach, National Bank has redesigned its branch network processes, giving the branches increased power to meet client needs. In addition, the bank plans to add about 100 wealth-management specialists in the branches and create a division that will focus on high net-worth clients.

“Wealth management — and corporate services to those boutiques servicing that segment — is where we need to be,” says Vachon, citing baby boomers’ need for income as they enter their retirement years. “There isn’t much space to grow in retail banking, and the current uncertainties mean that wealth management has to grow.”

The wealth-management space, however, is getting crowded. As the boomer market moves from capital accumulation to capital protection and retirement income, banks and insurers are focusing on this lucrative business. Given that about 15% of Canadian households have more than 80% of the investible assets, the fight is getting tough.

But Vachon is up for the fight. He notes that 40% of the bank’s assets under management are from outside Quebec, proof that it has a strong foothold in several markets throughout the country. “We’ve been in Calgary for the past 26 years, where our investment-banking arm does very well,” he says. “Our money markets management in Toronto, established in 1980, is also doing well.”

Then there is National Bank’s most recent acquisition — a 12.5% stake in Winnipeg-based Wellington West Holdings Inc. The deal injected $36 million in cash into the investment dealer and gave National Bank access to a small but reputable pool of investment advisors with more than $9 billion in assets under administration. That moves the bank deeper into wealth-management territory.

As well, Wellington West’s investment-banking operations — which are gearing up for an expansion — will give National Bank access to an area in which it would like to build a greater presence: capital markets.

That segment that has seen the departure of some major foreign players in recent months as a result of the global financial crisis, creating opportunities.

“‘Cleantech’ holds a lot of promises,” Vachon says. He notes that there are about 100 such companies trading on Canada’s senior and venture exchanges. “Those start-ups will need a banker.”

Then there are National Bank’s other acquisitions. Montreal-based Retirement Option Group, a full-service brokerage with $1.5 billion in AUM, was acquired in September. In May, National Bank bought Winnipeg-based Bieber Securities Inc. and, in February, Toronto-based Aquilon Capital Corp. and Montreal-based Groupe Financier Everest.

Vachon, heir to the Gâteau Vachon empire, says it’s no secret that National Bank is out to buy or partner with firms that will give it more clout in retail distribution and wealth management, as well as investment banking: “We’re on the lookout for financial services providers that we think will integrate well with us.

“There are two risks, other than financial, that need be addressed when buying into an operation,” he adds, “execution and transaction. Will the processes and back offices integrate well? Are people going to be happy with us?”

Already servicing many independent dealers in Western Canada through its Correspondent Network, National Bank can look to its existing partnerships both to build its market share and as possible purchases. It will also look at expanding its white-label offerings. For example, National Bank already has a contract through which it provides MasterCards for Investors Group Inc. clients; National Bank also offers investment loans to dealers. The bank is planning to grow this business in order to be ever-present in the minds — and on the shelves — of advisors in the West.

@page_break@”Getting your foot in the door,” Vachon says, “implies a long-term approach.”

But while National Bank is making many efforts to increase its revenue, it is also in the process of reducing costs; a major overhaul of its operations is underway. “We need to streamline our processes and improve the efficiency of corporate functions,” says Vachon.

He wants to maintain earnings growth and shareholder returns in a market that’s going to be tougher for the next three to five years.

“Although we had to manage growth in the past, we now need to manage costs, quality and risks,” he adds. “And so, we’re dedicated to growing our profits by 5%-10% a year, without taking undue risks.”

So, this all begs the question: where on the risk spectrum does investing in National Bank and, in effect, its strategy fit? A report by Catalyst Equity Research Inc. of Toronto considers the bank a “low-risk” investment, while Dundee Securities Corp. of Toronto’s report considers it “medium risk”; reports by Genuity Capital Markets and RBC Capital Markets, both of Toronto, label National Bank as an “average” risk.

All the analysts’ reports make note of National Bank’s high dependence on capital markets — one division it aims to grow.

Robin Cornwell, president and CEO of Catalyst, has developed a “market sensitivity” measure that calculates revenue from all market-sensitive businesses — trading, retail and discount brokerage, investment-banking fees, merchant banking, venture capital and securities gains — as a percentage of total revenue. Cornwall estimates that National Bank’s measure is 38% for the fiscal year ending Oct. 31, vs 18%-25% for the Big Five banks. As far as Cornwell can tell, National Bank’s market sensitivity is the highest in North America, not just in Canada.

This market sensitivity is partially offset by National Bank’s small exposure to the U.S. economy, in which it has no non-capital market activities, in general, and no subprime and other structured products, in particular. However, this, in turn, is partially offset by the bank’s exposure to Canadian non-bank asset-backed commercial paper. National Bank is the most exposed Canadian bank to ABCP, with about $2 billion in exposure.

Neither the Genuity nor Dundee reports say that future ABCP writedowns will be material. In fact, Genuity’s Aug. 29 report states that it believes National Bank will “outperform” its peers on credit.

A Dundee report issued on the same day suggests there is “very little evidence of deterioration in [National Bank’s] credit portfolio and the balance sheet is increasingly strong.” If the ABCP mess is resolved, National Bank will have “a much lower risk profile than the market is giving it credit for,” the Dundee report adds.

In contrast, an Oct. 7 Royal Bank of Canada report states that additional ABCP writedowns are a risk, while Cornwell says in an Aug. 29 report that National Bank’s plan to offer loans of up to 75% on the face value of riskier ABCP is “a sure way to incur more loan losses.” He expects another $250 million in writedowns over the next six months, including losses on those loans.

In the nine months ended July 31, National Bank made $95.1 million in provisions for credit losses, not that much higher than the $74 million made for the same period a year earlier. Total provisions as of July 31 were $464 million, vs $430 million a year earlier, while gross impaired loans were $274 million vs $232 million.

Net income, excluding unusual or non-recurring items, was $673.5 million in the nine months vs $716.2 million a year earlier. Revenue was $3 billion vs $3.2 billion. However, the 12-month trailing return on equity as of July 31 was only 10.5%, down from 20.7% for the same period a year earlier. The major reason for this was a loss of $164.2 million in the fourth quarter of fiscal 2007, which significantly lowered net income attributable to common shareholders for the four quarters ended July 31 to $482.7 million, down from $914.9 million in the four previous quarters.

As of July 31, National Bank had a Tier 1 capital ratio of 10%, vs a low of 9% on Oct. 31, 2007. It has total assets of $121.9 billion, subordinated debentures of $2.2 billion and common shareholders’ equity of $4.7 billion. There are 159.1 million shares outstanding.

Its shares closed at $42.71 on Oct. 27, a decline of 32.5% from their $63.23 high in July 2007, when the credit crisis emerged, and down by 36.1% from their all-time high of $66.80 in December 2006. Twelve-month price targets range from $50 a share (RBC) to $51 (Catalyst) and $55 (UBS Securities Canada Inc. and Dundee).

National Bank’s quarterly dividend is 62¢ a share, or an annualized $2.48 a share, which, at the Oct. 27 share price, is a 5.8% dividend yield. The bank has increased its dividend at least once and often twice a year since 1997, when it was only 15¢ a share. The latest 2¢ increase took effect with the Feb. 1 dividend.

“Investors should now expect to see slower dividend growth,” states Cornwell in his Aug. 29 report. Nevertheless, he does expect further increases over the next 12 months, to about 64.5¢ or 65.5¢ a share. At the Oct. 27 share price, that will produce a dividend yield of 6% or 6.1%. But if Cornwell is right and the share price reaches $51, the yield will be 5.1%, which is still very attractive.

The Dundee report agrees that another increase in the dividend is possible — if there’s additional earnings growth in the fourth quarter. (Results will be released Dec. 4.) UBS’s Aug. 29 report forecasts dividend increases of 3.2% in 2009 and 6.3% in 2010. However, the RBC report does not call for a dividend increase in 2009.

National Bank’s efficiency ratio — non-interest expenses as a percentage of total revenue — is in the middle of the sector pack at 63.5%. Cornwell says that National Bank controls its costs very well and in an astute way.

Here’s a closer look at National Bank’s main businesses:

> Domestic Banking. Cornwell estimates that domestic banking will contribute 51.2% of National Bank’s 2008 earnings. While, as Vachon says, it’s not a high-growth area, it is a core business.

National Bank is strong in Quebec but does not have much presence outside the province. There is one bright spot, says Tim Johal, a portfolio manager with I.G. Investment Management Ltd. in Winnipeg: the bank’s arrangement with the Power Financial Corp. group of companies. Under this agreement, National Bank provides lending and deposit products to Investors Group and London Life Insurance Co. customers.

> Wealth Management. Cornwell estimates that this growing area will contribute 14% to National Bank’s 2008 earnings. Margins are very high at around 50% and the business doesn’t require much capital.

Cornwell hasn’t been impressed with the performance of Altamira since National Bank acquired it in 2002. And certainly Altamira’s numbers haven’t been great. As a result, the bank is merging Altamira activities, including Altamira Financial Services Ltd., with National Bank Securities Inc., the manager of National Bank’s funds, on Nov. 1. The three entities will operate under the National Bank Securities banner. National Bank Securities will become manager of the Meritage portfolios.

Cornwall, however, does like the small acquisitions that National Bank has made in this area.

> Capital Markets. Subsidiary National Bank Financial Ltd. is very strong and has operations across the country as well as in the U.S. and Europe. NBF manages $52.5 billion in Canadian retail assets and another $47 million for institutional clients. Cornwell expects NBF to contribute 34.8% to National Bank’s earnings.

NBF is selling its controlling interest in Asset Management Finance, but will retain a 10.5% interest in the company. A net gain of about $45 million is expected in NBF’s fourth-quarter results. IE

Jean-François Parent is a journalist with Finance et Investissement in Montreal. Catherine Harris is a regular IE contributor.