[Please note that all currency references are to Canadian dollar except if indicated otherwise.]
Canadian Western Bank (OTCPK: CBWBF; $31.79; Banks; Shares outstanding: 89.7 million; Market cap: $2.84 billion) is a relatively small bank headquartered in Edmonton, Canada. The bank focuses on small and medium enterprises.
The bank has a strong track record of consistently growing earnings and dividends, but has lagged behind larger Canadian corporations over the past 7 years as economic growth in its main market, Alberta, has stagnated. Diversification into Ontario, the sharp improvement in energy and commodity prices and the specter of rising interest rates bode well for the bank’s better performance.
A business bank
Canadian Western Bank (“CWB”) provides personal and business banking services for small and medium-sized businesses, with an emphasis on general commercial banking, cash management services, equipment financing and financing of building construction.
Interest income is the bank’s main source of income, with 88% of 2021 income coming from this source. Wealth management is the main contributor to non-interest income. Just over 80% of its loan portfolio is granted to companies, with the balance being lent to individuals.
Historically, the CWB has generated most of its revenue from Western Canada, but over the past 5 years the bank has expanded its operations into Ontario and other parts of the country. The bank’s loan portfolio is now fairly evenly split between clients located in British Columbia, Alberta and the rest of the country.
The bank operated 40 banking centers and had 2,617 full-time employees at the end of fiscal year 2021 (October).
A solid operating history – but lagging behind the major Canadian banks
Although the bank has managed to grow its earnings and dividends at a reasonable pace over the past decade, its performance has lagged that of the major Canadian banks. Compared to the best performing National Bank of Canada (OTCPK: NTIOF), its annual earnings-per-share growth rate was less than half, while its return on equity was on average one-third lower.
Nonetheless, the bank has delivered consistent performance over the past decade, with its pre-tax net income growing 110% to $480 million by the end of fiscal 2021. As the number of shares rose, earnings per share rose only 81%, while dividends per share rose 115%. Book value per share was $33.10 at the end of fiscal 2021, 138% higher than 10 years ago.
During the same period, the loan portfolio increased by 166% to reach $32.9 billion, while deposits increased by 142% to reach $30 billion.
The bank’s operating ratio (expenses/non-interest income) was 50.1% in 2021 and averaged 49.1% over the past decade. Net interest margin (net interest income/total assets) was 2.50% in 2021, slightly below the 10-year average of 2.66%.
Loan write-offs as a percentage of average loans averaged 18 basis points over the past 10 years with a high of 32 basis points in 2016. Return on equity was 11.8% in 2021 and 11 .7% on average over the past decade.
Strong growth in 2021
In its fiscal year 2021, revenue increased 13% to $1.0 billion, with net interest income up 12% and other income (primarily from a wealth management acquisition) 26%. Expenses were also up 17% (mostly labor costs), but a strong reversal of loan loss provisions made in 2020 contributed to a 31% improvement in earnings per share to $3.74. .
The dividend rose slightly to $1.17 for the full year as Canadian banks were barred by the regulator from increasing their dividends until the end of 2021. The bank has an excellent track record in of dividends and currently has a payout ratio of only 31% of net income.
In December 2021, the bank said it expects “double-digit” loan and deposit growth for fiscal 2022 and “low to mid-single digit” growth in earnings per share. The bank also expects to see non-interest spending increase “into the lower teens” in 2022.
Ontario – more opportunities
The bank has expanded its operations outside of its home base in Western Canada over the past 5 years. Loans to customers in Ontario now cover 23% of the loan book, up from 15% in 2016. This part of the loan book grew 18% annually, well ahead of the bank’s average loan growth of 9.1 % per year. .
Ontario’s economy is considerably larger than that of any other Canadian province, accounting for nearly 40% of Canada’s gross domestic product. Ontario is also home to 450,000 small and medium-sized businesses, more than Alberta and British Columbia combined.
Given the size of the Ontario market, it seems likely that CWB will be able to continue to grow its business in that province and further improve its regional diversification.
Rising interest rates
Nearly 90% of CCB’s revenue comes from interest income – the bank’s profitability is therefore sensitive to the net interest margin. As banks are normally able to improve their margins when interest rates rise, the CWB should be one of the main beneficiaries if Canada’s central bank undertakes multiple interest rate increases, as expected, in 2022-2023.
The bank’s net interest margins (“NIM”) have fluctuated between 2.16% and 3.04% over the past 15 years. The bank’s net interest income (“NII”) sensitivity is shown in the table with 2021 earning assets and margin assumed as the base case. Holding all other variables constant, the bank would be able to increase its NII by 8.6% if it were able to improve its NIM to 2.80%.
Healthy commodity prices
Higher oil and commodity prices are supporting economic activity in Alberta, where mining, energy and agriculture directly contribute more than a third of gross domestic product. These sectors are doing very well right now, which will contribute to faster loan growth for the bank.
In previous energy and commodity booms, the bank managed to increase its return on equity (“ROE”) to over 15% (2007-2012). The table below shows the sensitivity of the bank’s net income to a higher return on equity. With 2021 as the baseline, and keeping all other variables constant, an improvement in ROE from the current 11.4% to 14% will increase the bottom line by 22%.
Balance sheet in good order
At the end of fiscal 2021, the bank had a common Tier 1 capital ratio of 8.8% and a total capital ratio of 12.4%. In both cases, these ratios are well above the minimum regulatory requirements. The CCB is not considered a systematically important bank and therefore is not subject to the additional capital requirement of 100 basis points.
Funding is largely provided by deposits from bank branches and term loans from brokers, which together account for 78% of current additional funding.
Risks on the horizon
Alberta, where growth depends on high commodity prices, remains an important market for the bank. Although the bank has reduced its reliance on Alberta over the past five years, weak energy and commodity prices will continue to impact the bank’s performance.
The strong correlation between the bank’s share price and the price of oil is also very noticeable. This does not, in our view, accurately reflect the diversified nature of the bank’s business, but there remains a risk that investors will link the bank’s performance to the unpredictable price of oil.
Despite the difficulties the bank has experienced in recent years in its home market of Alberta, it has managed to grow mainly through diversification in the Ontario market. The CWB has not performed as well as some of its peers, but it looks set to perform much better over the next few years.
The bank will continue its expansion in Ontario and the rise in interest rates should help its net interest margin. If the current strength in energy and commodity prices were to continue, the bank could show excellent performance for years to come.
Based on the current share price and consensus estimates for the next 12 months, the company is valued on a price-to-earnings ratio of 10.6 times and a price-to-book ratio of 1.1 times.
We consider the current valuation to be undemanding for a good company that has the potential to significantly increase its earnings over the next 2-3 years. If the bank managed to raise its return on equity to something closer to the peer group average, the stock would also rise accordingly. In our view, this leaves attractive upside potential with limited downside risk.