CA - Canadian Western Bank: Valuation May Be Undemanding But Operating Conditions Aren't

Summary

• Canadian Western is looking at a more challenging operating environment with slowing business activity, an inverted yield curve, and ongoing funding pressures.
• Management has executed well on a multiyear plan to improve the value proposition that CWB offers business clients, including treasury/payment capabilities, improved digital banking, and wealth management.
• I believe CWB can generate long-term core earnings growth around 5% and that supports a low-to-mid-C$30s fair value.

This year won't be an easy one for many Canadian banks. The economy is slowing, business loan demand is slowing, credit costs are going to track higher, and an inverted yield curve creates a more challenging lending/operating environment. I do think Canadian Western ( CWB:CA ) is in good shape with respect to above-average long-term core earnings growth potential, but the near-term still offers some operational challenges.

I wasn't that fond of the value proposition that CWB offered back in September of 2020 and the share price performance since then has been unimpressive, trailing larger Canadian banks like Bank of Montreal ( BMO ) and Toronto-Dominion ( TD ) by a wide margin, as well as the smaller Laurentian Bank ( LB.CA ). Given that I do think these shares are undervalued and that the longer-term growth potential is attractive, I think this is a name to watch, though I'd rather wait before starting a position.

Looking Back…

Canadian Western's fiscal fourth quarter results (reported early in February) were mixed, as the bank's spreads continued to see pressure. Revenue rose over 7% year over year and 3% quarter over quarter, but net interest income rose less than 5% yoy and declined slightly on a sequential basis, with net interest margin down 14bp yoy and 10bp qoq to 2.33%. Fee income rose 27% qoq, helping drive the top-line growth.

Adjusted operating expenses rose close to 6% sequentially (I subtract one-time costs, but do not subtract amortization), driving pre-provision profits that were basically flat versus the prior quarter.

Loans grew 2% sequentially, a slowdown from the 3.5% qoq growth in the prior quarter. General commercial lending continued to lead the way (up 3.4% qoq), while commercial real estate lending was almost flat. By my calculation, average loan yield improved about 70bp.

On the other side of the balance sheet, deposits rose 2% sequentially, with a slightly better 2.2% improvement in branch-based deposits. Branch-based demand deposits declined about 2% sequentially, but still made up 44% of total deposits - a nice bump from the 40% ratio when I last wrote about the stock and evidence of ongoing progress in building the branch-based deposit-gathering franchise. By my calculation, deposit costs rose almost 90bp qoq to about 2.7%.

Credit remained benign, with declines in provisioning as a percentage of loans and impaired loans (the latter down 15bp yoy and 7bp qoq to 0.46% percent of loans).

Looking Ahead…

CWB is due to report fiscal first quarter results on March 2, and I'm expecting to see modest sequential improvement in core earnings (around 5%). Loan demand should have remained strong enough to continue driving low-single-digit growth, though I do expect some modest creep in provisioning.

Spreads should start improving, and management previously guided to net interest margin expansion in 2023. Higher funding costs remain an issue, particularly with a loan/deposit ratio above 100%, but the bank should also benefit from more fixed loans repricing to higher spreads.

Executing on operating efficiency will be key to driving profit growth in 2023. I believe the company is past the worst of its reinvestment spending needs, but operating leverage targets have proven challenging in the past.

Looking Further Ahead…

The current environment is a challenging one for all banks, but CWB's capital and deposit positioning makes it more challenging. Management has done a good job of driving core deposit growth over the last five years, and this has helped improve the bank's spread leverage, but this is still a tough environment in which to grow low-cost deposits, and so loan growth comes at a higher cost.

Beyond the short-term challenges, I like what management has been doing. Once a very regional lender heavily tied to energy lending (and the impact of the energy sector on the economy in Alberta), CWB has successfully broadened and diversified itself into a more national middle-market and small/mid-sized business lender, including meaningful growth in specialty categories like equipment financing, franchise finance, and specialty verticals (health care, real estate, et al).

CWB has also been building up its service offerings, including treasury and payments services. By reinvesting here, as well as in other digital banking capabilities, the bank creates a more compelling case for the middle-market and smaller commercial clients it looks to attract - the bank can offer more personalized service than Canada's largest banks and is willing to take on more lending risk, but those clients increasingly don't have to worry about compromising their access to important treasury/payment services if they go with CWB.

Likewise, CWB has improved the value proposition for business owners. Not unlike First Republic ( FRC ) in the U.S., CWB structures its business with an eye toward comprehensive business relationships with business owners - offering lending, deposit, and treasury services for the business, but also offering personal loans, wealth management, and other services to the owners.

The Outlook

CWB's capital position isn't as robust as I'd like, and the company has been using an at-the-market facility to issue common shares. Given that, I don't expect a big improvement in capital returns in the near term, though the current dividend yield of 4.6% is hardly poor.

I'd also note that there are two classes of preferred shares ( CWB.PR .B) and ( CWB.PR .D) that trade, both of which offer a 6% yield at present. Detailed analysis of these securities is beyond the scope of this article, but I'm not concerned about CWB's ability to maintain its dividend payments.

I believe CWB could generate high single-digit core earnings growth this year and double-digit growth in FY'24 before decelerating toward the mid-single-digits. Long term, I'm expecting core earnings growth around 5%, against trailing core growth of more than 6% over the last decade. I do expect improving capital returns over time, but I expect reinvestment in the growth of the business to be the primary focus for a while longer yet, particularly given that there are still meaningful growth opportunities in areas like Ontario and Quebec.

Discounting the core earnings in my model, I believe CWB is undervalued below the low C$30's. I get a similar result with a ROTCE-driven P/TBV approach (C$35.50).

The Bottom Line

It seems pretty clear that the market is not willing to price in mid-single-digit growth for CWB, or at least sees more risk to the business (a higher discount rate). I'm accustomed to risk being a topic of conversation here, even though underwriting/credit quality has held up well through more recent periods of stress.

I do still see elevated risk of near-term disappointments versus expectations, but I think that's more than priced into the shares. I do think there is a risk of CWB shares jumping on good fiscal Q1 earnings and guidance, but I'm willing to take the risk of missing out in exchange for a little more security on the outlook before stepping up with my own money.

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