Published December 6th, 2016 by The Financial Canadian
It is well-documented that investors in smaller businesses are often rewarded by faster business growth.
The Canadian Imperial Bank of Commerce (CIBC) is the smallest of the Big 5 Canadian banks, a fantastic group of businesses with proven track records of delivering value to their shareholders.
The ‘Big 5’ Canadian Banks are:
- The Royal Bank of Canada (RBC)
- The Toronto-Dominon Bank (TD)
- The Bank of Nova Scotia (BNS)
- The Bank of Montreal (BMO)
- The Canadian Imperial Bank of Commerce (CIBC)
For investors looking for more upside potential from a smaller company, CIBC may be the right choice from this peer group.
This post will analyze the investment prospects of CIBC.
On December 1, 2016, CIBC reported earnings for the 3-month and 1-year period ending October 31, 2016. This post will analyze their earnings report in detail.
CIBC is a diversified financial services provider with operations in retail banking, business banking, wealth management, and wholesale banking/capital markets.
The Bank divides their business into three main operating segments, as defined below.
- Retail and Business Banking provides personal and business clients across Canada with financial advice, products and services.
- Wealth Management provides integrated advice and investment solutions to meet the needs of institutional, retail and high net worth clients.
- Capital Markets provides integrated credit and global markets products, investment banking advisory services and top-ranked research to corporate, government and institutional clients around the world.
Until recently, the major difference between CIBC and its peers was their lack of exposure to the U.S. retail banking sector. Fortunately, CIBC has recently made a sizeable acquisition in the United States that should rectify this concern. I will discuss this acquisition later in this article.
Fourth Quarter Financial Performance
On December 1, CIBC reported earnings for the quarter and year ending October 31, 2016. This section will outline their financial performance. I will begin with their GAAP financial results.
- Reported net income of $931 million, compared with $778 million for the fourth quarter a year ago, and $1,441 million for the prior quarter (+20% YoY)
- Reported diluted earnings per share (EPS) of $2.32, compared with $1.93 for the fourth quarter a year ago, and $3.61 for the prior quarter (+20% YoY)
- Reported return on common shareholders’ equity (ROE) of 16.8%
- Basel III Common Equity Tier 1 ratio on an all-in basis (CET1 ratio) of 11.3%, compared with 10.8% a year ago.
CIBC also increased their quarterly dividend by three cents to $1.24 per share.
The Bank’s GAAP financial results for 4Q2016 are fantastic. They’ve successfully grown earnings at a 20% clip on both a bank-wide and a per-share basis. They also improved their risk-weighted capital positioning as measured by the Basel III Common Equity Tier 1 ratio.
Next let’s consider their adjusted results for the quarter.
- Adjusted net income of $1,041 million, compared with $952 million for the fourth quarter a year ago, and $1,072 million for the prior quarter. (+9% YoY)
- Adjusted diluted EPS of $2.60, compared with $2.36 for the fourth quarter a year ago, and $2.67 for the prior quarter. (+10%)
- Adjusted ROE of 18.8%.
The large discrepancy in adjusted and GAAP metrics are due to a significant restructuring charge that deducted $0.25 from the Bank’s per-share earnings.
On an adjusted basis, their quarterly results are more normalized but still impressive on an absolute basis. It’s been a great quarter for CIBC.
Since the fiscal year for the Canadian banks ends on October 31, CIBC was also able to report financial results for fiscal 2016. The results were very positive.
- Revenues of $15.0 billion compared to $13.9 billion in the year prior (+8%)
- Net income of $4.3 billion compared to $3.6 billion in the year prior (+20%)
- Adjusted diluted earnings per share of $10.22 compared to $9.45 in the year prior (+5%)
It’s been a fantastic year for the smallest of the Big 5 Canadian banks.
Now that I’ve covered their recent earnings release, I will now evaluate CIBC’s investment prospects.
Penetrating the US Market
CIBC has often been the subject of criticism due to their lack of geographic diversification. Many of their peers have significant international operations:
- Scotiabank has more bank branches, ATMs, and customers in their International Banking segment than in Canadian Banking
- The Toronto-Dominion Bank has more branches in the US than in Canada, operating south of the border as TD Bank, America’s Most Convenient Bank
- Bank of Montreal has significant US presence through their American subsidiary BMO Harris Bank
- RBC has a strong and growing US presence, acquiring City National Corporation (a California-based financial institution) for US$5.0 billion in 2015.
In recent years CIBC has made significant progress in penetrating new markets. They have selected the US as their target, and have made the following transactions:
- An $848 million acquisition of American Century investment (which was sold last year for ~$1 billion)
- A $210-million purchase of Atlantic Trust Private Wealth Management
- The pending acquisition of Chicago-based PrivateBancorp (operating as The Private Bank)
The PrivateBancorp (PVTB) acquisition is something on the mind of many CIBC investors, because it is recent, still pending, and by far the largest acquisition that CIBC has made in the U.S. Here are the terms of the deal.
- Total transaction price is estimated at USD$3.8B, or approximately CAD$4.9B
- PrivateBancorp shareholders will receive US$18.80 cash and 0.3657 of a CIBC common share for each share of PrivateBancorp stock
- This represents a 24% premium over PVTB’s share price over the ten trading days prior to the announcement
- PVTB headquarters to remain in Chicago and Larry Richman (PVTB’s CEO) will remain their President & CEO while taking on an expanded role as Head of CIBC’s U.S. region.
Many CIBC investors were concerned by the announcement. After all, CIBC is making the acquisition at 18 times next year’s earnings and 2.2 times tangible book value, which are both expensive multiples for a bank.
CIBC has also stated that the transaction will be dilutive to earnings in the first 2 fiscal years. Earnings accretion will occur in 2019 after the Bank has identified and executed on various sources of cost synergies.
On the other side of the transaction, there has been a large swing in sentiment since the deal was originally announced. PVTB shareholders were originally elated at the hefty 24% premium they were being paid for their shares. Further, the deal was recommend by two well-known institutional governance advisors – Glass Lewis, and Edgan-Jones.
However, there have recently been concerns that CIBC is actually discounting PVTB. Last week PVTB stock closed at US$50.36 and CIBC stock closed at US$81.69. This means that the cash and fractional CIBC shares that PVTB shareholders will receive is worth $48.67, which is a 3.5% discount the PVTB’s current price.
As a result, Institutional Shareholder Services has recently recommended that shareholders vote against the deal.
I don’t believe this will happen. PVTB shareholders realize that CIBC’s shares will hold much more upside than the small lender that they currently own. There is much to be said about having the strength and stability of a large financial institution like CIBC.
I am confident that this transaction will close successfully and that CIBC’s forays into the United States presents upside for their investors.
Dividend Growth and Safety
CIBC is great dividend investment by a variety of metrics. It currently yields ~4.5% and it is are a member of the Canadian Dividend Aristocrats Index, which contains elite Canadian companies with 5+ years of consecutive dividend increases.
This is not to be confused with the traditional Dividend Aristocrats Index, which contains companies with 25+ years of consecutive dividend increases. You can see the full list of Dividend Aristocrats here.
CIBC would not qualify for the traditional index, as they froze their dividend during the financial crisis.
CIBC’s dividend growth record is also very impressive. Their fourth quarter dividend increase represents the 8th time in 9 quarters that the Bank has increased their dividend, each time by $0.03.
Looking back over a longer time horizon, note that CIBC paid $1.29 in dividend per share in 2000. Today’s annual dividend payment of $4.75 means that CIBC has compounded their dividend at 8.49% over the past sixteen years – impressive growth by any standard.
The Bank’s dividend also has a tremendous amount of inherent safety. They’ve paid a dividend every year since 1868. This is a 148-year streak of dividend payments. CIBC also did not cut their dividend during the financial crisis, when many of their US counterparties did. The Bank currently has a credit rating of A+ from S&P and Aa3 from Moody’s, both emphasizing the low risk of an investment in CIBC.
Their dividend is also well within their payout ratio targets.
CIBC targets a payout ratio of 50%. In fiscal 2016, they paid out only 44.3% of their net income as dividends to shareholders. These two facts, taken together, are strongly indicative that more dividend increases are coming soon for this bank.
In closing, CIBC is an investment that can provide safe, growing income for the foreseeable future.
Concerns About the Canadian Housing Market
I’ve spent the article so far discussing the strong points of CIBC’s business model. However, there are some risks that should be addressed, namely the Canadian housing market and CIBC’s exposure to the oil and gas industry.
It’s been well-detailed that the Canadian housing market is at all-time highs. Many are concerned about a housing bubble, particularly in hot markets such as the Greater Toronto Area (“GTA”) and the Greater Vancouver Area (“GVA”).
CIBC has done a tremendous job of hedging this risk.
Source: CIBC Fourth Quarter Investor Presentation
Looking at the geographical distribution of CIBC’s residential mortgage portfolio, it’s clear that less than half of their mortgage book is in the GTA & GVA. This will be a key risk reducer if investors’ concerns about the Canadian housing market were to materialize.
Source: CIBC 2016 Annual Report, Page 56
Further, CIBC explains via the above diagram than more than half (53%) their residential mortgage portfolio is insured by the Canada Mortgage and Housing Corporation (CMHC). This insurance will pay the Bank in the event of a mortgage default in return for monthly insurance premiums paid along with the mortgage payments. In return, borrowers are allowed to purchase a home with less than the 20% minimum down payment that is typically required by Canadian financial institutions.
This means that the majority of the risk in CIBC’s residential mortgage portfolio comes from the insured portion (which is naturally preferable).
Source: CIBC Fourth Quarter Investor Presentation
Looking at their uninsured mortgage portfolio in particular, there are two positive trends that can be appreciated by risk-conscious investors.
First of all, the distribution of credit scores is centered in the 751-800 range, which is considered excellent. The Bank’s GVA and GTA borrowers appear to have a higher credit score than the Canadian average, which is another insulator against the risk of a housing market slowdown.
Second, the Loan-to-Value (LTV) distribution of the Bank’s borrowers is reasonable. There is not a concentration in the upper tranches of the LTV spectrum. Knowing that Vancouver has been the hottest Canadian real estate market for the past few years, I am particularly encouraged to see that GVA borrowers have a noticeably lower average LTV compared to their peers across Canada.
With all this in mind, I’m not concerned about CIBC’s exposure to the Canadian housing market. The Bank has crafted a portfolio of well-diversified, high-quality mortgages and this will protect them from all but the most severe downturn in housing prices.
Exposure to the Oil and Gas Industry
With the continued downturn in commodity prices, many investors are worried that oil and gas borrowers will default on their loans as they struggle to survive in this difficult operating environment.
For CIBC, there are two components to this risk. The first is the actual oil and gas businesses, who are losing profitability as they continue to execute in a tough operating environment.
The second is the employees of these oil and gas businesses, who as a group are suffering layoffs and decreased job security.
I will now address each of these risks and how they might manifest themselves for CIBC.
First, let’s consider CIBC’s exposure to the oil and gas companies themselves.
Source: CIBC Fourth Quarter Investor Presentation, Slide 27
There are a number of positive trends in this slide that are risk insulators for CIBC.
First, 70% of the Bank’s direct exposure to the oil and gas industry is with investment grade counterparties. This means that the quality of CIBC’s corporate and business oil and gas book is inherently high, which should reduce the risk of defaults from their counterparties.
Secondly, an even higher proportion (77%) of the Bank’s undrawn oil and gas exposure is investment grade in nature. This means that if oil prices continue stay low and these companies are forced to draw on more credit to continue operating, then the investment grade proportion of CIBC’s drawn exposure to this industry will increase.
Two other positive factors of note are 1) the steady level of CIBC’s direct exposure to this industry over time and 2) the significant proportion (24%) of the Bank’s direct exposure that is with companies in the Midstream subsector. The steady level of the Bank’s direct exposure means their counterparties are not experiencing undue trouble. Additionally, the Midstream subsector is known to be lower-risk than the rest of the energy industry because they are in the business of the transportation of energy, not the production. Since their revenue depends on volume and not on the price of the underlying commodity, they are much more insulated from movements in commodity prices.
Next, let’s consider the effect of job losses and lowered job security of oil and gas employees that are customer of CIBC. For the Bank, the main effect is the inability of these customers to make their mortgage payments.
Source: CIBC Fourth Quarter Investor Presentation, Slide 28
There are three provinces in Canada whose economies are significantly tied to the oil and gas sector. These are Alberta, Saskatchewan, and Newfoundland, with Alberta being effected the most.
Looking at the Bank’s residential mortgage portfolio in these regions, it is very encouraging that almost two-thirds of the mortgage book is insured. This dramatically reduces the risk of CIBC’s exposure to the oil and gas sector.
One last risk insulator I’d like to mention before closing is the recent decision to cut oil supply by the OPEC. This has already driven oil prices higher and should be a long-term positive for the oil and gas counterparties that CIBC has lent money to.
With all this in mind, I am confident in CIBC’s ability to withstand any troubles that arise from their loans in the oil and gas sector.
A Word on Valuation
Historically, CIBC has traded at a discount to their peer group. While the others in the Big 5 typically trade at 12-14 times last year’s earnings, it has been possible in the last year to buy CIBC at 9x earnings, a very cheap valuation for this blue-chip Canadian company.
This is not because the bank is riskier. Rather, investors (myself included) did not want to pay the same price for a company that had no international exposure. This created the discount we see today.
With CIBC’s penetration into the U.S. markets through Atlantic Trust and PrivateBancorp (set to close in the first quarter of next year), this premium should slowly disappear, and today’s investors will be rewarded as a result.
The Bottom Line
As the smallest of the Big 5 Canadian banks, CIBC has many of the traits of a solid dividend investment.
They are the highest yielding of their peer group, and have a tremendous history of growing dividend income over time, paying dividends since 1868. They are also a member of the Canadian Dividend Aristocrats Index, an elite group of Canadian companies with 5+ years of increasing dividends.
They also trade at a discount relative to their peers. CIBC makes a compelling buy at today’s levels.