Description

Canadian Western Bank (CWB.TO) offers an attractive short opportunity.  CWB is a $2.2B market capitalization, $25.2B asset bank that claims to be the seventh largest schedule 1 bank in Canada (all numbers are in Canadian dollars).  Headquartered in Edmonton, Alberta, Canadian Western provides services in business and personal banking, equipment financing and leasing, trust services and wealth management for businesses and individuals.  Banking and wealth management services are offered primarily across the four western provinces while equipment financing and leasing and trust services are available across Canada.  Online banking and residential mortgages are available on a nationwide basis with the exception of Quebec.  

The investment thesis on Canadian Western Bank is based on the following points:

1.  CWB has a uniquely “risky” loan portfolio that is poised to see massive loan losses over the next several years.  The highest risk loan for any bank is a construction loan.  Real estate “project” loans account for 19.6% of CWB’s portfolio or 238% of TCE.  This specific loan category was up a staggering 35% year-over-year in the company’s third fiscal quarter.  Management has admitted that much of this growth is being driven by apartment and condominium construction.  Canadian Western is at the epicenter of the epic Canadian condominium and apartment construction boom with the current number of units under construction approximately 7x the 1997 trough and at historical highs on both an absolute and a population-adjusted level.  Residential investment as a percentage of GDP has been at extended peak levels and construction jobs as a percentage of total jobs are at historical highs.  Construction losses have the highest severity of any loan category and I expect to see massive losses in this book as oversupply looms.  Canadian Western has a $3.8B personal loan and mortgage unit with a sub-prime mortgage book (Optimum Mortgage) that has doubled since 2012 and was up 23% in the most recent quarter.  The company is a leader in equipment financing and leasing with a $3.7B loan book.  This area predominantly finances and leases construction equipment.  This construction equipment is largely being used to build condominiums and apartments that CWB is also financing.  Corporate lending is $1.1B, commercial mortgages are $4B, and general commercial loans are $4.2B.  CWB’s largest geographic area is Alberta, currently the weakest area of Canada economically due to its leverage to the oil market.  Alberta accounts for 38% of the company’s loan portfolio.  Employment and housing statistics in Calgary are already soft.  In tandem with the weakness in Alberta, CWB has pivoted their focus to British Columbia where loan growth was 23% year-over-year in the most recent quarter driven predominantly by condominium construction in Vancouver which is in the midst of a massive build-out.  

                                                                                        Source:  Canadian Western Bank public filings

RESIDENTIAL INVESTMENT TO GDP AT HISTORICALLY HIGH LEVELS:

                                                                    Source:  North Cove Advisors, Statistics Canada

CANADA IS DRIVEN BY CONSTRUCTION:

TOTAL UNITS UNDER CONSTRUCTION AT EXTREMELY HIGH LEVELS:

                                                                                             Source:  Statistics Canada

PRIMARILY DRIVEN BY CONDOMINIUMS AND APARTMENTS:

                                                                            Source:  Statistics Canada

        POPULATION-ADJUSTED, STILL A MASSIVE BOOM:

VANCOUVER – FOCUS AREA FOR NEW CWB GROWTH:

                                                                                  Source:  North Cove Advisors, Statistics Canada

ONTARIO – SUPPLY ISSUES AS WELL:

                                                                                                  Source:  North Cove Advisors, Statistics Canada

CALGARY – UNSOLD UNITS PILING UP:

CALGARY – MORE INVENTORY COMING:

CALGARY – VACANCIES ALREADY SURGING:

2.  Credit is deteriorating with past due loans soaring while the company continues to grow rapidly in high risk areas.  Net adjusted income fell 37% year-over-year for CWB in the second quarter and was down 8% in the third quarter.  The second quarter was affected by an increase in the loan loss provision from 17 basis points to 78 basis points but seemingly credit improved with a provision of 32 basis points in the third quarter.  Management has largely focused on their small energy book ($257MM) as the source of issues and has guided to full year losses of 35-45 basis points – an approximate 100% increase in loss expectations.  I believe that the losses to date are only a tiny fraction of what is likely to be experienced when the higher risk categories of the company’s construction project portfolio and equipment leasing portfolios begin to experience credit deterioration.  THIS PROCESS IS ALREADY BEGINNING.  Total past due loans increased 107% year-over-year and were up 48% sequentially in the third quarter.  On a sequential basis past due personal loans increased by 148%.  CWB is growing their portfolio rapidly at the PEAK of the cycle.  Personal loans and mortgages were up 19% over the last year while real estate project loans were grew 35%.  Total loan growth was 14% and CWB has increased loans at a double digit rate in 25 of the last 26 years.  Assets have increased from $1.3B in 1995 to $3B in 2000 to $5.7B in 2005 to $12.7B in 2010 to $22.8B in 2015.  Total loans are up APPROXIMATELY THREE-FOLD FROM 2007 from $7.4B to $21.4B with no meaningful acquisitions.  The equipment leasing portfolio has doubled since 2012.  The sub-prime mortgage lending portfolio has also doubled since 2012.  Extremely rapid growth in high loss severity segments of the loan market in the face of a property bubble, combined with surging past due loans point to an eventual credit implosion. This is a debt-driven, price appreciation-driven construction bubble and CWB is financing it.  Below are a few statistics worth noting:

• Household debt to income in Canada at 165% is far above the prior “bubble” peak levels in the United States and is the highest of any G7 country  

• Canadian household debt to GDP of 98% is also above the “bubble peak” levels of the United States  

• Real home prices are 26% above U.S. “bubble peak” levels

• Price to rent levels are 29% above U.S. peak levels

• Prices relative to incomes are 10% above U.S. peak levels.  

REAL CANADIAN & U.S. HOME PRICES:  

                                                                       Source:  The Economist

PRICES RELATIVE TO RENTS, CANADA & THE U.S:  

                                                                                                          Source:  The Economist

PRICES RELATIVE TO AVERAGE INCOMES, CANADA & THE U.S.

                                                                                  Source:  The Economist

3.  CWB trades at a significant premium to TBV despite a vulnerable capital base.  The company already raised capital earlier this year and more raises are likely.  Canadian Western trades at 1.23x TBV.  TCE is $1.8B relative to total debt (including preferrreds) of $1.5B, total assets of $25.2B and total loans of $21.7B.  TCE to total assets is 7.2% - while far above some Canadian peers the company is hamstrung as many of the risk weightings in their commercial and construction loan categories are 100%.  The company recently closed an acquisition of the Maxium Group with securitized lending assets in health care, golf, transportation, real estate, and general corporate finance as well as the acquisition of GE Capital’s Canadian Franchise Finance portfolio.  CWB completed the sale of 6.22MM shares of stock for $24.50 in June raising $150MM.  The bottom line is that debt to cap is almost 50%, they have a sub-prime portfolio larger than their TCE base, a construction portfolio that is 238% of equity and an equipment finance and leasing portfolio that is 206% of TCE.  I expect multiple capital raises over the next several years as the company battles insolvency and I expect the stock to trade at a large discount to TBV.  If this bank were headquartered in an oil producing region of the United States with similar past due characteristics it would trade at a meaningful discount to tangible book value.  Canadian Western is largely a spread-based lender that produced an ROA of 55 and 73 basis points over the prior two quarters.  As the company’s credit losses move higher profitability will vanish.  Loan loss provisions in Canada for the aggregate banking industry were 2-3% of loans for several years in the early 1990s.  I expect CWB’s losses to at a minimum approximate these levels – wiping out profits and impairing book value.   

Tangible book value is $20.54 per share.  As the credit cycle matures, I expect CWB to post substantial losses.  I expect the integrity of the company’s book value to called into question and CWB to trade at a substantial discount to tangible book value.

Catalyst

• Past-due loans convert to charge-offs
• New condo and apartment supply overwhelms demand- this process has already begun
• The BC Foreign Buyer tax marks a turning point in market psychology