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Another Canadian Bank Makes a Run for the Border

By Ari Charney on June 30, 2016

What do investors do when they’re worried about the domestic economy? They diversify their portfolios by investing in companies based overseas.

While the stock market is far more liquid than the one for mergers and acquisitions (M&A), companies do the same thing.

In Canada, for instance, businesses have been dealing with a weak economy, a falling exchange rate, and the shock from the collapse in energy prices. Further compounding these woes is a housing market that looks downright “bubblicious,” at least in Vancouver and Toronto.

Consequently, a number of Canadian companies have pursued cross-border M&A over the past year. Among dividend payers, Canadian utilities such as Emera Inc. (TSX: EMA, OTC: EMRAF), Fortis Inc. (TSX: FTS, OTC: FRTSF) and Algonquin Power & Utilities Corp. (TSX: AQN, OTC: AQUNF) have made noteworthy bids for American utilities.

And the country’s banks have been getting in on the action too. Last November, Royal Bank of Canada (TSX: RY, NYSE: RY) acquired California-based City National Corp. in a US$5.6 billion cash-and-stock deal, its largest-ever takeover.

But even before that deal, RBC already had a decent foothold in the U.S. and other international markets, as do most of Canada’s Big Six banks.

One of the most glaring exceptions has been Canadian Imperial Bank of Commerce (TSX: CM, NYSE: CM), Canada’s fifth-largest bank by market cap. The C$38.3 billion bank derived just 15.5% of its C$13.9 billion in net revenue last year outside of Canada. That leaves it significantly exposed to the fallout from a potential housing crash.

However, management has been shopping around for a U.S. financial to help give its earnings proper ballast.

On Wednesday, CIBC announced a US$3.8 billion cash-and-stock deal to acquire Chicago-based PrivateBancorp Inc. (NSDQ: PVTB), which serves middle-market companies, business owners, and wealthy families in 12 markets across the U.S. Midwest. The deal is expected to close in the first quarter of next year.

Although the transaction is much bigger than the US$1 billion to US$2 billion that the market had expected, analysts largely smiled upon the deal as being a necessary step toward CIBC diversifying its earnings stream geographically.

During the conference call following the announcement, management said that its goal is to grow the bank’s U.S. earnings to 25% of all profits within five to seven years, up from 5% prior to the deal and 10% following the deal’s closing.

“That strikes us as very audacious in a good way,” analysts with National Bank of Canada wrote. “The CEO is clearly setting a bold objective for his institution, and we like that. And it’s the right goal too, because they need to have a more balanced earnings mix.”

As income investors, of course, we’re ultimately interested in dividend growth, as well as dividend sustainability.

On that score, CIBC’s record of dividend growth in recent years has been somewhat weaker than its peers. Over the past five years, CIBC has grown its dividend by 6.0% annually, which is below the 7.9% average among the Big Six.

If properly executed, the deal could help spur future dividend growth by giving the bank exposure to the growthier U.S. market, while offering stability for the current payout amid the uncertainty in the Canadian market. To that end, management reiterated its commitment to growing the dividend, with a near-term payout ratio target toward the top of the bank’s customary 40% to 50% range.

With the cash component comprising just 40% of the deal, the transaction won’t add too much leverage to CIBC’s balance sheet. So it shouldn’t undermine dividend sustainability, though investors should be mindful of the fact that CIBC will likely pursue more U.S. deals in the years ahead.

In the near term, however, management acknowledged that their rich bid means the deal won’t be accretive to earnings until the third year following its consummation.

But disappointing news can also create bargains. With bank stocks already hammered due to Brexit, the deal’s announcement further walloped CIBC’s shares, which have fallen 6.6% over the past week, roughly double the decline of its peers.

As such, income investors can lock in a forward yield of nearly 5% on a stock trading at just 10.2x fiscal 2016 earnings.


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