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Canadians at the Gate

Why investors should beware the strategies that drive Canadian banks.

The drums of war are beating these days on Bay Street (the Canadian version of Wall Street). Armed with their high-flying stocks and "at-parity" currency, Canadian banks are set to conquer the U.S. banking market.

Not that anybody in the United States will stand in their way. Although some pundits mourn the fall of  Commerce Bancorp  to  Toronto-Dominion (TD), U.S. investors are generally more than happy to sell banks, especially if offered a nice premium. After all, the banking sector hasn't been the market's darling lately (to say the least). If the Canadians want to take a stab at it, they are more than welcome.

In Canada, the recent charge on U.S. soil led by TD must have brought some national pride. Just a few decades ago, Canadian banks were among the largest financial institutions in the world. They lost this status by falling behind in international expansion, and they have been trying to regain it ever since. Many believe they finally have a shot at succeeding--but we caution investors some Canadian banks have better strategies for pursuing growth than others. In this article, we dive into the reasons why many Canadian banks could be swayed to push further into the U.S. banking market--and why other firms might be smart to look elsewhere.

Canadian Banks See Growth Potential in the U.S.
Rolling the dice in the U.S. banking market isn't a new game for Canadian banks. All of the top five Canadian banks have wholesale businesses (investment and corporate banking) in the U.S. that focus on the middle-of-the-pack-type of clients, or cross-border transactions. But some of them always had the desire to expand beyond the limits of a second-tier wholesale business by developing a retail and commercial banking business in the U.S.

The prime justification for expanding into the U.S. is usually growth. With the banks buying many of their competitors and dotting major Canadian cities with branches, even the country with the second-largest territory in the world starts to feel a bit tight. So when the top brass pull out the world banking maps in a search for growth opportunities, it's only natural that the first market that catches their attention is just a one-hour drive from their headquarters.

Proximity is an advantage, but the size of the U.S. banking market is a major plus for Canadian banks. The U.S. represents a $6.5 trillion deposit market, while Canada's market is only a quarter of this size. That means there is a lot of room to grow--or at least that's what the executives at  Bank of Montreal (BMO),  Royal Bank of Canada (RY), and TD think. They also like the fact that the banking sector in the U.S. is fragmented, which allows the larger players like the Canadians to build their footprint by scooping up the smaller banks. Canadians also feel very comfortable in the U.S. business community, given the economic ties between the two countries and the North American Free Trade Agreement--NAFTA--that further cements the bond.

Peer Pressure Is Rampant
The Canadian banks closely watch each other's moves, and they are quick to analyze and react to the strategic decisions of their peers. Despite the fact that doing nothing is sometimes the right choice, the pressure to act is always part of the equation in such a small market. Given TD's Commerce acquisition, we think the pressure is now on Royal and BMO to expand in the U.S.

In a previous research note, I suggested that Royal should take a serious look at  BB&T (BBT). Royal has been busy making small fill-in acquisitions in southern states that hardly improve the bank's competitive position in the U.S. Buying BB&T would be a different story. The southern powerhouse has a very attractive footprint, a convincing share in many markets, an excellent management team, a diversified revenue stream, and solid underwriting. But most importantly for Royal, it has southern legitimacy. It has been more than five years since Royal bought its flagship business in the U.S., Centura Banks, but many in the south still view Royal as an outsider. That's why buying an entrenched southern franchise like BB&T would remove any doubts surrounding Royal's southern intentions.

BMO (through its Harris subsidiary) is in a different position in the Midwest. It has scale, and it has legitimacy. What it poorly lacks is performance. With returns on capital lingering at less than 10%, we think BMO's investment in Harris is a financial disaster. You can partly blame Chicago for Harris' woes; after all, Chicago is one of the most competitive banking markets in the U.S. Nevertheless, it is BMO who chose Chicago as its beachhead in the states, and BMO has been operating in Chicago for more than two decades--more than enough time to figure out that the winds blow against it in the windy city.

The best thing BMO can do with Harris is sell it. We doubt that its current strategy--to beef up Harris's footprint by buying small community banks in neighboring states--will solve Harris's core problems, which include a blotted cost structure, out-of-date branch network, and the lack of a meaningful competitive advantage over national giants, such as  J.P. Morgan Chase (JPM), and smaller players, such as  First Midwest . Harris is an underperforming business, and we don't think that BMO has a good plan to improve it. To add oil to the fire, once  Bank of America (BAC), a formidable competitor by any standard, swallows LaSalle Bank, BMO's life in the Midwest will become even tougher. In the short term, there might be some opportunities for BMO (Harris) to steal some clients as B of A integrates LaSalle, but in the long run, we think that B of A's efficient salesforce will prevail, and BMO (Harris) will be among the losers.

We think BMO should exit the Midwest before it's too late, but we doubt that it will. BMO can keep making pricey and insignificant acquisitions in Indiana and Wisconsin, but we see the bank eventually contemplating a large deal. Unfortunately, even buying a firm like  TCF Financial , with its good record of top performance, wouldn't solve Harris's core problems; it would only add new ones, like integrating two banks with two different cultures.

But Not All Canadian Banks Look to the U.S.
Some Canadian banks aren't shopping in the U.S. just yet, such as  Bank of Nova Scotia (BNS) and  Canadian Imperial Bank of Commerce (CM). Scotia has, in our opinion, the best global expansion strategy of all Canadian banks. The secret is simple; Scotia shies away from highly competitive markets like the U.S., opting instead to focus on countries where there are few competitors and friendly regulators--just like in Canada. While its Canadian peers squabbled over bits of U.S. market share, Scotia embarked on a journey to more exotic destinations, such as Mexico, Chile, the Dominican Republic, and recently even Thailand. Scotia's foreign inroads look like a risky adventure on the surface, but a deeper dive reveals that the bank has built a very profitable business overseas, so far unmatched by any Canadian bank. Scotia earns a more-than-20% return on equity in its international business, which grows at a very robust rate.

We support CIBC's decision to sit on the sidelines, as well. CIBC had its flops in the U.S. (such as Amicus FSB), which ended with losses and write-offs. The bank has also suffered from a major trauma after its relationship with Enron resulted in losses that eroded the bank's capital. These experiences changed the bank's "DNA," and it doesn't look like CIBC is in a mood for another U.S. adventure.

Canadian Mergers?
A few years ago, the Canadian government torpedoed an attempt of a double merger. TD agreed to buy CIBC, while Royal planned to buy BMO. Today, it looks like the Canadian banks have abandoned the double-merger scheme. However, if the gap between the big three (TD, Royal, and Scotia) and their smaller peers (BMO and CIBC) continues to increase, BMO and CIBC might feel pressure to join forces.

Putting political issues aside, a combination between CIBC and BMO makes sense on paper, but it might be tricky to execute because of different corporate cultures. CIBC and BMO complement each other in almost any business. CIBC would bring to the table its asset management group, investment banking expertise (especially in underwriting of equity and debt), and a nice western footprint. BMO has more dominance in eastern Canada and Quebec, and its investment bank is the white shoe firm of the business. BMO would also bring Harris to the table, though in its current state, it's more of a liability than an asset.

Even though there are many opportunities for Canadian banks to invest globally, we think it's important for investors to do their homework on a management team's strategy for future growth. We think peer pressure could lead some Canadian banks to make poorly conceived investments in the U.S. banking market, while others have clearly shown the ability to make expansion--in the U.S. and globally--a successful endeavor.

Michael Kon has a position in the following securities mentioned above: BAC. Find out about Morningstar’s editorial policies.