Friday, February 10, 2006

BMO NB's Preview of Cdn Bank Q1 2006 Earnings


• With bank earnings season beginning in two weeks, we believe that investors will be pleasantly surprised with results from Canada’s banks. Earnings growth (exclusive of unusual items) versus last year will be of the order of 5%, off what was a very strong first quarter last year. Cash ROEs look to remain in the 20%+ range.

• The story this quarter will be the same as it was in the second half of 2005: Personal and Commercial Banking. Solid volume growth, flat to improving spreads and controlled loan losses all argue for excellent results. The issue is whether the full benefit of these variables shows up this quarter or next, as spread improvements could lag somewhat. Simply put, however, we believe that there is a real chance for “blow-out” results in this business in the first half of 2006.

• Wealth Management and Capital Markets business also appear to be robust with strong equity markets, an increasingly active M&A environment and excellent funds flow. The one negative for the group overall is the strength of the Canadian dollar, which could temper overall earnings gains due to translation of profits.

• Dividend increases will continue to highlight the banks’ long-term earnings visibility, and Royal, Bank of Montreal and TD are expected to move this quarter. Another sign of the banks’ performance is that stock splits are becoming more likely, and we expect Royal Bank to lead on this front.

• We continue to recommend TD and CIBC. Both are rated Outperform and have good leverage in retail banking and wealth management. The former will have the noise caused by the closing of the Ameritrade and Hudson United deals, but we believe that ongoing improvements at TD Canada Trust should begin to drive earnings more quickly. In the case of CIBC, our belief is that the strong environment coupled with aggressive cost cuts will produce solid earnings—and more than offset any issues on the market share front.

• We continue to believe that Canadian banks are excellent investments at current levels. First and foremost, earnings drive stock prices, and we believe that any earnings variations will be to the upside. We recommend an overweight position in Canadian bank shares. We currently prefer Canadian banks over Canadian insurers. We believe banks have better leverage to a strong domestic environment.

TD Bank – A Noisy Quarter

This should be a solid, though very noisy quarter for TD Bank; in other words, more of the same. Domestic P&C should be strong, although Wealth Management will be compensating with a very strong fourth quarter. TD Securities is a bit of a “crap-shoot” with ongoing restructuring in what looks like a good quarter for the industry generally.

On the noise front, this quarter will see two large deals closing: Hudson United and Ameritrade. The net effect will be material to both reported earnings and the balance sheet. Specifically, the bank will book a gain of $1.6 billion ($2.25 per share on the AMTD deal), but this will be rightly viewed as a one-time item. Book value per share will obviously leap as a result of this (and retained earnings) to about $25. The impact on capital ratios is also meaningful, and lasting. Tier 1 ratio should rise to 11.5% and Tangible Common Equity to 8.5%.

We would not be surprised (but have not forecasted) incremental restructuring provisions for TD Securities or additions to legal allowances.

The closing of the AMTD deal also creates some interference. Waterhouse US will only be included for the period November 1, 2005, to January 24, 2006. According to the bank’s disclosures, it will contribute $32 million. This is well down from the unusually high $51 million in the fourth quarter, but ahead of the $20 million in the same quarter of last year.

From an operating perspective, the results from TD Canada Trust should reflect strong volume gains, stable spreads and low loan losses. We have been somewhat disappointed in market share performance for the bank over the past year, and hope for signs that this is now behind it. Outside of the “pre-announced” Waterhouse US results, we expect strong contribution from Waterhouse Canada, mutual funds and brokerage. TD Securities should have a reasonable quarter, exclusive of any further realignment initiatives. Banknorth results are lowered by the balance sheet charge, which reduces TD earnings by $0.03.

We are forecasting trading revenues of $275 million, which look to be a more “normal” run rate. Loan losses of $100 million will be well above the levels seen in previous quarters, but they simply reflect the lack of reversal of generals and sectoral allowances rather than any deterioration in credit overall.

With the strong earnings performance and an excellent balance sheet, we expect TD to increase its quarterly dividend to $0.45 from $0.42.

CIBC – Expect the Expected

It’s hard to believe, but we are forecasting a relatively unexciting quarter for CIBC with no major legal expenses and no unusually robust securities gains—essentially a quiet quarter with no surprises. The new management team seems intent on reducing volatility and this should show through in the quarterly result. We forecast Cash EPS of $1.45, essentially in line with earnings levels achieved in the year-ago and linked quarters.

Retail Markets (which now includes both Wealth Management and P&C Banking) should have a solid quarter with good volume growth, stable spreads and controlled expenses.

Investors should focus on two major issues: how quickly are expenses falling and how well can the Bank hold onto its market share in cards, unsecured loans and mortgages.

We expect expenses in this segment to be slightly lower than in the fourth quarter and revenues should be essentially flat. Market shares should continue to decline in consumer lending (due to more stringent lending and pressure in cards), but should remain robust in mortgages and deposits.

We are expecting a more “normal” contribution from World Markets in the $130–140 million range. This incorporates our assumption of $50 million of merchant banking revenues and trading of $175 million. Loan losses after several quarters of recoveries should be about $15 million in this division.

The rebuilding of the balance sheet should continue this quarter. We expect that with solid earnings, stable risk-weighted assets and little headwind from currency, Tier 1 should be close to 9% and TCE at over 7.3%. This is solid by international standards but still below the Canadian industry average. The market is likely to also focus on comments about buybacks and dividend increases, although we consider such a discussion to be premature at this stage.

National Bank – Fewer Upside Surprises in the Future

National Bank continues to produce results that reflect the benefits of a focused management team and strategy. In the first quarter, we are forecasting EPS of $1.20 (note that there are no cash adjustments for National Bank). On the surface, this appears to be disappointing when compared to the $1.20 in the fourth quarter and $1.37 in the same quarter of 2005. This reflects unusual items in the comparable quarters rather than any fundamental deterioration in operating conditions.

Specifically, the year-ago quarter included a $35 million pre-tax ($25 million after-tax and $0.15 per-share) gain on the disposal of an investment. In addition, NB Financial produced its best quarter ever with strong trading revenues, robust securities gains and low loan losses. The bank benefited from a reversal of general allowance in the fourth quarter, which added $0.10 to earnings.

From an operating perspective, we expect National to show many of the trends of other banks. Asset growth should be strong in P&C Banking, augmented by the ongoing success of various distribution agreements. On the other hand, the combined effect of the lower spreads from these agreements and increased competitive pressure in mortgages in Quebec could see the bank lag its peers on spreads. We are expecting to see some moderation in loan losses in P&C after a spike in the fourth quarter. The Wealth business should also have a strong quarter.

Financial Markets can create volatility in National’s profitability. We are assuming that loan losses are more normal at $8 million (compared to $4 million in the fourth quarter and $2 million in the year-ago quarter) and expect to see solid, though not stellar, trading results coupled with modest securities gains.

National continues to have a balance sheet that is roughly in line with industry averages.

We don’t expect to see a dividend increase this quarter, after the $0.04 increase in quarterly dividend at the time of the fourth quarter. Having said that, the bank’s payout ratio is still somewhat below average.

Royal Bank – Tougher Comps But Good Leverage to Retail

We are forecasting another solid quarter from Royal Bank, with the Canadian Personal and Business Segment contributing strongly. With the focus on costs announced late in fiscal 2004, there could also be good news on the expense front. Having said this, this is the first quarter in four when the bank is comping off a tough base.

The Canadian P&B segment (which includes Wealth Management) should have another record quarter. With excellent performance in mutual funds, a strong equity market and good loan growth, there is certainly some potential for earnings surprises. On the other hand, the bank seems to have been relatively immune to the spread pressure that others have seen as rates fell, so it should be unsurprising if its spreads do not improve much.

The U.S. and International P & B segment (which includes Centura, the Dain brokers, the Caribbean and Global Private Banking) should have a solid quarter, although below the level of the fourth quarter which included a goodwill reversal. The one variable here will be the uptick in loan losses associated with the industry-wide rise in personal bankruptcy filings. We are assuming loan losses of $10 million, all from the U.S.

There are several other moving parts that make Royal’s results difficult to forecast. RBC Capital Markets has performed well over the past year. Loan losses have been unusually low, while trading has been somewhat disappointing. We are forecasting trading revenues of $400 million compared to $321 million in the fourth quarter of 2005 and $506 million a year ago. A $100 million swing impacts EPS by about $0.10. We are also assuming no hits in the Corporate Segment and no further losses from discontinued businesses.

We expect another healthy dividend increase this quarter, to $0.68 from $0.64, pushing the payout ratio to the mid-40s. The balance sheet should be largely unchanged from year-end. We expect Royal Bank to announce a stock split.

BMO – Waiting for a Move in the United States

After an excellent fourth quarter, expectations for BMO have improved markedly. Unfortunately, the bank has less leverage to the factors that are positively impacting the overall bank group (spreads, loan growth, etc.) and more U.S. dollar denominated earnings.

Despite this, we still expect a solid quarter and a dividend increase. On the surface, the result this quarter will be below the $1.31 per share achieved in Q4/05 largely because of one-time items that inflated that quarter.

In P&C Banking, we forecast cash net income of $337 million, up about 10% from the first quarter of last year (which was slightly depressed). The headwind will be at Harris, where a spike in loan losses associated with personal bankruptcies and a stronger Canadian dollar will mitigate some of the fundamental improvements. Canada continues to be strong, but the focus will likely be on share trends. Private Client, which was inflated in Q4/05 by the sale of Harrisdirect, should also have a strong quarter.

The bank improved its balance sheet markedly with the divestiture of Harrisdirect. With the ongoing strong earnings, we expect a quarterly dividend increase to $0.52 from $0.49. Tier 1 ratio should continue to grow to close to 10.5%, and the market is clearly waiting to see how this capital is deployed. Comments on this front could affect the share price.

BNS – Headwinds from Currency, but Several Levers are at Its Disposal

Scotiabank is facing the biggest headwind among the banks from currency changes. The strong Canadian dollar will hurt U.S.-dollar-denominated earnings, and the ongoing weakness in the Jamaican dollar (the bank’s second-largest contributor to International Banking) is a feature that is unique to Scotia. Having said that, we expect solid Inverlat contribution (due to sound operating results and a relatively stable Peso) this quarter.

Domestic P&C (Retail Banking and Wealth Management) should be relatively strong at $352 million. The bank continues to punch “above its weight” in banking with solid share gains, while its wealth management will be strong in absolute terms but weak relative to the peer group.

After a weak fourth quarter, we expect a strong contribution from the International Banking segment despite the headwinds mentioned previously. The Peruvian deal didn’t close in the quarter so it won’t have an impact. We await Inverlat’s results, but given industry-wide trends, the contribution from Mexico should be solid. Incremental marketing expenses in the fourth quarter should moderate somewhat.

Scotia Capital had a weak trading result in Q4/05 and we are forecasting a more “normal” $230 million of revenues here. On the other hand, we are also forecasting loan losses in this segment of $10 million compared to net loan loss reversals of $7 million in Q4/05 and $9 million a year ago.

With massive unrealized securities gains (over $1 billion at year-end), Scotiabank has the ability to book gains periodically. Given the tightness in spreads on emerging market bonds, this is certainly a possibility this quarter for the bank.

The trends on capital will also be somewhat interesting. BNS picked up US$3 billion of GMAC paper in the quarter, which should affect risk-weighted assets. The bank still runs with one of the best capital ratios in the banking system, though the gap is tightening with TD and BMO having effected capital-friendly discount broker deals over the past year (Harrisdirect and Ameritrade, respectively). With BNS having moved last quarter, we don’t expect any news on the dividend front this quarter.