Friday, February 17, 2006

Scotia Capital's Preview of Cdn Bank Q1 2006 Earnings

Earnings Growth 4.3% YOY - Led by TD and RY

• Our first quarter earnings estimates are highlighted in Exhibit 1. First quarter bank earnings are expected to be up 4.3% year over year and 1.3% sequentially. TD and RY are expected to lead in earnings growth at 8% and 7%, respectively, with CM and NA actually forecast for a 3% decline in earnings.

• First quarter bank earnings are expected to be supported by continued firming of retail net interest margins (Exhibit 8). The 50 bps increase in the primate rate in late 2004, in our view, contributed to the stabilization of the retail net interest margin in 2005 after a four year decline. The more recent 100 bps increase in the prime rate as highlighted in Exhibit 7 bodes well for margin improvement in 2006 although the lag could be two or three quarters.

• Wealth management earnings are also expected to be strong although only three banks are now disclosing these earnings on a separate basis. The fact that RY, TD, and BMO have seen an increase in their mutual fund assets in the 20% range is a good proxy for significant operating leverage.

ROE Expected at 20.1%

• Profitability is expected to continue to run at historical highs on very large capital positions. Return on equity is expected to remain extremely high at 20.1%. Consensus earnings estimates and share price targets are highlighted in Exhibit 4.

BMO, RY and TD Dividend Increase Candidates - BNS Expected to Increase Payout Range

• We expect BMO, RY, and TD to announce dividend increases in the 6%-7% range. We also expect BNS to increase its target payout ratio to 40%-50%. A 2-for-1 stock split for RY remains in the cards although the bank might want to see its share price go through a $100 per share first.

• Bank of Montreal is expected to report $1.18 per share, a modest 4% YOY increase. We expect the bank will be challenged to repeat the level of trading revenue it recorded in the previous quarter especially given the major shift in the natural gas market. Security gains have a low level of sustainability ($0.04 per share in Q4/05) given minimal unrealized security surplus. Harris earnings growth is expected to remain sluggish. A dividend increase is expected of 6.1% to $2.08 per share.

• Bank of Nova Scotia is expected to report $0.80 per share, a 4% increase YOY. A strong Canadian dollar continues to mute the bank's earnings growth from Mexico and the Caribbean. A large unrealized security surplus provides for sustainable security gains. Dividend payout ratio increase expected.

• Canadian Imperial Bank is expected to report $1.42 per share, a 3% decline from a year earlier. The bank's earnings will be challenged as the bank needs a repeat high level of securitization revenue ($0.08 per share - Q4/05) as well as repeat or replace security gains ($0.12 per share - Q4/05 excluding Global Payments/Shoppers). Security gains are much more difficult given the very low level of unrealized security surplus (Exhibit 17). The bank needs to rely on acceleration in costs saves and to benefit from its interest rate positioning for higher short term rates. The interest rate positioning needs to offset its high dependency on wholesale deposits to fund its retail loan book. Also, the bank needs its unsecured personal loan portfolio to stabilize from a credit perspective and avoid the negative impact on this portfolio of a 25% increase in short term rates. The impact of rising rates on this portfolio is likely to be felt over the next year.

• National Bank is expected to report earnings of $1.18 per share, a 3% decline from a year earlier. The bank needs to continue to generate strong trading and capital market revenue with its retail bank performance expected to remain strong. Unrealized security surplus remains healthy.

• Royal Bank is expected to report $1.62 per share, a 7% YOY increase. Retail and wealth management earnings are expected to remain solid, supported by strong insurance earnings. As a proxy, ING Canada reported fourth quarter calendar operating earnings growth in the 15% - 20% range. RY is expected to increase its dividend 6.2% to $2.72 per share and the possibility of a stock split remains.

• Toronto Dominion Bank is expected to report $1.12 per share representing the highest YOY growth rate of 8%. Like at Royal, retail and wealth management earnings at TD are expected to remain solid, supported by strong insurance earnings with the recent results from ING Canada a positive indicator. This is an important quarter for TD as it consolidates and closes the Ameritrade and Hudson United transactions. TD book value is expected to be given a $2 per share boost from the Ameritrade transaction. In addition we are hopeful that this is the last quarter of the TDSI restructuring of its global structured products division and the last of the interest rate immunization at Banknorth. Thus we expect the second quarter of 2006 will be a relatively clean, straight forward quarter for the bank and will not distract to investor focus from the operating performance of the bank's core businesses. TD is expected to increase its dividend 7.1% to $1.80 per share.

Strong Fundamentals - Remain Overweight

• We believe bank fundamentals remain the strongest in history with low balance sheet risk, high capital levels, strong asset quality, record profitability, and historically low earnings volatility.

• Bank stock valuations remain attractive although not as compelling as they have been. Banks are trading at a low (based on fundamentals) 13.9 times our 2006 earnings estimates with bank dividend yields relative to bonds (Exhibit 9), equity markets, income trusts (Exhibit 10) and pipes and utilities (Exhibit 11) all in the Buy range although not at the previous extreme discounts.

• Solid earnings growth outlook and double digit dividend growth expected for the next three to five years bodes well for continued appreciation in bank share prices.

• We reiterate our Overweight Banks recommendation based on compelling valuation, strong fundamentals, and low relative low risk.

• Maintain 1-Sector Outperform ratings on RY, TD and LB, and 2-Sector Perform ratings on BMO, CWB, and NA, with a 3-Sector Underperform rating on CM. We are restricted on BNS.

• We expect TD and RY to move to 10% P/E premiums to the bank group with CM and BMO declining to 10% discounts based on relative fundamentals.