Wednesday, April 05, 2006

RBC CM's Highlights on Cdn Banks' Valuation Premium

RBC Capital Markets, 5 April 2006

Valuation and Recommendation

In this report, we take a closer look at the Canadian banks remarkable price run over the past five years relative to U.S. banks. We focus on what we believe is a reasonable basis for the current valuation premium as well as risks to our call. Our Market Weight recommendation for Canadian banks reflects a view that sector valuation is now full by conventional measures. We are also now selectively wary of negative EPS revisions.

Since May 2005, the bank sector is up 23% largely on a 12% revaluation to 13.7x from 12.2x forward consensus earnings. Our target valuation outlook at 13.1x 2007 estimated factors a 4.25% bond yield estimate in the coming year. For every 50 basis point increase in the 10-year bond yield, our model predicts a 1 multiple reduction in the target P/E.


Exceptional Price Performance. Canadian bank stocks are among the top price performers globally over the one and five year time frames. Canadian banks are now up 79% in the past three years relative to the U.S. banks’ 36% rise. The Canadians’ +43% relative price performance versus U.S. banks has been driven by 22% higher EPS growth with the balance driven by incremental re-valuation.

P/E Premium Reflects Higher EPS Growth. The Canadian bank one-year forward relative price-earnings multiple has expanded from the perennial 10% discount versus US banks to now command a 22% P/E premium. Still, the 2006 consensus EPS growth estimates indicate Canadian banks look more attractive at a P/E-togrowth (PEG) ratio of 1.5x compared to U.S. banks at 1.65x. In 2005, Canadian banks recorded recurring EPS growth of 14% versus 6% for U.S. banks.

Price/Book Premium Reflects Higher ROE. The Canadian banks’ relative price/book valuator has expanded from a long-term average at 84% of the U.S. banks to 148% of U.S. banks. During this transition, Canadian bank ROE has held at 20%, well in excess of U.S. banks at 15%. In addition, from deficits only a couple of years ago: (i) Canadian bank Tier 1 capital has jumped out to a 10% higher level than for U.S. banks and (ii) credit reserve coverage is 33% higher.

Non-Fundamental Factors. Recurring speculation that intra-market consolidation may be allowed could be cited as partly responsible for the creeping Canadian premium. Another corollary factor would be the prospect for break-up and related NAV analysis if the latter does not materialize. The unique-to-Canada income trust market indicates higher-than-normal potential spin-off valuations than found in other countries.

Valuation Risks. Versus history, Canadian bank valuations are through the range indicated appropriate for current bond yields and relative to the market multiple, for the first time since late 2003. Second, the Canadian banks’ ROE is not as high as the current price/book ratios are suggesting appropriate per our ‘value map’ against U.S. banks. Third, we would be concerned that current EPS estimates are now fully reflecting the good news on credit, and that the next series of surprises may start to prove disappointing as opposed to positive.