Monday, August 21, 2006

Banks to Deliver Solid Q3 Profits Despite Capital Markets Slowdown

The Globe and Mail, Sinclair Stewart, 21 August 2006

Canada's major banks are expected to flirt with record profitability when they begin reporting their third-quarter results this week, signalling a potential rally for a sector that has endured a bruising slide.

On average, the country's bank stocks lost 5 per cent of their value between May and July, and as a group, they remain about 10 per cent below their 12-month highs, according to research from Robert Wessel at National Bank Financial Inc.

Heading into earnings season, however, analysts are beginning to feel that the selloff was too severe, and the murmurs are growing louder that banks are a bargain again. Why the change of heart?

Lending, lending and lending. Interest rates have crept higher over the past year, easing some of the pressure on the industry's retail profit margins, but they haven't risen high enough to make consumers stop borrowing at a fevered clip. There is also a resurgence in business lending, with more and more companies venturing back into the loan market. And, perhaps most important, bad loans remain a relative rarity, helping the sector keep loan losses at unusually low levels and cushion its profitability.

"We expect Canadian banks to report one of their best operating quarterly results ever," Ian de Verteuil, an analyst at BMO Nesbitt Burns Inc., wrote in a preview report.

Mr. de Verteuil predicted that loan books should grow more than 10 per cent compared with last year, and said this surging demand for credit will offset a slightly weaker performance from investment banking and trading this quarter.

Tepid stock markets this spring were one of the main reasons bank shares lost so much of their shine, since the drop in underwriting activity foreshadowed a drop in lucrative fees. There were also concerns that profit growth was ebbing just as the banks were headed toward a more malevolent part of the credit cycle, further sapping investor confidence in the sector and erasing the premium Canadian bank stocks wielded over their U.S. peers.

But the gloomy predictions on credit -- made seemingly every quarter for the past couple of years -- have not come to pass.

Mr. Wessel, who described the current environment as a "near perfect" one for banks, believes the credit cycle will darken much more gradually than had been expected, and is not looking for loan loss provisions to rise meaningfully until the first half of 2007.

If there is a weak spot for the banking industry this quarter, it would likely be wholesale banking, which consists of investment banking and capital markets operations. Yet there are signs for optimism. Although several companies scrapped or postponed initial public offerings in late spring, when markets were sluggish, the recent frenzy of takeover activity in the domestic mining industry promises a healthy increase in advisory fees.

Much of that will not be recorded in the third quarter, but it can help the banks carry momentum into the final quarter of the year.

Bank of Montreal kicks off the reporting tomorrow, and all eyes will be trained on its retail division, which has struggled recently following overly aggressive pricing on mortgages. The bank is also in transition, with a newly appointed head of Canadian retail and a new boss of its U.S. Harris Bank unit.

Royal Bank of Canada releases its numbers on Friday and, as the largest bank in the country, is considered the bellwether for the industry. Mr. de Verteuil is forecasting good results, though he doesn't expect the bank can match the record trading and investment banking fees it generated in the prior quarter.
Canadian Press, Rita Trichur, 20 August 2006

Canada's six biggest banks continue to feast on "outstanding" credit quality and are expected to deliver a slate of solid results when they report their third-quarter earnings over the next two weeks, analysts say.

Most analysts are forecasting median earnings per share growth of about 10 per cent over last year. They caution, however, that capital markets revenues will be less robust than last quarter, while results from core retail banking operations are slightly pinched by pressure on net interest margins.

"Things that we're particularly watching are the quality of the loan portfolios for the banks," said Tom Kersting, a financial services analyst with brokerage Edward Jones.

"We expected continued good credit quality, though moderating slightly from really great conditions that we've seen recently."

The Big Six are benefiting from a "benign" interest rate environment, with both the Bank of Canada and the U.S. Federal Reserve calling a halt to interest rate hikes over the last two months.

That spares the banks' net interest margins - which is the difference between the interest they earn and expend - from shouldering any extra pressure.

Despite previous predictions for a more marked deterioration in credit quality in the back half of 2006, conditions are holding up fairly well because of a strong domestic economy, analysts say.

"There is still a low jobless rate and strong demand for jobs," observed Kersting.

"I think that consumers, for the most part, are in a pretty manageable position with their credit. So, having said that, we do expect loan losses to continue to creep up from very low levels, but we're not really expecting the jump up that even I thought might happen in the second half of this year."

In particular, analysts will be closely monitoring credit quality at CIBC, which is the country's largest credit-card operator. In June, CEO Gerald McCaughey said retail credit is the bank's "primary challenge" because "consumer loan losses remain higher than we would like."

CIBC has been trying to increase the origination of secured loans to improve its portfolio's overall asset quality, but has also predicted that lending growth will likely decline because of higher interest rates and energy costs.

For the group as a whole, contributions from capital markets businesses are expected to be less potent than in the previous quarter.

"It looks as if the normal seasonal slowdown is underway," said Andre-Philippe Hardy of Merrill Lynch in a note to clients. He estimates that revenue from capital markets activities to decline six to seven per cent from the previous quarter.

"The slowdown appears broad-based in nature - we estimate sequentially weaker results for debt and equity underwriting revenues, mergers and acquisition advisory fees, wealth management revenues and flat to down trading revenues."

The third-quarter earnings season runs between Aug. 22 and Aug. 31, with Bank of Montreal kicking off the earnings parade.

It will be followed by TD Bank on Aug. 24 and Royal Bank the following day. Scotiabank will report Aug. 29, leaving CIBC and National Bank of Canada to cap off the season on Aug. 31.

Consensus analyst estimates for third-quarter earnings per share, according to Thomson Financial:

-BMO: $1.20, up 11 per cent from a year ago

-TD: $1.16, up 11 per cent

-Royal Bank: 84 cents, up 11 per cent

-Scotiabank: 86 cents, up 12 per cent

-CIBC: $1.60, down five per cent

-National Bank: $1.24, up five per cent

For his part, Kersting remains bullish on the Big Six's longer term prospects, forecasting earnings to grow at about an eight per cent clip over the next five years.

He points to the long-term drivers of the financial services industry, including an aging population, with less dependence on both company and government pensions, that will spark more demand for financial services.

"That's a very strong wind at the back of the financial services industry," he said.

"And I think the banks are well positioned with the customer relationships that they already have to take advantage of additional services."