Thursday, August 10, 2006

BMO CM Preview of Cdn Banks Q3 2006 Earnings

BMO Capital Markets, 10 August 2006


We expect Canadian banks to report one of their best operating results ever for the third quarter ending July 31, 2006. The story should be continued strength in the retail businesses, offsetting somewhat weaker market-related businesses.

Loan growth and stable spreads are the basis for our optimism in retail banking. Industrywide data suggests loan growth is over 10% year over year with the commercial loan book adding to the strength in consumer loans. On the spread front, we expect higher absolute levels of interest rates and more muted competition across a variety of products will offset the ongoing pressure on Prime-BA spreads and the need for additional wholesale funding. The net of these factors is that spreads should be stable.

In the wholesale operations results should, in aggregate, be down 10–15% from the first two quarters of the year. The obvious slowdown in issuance, a less robust trading environment and fewer loss recoveries will only partially be mitigated by stronger M&A activity. Outside of these fundamentals, this could be a noisy quarter. Tax rate changes (which could impact the valuation of deferred tax liabilities), unusual gains and ongoing accounting changes could make for a less than clean quarter for several banks. We expect the market to see through these items.

We expect two banks to increase their quarterly dividends – TD and RY, following on the heels of increases by the other four banks following last quarter.

Perhaps it is the market’s propensity towards mean-reversion, but we expect CIBC and TD’s results to look somewhat more positive. CIBC’s market share performance should look less ominous while TD’s pre-release of Banknorth and Ameritrade results takes some of the uncertainty out of its reporting. We continue to trumpet these two as our favourite bank stocks at current levels.

Loan Growth – The News Remains Very Positive

The third fiscal quarter of 2006 will again show faster than expected loan growth by Canadian Banks. The story continues to be ongoing strength in consumer loan demand, coupled with a resurgence of commercial and corporate (business) credit demand. In aggregate, bank loan books should grow by over 10% compared to year-ago levels, and over 2% on a linked quarter basis. We should note, however, that the “Big 6” are growing loans somewhat below this rate as they have not been as aggressive as some of the foreign lenders—particularly in sub-prime and asset-based lending.

We continue to expect slower consumer loan growth over the coming quarters as higher interest rates slow the demand for residential mortgage credit and HELOCs. The case is more sanguine for business credit. We have made a case in the past (last quarterly earnings preview, May 3, 2006) that the growth in business borrowings was due to a culmination of factors that is unlikely to reverse in the short-term. Specifically, these factors include pent-up demand after several disappointing years, more fixed asset investment (to combat the impact of the rising Canadian dollar), better agricultural lending and less pre-selling of new homes by developers.

Whatever the cause, as we show in Chart 1, the growth in business credit remains very robust in the short term. In fact, in June 2006, business credit by chartered banks grew at the fastest rate in the past two decades. It is also worth noting that even if business loan growth was 4–5% in the medium term (in line with nominal GDP growth), this would likely support solid overall loan growth into 2007.

Spreads – Stable, Again

Trying to predict reported spreads for Canadian banks on a quarterly basis is a thankless exercise. You can be completely accurate, but still arrive at the wrong conclusion on earnings, and vice versa. Suffice it to say that we believe that the majority of the spread compression witnessed over the past four years is behind us (Chart 2 shows our specific forecast for this metric).

It is probably more useful to consider the mix of variables that structurally impact spread, as these items point to what is driving overall profitability. Below, we detail the four major factors arguing for tighter spreads:

• Rapid loan growth. This is a vivid example of exactly why nominal spreads (net interest income divided by average earnings assets) can be so misleading. When loan growth exceeds retail deposit growth, this causes some structural pressure on spreads. The incremental loans need to be funded in the (more expensive) wholesale market. It should be noted that while lower nominal spreads are a side effect, the overall impact of loan growth on bank profits is positive.

• Term extension in the mortgage book. Recent meetings with senior retail bankers suggest that the consumer has been more aggressive in terming out the retail mortgage book. Over the past two decades, consumers have generally been winners by opting for the shortest duration mortgage (i.e., variable rates). However, with more first time buyers in the market (buyers who are typically more concerned about the visibility of payments over some period of time) and increased concerns following multiple increases in short term interest rates, there has been an anecdotal shift to longer-term mortgage duration. This has had a negative impact on spreads.

• New mortgages continue to be originated at tighter margins than a year earlier. There is little doubt that the residential mortgage business has been commoditized even further over the past year. Banks view this product simply as a way to get into the consumer pocketbook and to anchor the relationship.

• Tighter Prime BA spreads. Even outside of the discrepancy between loan and deposit growth rates, banks use the BA market to fund some of their Prime-priced loans. With relatively clear signs of ongoing Bank of Canada tightening in the past year (seven increases in the Bank Rate since late 2005), the wholesale market has consistently anticipated increases in short-rates. This has put pressure on Prime-BA spreads since the fourth quarter of 2005 (Table 1). The good news here is that this phenomenon has largely run its course (i.e., rate increases will be less regular, if at all) and we believe that the outlook is more positive over the next 12 months.

However, there are several factors that are working in support of margins:

• Faster commercial loan growth. With the commercial book growth beginning to outpace the growth in the residential mortgage book for the first time in over five years, banks appear to be growing higher-spread loans faster than lower-spread loans. The differential is meaningful: spreads on commercial loans are several times that of secured residential mortgages. As we have indicated before, we expect business loan growth to continue to eclipse residential mortgage growth in the medium term.

• Less competitive posted pricing in residential mortgages. Bank of Montreal has been the most aggressive bank in discounting posted pricing on 3- and 5-year residential mortgages over the past 12 months. With the disappointing performance on spreads in the first half of 2006, the bank moved away from this strategy (Chart 3). In addition, anecdotal evidence suggests that discounting by BMO off of these higher posted rates has also been reduced.

• Less competition from ING in high-interest savings accounts. We believe that declining profitability at ING Bank (not the Property and Casualty insurer) has caused a more cautious stance on pricing of high-interest savings accounts. While we are not suggesting that competition has disappeared (we note the pricing moves by Altamira over the past few quarter), we believe that it is, at worst, a stable environment for pricing of this product.

• Higher overall interest rates. We have long highlighted that when interest rates moved to unusually low levels, banks were faced with increased pressure on spreads—declining yields on loan books combined with effective “floors” on deposit rates (particularly in checking or basic savings accounts). The reality is that the value of the “free float” in these accounts diminished as rates declined. With the rise in rates, we believe the pressure on spreads in the deposit books is abating somewhat.

With regard to spreads, there are certainly specific factors that impact various banks. For instance, it appears as if BMO and BNS are more impacted by the Prime-BA spreads and CIBC benefits less than its peers from rising rates due to its large credit card book. But overall, we believe that spreads for Canadian banks should be stable compared to the second quarter.

While this doesn’t sound impressive on the surface, it is a solid achievement and is all that is needed in an environment of rapid loan growth.

Loan Losses – Somewhat Higher Levels but Still No Signs of Concern

We expect loan losses of roughly $625 million across the six big banks this quarter (Table 2). This is somewhat higher than in the past several quarters and is simply a reflection of fewer reversals in the investment banks as gross impaired corporate loan books have continued to decline.

Over the past year, loan loss surprises have consistently been on the downside and though we are comfortable with our forecasts at this stage, this trend may again be repeated. We note that were loan losses to remain in the $450–500 million range, overall bank earnings this quarter would be 2–3% higher than we are forecasting.

Trading Revenues – Less Robust Than in the Past Two Quarters

After two outstanding quarters, we believe that trading revenues will be more moderate in the third. We forecast trading revenues of $1.45 billion across the big six banks (Table 3). Indeed, our expectations of moderation in trading revenues which we detailed in our second quarter preview (May 3, 2006) was essentially “on-the-money” except for Royal Bank which had a blockbuster quarter. Royal surprised us in the last quarter with trading revenues that were almost as much as that of BMO, TD and CIBC combined.

Predicting trading revenues is fraught with risk. Our basic premise is that the reversal of several consistent trends (caused by oil and gold price weakness, stable Canadian-U.S. dollar exchange rates, etc.) as well as a less clear stance by the Fed argue for more difficult liability trading conditions. On the other hand, the client demand for hedging in interest rates, currencies and commodities remains robust.

Capital Markets – The Market Giveth, and the Market Taketh Away

Because of timing issues and the breadth of revenue sources, it is difficult to generalize about quarter-to-quarter variation in performance in the Wholesale (capital markets and investment banking) operations of Canadian banks. Having said that, it does appear as if the third quarter will see Canadian Banks report somewhat lower fee revenues. Issuance appears to be down 40% versus the second quarter and the same quarter of last year. M&A, on the other hand, has returned with a vengeance—meaning fees in this business should be essentially flat with the second quarter and up about 10% from yearago levels. In aggregate, ie. inclusive of issue and M&A fees, we expect fee revenues to be down 25% from the second quarter.

Picking the relative winners and losers is even more difficult than summarizing how the industry performs on a short-term basis. Royal’s wholesale operations had an excellent second quarter, so did BMO’s with its skew towards the resource sector. TD, BNS and CM were somewhat weaker, while NA had reasonable performance. We hold little optimism for TD, BNS, NA or BMO this quarter, but believe that CM will rebound (largely for the timing reasons detailed by management during the second quarter conference call) and that RY, while down, will still be quite strong.

Of course, the actual “bottom line” contribution of the Investment Banks (i.e. RBC Capital Markets, ScotiaCapital, etc) is a function of these fees but also of the scale of loan loss recoveries and the trading success factors discussed previously. This being the case, we believe that Royal will continue to be Canada’s most profitable investment bank, but that it will be most affected by the confluence of the factors mentioned. We expect a contribution of closer to $300 million than the $433 million reported in the second quarter by Royal.

Writedown of Tax Assets – Expect Modest Charges

We expect some banks to take one-time charges for a reduction in the carrying value of deferred taxes. With the reductions in Canadian Federal Tax rates now clearly in place, banks which have built up deferred tax assets and liabilities (as a result of timing differences in the recognition of income for tax purposes) will need to account for the reduced value of the future net asset. We do not expect any of these charges to exceed $100 million for any bank, but we do note that the impact is very difficult to quantify. We expect any banks impacted to report and disclose clearly the one-time charges associated with these changes.

The irony of these charges is that reduction of tax rates are actually a positive for long term earnings power. This is a useful cautionary example of the limitations of “GAAP” earnings as a yardstick to value an enterprise.

Dividend Increases and Indications of Buybacks

We expect two banks to increase their dividends this quarter – TD and Royal. In the case of the former, it is clear that management is intent on building balance sheet strength in the face of developing opportunities in the U.S. Furthermore, it appears as if the final structuring of the Basel II rules will have the most impact on TD given its large investment in associated businesses. As a result, the bank has been the most tentative on returning money to shareholders. In fact, TD has been consistently increasing its share count through its dividend reinvestment program and through issuance related to acquisitions. While we remain supportive of the growth plans, we believe that a somewhat less lethargic stance on returning money to shareholders is warranted. We are forecasting that TD’s quarterly dividend will be increased from $0.44 to $0.46, and we believe that some buyback is possible over the next few quarters.

In the case of Royal, which in many ways has been following a polar opposite strategy to TD (i.e., significant buybacks and more aggressive increase of the dividend), we are also expecting an increase from $0.36 to $0.38.

With CM, BMO, NA and CIBC having increased quarterly dividends last quarter, none are likely to move again. We do not assume that any other banks will follow BMO’s aggressive change in payout ratio.

We have not yet seen share buyback levels for the month of July, but we believe that BMO and BNS have been quite active in repurchasing shares over the past quarter.

Individual Company Comments

• Bank of Montreal – All Eyes on Spread

Bank of Montreal leads off the reporting cycle on Tuesday, August 22. We are calling for cash EPS of $1.27, marginally ahead of the seasonally weak second quarter and up strongly from the weak third quarter of 2005. We expect relatively steady (but strong) capital ratios. We would not be surprised to see the bank become more aggressive on U.S. expansion within the next 12 months, particularly if the performance of the domestic P&C bank stabilizes.

The real focus for investors (as it has been for the past few quarters) will be the Personal and Commercial Banks (P&C) – both in Canada and the U.S. The former has produced somewhat worrying trends in margins – partially driven by overly aggressive pricing of residential mortgages. As we have noted previously, the bank has clearly back-tracked on this strategy, but given the seasonal bias towards heavy Spring origination volumes, we don’t believe that margins can turn dramatically until the fourth quarter. Having said that, any stability on this front would be welcomed. Another issue is how well volumes (and market shares) hold up given the pricing changes. Harris continues to limp along with ongoing reinvestment offsetting volume growth.

Recent management changes are on-balance slightly positive. The return of Frank Techar to Canada is a welcome development. He certainly had success in building the Bank’s commercial book in Canada before moving to Chicago, and we believe he is well liked and knows the business well. The job for Ellen Costello in Chicago is more daunting. She has limited retail banking experience and will need to depend on her direct reports in the early stages.

The Wholesale Bank, after a very strong second quarter, should be less robust, though still well ahead of the third quarter of last year when the bank was dealing with the flattening yield curve but without the benefit of higher commodity trading. In addition, expense accruals in the third quarter of 2005 appeared to be somewhat elevated. The Corporate segment should see more moderate contribution; the second quarter was inflated by somewhat lower tax rates. The modest MasterCard gain should also help this segment this quarter.

• TD Bank – Improved Visibility

TD’s quarterly results, to be released on August 24, should be far less exciting given the bank’s pre-release of the contributions from Ameritrade and Banknorth. The market will certainly concern itself with the ongoing repositioning of TD Securities. Indeed, the truism, “the only constant is change” appears to carry tremendous weight in the case of TD’s wholesale banking business.

The good news on TD Securities is that despite all the changes, it seems able to report solid, consistent earnings regardless of the environment. The strong second quarter environment didn’t do much for earnings in this segment, and we don’t expect the weaker underwriting in the third quarter to impact much either. As such, we forecast another quarter of earnings between $125 million and $175 million, with trading revenues back to more normal levels. In the event of merchant banking gains (which are certainly possible this quarter), we would not be surprised to see more aggressive exiting of some of the structured product businesses. In aggregate, the market may try to micro-analyze TD Securities. As we have said in the past, we broadly view this entity as a trading book, with a small investment bank strapped onto the side. It is unclear whether additional investment of capital, or of people, would change this reality.

TD Canada Trust should continue to show very strong trends. One variable that is difficult to gauge is the impact of the seasonally weaker trading volumes on the contribution from the domestic Wealth Management business. On this front, we have assumed that TD Waterhouse Canada (which we believe to be disproportionately important to overall profits) will negatively impact earnings this quarter.

It will also be interesting to see what the bank does with its ongoing build of excess capital. Tier 1 should punch well into the mid-12s, yet the bank has continued to issue stock to its dividend reinvestment program and has been somewhat stingy on its dividend increases. We are expecting a dividend increase this quarter of $0.02 – from $0.44 to $0.46 quarterly.

• Royal Bank – Ongoing Strength

As always, Royal Bank, with its earnings release on August 25, will set the tone for how the street considers quarterly performance within the bank group. We expect another excellent quarter. The Canadian Personal and Business unit (which includes the retail bank and the wealth management businesses) should have a record quarter. Strong volume growth, ongoing stable spreads and excellent flows in wealth management all argue for a record quarterly profit.

The U.S. and International Personal and Business Operations (which include the large global private banking unit) should again have a reasonable quarter. Some currency headwinds are likely to be offset by good growth in private banking. We believe that the contributions of Centura and Dain should be relatively stable.

The swing factor this quarter for Royal will be RBC Capital Markets. The second quarter showed how materially this unit has separated itself from the other Canadian investment banks. Having said that, the less robust underwriting environment should take some toll and we expect to see earnings closer to $300 million rather than $400 million. A large factor for this unit will be bonus accruals, which were very high in the second quarter. In the end, weaker revenues could be largely offset by lower expenses.

We are also expecting a dividend increase at Royal Bank, from $0.36 to $0.38. The bank’s Tier 1 is not as good as its peers, but as a result of the strength and diversity of Royal’s franchises, the market (and the rating agencies) does not penalize the bank. With the recent decision to acquire Flag Financial, and relatively consistent increases in risk-weighted assets within RBC Capital Markets, we don’t expect to see much higher Tier 1s during the rest of 2006.

• Scotiabank – Building the International Footprint

Scotiabank’s earnings, to be released on August 29, are generally predictable and strong, and the results this quarter should be no different. Like other banks, the domestic retail business should be up from last year. We expect to see earnings rise by 6% year over year, not as strong as TD or RY, but still solid.

On the other hand, Scotia Capital benefited in the second quarter from unusually high loan loss recoveries. While we don’t see any specific problems on this front (and gross impaired loans haven’t declined much over the past year), we still believe that the third quarter will have de minimus recoveries, and overall earnings that are somewhat lower than in the second quarter. One variable that is difficult to quantify is the impact of the deal with GMAC, which could contribute more than we are expecting.

One area that always creates some confusion for the market is the International Banking business, because of the multitude of countries that contribute to overall profits. This quarter, Scotiabank Mexico reported a solid operating result, and was also able to book an unusually large tax gain (equal to about $0.04 per Scotiabank share). Given this strength and the tremendous performance of the non-Mexican businesses in the second quarter, one could speculate a “blow out” result for Scotiabank. If history is any guide, the bank will use the opportunity created by one-time gains to heavy up on marketing and integration costs in Central America and the Caribbean. Whatever the decision, we remain confident that Scotia has a powerful franchise in these regions.

After leading the industry on capital ratios for some period, Scotiabank’s capital strength appears to be more in line with the group as it has built risk-weighted assets from the GMAC deal and from acquisitions. We believe, however, that the bank still has significant capacity to add leverage in Tier 1 and has been virtually inactive in securitization. We continue to see share buybacks, but given the move on dividend last quarter we don’t expect any change here.

• CIBC – Losing Its Reputation for Excitement

We expect another “workmanlike” quarter from CIBC on August 31. The story continues to unfold with ongoing cost reductions, reduced risk and less capital markets volatility. We believe that the market will come to value this consistency over time.

In the short term, the market is too focused on market share losses. This isn’t to say that we are indifferent to share: We have seen Canadian banks embark on transitions in the past and none have permanently hurt the franchises. We believe that this situation is the same and believe that share will stabilize. It is, however, tough to predict when this occurs. We think that CIBC’s card business has turned the corner, but the ongoing repositioning of the consumer loan book will continue to have a negative impact on share in some products. With BMO’s residential mortgage share under some pressure, CIBC could well benefit. Like with BNS, the bottom line contribution in Retail Markets (which includes banking and Wealth Management) should continue to produce solid year-over-year fundamental growth.

We also note that there is concern that CIBC World Markets, on the heels of cost cutting and on departures to Genuity, has lost some of its franchise value. This concern was exacerbated by a weak revenue performance in the second quarter despite a solid operating environment. We will chalk some of this up to timing of deal closing, and remain confident that this entity can produce $100–125 million in quarterly earnings. This assumes higher loan losses offset by better revenues. We don’t expect much in the way of merchant banking gains this quarter.

CIBC continues to rebuild its balance sheet in advance of the FCIB deal at year-end. Buybacks are on hold and, to our surprise, the dividend was increased last quarter. We believe that CIBC is most likely to provide an earnings upside surprise this quarter.

• National Bank – Nothing too Fancy

As with CIBC, we believe that National Bank will report a solid quarter on August 31. Mid-single-digit gains in retail banking and ongoing strength in Wealth management should allow the bank to exceed what was an excellent quarter last year.

The retail operations continue to perform well. In addition, we look for leverage from the partnership relationships with the Power Group and the benefits of the deposit gathering capabilities of Altamira. Both have been successful in building the balance sheet, but so far the bottom line benefits are not apparent. We believe that both offer good medium term growth potential.

NB Financial, run by Louis Vachon who was recently appointed COO of the bank, has put together an impressive track record of stable earnings. Whether it be trading, securities gains, investment banking or yield curve management, the bank has consistently produced earnings in the $50–70 million range, and we expect more of the same this quarter. We forecast somewhat weaker underwriting and trading, but assume that the Mastercard gain ($5–7 million after tax) will be included in this segment. Trading after a blowout result in the third quarter of 2005 should be more modest.