Tuesday, August 22, 2006

RBC CM on the Financial Sector

RBC Capital Markets, 22 August 2006


Our positive call on the bank sector reflects our view that sector valuation became attractive as a result of the sector price weakness through to June combined with strength in the bond market, particularly in the last week. Our target P/E of 13.1x 2007E cash EPS assumes a 4.25% Canadian 10-year bond yield (the 10-year closed at 4.18% Monday). According to our regression model linking the history of bank P/E’s and bond yields with an R-squared of ~90%, the consensus forward P/E indicated at 13.2x implies the market is factoring a 4.15% 10-year bond yield in its outlook. Risk: If, as and when the 10-year Canada yield sustains itself above 4.50%, there is downside risk to our 13.1x target P/E for the sector, but for now, the group looks fairly valued. Canadian bank P/E’s adjust by one P/E multiple for each 50-basis-point (bps) change in 10-year bond yields.

Year to date in 2006, the banks are now up 5.5% based on price return. This lags the 7.7% increase for the TSX overall, and is ahead of a 2.5% increase for the Lifecos. As of August 18th, Financials were up 5.6% year-todate on a total return basis and are the 4th-best of the 10 major TSX sub-sectors (well behind Materials +23.3%, Energy +9.3%, and Telecom Services +8.3%). The bank sector accounts for 17.4% of the TSX market capitalization, up from 16.6% last quarter, largely owing to the banks’ 1.6 percentage point outperformance relative to the S&P/TSX Composite since Q2/06 earnings season.

Life Insurance Companies

Our “Higher Rates, Better Valuation” Thesis is on “Hold” for Now. We have expected the Lifeco’s would attract a higher P/E multiple as the 10-year yield increases, with the ideal earnings and valuation scenarios occurring when the 10-year yield sits between 5.25% and 6.00%. Instead, the 10-year Canadian bond yield has retraced the year’s earlier increases, falling back from a 4.68% peak in June ’06 to the current level of 4.18%.

Valuation Still OK, But Sector Target P/E Reduced. Canadian lifecos are trading at 13.1x consensus forward earnings, now slightly below the domestic banks and well below their typical 13% premium to banks averaged since demutualization. The Canadian lifecos still trade at a 6% premium to U.S. lifecos, which are at 12.4x forward earnings, and in line with the historical average since demutualization. After the Q2 earnings cycle, we reduced our sector target P/E by 1/2 point on average from 15x to 14.5x to reflect higher EPS uncertainty. Interest rates have tracked back down, equity markets have been more volatile (wealth in-flows are more at risk) and accounting changes in 2007 may further heighten the earnings volatility optics (mark-to market discipline on surplus equity). IAG was excluded from our target P/E change - IAG’s Canadian-only exposure eliminates the non-controllable USD risk.

EPS Outlook “Strained” by Equity and Pricing Issues. Canadian lifecos reported 5% YoY EPS growth versus our expectation of ~10%. Moreover, the EPS quality was sub-standard, buoyed by reserve releases and suggesting core EPS was truly “light” in most instances. The underlying EPS shortfall appeared to be a function of the weak equity markets. The good news is that equity markets have recovered 50% of Q2 losses since June 30th so this may be a short-lived issue. Also for Sun and IAG, matters were complicated by unusually heavy sales strain expense generated by offpriced product that is in the process of being re-priced. This inflated sales temporarily and we do expect sales to fall back towards normal next quarter. We think this will probably create near-term buying opportunities in Manulife and IAG; however, we believe the sector as a whole will likely lag the banks overall for the near-term.

U.S. Mutual Fund Out-Flows Persist. Equity funds report net cash outflows totalling -$938 million in the week ended 8/16/06 with Domestic funds reporting net outflows of -$1.384 billion and Non-domestic funds reporting net inflows of $446 million. This makes Sun’s intended turnaround for MFS all the more difficult.
The Toronto Star, Tara Perkins, 22 August 2006

Canada's big banks have been wallflowers on Bay Street for the past three months as the country's big miners muscled into the spotlight and drew investor attention.

But banks will be back on stage in coming weeks, as the Bank of Montreal kicks off third-quarter earnings season today.

Bank shares are up less than 1 per cent so far this year, trailing the resource-heavy S&P/TSX composite index by more than 500 basis points, Genuity Capital Markets analyst Mario Mendonca said in a recent note to clients.

Canadian bank stocks did manage to rise more than 1.5 per cent in the last three months, but they still lagged the market and the rise only comes after banks carried the title of worst-performing sector on the index for the previous three months, Mendonca said.

While Canadian banks have remained essentially flat so far this year, U.S. banks have risen more than 7 per cent, closing the value gap between the two, BMO Capital Markets recently noted.

But Mendonca expects the performance of Canadian bank stocks to improve in the second half of this year.

One reason for that is the decision by central banks on both sides of the border to take a breather from hiking interest rates.

"We believe that the pause by the (Bank of Canada) should help to leave intact the sweet spot that Canadian banks have enjoyed with regards to net interest income," Mendonca said.

Interest rates have not trended high enough to choke off significant consumer and commercial loan demand, he said.

UBS Investment Research analyst Jason Bilodeau said in a note to clients that he continues to like the bank shares, partly because UBS is calling for both the U.S. and Canadian central banks to cut interest rates next year, which is historically a good move for bank performance.

"While we are not expecting a blockbuster earnings quarter, expectations appear to be very appropriate and a decent quarter from the group should be sufficient to carry reasonably attractive mid-teens returns from current levels for a group that has only recently begun to recover from notable spring underperformance."

One key area to watch as earnings trickle out in coming days is the portion of the banks' revenue that rises and falls with the stock market, Mendonca said.

Market-sensitive revenue — including institutional trading, investment banking, retail brokerage, mutual funds and investment management fees — is making up a bigger part of the banks' top lines, and from October 2002 to the end of April 2006, the S&P/TSX Index nearly doubled, Mendonca said.

But commodity prices dragged down markets in May and June, and he expects that to take a bite out of market-sensitive revenues. He suggested investors in BMO should pay close attention, as 90 per cent of the bank's revenue growth in the first two quarters of fiscal 2006 came from market-sensitive areas.

Some analysts expect TD Bank Financial Group to steal the third-quarter earnings show. Moody's Investor Service has just boosted its outlook on the bank to positive from stable.

"TD's performance on key credit ratios exceeds that of similarly-rated U.S. and Canadian banks," said Moody's vice-president Peter Routledge.

"Following a rather difficult stress period in 2002, TD shifted its business mix away from a market with poor risk-return characteristics, U.S. corporate lending, and towards markets with strong risk-return characteristics, Canadian personal, commercial, and wholesale banking," Routledge said. Overall, analysts are expecting the Bank of Montreal to post third-quarter earnings of $1.20 per share; Bank of Nova Scotia 86 cents per share; CIBC $1.58 per share; Royal 84 cents per share; TD $1.16 per share, and National Bank $1.24 per share.