Friday, August 18, 2006

RBC CM Preview of CIBC Q3 2006 Earnings

  
RBC Capital Markets, 18 August 2006

Q3/06 Preview – Consensus Looks High - Costs Under Control, But Watching Revenue and Credit

Our Cash EPS Estimate 5% Below Consensus. CIBC reports Q3/06 earnings on August 31. Our normalized cash EPS estimate of $1.51 is 8¢ or 5% below the Thomson First Call mean estimate of $1.59 and results in a year-over-year decline of 10% (down 2% sequentially). CIBC is doing an excellent job of cost cutting, which combined with continued benign credit, has been responsible for better-than-expected EPS results. However, our concern with CIBC is the deteriorating revenue outlook and the challenge CIBC may face in stabilizing its revenue line.

Last Quarter CIBC Beat Consensus with Low Costs. In Q206, CIBC’s revenue missed our estimate by 3% to generate a -0.5% year over year decline. Fortuitously, CIBC’s expenses were 5% below our estimate and down -3% year over year. For CIBC, success is being measured by the effectiveness of that team’s cost control. On expenses, CIBC is already ahead of its plan on cutting $250 million in expenses (annualized). In fact, management confirmed it expects to beat its target quite easily, however, the CFO also indicated that second half 2006 expenses will likely be a bit higher than in H106. Accordingly, it would be most helpful if the revenue decline stabilized somewhat, though we think that’s a challenge.

Key Themes:

1. Lack of Revenue Growth is a Concern. For the banks in aggregate, we think revenue growth is likely to be the core earnings driver in the next one to two years, and there is a possibility that CIBC may be left out.

CIBC’s retail banking (loan and deposit) and wealth revenue production has lagged the pack, and the gap may be widening. The trailing 4-quarter revenue growth rate for the peer banks is 8%, double CIBC’s 3.7%. In the most recent quarter, CIBC retail & wealth suffered a -2% decline, while the peers still generated +7%.

We expect CIBC’s retail spread may continue to lag the system average as CIBC makes a deliberate and structural shift to more secured loans and away from unsecured lending – this includes curtailing its card lending growth, all aimed at ‘de-risking’ the CIBC’s retail loan portfolio. Also and not so deliberately, CIBC’s mutual fund complex continues to face heavy outflows, with $195MM in redemptions in Q306, while the peer banks are accumulating net new inflows at a healthy pace, ~$1.4 billion collectively excluding the CIBC. Instead, CIBC has been more successful at growing its fixed-rate deposits, which is a much more commoditized, low-spread product and contributes to spread compression.

Typically, retail brokerage is a brighter subject for CIBC, which benefits from both large relative AUM and good production, including distribution fees on a large share of sister CIBC World Markets underwriting volume. This may be less evident this quarter as our calculations show that CIBC’s underwriting production tailed off sharply, both relative and absolute. The risk of lower retail broker revenue was highlighted at the Q206 analyst meeting.

Retail credit risk is also a unique situation for CIBC. The higher proportion of unsecured personal loans at CIBC adds a risk element that is distinctly less pronounced at the peer banks. CIBC is moving quickly to eliminate the differential, before a general credit downturn occurs. So far, CIBC is looking very smart in this respect, as impaired loans have been managed to very low levels and reserve coverage to second-best within the major bank peer group. A key credit statistic to watch this quarter will be retail loan impaired loan formations, typically in the $300 million range each quarter. A meaningful blip either way, say on the order of $50 million, would be cause for close study, concern or celebration.

2. Time for a New Plan? The clear goals of the new CEO at CIBC are to: (i) reduce volatility and (ii) realign the cost structure to capture $250 million in savings and match the peer average cost/revenue ratio. On the first goal, CIBC has been very successful - earnings volatility is now negligible. On the second, we are measuring CIBC’s cost objective by the bank’s $250 million cost savings target aimed at matching the peer group’s cost/revenue ratio (C/R), and find the bank falling shy. This may become an exercise in “chasing-one’s-tail” - as expenses fall, revenue also declines and perhaps faster. By our calculation, CIBC’s company-wide C/R is now running about 6 points above the peers. This gap has now more than doubled the level identified when the plan was first outlined over a year ago. To manage its C/R down another 6% and thereby match the peer average indicates CIBC would need to cut another $675 million in annualized expenses.

In fairness, a high-level C/R comparison can be clouded by business mix differentials, though, so a better comparison may be to line up the various banks’ retail & wealth division C/R’s specifically. By the measure, CIBC’s has averaged 2-3% higher than the peers, indicating CIBC still has a $160 million in excess annualized cost relative to the peer average.

Other Issues:

CIBC Litigation Jitters Resurface. While the Global Crossing lawsuit poses a risk to the stock, we believe it is fairly well contained at this point. News surfaced in late June that CIBC is being hit with a lawsuit from the estate of Global Crossing Ltd. However, the bank indicated that the lawsuit adds no new claims against CIBC relative to an action filed in 2004; rather it seeks to add some CIBC affiliates. CIBC’s January motion to dismiss the claims is still pending, with no clear time frame for the decision. The bank maintains general legal reserves and believes they are adequately provisioned. Litigation is a sore spot for CIBC investors, as the bank is still licking wounds caused by a $2.8B settlement last August for its part in an Enron class action suit.

First Caribbean Deal Limits Dividend Hikes and Precludes Share Buybacks in 2006. In Q2/06, CIBC announced the purchase of its joint venture partner Barclays’ share in First Caribbean Bank (FCB) for US$1.08B. The deal is set to close by year-end, subject to regulatory approval and due diligence. The ‘cost’ of this transaction is that CIBC will likely be precluded from engaging in share repurchases and limited from making any meaningful dividend increases prior to year-end 2006. CIBC stated that the share buyback program is on hold until mid-2007.

Retail Spread Challenge. Last quarter, management described renewed spread challenges in mortgages, especially as an increasing number of clients lock in their loans. The dollar amount of fixed-rate originations in mortgages and personal lending is now higher than variable-rate products. Deposit spreads, particularly in fixed-term, are indicated very tight.We are modeling flat spreads over the next few quarters. We think the trend towards fixed-rate products will continue as rates rise and the bank will maintain its appetite for secured loans (47% of the portfolio in Q1/06), as it tries to improve the credit profile of the retail loan book. Credit card competition also remains intense. CIBC is no longer taking its mono-line approach to the business as the bank’s in-branch sales offer now includes a total of 25,000 Aeroplan points available for balance transfers, chequing and deposit accounts.

Wholesale Activity Slipped a Bit. Our research indicates that CIBC World Markets had a light quarter by CIBC standards in equity underwriting with 19% market share, down from 32% average in last 6 quarters. We estimate CIBC’s M&A market share has also dipped to 20%, down from 31% last quarter. Debt underwriting at 16%, we also estimate is a few percentage points below normal. Having said that, from in-quarter meetings with management we came away with the impression CIBC wholesale will start growing again in 2007, as CIBC is convinced they can turn on the tap and hit the ground running again. This sounds reasonably compelling, so we will be watching for reiteration and rationale this quarter.

Capital & Dividends

No Dividend Hike. CIBC delivered its first dividend hike last quarter (up 2¢) since it took the $2.5 billion Enron litigation reserve in August 2005. We believe any more meaningful dividend hikes are on hold until mid-2007, given a US$1.08 billion capital commitment at year-end 2006 for First Caribbean Bank. Management has categorically stated that its share repurchase is indeed on hold until sometime in 2007.

Tier 1 Capital Ratio Similar to Q2. We are looking for a Tier 1 ratio of 9.3% this quarter, compared to 9.2% in Q2/06 and 7.5% a year ago (as a result of the Enron litigation settlement). CIBC is aiming to hold its Tier 1 capital ratio at 8.5% following the acquisition of First Caribbean, which may be achieved through slowing or reversing balance sheet growth (i.e. securities or loan growth) or perhaps by raising loan securitization levels.

Valuation

Our $85 price target is set at 12.5x our 2007 cash EPS estimate of $6.77. Our target P/E for CIBC indicates a 4% discount to our target P/E for the bank sector to reflect CIBC’s lower revenue growth profile. We have factored mid-single-digit earnings growth over the next two years, roughly in line with our estimated loan and revenue growth for the bank. We expect that the $250 million in expense saves will be realized roughly half in 2006 ($0.25) and half in 2007. In our view, the primary risk remains revenue shortfall, as the bank will be focusing on cost cuts rather than revenue growth.

Price Target Impediments

Risks include (i) CIBC’s poor track record of high absolute and relative earnings variability, (ii) high correlation of earnings revision power to credit losses and capital markets revenue and (iii) further potential class action settlements. Positives include a corporate loan book that has been managed down and, in our opinion, effectively hedged, as well as improving cost control in recent quarters, owing partly to divestitures. Our price target may be exceeded if domestic mergers become hot again, though we see this risk as very low given the recent election of a minority government with several higher priority items on the agenda.
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