Friday, August 18, 2006

RBC CM Preview of National Bank Q3 2006 Earnings

RBC Capital Markets, 18 August 2006


National Bank reports Q3/06 earnings on August 31.

Investment Opinion

• Looking for Above-Consensus Q3/06. Our cash EPS estimate of $1.25 is 1¢ above the Thomson First Call mean estimate of $1.24, and indicated up 6% YoY (2% QoQ).

• Strong Earnings Outlook and Quality. Last quarter, we upgraded our outlook for National based on (i) evidence of an extended favourable credit cycle; (ii) improved control around operating leverage; (iii) rising customer cross-sell success, and (iv) disciplined revenue generation.

• Loan Losses Forecast at 0.19% of Portfolio. We are forecasting a loan loss provision of $26MM (0.19% of loans) versus last quarter’s provision of $22MM (0.17%) and $15MM (0.12%) a year ago.

• Iterative Approach to Improving Operating Leverage. We think the Q3/06 results will feature a higher mix of core operating leverage and less contribution from trading and securities gains. Our Q3 estimate for 3% operating leverage factors 5% YoY revenue growth and 2% expense growth for a cost/revenue ratio of 65%.

• Disciplined Focus on High Margin Products in the Retail Branch Network. We are forecasting net interest income growth of 10% YoY in Q3 on similar loan growth. National is in the opportunistic position of being able to grow higher margin products and de-emphasize lower margin products as competitive cycles ebb and flow.

• No Dividend Increase Expected. We are not factoring any dividend increase this quarter, as the bank just delivered a 2¢ increase to $0.50 per share with the announcement of Q2/06 results.

• Valuation. Our $68 price target reflects our 12.5x target P/E on our 2007 cash EPS estimate of $5.42. Our target is set at a 4% discount to our sector target P/E, above NA’s ~10% five-year average discount to the peer group, reflecting much improved relative ROE, EPS growth and quality.

We feel NA EPS revision potential is positive, and cite solid capitalization and good prospects for continued dividend payout increases as positive features. While the capital markets business is operating at what we feel is full capacity, the retail and wealth operations are maintaining solid volume and revenue growth, and we are confident divisional operating leverage will remain buoyant. Although ROE is at or near peak levels, we are encouraged that management are planning to add innovative capital, in the next quarter, adding prudent financial leverage. Our price target is indicated at ~2.3x our estimated book value of $29.98 (as at Jul. 31/07).