Tuesday, August 01, 2006

RBC CM Review of Last Week's Sector News

RBC Capital Markets, 1 August 2006

Canadian banks were up 0.7% last week, in our view, pulled by along their U.S. peers’ solid Q2 results. The commodity laden sectors of the S&P/TSX Composite Index were on a tear by comparison, helping the index gain 3.5%. Canadian lifecos netted only a 0.5% gain, held back by Sun Life’s weak Q2 result. We view Sun Life’s Q2 as company-specific, and see excellent value in IAG and Manulife at these levels.

BMO, up 2%, was strongest of the banks last week. BMO is tagged by many as “the defensive” bank, but we think investors are paying too high a P/E premium considering there may be a larger U.S. bank acquisition program in BMO’s future. We also see BMO’s credit portfolio as quite mediocre: higher-than-average impaired loans and lower reserve coverage. We prefer TD for its lower P/E, higher reserve coverage, and in our view, higher-growth U.S. expansion program. For a catalyst, TD Banknorth beat consensus for the first time in two years last week and is now entering the accretive stage of its U.S. integrations.

• Lifeco Q2/06 Review – Mixed News

Sun Life and IAG kicked off the lifeco’s Q2 reporting cycle with confusing signals, leading to significant price volatility last week. Using conservative interpretations, both missed consensus estimates, but we see IAG’s Q2 EPS at +7% YoY while Sun Life’s EPS growth was negligible. At both, sales growth was ahead of expectations in all segments: life, wealth and group, speaking to good underlying momentum for the sector.

One-Time Tax Breaks Boost Bottom Lines. In both cases, earnings were boosted by the change in the Canadian corporate and capital tax rates, both with retroactive, prior period gains and to a lesser degree on a run-rate basis for the foreseeable future. IAG flagged its past tax benefit as non-recurring, while Sun Life argued that tax gains were offset by other unusually low operating numbers. IAG stands to benefit more than Sun Life: (i) it is proportionately more levered to Canada and (ii) it starts from a much-higher tax base.

Sales Strain Hurt. Also in both cases, onerous “sales strain” was a mitigating earnings feature: both lifeco’s carried lower-than-market universal life (UL) pricing in individual life (IAG in Canada, Sun Life in the U.S.), and realized unusually high sales growth. In Sun Life’s case, Sun Life carried ‘outdated’ prices for an extra quarter to maintain good initial impressions with new major distribution partners – this may lock in some goodwill, time will tell. For IAG, sales were extra-strong for Level-premium UL that is attracting onerous reserves given the low-rate reinvestment environment. For both, we expect sales will be correcting in future quarters, though we have much better visibility regarding the potential EPS pick-up for IAG than for Sun Life.

Sun Life’s Group Sales Beat Expectations. Sun Life’s domestic group sales of $163MM caught our eye this quarter, well above the normal 8-quarter trailing average of $63MM. This reflected a very large Quebec account ‘win’, pushing Sun Life’s Administrative Services Only (ASO) to $120B in Q2, triple Sun Life’s normal level.

Big Group Win, What Quality? Despite the large size of account ‘win’, we just wonder about its value. Of course this musing runs counter to the view that Sun Life runs the highest-quality Group business; a high-tech, comprehensive value-added service. Sun Life argues that it may miss on price, but rarely on value proposition.

Sun Life is Growing Group Fast, Manulife Faster. Sun Life has averaged $10-20MM (10-15%) lower Group earnings than its peers since 2004, but is closing the gap, at least versus GWO. Our specific concern with Sun Life reflects a finer cut at the comparable Group segment financials. The good news is that, among the major three major lifeco’s, Sun Life’s sales are up 50% (4-qtr rolling average), even before the big Quebec win, compared to Manulife up 9% and GWO Nil. Sun Life has grown Group revenue 15% YoY (4-qtr avg) versus 9% for Manluife and 3% for GWO. Sun Life’s operating margin, however, is up only 7% versus the others’ 15%+ margin expansion (Manulife 18%). Sun Life’s earnings growth has kept pace with Manulife – GWO has been a laggard. Our conclusion is Sun Life’s supremacy in Group is less obvious to us after a cursory glance at respective financials. And watch Manulife…

• Bank Rank Notes

TD Banknorth Beats Expectations RBC’s U.S. bank analyst, Jim Ackor indicates TD Banknorth beat estimates this quarter with operating cash EPS of US$0.56 vs. RBC at US$0.54 and consensus at US$0.55 on better than expected margins. The margin lift was driven by BNK’s ongoing reduction in wholesale leverage and the margin accretive impact of the Hudson United acquisition. BNK had better than expected expense control during the quarter, strong sequential commercial business (+3.6%) and consumer loan growth (+4.8%). Core fee income was up 6.9% sequentially from seasonally weak Q1/06. Asset quality held steady. Perhaps this is the turn for BNK’s fortunes.

Banknorth’s Q2/06 release indicates BNK will contribute $68MM (our estimate was $70MM) or 8% to TD’s Q3/F06 cash net income, up from 7.5% in Q2/F06. On July 18th, Ameritrade’s Q3/F06 indicated a $55MM contribution (our estimate was $59M) to contribute 6.5% to TD’s income, up from 5% last quarter. The two U.S. subsidiary results may cost $0.01/share versus our TD Q3/F06 estimate of $1.17 (consensus is $1.16).

We now believe TD’s U.S. subsidiaries are set up as good news stories, rather than the weight on valuation they have been. Specifically, relative to TD’s washed out valuation and the subsidiaries washed out EPS estimates, TD stock is now looking very interesting.

Scotia Mexico Contribution To Beat Our Estimate, But Underlying Income is Lower Grupo Scotiabank (Mexico) reported Q2/06 earnings of P$1,487MM or P$993MM excluding a VAT tax recovery of P$494MM. This translates into ~C$148MM or ~C$99MM (excluding one-time items) at the Scotiabank level. We were expecting a similar C$125MM contribution to earnings as last quarter, even considering adverse F/X translation. Strong loan growth continued in calendar Q2, as mortgage balances increased 30% YoY, personal and commercial loans grew 38% YoY).