Tuesday, December 05, 2006

Banks Mid-Earnings Cycle Update

RBC Capital Markets, 5 December 2006

• Results Beat Consensus But Quality a Concern. Last week, 3 banks posted EPS and dividends above consensus. Still, investors were dissatisfied with underlying EPS, whether it was the low tax rate at BMO, excess trading & securities gains at NA or a combination of both at RY. Also notable was a rise in impaired loans and corporate loans. In our view, underlying EPS was better than judged given improved retail loan spreads and stable loan volume, and the credit cycle finally coming to life should be as expected. We remain selective buyers: TD, RY and NA.

• Retail Spreads & Volumes Diverging. Retail loan and deposit spread rose at RY and NA, while for BMO retail spreads resumed their decline. Retail loan volume was robust at RY and NA, less so for BMO. Later this week, we expect TD will also do well, but CIBC not so well.

• Marking the Credit Turn. Impaired loans rose in both corporate and retail, and reserve coverage declined. This had been anticipated for over a year and should not come as a surprise. TD maintains the highest reserve coverage at ~360%, BNS at 146% is lowest. The sector average is ~180%.

• Corporate Loans up Sharply, For Now. Corporate loans were drawn at an increasing rate; balances were up 35% YoY at RY, 38% at BMO and 22% at NA. The growth reflects pre-qualified corporate borrowers tapping existing lines to fund cash flow deficiencies and/or investment, rather than new approved loans. We think liquidity remains strong and that this may be a balance sheet blip, ahead of another round of syndication & sales.

• BMO Investor Day Wednesday. The senior management team will be re-introduced to investors this Wednesday as BMO profiles its objectives and business priorities for 2007. We will be listening for BMO’s domestic retail turnaround plan, and for any hints of directional change in the U.S. expansion around BMO Harris.

• Mutual Fund Sales Up in November. IFIC released improved in-flows. RY and TD led by a wide margin as usual, but BNS and CIBC did better than expected, closing in on BMO. This is the highest November sales result since 2001, and raises expectations ahead of the RRSP season.

• Tight Valuation Range. The sector P/E at 13.5x forward consensus EPS is in-line with where the 10-year bond yield relationship suggests is fair, however the peer range is at the low end of its historic range. Investors are giving little or no incremental value for performance record discrepancies. However, we see sustainable differences emerging in retail performance, which, in our view, should drive valuation premiums for RY and TD. We also believe BMO and CIBC should trade to relative discounts until they demonstrate some market share ‘staying power.’