Tuesday, June 26, 2007

Banks' Valuation Imply a 21% Earnings Decline or 10-year Bond Yield of 5.8% to 6.5%

  
Scotia Capital, 26 June 2007

Event

• Bank earnings have been extremely strong in the first half of 2007, significantly better than expectations. Earnings growth in the second quarter was high at 17%, although down from the first quarter blockbuster with 24% growth.

What It Means

• One of the keys to the bank earnings growth picture has been the acceleration in risk-weighted assets and revenue growth, as the banks have stopped delevering for the first time since the early 1980s. Bank revenue growth was 10% in the first half of 2007, one of the highest levels in the past five years. Bank profitability has soared to new heights with an ROE of 24% in Q1 and 22% in Q2.

• Bank share price performance has been muted, in our view, due to a backup in bond yields, concerns about higher short-term rates, and appreciation of the CAD, as well as liquidity offered by bank stocks. In addition, bank shares are in their seasonally weak performance period.

• The market, we believe, is very aggressively discounting bank earnings.

• Reiterate overweight recommendation on the bank group based on attractive valuation and strong fundamentals.

Banks Second Quarter Overview : Earnings Growth 17%, ROE 22%

• Bank earnings have been extremely strong in the first half of 2007, significantly better than expectations. Earnings growth in the second quarter was high at 17%, although down from the first quarter blockbuster with 24% growth.

• Earnings growth and resilience has surpassed market expectations for the past three years. We are forecasting earnings growth in 2007 of over 14%, which would represent the fifth straight year of 14%-plus earnings growth for the bank group and has never been achieved before in history. One of the keys to the bank earnings growth picture has been the acceleration in risk-weighted assets and revenue growth, as the banks have stopped delevering for the first time since the early 1980s. Bank revenue growth was 10% in the first half of 2007, one of the highest levels in the past five years. Bank profitability has soared to new heights with an ROE of 24% in Q1 and 22% in Q2.

• Despite the earnings performance bank share prices are unchanged year-to-date versus a market gain of 8% (assisted by M&A activity). Bank share price performance has been muted, in our view, due to a backup in bond yields, concerns about higher short-term rates, and appreciation of the CAD, as well as liquidity offered by bank stocks. In addition, bank shares are in their seasonally weak performance period. The bank group’s trailing P/E multiple has declined to 13.6x from the 14.5x range earlier in the year due to earnings growth. This pattern is similar to that of last year when bank P/E multiples drifted to a low of 13.0x in June 2006 from the February 2006 peak of 15.1x. If we use 13.0x as support, bank stock downside risk is very modest from these levels at 3%.

Bank valuation is implying a 21% decline in bank earnings or a 10-year bond yield of 5.8%-6.5%, or combination of both. The implied bond yield is substantially above the current 10-year bond yield of 4.65%.

• We have stress-tested bank earnings for a recession and believe earnings would decline approximately 8% with ROE levels expected to trough above the mid-teens. The market, we believe, is very aggressively discounting bank earnings.

• Bank earnings strength in the second quarter has been derived from all business lines, with wholesale earnings exceeding expectations the most and wealth management and retail remaining extremely robust. In the cases of Toronto-Dominion Bank (TD) and Royal Bank (RY), wholesale earnings growth was the determining factor between a positive earnings surprise and disappointing earnings. Both RY and TD had strong earnings growth from their respective retail and wealth management platforms. However, TD reported impressive wholesale earnings growth of 55% while RY’s wholesale earnings declined 15% from a year earlier.

• Credit quality remains at very high levels, although loan loss provisions are increasing modestly and impaired loans are also rising slightly. Bank of Montreal (BMO) had extremely low levels of loan loss provisions this quarter at 8 bp and 14 bp, respectively. Canadian Imperial Bank (CM) and TD continue to have higher levels of loan losses at 47 bp and 39 bp, respectively.

• The rapidly appreciating CAD and possible short-term rate hikes are causing some investor concerns about the negative impact on earnings. If the CAD were to remain at the current level of $0.935 against the USD, we estimate bank earnings in 2007 would be negatively impacted by 1.1%, with 2008 earnings estimates negatively impacted by 2.0%. The individual bank’s impact varies, with National Bank (NA) being impacted the least.

• The bank group’s strong earnings and profitability is being translated into consistent and frequent dividend increases. Banks have increased their dividends by 211% since the beginning of 2000. NA raised dividends this quarter by 7%. This follows dividend increases by the remaining major banks in the range of 5% to 15% in the previous quarter. Bank dividend payout ratio is 43% based on our 2007 earnings estimate, in the low end of the target ranges.

• Bank valuations are extremely compelling on both a yield and P/E multiple basis. Bank valuations on a yield basis relative to bonds, pipes and utilities, income trusts, and the S&P/TSX Composite are all in the strong buy range, with reversion to the mean suggesting an increase in the bank index of 52%, 30%, 28%, and 44%, respectively.

• Bank dividend yields have increased to 3.4% or 72% relative to the 10-year bond yield, which is 2.1 standard deviations above the mean (Exhibit 26). Reversion to the mean would imply a 6.4% bond yield or a 37% increase in the bank index. Bank valuations are extremely attractive with a P/E multiple of 12.9x our 2007 earnings estimate and 11.6x our 2008 earnings estimates.

• We reiterate 1-Sector Outperform ratings on TD and RY.

• TD had particularly strong earnings in the second quarter (leading earnings momentum), driven by TDCT and Wealth Management and impressive earnings growth from wholesale banking. Wholesale banking was the main source of TD’s positive earnings surprise this quarter with earnings growth of 55%. TD’s valuation relative to the bank group is attractive given the strength of TDCT’s operating platform and the decline in earnings risk at TD Banknorth. We expect strong relative share price performance.

• RY, despite a relatively weak quarter, reported 24% ROE with both retail and wealth management earnings growth of 20% plus. RY has no meaningful P/E premium despite higher profitability and strength of its higher P/E retail and wealth management businesses.

• We maintain 2-Sector Perform ratings on Laurentian Bank (LB), Canadian Western Bank (CWB), and CM, with 3-Sector Underperform ratings on BMO and NA. We have no sell recommendations on an absolute return basis.

• Our 12-month bank index target is 30,700 for a total expected return of 29%. Our target is based on a forecast P/E of 16.2x our 2007 earnings estimate or 14.6x our 2008 earnings estimate.

• Our 12-month share price targets on BMO, CM, NA, RY, TD, LB, and CWB are $80, $115, $75, $75, $90, $39, and $30, respectively.

• Reiterate overweight recommendation on the bank group, based on record profitability and capital levels, low financial and earnings leverage to credit, diversified revenue mix, reasonable earnings growth outlook, low earnings volatility, ability to increase dividends, and attractive valuation, including extremely high dividend yields, low P/E multiples, and low relative risk.

Second Quarter Earnings Highlights

Dividend Increases : BNS, NA

• NA increased dividends this quarter as expected by 11%. NA indicated that it intends to review its dividend more frequently, every quarter as opposed to every other quarter, in order to remain within its targeted payout ratio of 40%-50%. NA’s dividend of $2.40 per share represents a 42.5% payout ratio on our 2007 earnings estimate, the lower end of management’s target range.

TD and BNS : 13% Revenue Growth

• Revenue growth for the bank group was 10% in the second quarter. Four of the six banks had double-digit revenue growth. TD and BNS led the banks with revenue growth of 13%, followed by NA with revenue growth of 11% and RY at 10%. CM’s revenue growth was 9%; however, excluding First Caribbean growth was modest at 3.2%. BMO was the outlier this quarter with relatively weak revenue growth of 3% primarily due to commodity trading losses recorded this quarter.

Retail and Wealth Management

• Domestic retail and wealth management earnings were strong, increasing 20% year over year, but declined 5% sequentially (due to fewer number of days). CM led retail earnings growth at 24.9% (14% excluding First Caribbean), primarily due to its recent acquisition of First Caribbean. BNS recorded impressive growth of 23% after five quarters of modest growth. RY earnings increased 21.2%, led by strong retail and wealth management results. BMO and TD also recorded solid earnings growth of 18.2% and 16.6%, respectively. NA earnings growth in retail and wealth management lagged the bank group at 10.1%.

• In terms of personal deposit market share CM is leading the bank group with a 140 bp increase. The remaining four banks all experienced market share declines of 7 bp to 64 bp, with RY at a high of 64 bp and NA at a low of 7 bp.

• CM and NA had solid gains of 58 bp and 29 bp in demand and notice deposit market share, respectively, followed by TD with gains of 14 bp resulting in a leading market share of 25%.

Underlying Retail Margins Stabilize

• Retail net interest margin (NIM) (Exhibit 6, columns 4 and 5) was unchanged from the previous quarter, but declined a modest 3 bp year over year to 2.99%. TD showed strongest margin results with increases of 7 bp YOY and 2 bp from the previous quarter.

Wealth Management Earnings Strong, Led by TD, RY

• Wealth management earnings results were mixed this quarter despite an extremely strong RRSP season. TD and RY experienced high levels of growth in their wealth management businesses, whereas BMO and NA recorded modest growth. TD had 30% growth, the strongest of the bank group, with domestic wealth management earnings increasing an impressive 19%. RY’s newly created wealth management segment recorded solid earnings growth of 21% this quarter. NA and BMO had lacklustre growth of 10% and 4%, respectively.

• Mutual fund assets for the bank group increased 16% to $254 billion after a nearly record breaking RRSP season. RY led growth at 21%, followed by TD at 18%, BNS at 15%, BMO at 14%, NA at 10%, and CM at 9%. RY and TD remain the industry leaders in net long-term asset (LTA) sales including transfers, with impressive market share of 20% and 14%, respectively.

International Divisions - Earnings Growth Modest

• International earnings were lacklustre for the bank group this quarter with growth of 11%, as U.S. operations continue to suffer from the difficult operating environment and net earnings were weaker from Mexico. RY, BMO, and TD reported modest earnings growth of 11%, 6%, and 5%, respectively. RY’s U.S. & International earnings weakened due to the absence of the U.S. Wealth Management business line, which has become a part of the new RY Wealth Management segment. We believe that downside earnings risk at TD Banknorth is low.

Wholesale Banking Earnings Increase 14%

• Wholesale banking earnings varied considerably this quarter, ranging from an increase of 55% at TD to a decline of 15% at RY and a decline of 19% at BMO due to a large commodity trading loss. Wholesale earnings for the bank group increased 14% excluding the impact of BMO’s large commodity trading loss (7% including the commodity trading loss). CM and NA reported strong wholesale earnings growth of 49% and 32%, respectively. BMO (excluding the commodity trading loss) and BNS also had growth of 17% and 15%. RY was the laggard this quarter with a decline in earnings of 15% due to lower trading revenue and lower loan loss recoveries.

• NA continues to have the highest earnings reliance on wholesale banking at 41% of earnings, followed by BMO at 37% (excluding the commodity trading loss), BNS at 32%, RY at 27%, CM at 26%, and TD at 22%.

Trading Revenue

• Trading revenue in Q2/07 was $1,610 million (excluding BMO’s large commodity trading loss of $171 million), an increase of 3% year over year but a decline of 10% from the seasonally high Q1 (excluding BMO’s large commodity trading loss of $509 million). Including the trading loss, trading revenue for the bank group was $1,439 million, an 8% decline from a year earlier. The trading revenue strength indicator excluding the commodity trading loss was 110% versus 103% including the trading loss.

• NA and TD had the strongest trading revenue growth at 61% and 15%, respectively. CM had a modest year-over-year declines in trading revenue of 5%, with RY experiencing the largest decline in trading revenue of 7%. RY’s weakness in trading revenue was due to lower fixed income trading revenue.

Capital Markets Revenue Strength Indicator : 112%

• Capital markets revenue was $2,378 million, a 10% increase year over year. The capital markets revenue strength indicator was at 112%, with BMO, and RY above average at 126%, and 117%, respectively, with TD and CM the weakest at 98% and 104%, respectively.

Market-Sensitive Revenue - NA High Reliance, BNS Low

• Market-sensitive revenue (trading and capital markets revenue) for the bank group represented 20% of total revenue, slightly below the eight-year average of 21%. NA led the group with market-sensitive revenue representing 30% of total revenue, with BNS at the low end representing 17% of total revenue. BMO’s market-sensitive revenue was fairly high at 19% of total revenue (26% excluding commodity trading loss) despite the $171 million commodity trading loss it recorded this quarter. Market-sensitive revenue for CM, RY, and TD represented 19%, 20%, and 21% of total revenue, respectively.

Loan Loss Provisions

• Specific loan loss provisions (LLPs) increased 39% year over year to $677 million but remain extremely low at 27 bp.

• BNS and BMO recorded the lowest LLPs, at 8 bp and 14 bp, respectively. CM and TD had relatively high levels of LLPs at 47 bp and 39 bp, respectively.

• We have reduced our 2007 LLP forecast by a modest $50 million or 2% to $2,500 million or 23 bp of loans due to continued strong credit quality and lower-than-expected LLPs at BNS. Our 2008 LLP estimate remains unchanged at $3,025 million or 27 bp.

Impaired Loan Formations Increase Moderately

• Gross impaired loan formations increased modestly to $1,637 million versus $1,435 million in the previous quarter and $1,320 million a year earlier. Gross impaired loan formations are at extremely low levels, at 16 bp of the bank group’s loan portfolio, for an annualized rate of 66 bp.

• Net impaired loan formations declined slightly to $830 million versus $961 million in the previous quarter but increased from $574 million a year earlier.

Risk-Weighted Asset Growth Continues

• Bank risk-weighted asset (RWA) growth has been accelerating over the past three years from the lows of 2002 and 2003, which saw actual declines in RWA levels. Bank RWA growth in first half of 2007 was 13%, the highest growth since 1996/1997. Market at risk growth was high at 45% in the second quarter. Banks have increased their trading operations, with market at risk being a growth driver in overall bank RWA levels. However, market at risk as a percent of RWA has been relatively stable and is now at 5%, only slightly higher than the 4% range since mid-2003. The leaders in RWA growth have been RY, and BMO. Despite RWA and market at risk growth leverage has not increased meaningfully.

Extremely High Profitability : RRWA : ROE

• The bank group recorded extremely high profitability in Q2 with return on equity (ROE) of 22% and return on risk-weighted assets (RRWA) of 2.09%, near the record highs of Q1/07.

• CM, RY, and BNS led the bank group in ROE at 24.9%, 24.0%, and 23.2%, respectively. BMO was the laggard this quarter with an ROE of 18.3% including the commodity trading loss (ROE of 20.8% excluding commodity trading loss).

• Bank RRWA ranged from a high of 2.72% at TD to a low of 1.57% at BMO, a spread of 115 bp. TD and BMO were the major outliers. The remaining four banks recorded RRWA within a 32 bp range with CM leading at 2.17%, followed by RY with 2.16%, and BNS and NA at 1.99% and 1.85%, respectively.
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• 15 June 2007 More Analysts' Remarks on Banks' Q2 2007 Earnings
• 6 June 2007 Review of Banks' Q2 2007 Earnings
• 24 May 2007 BMO
• 1 June 2007 CIBC
• 1 June 2007 National Bank of Canada
• 28 May 2007 RBC
• 30 May 2007 Scotiabank
• 30 May 2007 TD Bank;