Thursday, August 23, 2007

BMO Capital Markets on Bank Dividends

BMO Capital Markets, 22 August 2007

We aren't in the camp that is encouraging banks to boost dividends and buybacks aggressively. Maybe we are just showing our age, but we continue to believe that the short-term fixed income market volatility warrants some caution.

We believe that CIBC will boost its dividend this quarter (it has meaningfully lagged its peers on this front over the past year); we think there is a chance of RY and/or BMO moving, and we expect all other banks to stand pat.

In many ways, the dramatic volatility over the past couple of weeks should cause Bank Directors to pause. We believe there will be lots of opportunities in the future for banks to commit to return more annual earnings to shareholders (which dividend increases effectively do) and to reduce their permanent capital (which buybacks do). Given the current environment, discretion is the better part of valour.

We continue to recommend bank shares, with a preference for TD, CM and RY (all rated Outperform). All three have above-average exposure to the domestic Canadian economy, and we believe that the news on this front remains good. The risks appear to be quite manageable given the strength of the core franchises and the high degree of capital in the banking system.

Volatility Is High

It is clear that what started as a problem in the U.S. sub-prime mortgage market has spread. Risk has again become a four letter word, as evidenced by the recent problems in the non-bank asset backed commercial paper (ABCP) market in Canada. Conduits, which according to all reports continue to hold performing assets, have been unable to roll commercial paper, at any price. In this case, the perceived risks have more than outweighed the current cash flows of these vehicles It is the issues beyond Canada's borders, however, that have caused us the most concern. The rate on 90-day US T-Bills varied from 2.9% to 3.6% inter-day yesterday (see chart). If this isn't a sign that there are liquidity problems in short-term markets, we don't know what is. We expect Canadian banks to weather these problems, but we highlight that fourth-quarter trading revenues for Canadian banks tend to be seasonally weak, and this will likely be exaggerated by the current environment.

Banks have Already done a lot

Investors view (rightly) bank dividends as sacred, and the increases in dividends have put long-term commitments on all banks (in our opinion). Canadian banks have boosted their annual common dividends to shareholders from under $3 billion in 2000 to over $8 billion currently (see chart below). In a period of unprecedented volatility, a breather on increases seems justified.

Buybacks seem far less permanent, and investors seem to pay far more for dividends (again rightly so). Over the past couple months, banks have already begun to ratchet up their share repurchases. In July, banks bought back about three times their monthly average. We try not to be swayed by monthly purchases, and rather consider six rolling averages. Even on this front, banks have already moved to take the opportunities of weaker share prices (see chart below).


It is possible that investors will be disappointed by a more cautious view on the dividend and buyback front. If the earnings outlook is so solid, they may well ask, why not continue to boost dividends aggressively? We remain comfortable on the earnings outlook (although continued market volatility could spill over into the broader economy, which would reduce earnings expectations somewhat). We are confident that the Canadian economy will continue to perform well relative to its peers. Having said that, we believe that some caution is warranted, and not just for defensive reasons. Many cynics of Canadian banks suggest that they missed an opportunity in the early 1990s to build a larger non-Canadian presence following the debacle of commercial real estate in North America. At that stage, however, they were facing their own problems. The situation is different today. We believe that given their relatively strong balance sheets, the strength of the Canadian dollar and the relatively robust Canadian economy (which still drives the core of bank profitability) there could well be an excellent opportunity to expand at a fortuitous time.

We continue to recommend Canadian banks, with a preference for TD, CM and RY which have above-average exposure to the domestic Canadian economy. We think that TD is particularly well positioned to expand if the U.S. economy deteriorates. We just aren't sure that the time is right to reduce permanent capital (through buybacks) or to commit to increased annuity payments to shareholders (through dividend increase).