Friday, August 31, 2007

National Bank Q3 2007 Earnings

RBC Capital Markets, 31 August 2007

Q3/07 better than expected - Maintain Underperform

National Bank's core cash EPS of $1.48 were ahead of our expectations of $1.40, and up 18% versus Q3/06. The wholesale division contributed most of the earnings beat, with other divisions close to our estimates. The quarterly dividend was maintained at $0.60 per share, whereas we had looked for an increase.

As expected, the bank was not in a position to clarify two key issues related to developments in the Asset Backed Commercial Paper market and its purchase of $2.0 billion in ABCP from clients. (1) How much credit risk is there in underlying assets? and (2) What is the financial impact of potential business lost from commercial and corporate customers?

Lowered EPS estimates and target price

Our 12-month target price of $60 is down from $64 as we lowered our 2008E cash EPS by $0.10 (reflecting lower estimated financial markets earnings) and we lowered our target multiple to 10.8x 2008E EPS. This 2 point valuation discount versus our target average for other banks reflects (1) slower expected retail earnings growth; (2) uncertainty related to the ultimate outcome of the bank's

ABCP-related challenges; and (3) greater reliance on wholesale markets as a percentage of total income.

We maintain our Underperform rating as we believe the shares of the 4 lifecos we cover and most other banks offer more upside. The two major risks to our rating would be (1) a rapid and favourable resolution to ABCP challenges; and/or (2) improving relative retail revenue and earnings growth.

We remain concerned that Canadian banks could trade sideways or down in the near term on negative news flow out of world financials, as well as potential earnings disappointments in Q4/07. The increased risk aversion and tightening of liquidity, if it continues, could have a much larger impact on wholesale revenues in Q4/07 than it did Q3/07, in our view. The biggest risk to our positive 12-month outlook on the industry is that capital market issues become economic issues; a scenario that our economists do not envision at this time.
The Globe and Mail, Tara Perkins, 30 August 2007

National Bank of Canada's CEO cautioned Thursday that a proposal designed to fix problems in a troubled corner of the commercial paper market is an unprecedented undertaking, casting some doubt on whether the plan will salvage all investments in the $35-billion sector.

“As far as I know, there's never been a case of restructuring of one of these vehicles in Canadian legal history,” said chief executive officer Louis Vachon, who took up his job this summer.

“So, you know, we're sort of going forward all in good faith,” he said. “But, you know, exactly what the outcome will be after 60 days, it's too early to say.”

Mr. Vachon was referring to the so-called “Montreal proposal,” a plan to save the portion of the Canadian asset-backed commercial paper (ABCP) market that's not sponsored by banks. It was driven by the Caisse de dépôt et placement du Québec and endorsed by more than 10 financial institutions from Canada and abroad, including National Bank.

Executives at National cautioned Thursday that it's too early to know whether investors in non-bank ABCP will recoup all of their money, and the bank could face a “material charge” to its earnings in the future.

National recently announced that it's buying $2-billion in non-bank ABCP back from its mutual funds and clients, to protect its reputation, after recommending the paper as an investment. But Thursday one of its executives acknowledged the bank isn't sure what assets are behind that ABCP.

Asset-backed commercial paper is a complicated type of short-term debt that's backed up by packages of loans, ranging from credit card receivables to car loans to mortgages. The sector lacks transparency, and many investors did not know whether their paper was backed by subprime mortgages.

That fuelled some of the panic that led to the troubles in recent weeks, as liquidity dried up and some of the paper could not be rolled over, leaving some investors without their cash.

In a presentation to analysts Thursday, National said the $2-billion it's buying includes “minimal” exposure to the U.S. subprime mortgage market.

When an analyst asked for further details on the assets underlying the ABCP, Ricardo Pascoe, co-chief executive officer of National Bank Financial Inc., said “we are still in the process of doing our due diligence and really getting into what's in those assets. But, you know, I just refer to DBRS's statements that, as far as the credit quality of the underlying assets, they are very comfortable that those assets are still performing like triple-A assets.” That means that, even where there's subprime exposure, the assets are still highly rated, he added.

Mr. Pascoe, like Mr. Vachon, went on to warn that the Montreal proposal is not yet a solution for the troubles in the non-bank ABCP market.

Two key elements of the Montreal proposal were, first, to slap a 60-day moratorium on investors trying to get their money out of the trusts as well as issuers seeking funds from lenders, and then, second, to convert the paper into longer-term debt instruments called floating-rate notes (FRNs).

National described the proposal as “at a very formative stage” Thursday.

Mr. Pascoe said it's too early to say what the outcome of the process will be, and whether ABCP investors might recoup all of their money.

“When the consortium announced the proposal for the long-term restructuring that included the FRNs, that was just a proposal, and we are engaging a number of players in the debate, so it's hard to say what will actually come out,” he said.

National Bank also reported profit of $243-million Thursday, up 10 per cent from a year ago.

But its stock was downgraded to “neutral” from “outperform” by Credit Suisse analyst James Bantis, who said there are “tougher times ahead” for the bank.

It has an excessive reliance on wholesale banking activities, and there are difficult capital markets conditions ahead, Mr. Bantis said. National also has weaker-than-expected trends in consumer banking and wealth management, he said.