Wednesday, August 22, 2007

Preview of Banks' Q3 2007 Earnings

Financial Post, Jonathan Ratner, 22 August 2007

Appreciation of the Canadian dollar has slowed, which helps banks with operations outside of Canada and the domestic economy.

Investor rotation into short term treasuries has driven down yields, which should boost bank margins since they borrow short term and lend long term.

With prices having dipped 15% since January, valuations for Canada’s financial stocks have become more attractive. The Big Six banks are trading at 10.98 times forward earnings per shares estimates, compared to 12.55x in 2006 and 12.86x in January 2007.

These are some of the reasons Canadian banks present an attractive investment opportunity, Citigroup analyst Shannon Cowherd said in a report previewing their third quarter results.

However, she is predicting an increase in the range of 50% for credit loss provisions compared to the third quarter last year.

As a result, Ms. Cowherd’s estimates average 4% below consensus (excluding Bank of Montreal).

She thinks BMO and CIBC could show upside earnings surprises, while Royal Bank and Toronto-Dominion may disappoint given their debt securities exposure.

Ms. Cowherd rates BMO a “buy” with a $85 price target, saying very little is expected given its earlier losses related to commodities trading.

Bank of Nova Scotia is also a “buy” with a $64 target, while its geographic diversification is considered a source of stability.

CIBC is the last of her “buy-rated” names in the group, with a price target of $121. It pre-announced third quarter results and is most exposed to the U.S. subprime market, Ms. Cowherd said. “Given the bank will likely report strong results it is best to buy ahead of the quarter’s results,” she added.

National Bank is rated “hold” with a $67 price target, while the analyst noted its dependency on its capital markets businesses.

Royal Bank is also rated “hold” with a $59 price target, given the lack of any clear catalyst that would boost the stock and less expected benefit than its rivals from the yield situation.

Finally, TD is rated “hold” with a $73 price target, both of which will be re-evaluated when more information surfaces about its asset-backed commercial paper exposure.
Scotia Capital, 16 August 2007


• Banks begin reporting third quarter earnings August 23. There is tremendous nervousness in the equity markets, particularly with respect to bank stocks, given the current liquidity and credit crisis. Our forecast of earnings growth of 13% year over year (YOY) and 2% sequentially is unchanged with some potential for weaker earnings due to losses in the banks’ trading books. However, we believe bank trading revenue, although weak, will not have the impact on overall earnings the market is implying.

Banks Begin Reporting August 23

• Banks begin reporting third quarter earnings with Toronto-Dominion Bank (TD) on August 23, followed by Royal Bank (RY) August 24, Bank of Montreal (BMO) and Bank of Nova Scotia (BNS) August 28, Canadian Imperial Bank of Commerce (CM) and National Bank (NA) August 30, and Laurentian Bank (LB) and Canadian Western (CWB) closing out reporting September 6. Scotia Capital’s earnings estimates are highlighted in Exhibit 1, consensus earnings estimates/target prices in Exhibit 2, conference call information in Exhibit 3, and dividend increases and trends in Exhibit 6.

Q3 Earnings – Relief Rally?

• Canadian banks’ shares continue under selling pressure due to the liquidity crisis and credit concerns. Bank stocks have declined 8% year-to-date and 13% from their all-time highs. The bulk of bank share price weakness has occurred since the end of June. Canadian bank share price declines have been similar to Bank of America, Wells Fargo, Wachovia, and JP Morgan. We expect third quarter earnings to give the market some comfort about the sustainability of earnings, although follow-through into 2008 is likely needed.

• Our earnings forecast for Q3/07 is unchanged although the risk of weaker earnings than expected due to capital market volatility and significant widening of credit spreads has increased.

• Market concerns have moved from sub-prime mortgage loans to CDOs/CDOs squared to commercial paper and LBO financings.

• The banks’ loan exposure to major problem loan areas, highlighted in Exhibit 9, reflects the banks’ high capital and earnings levels relative to asset risk especially compared to previous cycles. Exhibit 7 also highlights the relatively benign Canadian sub-prime market compared with the United States. Pricing of sub-prime mortgages (ABX-BBB) and LBO loans (LCDX) have shown declines, as highlighted in Exhibits 10 and 11. The Canadian market is being hit by liquidity concerns with credit thus far remaining relatively solid.

• Bank stocks typically absorb the bulk of the market sell-off early given their liquidity, inherent financial risk, and the fact that their share prices have been trading at all-time highs.

• Bank market capitalization has declined $34 billion from its high. Bank valuation, we believe, is discounting a 31% decline in bank earnings, or a $9 billion decline pre-tax, which we believe is excessive. Bank trailing P/E multiples retraced early in the year based mainly on earnings strength as bank earnings increased nearly 20% in the first half of 2007. The recent sell-off has caused bank P/E multiples to decline further to 12.4x trailing earnings, the lowest since October 2002 and below the 2006 trough of 13.0x.

• Upon surviving the 2002 Telco-Cable, Power, Power Generation loan fears with earnings relatively intact (ROE 15%), the market expanded the banks’ P/E from 11x to 15x trailing earnings over the subsequent two years. Bank P/E multiples have been consolidating in the 13x-15x range over the past several years.

• We expect the banks to weather the most recent storm with earnings relatively intact and a trough ROE of 18%. Upon scaling yet another wall of worry we would expect P/E multiples to expand to the 15x-16x range. However, prior to these events unfolding we expect volatility and worry to persist in the near term.

• Bank valuation has become extremely compelling with the bank dividend yield relative to the TSX at its highest level in history (except for the Nortel impact), and the bank dividend yield relative to 10-year bonds moving back to 3.2 standard deviations above the mean. Bank dividend yields against pipes and utilities have also moved to all-time highs.

• Bank P/E multiples relative to Insurance companies are now 1.9x lower, the lowest relative P/E multiple in six years.

• We remain overweight the bank group despite the liquidity crisis and credit concerns based on strong underlying capital position, earnings power, and compelling valuation.

• RY and TD remain rated 1-Sector Outperform with LB, CWB, and CM rated 2-Sector Perform. We upgraded NA to 2-Sector Perform from 3-Sector Underperform based on a 16% decline in the share price year-to-date 2007 and the fact that the P/E discount has widened to 15%, at the higher end of our expected range. We maintain a 3-Sector Underperform rating on BMO based on weaker expected earnings and lower profitability with no meaningful P/E discount.

Dividend Increase expected from BMO, CM, RY, and TD

• Dividend increase candidates this quarter are BMO, CM, RY, and TD, with dividend increases expected in the range of 5% to 9% (Exhibit 6). This follows dividend increases by

BNS and NA last quarter of 7% and 11%, respectively.

• The bank group’s dividend payout ratios on our 2007 and 2008 earnings estimates are 46% and 41%, respectively. BMO dividend payout ratio on our 2008 earnings estimate is a high of 51%, and CM is at the low end at 37%. We continue to expect bank dividend payout ratios to drift towards 50%.

Wealth Management Earnings Expected to Be Solid

• Wealth Management earnings are expected to remain strong this quarter driven by solid mutual fund sales and continued AUM growth. Bank average mutual fund assets are up 16% from a year earlier and 3% sequentially. The banks continue to dominate mutual fund sales, particularly RY and TD, with market share of net long-term asset sales at 19% and 9%, respectively, during the quarter. NA experienced relatively low levels of net long-term asset sales due to continued weakness at Altamira.

Retail Bank Earnings Expected to Be Strong

• We expect retail bank earnings to be solid, driven by strong volume growth, stabilizing net interest margin, and stable loan loss provisions and cost management. RY and TD continue to have the strongest earnings momentum in this segment.

Wholesale Banking Earnings to Remain Solid

• The Canadian banks stand to benefit this quarter from the continuing high levels of capital market activity. The number of M&A deals closing this quarter increased 11% YOY and 29% sequentially, while the value of completed transactions increased 40% from a year earlier. TSX trading volume was also up a significant 34% YOY although remained flat quarter over quarter (QOQ). IPO dollar value increased sequentially by 10% but declined 29% from a year earlier. Secondary financing dollar value increased 79% from a year ago but declined 31% sequentially.

• In the third quarter, the Canadian dollar appreciated an astonishing 8%, a magnitude that compares with yearly appreciations in 2002, 2003, and 2004. The rapid increase in the Canadian dollar is expected to negatively impact the bank group’s international earnings, with the largest impact on BNS and a negligible impact on NA, which does not have any foreign subsidiaries.

Third Quarter Highlights

• Bank of Montreal is expected to report earnings of $1.32 per share versus $1.30 per share a year earlier, an increase of 2% YOY and 1% sequentially. We expect the bulk of BMO’s earnings growth to come from wholesale banking and wealth management as the bank continues to reinvest in its Canadian and U.S. retail businesses. We are concerned about the bank’s structured investment vehicles (SIV) business in the United States, which it started in January 2006.

• Canadian Imperial Bank of Commerce is expected to report $1.99 per share, an increase of 17% YOY and 2% sequentially. On August 13, 2007, CIBC announced it expects Q3/07 reported earnings to be approximately $2.30 per share including unusual items such as gains on securities and credit derivative hedges, reversal of litigation, and income tax accruals. Expected Q3/07 operating earnings (excluding unusual items) were not disclosed; however, CIBC expects they will be above analyst consensus of $1.90 per share. Expected earnings include a $290 million ($190 million after tax or $0.56 per share) write-down on assets with U.S. sub-prime exposure. Revenue growth excluding FirstCaribbean is expected to remain challenging.

• National Bank is expected to report $1.40 per share in the third quarter, an increase of 12% YOY and flat from the previous quarter. We expect solid earnings growth from all segments and very little negative impact from recent currency appreciation. However, we remain concerned about NA’s high reliance on market-sensitive revenue.

• Royal Bank is expected to report $1.07 per share, an increase of 18% YOY and 8% QOQ. Strong earnings growth is expected from RY’s retail and wealth management businesses, with potential weakness from U.S. & International Banking driven by appreciation in the Canadian dollar.

• Toronto-Dominion Bank is expected to report $1.35 per share, an increase of 12% YOY and a decline of 1% QOQ. Retail and Wealth Management earnings are expected to continue to drive earnings, with wholesale banking contributing increasingly to earnings growth. We continue to believe that downside risk from TD Banknorth is limited going forward as management has shifted its focus from acquisitional growth to improving operating inefficiencies. TD Ameritrade earnings contributions for Q3/07 are estimated at $0.08 per share versus $0.09 per share in the previous quarter and $0.08 per share a year earlier.

BMO – Two Small Wisconsin Acquisitions

• On July 10, 2007, BMO announced two small acquisitions in Wisconsin for a combined US$372.2 million, of which US$137.2 million will be paid in cash and US$190 million will be paid in stock. The purchase price represents 25.4x LTM earnings, 2.2x combined book value, 3.0x tangible book value, and a combined deposit premium of 19%. We view these acquisitions as mildly negative given price, low market share, difficult operating environment, execution risk, and low expected shareholder return.

BMO – Renews Normal Course Issuer Bid

• On July 24, 2007, BMO announced the renewal of its normal course issuer bid commencing September 6, 2007, and ending September 5, 2008. BMO will have the ability to purchase up to 25 million shares or 5% of the public float for cancellation. BMO’s current normal course issuer bid expires on September 5, 2007.

BNS – Scotiabank Mexico Earnings and Contribution Disappointing

• Scotiabank Mexico reported Q2/07 consolidated net income of C$91 million (P$927 million), a decrease of 21% from last quarter and a decrease of 13% from a year earlier. Negative earnings momentum was due to a more normal tax charge and the absence of loan loss reversals.

CM – Announces Write-Down on CDO Exposure

• On August 13, 2007, CIBC announced it expects Q3/07 reported earnings to be approximately $2.30 per share including unusual items such as gains on securities and credit derivative hedges, reversal of litigation, and income tax accruals. Expected Q3/07 operating earnings (excluding unusual items) were not disclosed; however, CIBC expects they will be above analyst consensus of $1.90 per share.

• Expected results also include a mark-to-market write-down of approximately $290 million ($190 million after tax or $0.56 per share) of CDOs and residential mortgage-backed securities related to the U.S. residential mortgage market.

TD – TD Ameritrade Earnings

• TD Ameritrade reported Q3/07 cash earnings of US$0.28 per share versus US$0.24 per share in the previous year, above IBES estimates of US$0.25 per share. At its current ownership level of 39.8%, the estimated contribution to TD would be C$59 million or C$0.08 per share, versus C$0.09 in the previous quarter and C$0.08 per share a year earlier. TD Bank’s contribution declined QOQ due to the appreciation of the Canadian dollar.
RBC Capital Markets, 14 August 2007

• The Big 6 Canadian banks report Q3/07 results between August 23rd and August 30th.

• We estimate EPS growth of 11% on average versus Q3/06. We forecast five banks in the 10-13% range, with BMO trailing at 6%, on weaker expected growth in domestic retail earnings.

• Our estimates are below consensus for all the banks except for NA, probably because of a more cautious outlook on wholesale earnings.

• If wholesale earnings are ahead of expectations, we would caution against assuming that Canadian banks are unaffected by worldwide capital markets jitters. Canadian banks' Q3/07 include the months of May and June, which were good months for capital markets businesses in general. We believe that future revenue shortfalls are possible not only in U.S. sub-prime securities, but also in debt underwriting, M&A and trading. A spillover of debt market issues into equity markets would also have negative implications.

• Retail businesses should show continued strong growth in earnings on continued strong loan growth, stable margins and higher equity markets. We believe that higher loan losses due to growth in credit card portfolios and lower commercial recoveries will partly offset these positives.

• Bank valuations are currently below their 5-year average (11.2x NTM P/E versus 12.2x) and stock prices are well below our 12-month target prices. We do believe, however, that bank stocks may see share price weakness in the near term because:

a) we do not believe that the street's estimates reflect much deterioration in wholesale earnings;

b) News flow out of world financials is likely to be negative with the potential for negative surprises outside of U.S. sub-prime housing;

c) We do not believe that banks are trading at valuations that are low enough to attract incremental money. Banks are trading above their trough valuations of the last 5 years (10.5x NTM P/E) and banks in the U.S. and Europe are trading at lower valuations. Canadian banks may indeed face less potential issues related to U.S. housing, but we believe foreign money flows are easier to attract when valuations are distinctively cheap.

• Within the bank space, we favour the stronger retail banks (TD and RY and/or those with lower exposure to wholesale income (TD and CIBC). CIBC clearly has the most direct exposure to U.S. sub-prime housing, but we believe that its stock price reflects that risk.
BMO Capital Markets, 3 August 2007

Loan Growth – Outstanding

It is difficult to describe Canadian loan growth as anything other than outstanding. We now have volumes for both May and June (two of the three months in the quarter). Both months saw loan balances across the banking system grow by over 10%, with both the business and consumer books contributing strongly.

We continue to forecast a slowdown in loan growth in the coming months. This view is predicated on the strength of the dollar, and a simple statement of fact: every period of 10%+ loan growth in Canada has been followed by a decline to about 5% within the next year or two. We believe that dollar strength has negative implications for Central Canada (the core of the Canadian bank loan book) as business becomes less competitive vis-à-vis U.S. competitors. This should slow demand for commercial credit, and ultimately job growth in Ontario and Quebec. We are assuming loan growth in 2008 of slightly less than 5%, so we are clearly forecasting a fairly rapid decline from current levels.

Spreads Should Remain Stable

We expect spreads to remain stable in the third quarter. Dramatic shifts in loan mix in the period 2002 until the end of 2006 resulted in sharp declines in domestic P&C spreads. Most importantly, we saw rapid growth in residential mortgages and a decline in demand for business credit. Effectively, we were replacing 300 basis point loans with 70-basis-point loans. Furthermore, the non-residential mortgage book experienced a material shift from unsecured to secured credit. Both of these shifts caused tighter spreads, but bode well for the next credit cycle (discussed later).

Of course, there are several other factors that impact spreads, including Prime-BA spreads, slope of the yield curve, absolute levels of interest rates and competitive pressures. On the first, the anticipation of a rise in Prime (analogous to the situation in 2006) resulted in wholesale rates squeezing in on Prime. This caused some compression in the Prime-BA spread—back to the lower levels of 2006. Overall, we believe that this impact will be modest. If anything, BNS would be marginally more impacted than the rest.

The second factor, the slope of the yield curve, has become more positive this quarter, particularly when compared to the past four quarters. A perception of rising inflation fuelled an intra-quarter rally in longer-dated bonds. However, with less pressure at the short-end, we saw the yield curve move from inverted to slightly sloping during the quarter. As in the case of Prime-BA spreads, we believe BNS is the most exposed. In reality, these two counter trends will likely offset.

The last two variables don’t appear to have changed much. The prime rate moved modestly higher in June and this should continue to help deposit spreads. We see little significant change on the competitive front. ING, long the price leader, has moved away from its Everyday Low Price strategy and hasn’t actually moved the rate on its ISA account for over six months. It has relied on “limited time offers” which we believe are far less compelling to the consumer. This isn’t to say that price competition has gone away (ICICI and Manulife appear to be picking up the slack), but with ING’s retreat, the situation isn’t getting any worse. To date, Royal’s high interest account has been relatively low key, and we expect it to stay that way.

Dividends, Buybacks and Balance Sheets

We believe that at least one, likely two, and possibly three, Canadian banks will raise dividends this quarter. CIBC should institute its long-telegraphed dividend increase with the third quarter release—probably by more than 10%. We also expect BMO, which has been quite intent on returning excess money to shareholders, to increase its quarterly dividend by a modest $0.02. There is some chance that RY boosts its dividend as well this quarter.

The news on balance sheets should remain very good. High ROE, and more modest RWA growth, should ensure that Tier 1 ratios don’t change much in the current quarter. Buybacks have become noticeably more active in the third quarter, and we would expect to see more of the same in the fourth. Specifically, BNS and CM have significant room to boost buybacks.

Better Disclosure Would Be Helpful

Consistent with greater scrutiny, we expect to see Canadian banks again improve their disclosure. It goes without saying that additional disclosure would be welcome. It seems to us that Canadian banks remain their own worst enemies in disclosure. More information will highlight the modest levels of risk, while lack of information causes the market to jump to extreme conclusions. There are several suggestions that we would make that we believe would provide investors with some comfort. The following list is not exhaustive: CDO exposure (including ratings and tranches), subprime exposure, bridge lending commitments, loan exposure to hedge funds, etc.

Specific Company Comments

• TD Bank – High Expectations

It is clear that the market has begun to reward TD for its strategic changes over the past couple of years. Banknorth and Ameritrade seem to have found a base of earnings, while the Canadian businesses (both wholesale and retail) have solid momentum.

We are forecasting Cash EPS of $1.34 compared to $1.21 in the same quarter of a year ago. With Basel II a couple quarters away, and the potential for more M&A activity in the U.S., TD will probably be reluctant to boost its dividend—even though it has the lowest payout ratio among the big banks.

We expect strong performance in the domestic retail businesses. In the case of TD Canada Trust, we continue to believe that earnings growth will slow. Having said that, with the great volume growth industry-wide and the outlook for stable spreads, this could easily be another excellent quarter. We have continued to be surprised by the strength of the Wealth Management business. It is clear that the build-out of the full-service business has been better than we expected, and on the mutual fund and discount brokerage businesses, the results have gone from strength to strength.

• Royal Bank – More Moderation in Wholesale, More Strength in Retail

We expect the retail business of Royal to continue to power earnings growth. Overall Cash EPS growth of 12% looks reasonable, as long as trading revenues don’t decline too much. The market reacted poorly towards the results in the second quarter, as the wholesale business underperformed its peers. We believe that the market will be far more discerning this time, and will focus on how the retail businesses perform.

We aren’t forecasting a dividend increase this quarter, but there is some chance that one could occur. If there is an increase, it would be minor, $0.02 quarterly.

• BMO – Back to a More Normal Pattern

After the commodity trading loss, this should be an uneventful quarter. Year-over-year earnings growth should be driven by good investment banking and private client results. We are forecasting Cash EPS of $1.41 compared to $1.30 a year ago. BMO moved on its dividend two quarters ago, and we are expecting a modest $0.02 increase. This would maintain the payout at the mid-point of the bank’s 45–55% range.

There is little reason to be optimistic on either Harris or the domestic P&C Bank. In Canada, the year-ago results include the MasterCard gain and a tax recovery, so the lack of growth is misleading. Excluding unusuals, the growth should be about 10%. Harris is more difficult to call. Continued pressure on margins and the potential to see some rise in loan losses could result in even weaker performance than we are forecasting. The strength of the Canadian dollar is also a headwind.

We are forecasting a more robust result from the Private Client business, after what we would describe as a disappointing earnings result in the second quarter. We expect to see better cost control and the benefit of good volumes both in mutual funds and brokerage.

• Scotiabank – Domestic Strength to Bolster International

This should be another workman-like quarter from the Scotiabank. Investors will likely be impressed with the bank’s ability to earn through headwinds both from currency and from a more normal result from Mexico. We forecast Cash EPS of $1.00 compared with $1.03 in the second quarter and $0.88 a year ago.

The bank raised its dividend at the second quarter’s release so there will be no news here. The balance sheet remains very robust and with the pullback in share price, we believe that buyback activity should begin to accelerate. There will likely be some update on the ongoing opportunities in international. The Puerto Rican deal has been delayed, and there is now additional speculation on a deal in Chile. Let’s hope, for Scotia’s sake, that the Toronto Police Force isn’t involved in the negotiations (memories of the U20 World Cup earlier this summer remain).

• CIBC – No News Is Good News, I Guess

We have cut our earnings estimate for CIBC to $1.75 from $1.97. This compares with $1.95 in the second quarter and $1.70 in the third quarter of 2006. We have articulated in the past that CIBC could take a $100–150 million hit from its CDO exposure. Given the lack of a pre-announcement, we are maintaining this estimate.

That’s the bad news. The good news is that we believe the bank will move meaningfully on dividend (to $0.86 from $0.77), and to reaffirm its commitment to complete its buyback by yearend. Given the run rate of re-purchases (1.5 million shares a month), this looks very achievable. We note that CIBC’s balance sheet remains stable with a Tier 1 ratio of about 9.5%. For the third quarter in a row, we again expect a stock split—maybe this time we will be right.

• National Bank – More Help from Retail, Less from Wholesale

We expect somewhat slower growth this quarter from National Bank. Our EPS estimate of $1.39 compared to $1.25 in the year-ago quarter reflects modest retail growth, a flat wholesale result and lower loan loss recoveries. After the robust dividend increase last quarter, there likely won’t be any change to the quarterly dividend.