Saturday, November 03, 2007

Banks & C$ Strength

The Globe and Mail, Sinclair Stewart, Boyd Erman, Andrew Willis, 3 November 2007

Last month, just hours after Toronto-Dominion Bank pulled off its $8.5-billion (U.S) takeover of New Jersey's Commerce Bancorp, Jim Cramer was dancing in front of a television camera in characteristic madcap fashion, giddily instructing his legion of disciples to brace for what he described as the “Canadian Invasion.”

“It's not going to be as cool as the British Invasion,” he warned followers of his popular CNBC investing show, “but it could make you more money!”

There was the obligatory needling of his “warm and lovable” northern neighbours, of course, like the tendency to twist “about” into “a boot,” but for all his screwball showmanship, Mr. Cramer was on to something.

The loonie, so long the butt of jokes for U.S. currency traders, was suddenly trading on par with the greenback for the first time in 30 years. American banks, meanwhile, had been getting the stuffing knocked out of them, courtesy of an ill-advised romance with subprime lending. Traditionally, they had traded at a 20-per-cent premium to Canadian banks, but with their recent swoon, they were now trading at considerably less.

“The Canadians can use their strong currency and their strong stock to pay huge premiums … they can get a much better deal than they could a year ago,” he insisted. “They've all got great reasons to invade.”

Perhaps. But do they have the stomachs? And if they don't now, when will they?

Since Mr. Cramer did his Copernicus routine and pronounced the stars aligned, the reasons for a cross-border incursion have only become more persuasive. The dollar has defiantly continued its surge, closing yesterday with another record at 107.04 cents. That has spurred speculation that we may see a counterweight to the hollowing-out narrative, led by both Canadian banks and insurers, the two sectors with the financial muscle and size to make headline-grabbing U.S. acquisitions.

Right now, the banks appear to have an advantage. Wall Street has become a repository for ever more grisly news, spooking the markets with billions of dollars worth of charges on the subprime mortgage fiasco, a litany of executive purges, and even intimations of dividend cuts at the likes of stalwarts such as Citigroup Inc.

To put this recent slide into perspective, consider this: TD is currently worth more than Merrill Lynch, the 93-year-old bastion of the retail brokerage industry. And Royal Bank of Canada, the country's largest company, has now eclipsed the storied Morgan Stanley in terms of market valuation.

The declining stock market values in the U.S. financial services industry aren't confined to the bulge-bracket firms, either.

Investors today are willing to pay about $2.60 for every dollar of book value at a Canadian bank, compared with $1.70 in the United States, according to figures compiled by Bloomberg. That ratio is about the reverse of where it stood in late 1999.

“If I was managing a Canadian bank, I'd be thinking if I was ever going to buy a U.S. asset, now would be the time,” said Peter Misek, who heads up research at Canaccord Adams in Toronto.

The strength of the dollar and relative weakness of U.S. bank prices removes two significant hurdles Canadian bank chief executive officers routinely cite when questioned about their tepid expansion plans.

The last time the U.S. financial market cratered, many Canadian bank CEOs were criticized for not making a more concerted buying effort. Some believed that these CEOs preferred (misguidedly) to wait for Ottawa to bless domestic mergers rather than take a shot in the U.S. market, although given the government's persistent refusal to deal with the file, it's a safe bet that few will make that mistake again.

And it should be pointed out that Canadian banks have much stronger balance sheets today than they did 10 or 15 years ago, putting them in an even better position to be aggressive.

And yet, only TD's Ed Clark has really taken the plunge, shelling out considerable cash and equity to grab Commerce, and make TD the seventh-largest retail bank in the United States.

RBC made two smaller purchases in succession this fall, the $2.2-billion takeover of Trinidad's RBTT Financial Holdings Ltd. and the $1.6-billion acquisition of Alabama National Bancorporation. Since running into problems with its purchase of North Carolina-based Centura a few years back, however, RBC has shown a preference for making smaller, bolt-on purchases rather than rolling the dice on a transformative deal.

Ditto Bank of Montreal, which has had the longest U.S. presence through its Harris Bank subsidiary, but seems congenitally unable – or unwilling – to dig deep for a big-ticket bank.

Bank of Nova Scotia has sidestepped the U.S. market, preferring measured growth in Latin America.

Canadian Imperial Bank of Commerce remains something of a wild card. It has been nursing itself back to health since a punishing settlement with Enron investors, although it did buy a stake in a Caribbean bank.

It is not out of the question that CIBC could seek a small foothold in the U.S. retail sector, either in branch banking or wealth management.

But if the logic is this compelling to do a deal now, why are investors not seeing more deals?

The rising dollar, in truth, can cut both ways: Yes, it makes U.S. targets cheaper, but it also hurts profitability. Canadian banks will be buying U.S. earnings streams, which will tumble when they're translated back to the loonie. The banks would have to do some currency speculation on these transactions, and hope that the dollar's torrid clip will ease.

It should also be pointed out that these U.S. banks aren't cheaper simply because of margin pressures or the like – for many, the mortgage crisis has hit hard, and their securities portfolios are in disarray.

The most important factor against doing a major deal, though, is history.

For all the psychological motivations of a higher dollar, there are deeply embedded memories of previous expansion plans gone awry: RBC's troubles with Centura, CIBC's ill-fated flirtation with Wall Street investment banking and brokerage, and even TD's purchase a few years back of Banknorth, which has not been viewed favourably.

There is a gun-shy mentality, in other words.

That said, Canada is a mature market, and if the big banks want to demonstrate growth prospects and be recognized as world players – as they often lament when they complain about the prohibition against mergers – the climate is arguably better for U.S. acquisitions than it ever has been.

“If you're going to go to the U.S., you have to get scale,” suggested Dundee Securities analyst John Aiken. “And there has not been a better time than now to get it done.”

Among the big financial services companies, insurers such as Manulife Financial Corp. and Sun Life Financial Inc. too could look south. The third of Canada's top three, Great-West Lifeco Inc., paid $4.6-billion (Canadian) earlier this year to acquire Putnam Investments Trust, a major money management firm.

In a recent research note, RBC analyst André-Philippe Hardy said Manulife is well-positioned to make a U.S. purchase, in part because of the loonie's rising valuation. He estimated the insurer has more than $3-billion in excess capital to deploy toward a purchase, and mentioned Lincoln National Corp. and Principal Financial Group as particularly good fits.

But the insurers face the same issue with getting bigger in the United States – those earnings come with a built-in discount when brought back across the border to the coffers at the home office.

Don Stewart, head of Sun Life Financial, pointed out this past week on a conference call that for 14 of the past 15 quarters, Sun Life has run into “headwinds” because of currency moves. Even so, he said he doesn't think much about the dollar when contemplating deals.

“If we are thinking in terms of merger and acquisition transactions, the fit is vastly more important than the currency at a point in time,” Mr. Stewart said.

And, U.S. life insurers haven't been hammered by the credit meltdown, meaning their relative valuations haven't sunk like American banks.

Lincoln and Principal, to take these two examples, have plenty of extra cash, and are both accelerating their share buyback programs – not the sort of weak environment that typically tempts Canadian insurers from strolling across the border with an offer, as Manulife did when it acquired John Hancock.

Money managers like Putnam could prove attractive, though, if for no other reason than many of the competitive bidders for these firms – U.S. banks – are not in a position to spend right now. That could keep prices down, and just maybe make Mr. Cramer look like a genius.