Monday, November 19, 2007

Modest Writedowns, Market Overshoot, P/E Divergence

Scotia Capital, 19 November 2007

• Canadian Banks pre announced write-downs for the fourth quarter of $2.2 billion (including NA estimate) or $1.3 billion after-tax representing 1.5% of common equity. These writedowns are modest and pale by comparison to global players. The banks also announced credit card gains of $1.1 billion after-tax offsetting the write-downs caused by the liquidity and credit crunch.

• Canadian Banks have the lowest relative exposure in history versus global players to high risk assets. Canadian Banks had more than their share of LDC loans in the early 1980s, excessive exposure to Commercial Real Estate (O&Y- Canary Wharf) in early 1990s and Telco/Cable/Power in 2002. The banks have incredibly low exposure to U.S. Sub Prime, CDOs and LBOs. The market has not differentiated much between Canadian Bank balance sheets and U.S. and other global players. It seems the Australian Banks represent the few to escape the contagion.

• The market's reaction has been severe (no differentiation) peeling off $35 billion in bank market capitalization or an excessive 27x the amount of the write-downs. Bank valuation is extremely compelling. Individual bank relative P/E multiples have started to diverge following the debt markets.

• Conclusion: Major market overshoot on discounting balance sheet risk. Best Buying Opportunity in five Years. Reiterate Overweight. P/E Divergence favours RY and TD - 1 Sector Outperforms.

Bank Write-Downs Estimated at $1.3 Billion

• Pre-released bank write-downs (exhibit 2) for Q4/07 totalling $2.2 billion (excluding NA estimate) or $1.3 billion after-tax representing 1.5% of common equity. This amount is not a significant haircut to earnings or equity and pales in comparison to some of the global players. Pre-released VISA/MasterCard gains offset write-downs this quarter.

• BMO and CM have the largest write-downs of $530 million or $0.69 per share and $463 million or $0.90 per share, respectively.

• Total write-downs of $1.3 billion after-tax represent 5% of the banks' $20 billion earnings base which we estimate is two weeks worth of bank earnings.

• The market has peeled off approximately $35 billion in market capitalization from the banks' 52-week highs. The loss in market capitalization represents 27x the amount of write-downs expected in the fourth quarter.

NA - $500M Write-Down Expected

• BMO, BNS, RY, CM and TD (VISA gains only) have pre-released write-downs with NA the only bank of the major six to not have press released. We continue to expect NA to announce a $500 million (or $2.00 per share) write-down on its $1.85 billion exposure to non-bank ABCP.

Visa/Master Card Gain Recap

• Banks announced gains from the restructuring of VISA International (Exhibit 3).

• CM and TD announced VISA gains of $456 million ($381 million after-tax and $1.14 per share) and $163 million ($135 million after-tax and $0.19 per share), respectively. RY announced a $325 million gain ($270 million after-tax or $0.21 per share) and BNS a $200 million gain ($160 million after-tax or $0.16 per share), slightly higher than expected due to prior ownership of VISA International in addition to VISA Canada.

• BMO will also record a gain of $110 million ($85 million after-tax or $0.17 per share) aftertax from the sale of MasterCard shares.

Bank Relative P/E Multiples Taking Cue from Debt Markets

• Bank P/E multiples have started to diverge after a period of abnormal P/E convergence (Exhibit 4). This trend is following the same pattern that has happened with the debt markets and corporate spreads. Just as the debt market was not differentiating for risk, bank P/E multiples were not reflecting differences in profitability, quality of earnings, business mix (retail versus wealth management versus wholesale) or growth prospects (including degree of reinvestment).

• The debt market is now discounting for risk as corporate spreads have blown out and we are now seeing Bank P/E multiple divergence. Individual Bank P/E differentials generally tend to mirror bond spreads over time and this cycle seems to be no different (Exhibit 5). We continue to believe bank relative P/E multiples will trend towards levels highlighted in Exhibit 1. We expect divergence in P/E multiples will favour Royal Bank and Toronto Dominion based on the quality and size of their retail and wealth management (especially RY) platforms, relatively low earnings exposure to wholesale, high profitability and growth prospects.

Valuation - Extremely Compelling

• Bank valuation is extremely compelling. Bank dividend yield relative to bonds is 95% (Exhibit 8) or 4.4 standard deviations above the mean and with dividend growth projected at double digit over the next five years this valuation is extraordinary.

• Bank dividend yield relative to the TSX (Exhibit 9) is also at a record high except for the 1999/2000 peak caused by the major appreciation in Nortel's share price. Bank dividend yield is 2.2x that of the TSX.

• On a price earnings basis we believe we bottomed Nov 9 at 11.9x and look for major P/E expansion post the credit and liquidity crisis. Bank earnings need to be stressed tested in order to garner higher P/E multiples from the market.


• Reiterate overweight bank recommendation based on extraordinary valuation and exceptionally strong absolute and relative balance sheets. Reiterate 1-Sector Outperforms on RY and TD.