Tuesday, July 31, 2007

Scotiabank Mexico Q2 2007 Earnings

  
Financial Post, Jonathan Ratner, 31 July 2007

Solid second quarter results from Bank of Nova Scotia’s Mexican banking business showed net earnings rose 15% on a quarterly basis to $994-million pesos.

Blackmont Capital analyst Brad Smith thinks this should more than offset the 5% quarterly gain for the Canadian dollar as reflected in Scotiabank’s third quarter results.

He continues to rate BNS a “buy” with a $61 price target, representing upside of more than 20%.
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Dow Jones Newswires, Ken Parks, 31 July 2007

The Mexican banking arm of Canada's Bank of Nova Scotia said Tuesday its 2nd quarter net profit fell 36.3% mainly as a result of a one-time tax gain the previous year.

Net profit was 993.8 million pesos ($90.5 million), down from MXN1.56 billion in the year-ago quarter, Grupo Scotiabank said in a press release.

Net interest income for the quarter rose 16.7% to MXN2.20 billion thanks to strong growth in retail loans and an improving cost of funding, while non- interest income fell 31.5% to MXN1.11 billion.

Scotiabank reported an extraordinary gain of MXN528.9 million, principally from a tax refund, in the second quarter of 2006.

Administrative expenses increased 2.5% to MXN1.78 billion, while loan loss provisions soared to MXN502.9 million in the quarter from MXN44.6 million a year ago.

The bank's assets rose 5.3% to MXN136.67 billion at the end of June, while retail deposits grew 5.5% to MXN104.02 billion.

The bank's performing loans rose 4.5% to MXN90.01 billion, with strong growth in mortgages offsetting a drop in commercial and government lending.

Asset quality slipped during the quarter, with the bank's non-performing loan ratio rising to 2.5%, from 2.4% in the first quarter and 2.0% a year ago.

Scotiabank Mexico opened 15 branches during the quarter, ending June with just over 520 branches. The bank said its on track with plans to open 85 new branches in 2007.

Scotiabank Mexico ranks as the country's sixth-largest bank.
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Banks May See Decline in Trading Revenue

  
The Globe and Mail, Tara Perkins, 31 July 2007

Today is the last day of the fiscal third quarter for Canada's big banks, meaning what the markets do today will affect the profits they report.

While those profit announcements are still weeks away, Desjardins Securities analyst Michael Goldberg says he's going to be watching for possible profit warnings after today.

The banks need today's closing prices to determine the value of their trading books for the quarter. The prices will be used to figure out what the paper gains or losses are on securities the banks are holding.

The past week has seen concern intensify about the impact of credit related to U.S. subprime mortgages, as well as debt financing for leveraged buyouts. Mr. Goldberg said he now believes there is the chance of a systemic decline in banks' trading revenues for the first time since 1998.

Banks' trading revenues generally fluctuate from quarter to quarter, with the direction at each bank moving independently. The exception was the fourth quarter of 1998, when four of the big banks all suffered sharp declines in their trading revenue, driven by a downturn that followed billions of dollars in losses at the hedge fund Long-Term Capital Management.

Spreads on collateralized mortgage-backed securities have widened dramatically very recently, and that "could be the catalyst for another systemic downturn in trading revenue," Mr. Goldberg wrote in a report yesterday. The wider spreads may have serious negative repercussions for debt investors, he said.

"We believe that this increased risk explains the pullback that has taken place in many financial services stocks."

The situation might have an impact on investors far beyond just those that hold deeply subordinated exposure to collateralized mortgage-backed securities, he said. And he is not going to guess which banks may or may not be affected.

"It's very hard to tell where the actual exposures are going to turn up, because it's gone beyond just kind of junior exposures and it's widened out in the debt capital markets," Mr. Goldberg said in an interview yesterday. There is a lot of leverage that is related to the subprime mortgage-backed securities, and that adds to the complexity of figuring out where banks might be exposed, he said. "It may be in places that nobody has even thought of."

Increasing credit spreads, U.S. banks turning off the subprime lending tap, and the spectre of failed leveraged buyouts sent markets tumbling last week. And this time, the Canadian financial players saw their stocks fall along with the U.S. names, Genuity Capital Markets analyst Mario Mendonca pointed out in a note to clients yesterday. The bank stocks were down about 5 per cent on average.

"Like the U.S. financials, Canada's large-cap banks and insurers are trailing the composite by levels not seen in years," he wrote.

Shares of Toronto-Dominion Bank fell because the $3.3-billion in debt and $500-million equity bridge it had contributed to the buyout of BCE Inc. attracted renewed attention as other high-yield debt offerings had troubles, Mr. Mendonca said. With credit spreads widening, he said he would not rule out TD taking "at least a modest charge" as it tries to syndicate its exposure to BCE.

The market is not going to ignore the number of looming financial risks facing the banks in the near term. But that means that bank stocks are now heading toward attractive - i.e. reasonably priced - territory, Mr. Mendonca said.

There are numerous risks of bad headlines ahead, he said. Credit rating agencies are likely to downgrade some securities related to the subprime sector. There could be a leveraged buyout problem. A hedge fund could get into trouble, and "all of our banks have done some kind of lending to hedge funds." And, widening credit spreads are an indication that "this long period of the credit environment being perfect looks like it could be coming to some kind of end, or at least deteriorating."

While the potential headaches are numerous, and investors will react, Mr. Mendonca does not believe any bank will be crushed by any of these issues.

"So, I would say in the near term you're going to find opportunities to buy these banks cheaper."
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Financial Post, Grant Surridge, 30 July 2007

More word today regarding the imploding subprime mortgage situation south of the border. In a note to clients this morning, Desjardins Securities analyst Michael Goldberg says Canadian banks and lifecos could see reduced trading revenues as a result of exposure to such debt.

He refers to a Web site (www.markit.com) that measures the spreads for collateralized mortgage-backed securities (CMBS). Recently the spreads for even the AAA-rated tranches of CMBS have risen steeply, which could affect investors beyond those exposed only to the subordinated debt.

The implication, writes Mr. Goldberg, is that banks and lifecos could see significant declines in their trading revenues. He sees this possibility as being behind the recent pullback in financial sector stocks, and advises investors to watch for possible profit warnings after the banks’ July 31 quarter end.
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Wednesday, July 25, 2007

BMO Renews Buyback Plan for 25 Million Shares

  
Dow Jones Newswires, 25 July 2007

There could be more than meets the eye in Bank of Montreal's renewed normal course issuer bid for 25 million shares, says Genuity Capital Markets. The proposed Normal Course Issuer Bid is much larger than the bank's 4 year average, and if completed, means BMO will have returned more than 100% of earnings in dividends and buybacks. Analyst suggests BMO's move means "the bank is modeling for a substantial reduction in capital requirements under Basel II" by building "sufficient capital flexibility to manage under the new requirements." This, Genuity says, "does alert us to the potential for a material increase in buyback activity heading into 2008."
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Bloomberg, Doug Alexander, 24 July 2007

Bank of Montreal, Canada's fourth-largest lender, plans to buy back as much as 5 percent of its stock, extending its share repurchase program for another year.

Bank of Montreal will buy up to 25 million shares over 12 months starting Sept. 6, the Toronto-based bank said today in a statement. The bank had bought back about 5.33 million shares for an average price of C$69.72 as of the end of June under its current program, which ends Sept. 5.
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Tuesday, July 24, 2007

RBC CM Lowers CIBC's Q3 2007 EPS Estimate

  
The Globe and Mail, Tara Perkins, 24 July 2007

Canadian Imperial Bank of Commerce could be forced to take a hit of about $100-million this quarter because of its exposure to securities related to the U.S. subprime mortgage market, analysts say.

"The continued weakness in securities related to U.S. subprime housing will likely force CIBC to mark down its exposure to the space, as most of its securities are held in its mark-to-market trading book," RBC Dominion Securities Inc. analyst André-Philippe Hardy wrote in a note to clients yesterday.

"We believe that a $50-million to $100-million markdown is possible."

BMO Nesbitt Burns Inc. analyst Ian de Verteuil recently estimated CIBC could take a charge of $100-million to $150-million this quarter.

It is still in the midst of its fiscal third quarter, which runs to the end of this month. Financial results are scheduled to be released Aug. 30.

"Given that CIBC should earn $675-million after tax in the third quarter, such a charge could amount to about 10 to 15 per cent of quarterly earnings," Mr. de Verteuil wrote in a note to clients.

He is assuming the bank's total exposure, or holdings, of this type of securities could be about $1.2-billion. The bank has not disclosed how much exposure it has and CIBC declined to comment on the analysts' reports yesterday.

Any markdown or loss would almost certainly be partly offset by lower taxes and lower employee bonuses, Mr. Hardy said.

He revised his per share earnings estimate down from $2.01 to $1.90. Analysts' consensus is $1.95.

"The bank has not issued a press release on its quarterly results, which is somewhat comforting as the current quarter is only seven days from being over," Mr. Hardy wrote. "In our view, this suggests that the bank's exposure to U.S. subprime housing securities will not cause a material shortfall to earnings estimates."

At this point, CIBC's losses are probably paper losses rather than realized cash losses, Mr. Hardy said.

The paper value of these investments on the bank's books can be volatile, Mr. de Verteuil explained.

The holdings must be valued, or marked, regularly. A weak mark at quarter's end can cause a large mark-to-market - or paper - loss, only to have the position reverse the next quarter, he said.

"Given the poor market currently, this could easily be a problem in CIBC's third quarter, even though holding the positions to maturity may produce no economic [or actual cash] loss," he wrote.

But the idea that any losses would only be on paper is scant comfort, he added.

"The reality is that CIBC purchased a security [or the derivative of a security] that is worth less than when it was originally acquired. In the cold light of hindsight, there must be some negative consequences for the income statement."

Taking a charge this quarter "would be a disappointment for CIBC," which has "done a tremendous amount to de-risk the bank," Mr. de Verteuil added.

CIBC chief executive Gerry McCaughey has made reducing risk a major priority since the bank took a $2.4-billion (U.S.) charge in 2005 to settle a lawsuit related to Enron.

The bank now earns a larger proportion of its profit from bread-and-butter Canadian consumer banking than any of its peers, Mr. de Verteuil said. And, disregarding this situation with the subprime-related securities, it seems to be on track for a strong operating year, he added.

Mr. de Verteuil said he takes comfort from the fact that Bank of Montreal took a "very surprising" $680-million charge earlier this year from its commodity trading operations, and has still performed roughly in line with its peers since.

Blackmont Capital analyst Brad Smith pointed out in a note to clients yesterday that CIBC was the only Canadian bank to make the list of "Top 20 Counterparties by Trade Count" released in Fitch Ratings Ltd.'s recent credit derivative survey. CIBC crept onto the list at No. 20. It did not rank in the top 20 counterparties by notional amount. Morgan Stanley topped both lists.

Fitch's report notes that valuations of credit derivatives are being largely driven by assumptions that may not always reflect market prices, and so "institutions may be understating losses or overstating gains." That "leaves little doubt in our view as to the potential for broad-based mark-to-market losses over coming quarters," Mr. Smith wrote in yesterday's note on the banks and structured finance.

Eleven U.S. banks, investment banks and brokers reported financial results last week, and on average they beat analysts' consensus estimates by 5 per cent. But their stocks ended the week down 4 per cent, as investors focused far more on risks than near-term earnings, Genuity Capital Markets analyst Mario Mendonca said in a note to clients yesterday.
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RBC Capital Markets, 23 July 2007

Investment Opinion

• The continued weakness in securities related to U.S. sub-prime housing will likely force CIBC to mark down its exposures to the space, as most of its securities are held in its mark-to-market trading book.

• We believe that a $50-100 million mark down is possible, based on our belief that the April quarter mark down was in the $25 million range. A mark down would almost certainly be partially offset by lower income taxes and incentive compensation.

• Our prior core cash earnings estimate was $685 million, so the net income hit we expect represents 5% of Q3/07E earnings. We expect the bank to earn a ROE of 23.0%.

• The bank has not issued a press-release on its quarterly results, which is somewhat comforting as the current quarter is only 7 days from being over. In our view, this suggests that the bank's exposure to U.S. sub prime housing securities will not cause a material shortfall to earnings estimates. Our core cash EPS estimate is revised from $2.01 to $1.90, compared to the consensus estimate of $1.95.

• Management has stated that the majority of its exposures to the U.S. subprime real estate mortgage market are in securities that are AAA-rated. AAA-rated securities have seen price weakness, with drops in some ABX indices of 5%, certainly a large decline for AAA-rated securities (and a disastrous drop for holders that employ leverage), but not as drastic as the 50%+ declines in some lower-rated indices.

• CIBC has stated that its unhedged exposure to this sector is well below the US$2.6 billion exposure that media reports have estimated. If CIBC's exposure was indeed that large, we believe that the mark-to-market would have been larger than $25 million in Q2/07.

• We believe that CIBC's losses so far have been limited to mark to market adjustments, rather than real losses. Since CIBC probably holds these securities in trading books, we do not mean to imply that the losses would not be incurred if CIBC sold its positions today but rather point out that loss rates in underlying assets need to rise higher than they are today before holders of AAA tranches begin to lose real money.

Maintain Outperform rating

CIBC trades at 12.0x our estimated 2007E earnings versus a peer average of 12.6 times. We believe that the relative multiple makes CIBC's stock attractive, in spite of a lower revenue growth profile and greater exposure to U.S. sub-prime real estate, hence our Outperform rating. The following points summarize our investment thesis on CIBC shares:

• Potential for upward earnings revisions. We expect the consolidation of FirstCaribbean's results and improving retail revenue growth, combined with flat expenses in Canada, will drive earnings growth that exceeds expectations in 2008. We also believe that Q2/07 retail loan losses could prove to have been abnormally high in the near term.

• 17% increase in the dividend expected in Q3/07. The current dividend rate of $3.08 implies a payout ratio of 38% based on our 2007E EPS, well below the bank's official target range of 40%-50%.

• The bank's multiple should benefit from having the second-lowest exposure to wholesale income. The retail mix should also increase given the acquisition of FirstCaribbean, improving revenue growth in retail businesses and a likely reduction in merchant banking gains.

• Less exposure to potentially rising business loan losses, the area that most concerns us from a credit quality standpoint. Business loan losses for the Canadian banks are currently non-existent, compared to a 17-year average of 80 basis points. CIBC's loan book has the least exposure to business and government loans and the bank holds $10.4 billion in credit default swaps - a large amount relative to its $34.0 billion business and government loan book.

• CIBC's stock is likely to trade on news in the near term. However, the bank's exposure to sub-prime real estate does not prove costlier than we estimate, we believe that those willing to handle short-term volatility will benefit. The disclosure of Q3/07 results on August 30 is likely to shed some light on the issue.

Valuation

Our 12-month price target of $114 is a combination of our sum of the parts and price to book methodologies. It implies a multiple of 13.0x 2008E cash EPS, compared to the 5-year average forward multiple of 12.0x. Our target multiple is high versus the historical multiple because we believe there is upside to earnings estimates. Our relatively high price to book target multiple of 3.0x reflects the bank's industry-leading ROE and low credit risk. Our sum of the parts target P/E of 12.3x is in line with our target average for the banks, as lower exposure to low-multiple wholesale businesses is offset by slower than average revenue growth.

Price Target Impediment

Risks to our price target include the health of the overall economy, sustained deterioration in the capital markets environment, loss of domestic market share, a decline in underwriting activity and U.S. subprime CDO markets, and weakening retail credit quality.
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BMO Capital Markets, 13 July 2007

Establishing Limits

Concerns on CIBC’s exposure to sub-prime have clearly weighed on the stock. With the bank having made little disclosure as to the potential hit to earnings (other than to say that the “un-hedged” exposure is less than US$2.6 billion), it is scarcely surprising that the market is suspecting the worst. What is interesting is that the market seems to be discounting the stock far worse than a worst case scenario. Clearly, the Enron fiasco still weighs heavily on the market’s perception of how the bank is run.

Before we get into our understanding of the details, it is worth noting that the vast majority of CIBC’s business is domestic, retail-oriented. Indeed, in the first half of 2007, CIBC got a larger proportion of its earnings from retail banking in Canada than any of its peers (see table below). Outside of the CDO situation, CIBC seems to be on track for a strong operating year. We believe that the market has overcorrected and we are reiterating our Outperform recommendation on CM shares.

Our continued preference for CIBC shares is not to say that we are confident that CIBC won’t at some time in the next few quarters take a “mark-to-market” loss on its CDO positions. Indeed, a charge of $150 million (pretax) seems likely in the third quarter if, at quarter end, the market remains as hostile as it currently is. What gives us comfort however is this: Bank of Montreal took a very surprising $680 million charge on commodity options, despite its reputation as a conservative institution. Since that charge, the bank has performed roughly in line with its peers. We are relatively confident that CIBC charge will be less than $680 million, yet its stock has already underperformed its peers by roughly 7% since this “kerfuffle” began.

A Look at Tricadia

CIBC was relatively late to re-enter the game of underwriting Collateralized Debt Obligations (CDOs) - and its timing was atrocious. The underwriting of Tricadia 2007-8 coincided with a sharp sell-off in residential mortgage backed securities (RMBS) - the collateral that often backs these CDO structures. This isn’t to say that CIBC was totally ignorant of the CDO market. It is clear from notes to the financial statements that the bank had ongoing involvement in “warehousing” these securities on behalf of various underwriters or managers. It does, however, seem as though the bank picked the wrong time to become more aggressive in this business.

In April 2007, with the Tricadia deal in the late stages of underwriting and with the well-publicized weakness in the residential mortgage market, demand for high-rated CDO paper declined (from what we can determine, the demand has typically been relatively good for the lower quality, higher yielding parts of these CDOs). As such, CIBC as underwriter was left holding most, if not all, of the US$330 million senior-secured tranche of the deal.

We have not been able to see what collateral/securities are in Tricadia, but from analysis of various deals done by this manager, we can assume that the underlying collateral was RMBS and that some proportion was investment-grade. Given the rating of the tranche held by CIBC (US$330 million out of an entire deal size of US$507 million), we assume that the majority of the collateral was investment-grade at the time of origination. This probably means default rates on the mortgages that back the structure need to be well over 10% before the AAA tranche takes a haircut. Above this level however, there would be fundamental impairment on these securities. As we show in the chart on page 4, which shows the ABX-AAA Index, and despite material concern within the market, indicative bids for AAA rates RMBS securities remain in the high 90s.

Fundamentals are Only Part of the Story

Whatever the fundamentals, CIBC holds its Tricadia and other CDO exposures in its mark-to-market, or trading book. A quick note on the accounting for these positions: Given the lack of transparent markets for some positions, banks occasionally have to mark-to-“model” rather than mark-to-“market”. The CDO market requires this, given the unique nature of each structure. Having said that, indicative prices and/or prices for various indices provide important ingredients in establishing the carrying value of these positions.

As we have said above, these CDO positions are maintained in CIBC’s trading book. This is both good news and bad news. On the good news front, accounting regulations force management to “fess up” quickly to problems. The bad news is that the quarter-end “marks” are important in establishing the P&L, which can result in increased volatility—a weak mark at quarter-end can cause a large mark-to-market loss, only to have the position reverse the next quarter.

Given the poor market currently, this could easily be a problem in CIBC’s third quarter, even though holding the positions to maturity may produce no economic loss. This is however scant comfort to us. First, the maturity date of the Tricadia senior secured note is 2052 (about my retirement date), and second, the reality is that CIBC purchased a security (or the derivative of a security) that is worth less than when it was originally acquired. In the cold light of hindsight, there must be some negative consequence for the income statement.

How Can We Estimate the Quarterly Pain?

To date, CIBC has indicated that its 'unhedged' exposure to CDO’s is less than US$2.6 billion, but given its comments on Tricadia, one can assume that it is greater than the US$330 million that made up the original senior secured notes. A wild guess would be to simply use the mid point of these numbers, about US$1.5 billion. Note that management continues to state that the “majority of the positions are AAA”.

Another yardstick is to consider the exposure as disclosed in the bank’s annual report as of October 2006. The bank states that at that time, the maximum loss on its exposure to CDOs was $729 million. If we assume that the current level includes both the Tricadia deal and incremental growth in the business, the number could be in the $1.0-1.2 billion range.

A third way to approach the bank’s exposure is to consider the impact of the weak market for CDO pricing at the end of April on CIBC’s second quarter earnings. Management indicated on the conference call that the weak trading revenues were a result of problems in structured product (read CDO’s) and credit markets. From the trend in the “other” segment of trading revenues, it appears as if revenues were $50 million below normal. Some of this would be due to the weakness in overall credit markets, and some to the CDO problem, but in the most punative situation, the entire figure could be due to the CDO’s. Using the ABX levels across various tranches (assuming a 50:50 split AAA to non-AAA) and using some rudimentary arithmetic, we can reverse engineer the current size of the book to be $750 million.

Conclusion

In conclusion, we believe that an estimate of $1.2 billion of CDO exposure for CIBC sounds reasonable. Assuming this, a 50:50 mix of AAA and non-AAA, and using yesterday’s closing prices (see graph below to see indicative pricing on AAA, A and BBB exposures), we estimate that the loss in the third quarter could be $100-150 million. Given that CIBC should earn $675 million after tax in the third quarter, such a charge could amount to about 10-15% of quarterly earnings. Of course, mark-to-market pricing is just that, so that inter-quarter volatility doesn’t require the bank to disclose any issues until the quarter end. Needless to say, early August will be an interesting time for CIBC investors.

From our perspective, such a charge would be a disappointment for CIBC. It has done a tremendous amount to de-risk the bank – despite the numerous detractors that have focused on items such as single elements of trading and derivatives. This situation again raises the spectre that the bank is accident-prone. However, we continue to believe that investors in CIBC shares, which are trading at roughly a multiple point lower than their peer group, are adequately compensated for the risks.

Another situation that provides us with comfort is the events surrounding BMO’s recent $680 million trading loss. From the day prior to the BMO announcement of its initial estimate of the loss until today, BMO shares have roughly traded in line with the bank group. It is therefore interesting that since the start of the sub-prime debacles, CIBC stock has lagged by 7% even though we believe that the loss will be less than half that experienced by BMO. The one difference is that BMO was relatively clear that it believes it has its “hands around” the problem. We believe that if CIBC was able to actually quantify a charge in the third quarter in the order of $100-150 million, the stock would actually perform well.

One material risk to our analysis is that CDO structures are opaque. We have heard second hand reports that even prospective buyers have been denied details on the collateral backing these structures. If the CIBC’s CDOs are in fact “mezzanine” structures or CLO-squareds, it is possible that their entire holdings could be worthless. We are assuming that they aren’t, and are also assuming that when management says the majority of the securities are AAA-rated they, as holders of (and in some cases underwriters of) the CDO are comfortable that there won’t be complete loss unless there is a widespread melt-down in the U.S. housing market. If we are wrong, the entire $1.2 billion position may be at risk. This would certainly hurt, but given CIBC’s ROE and capital position, we note that it would be handled without material risk to solvency.
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Friday, July 20, 2007

TD Ameritrade Q3 2007 Earnings

  
The Globe and Mail, Tara Perkins, 20 July 2007

Nearly two months after hedge funds began pressuring TD Ameritrade Holding Corp. to merge with a rival, the online brokerage firm shows no signs of acquiescing. And the hedge funds show no sign of backing down.

As TD Ameritrade reported record profit yesterday, its chief executive officer, Joe Moglia, told investors that the company has "an absolute focus on organic growth."

And a spokesman for Jana Partners LLC - one of the two hedge funds putting heat on TD Ameritrade to pursue a merger - said its financial results continue to show the need to pursue a strategic combination, given the challenges in growing organically.

"They just want to run their business for six or nine months and see if they can actually start generating some organic growth in client assets, better growth in client accounts, and see if they can actually take the tools that they combined from the two entities and add some value for their customers," BMO Nesbitt Burns Inc. analyst Michael Vinciquerra said yesterday.

While a merger with a rival could add value for shareholders, the company does not want to do anything in the near term, he added.

TD Ameritrade has just finished moving the customers it obtained from last year's acquisition of TD Waterhouse USA over to its own online trading platform. Causing more disruption for customers at this point could prompt some of them to leave, Mr. Vinciquerra said.

The company's profit was $159-million (U.S.), up from $140-million a year ago. But that didn't come from new revenue, with the top line remaining virtually flat.

A lower tax rate helped a bit, as did lower expenses.

"A mediocre earnings report increases pressure on management to find a merger partner," said Patrick O'Shaughnessy, an analyst at Morningstar who gives TD Ameritrade one star, the lowest rating on a scale of five. "At least they can put the merger with TD Waterhouse behind them, and they have done a pretty good job of managing their expenses."

TD Ameritrade had total client assets of $298.2-billion at the end of the quarter, up 5.7 per cent from three months earlier, Mr. Vinciquerra pointed out in a note to clients. It had 6.321 million total accounts, having gained 152,000 new customers but losing 61,000 during the quarter. Average client trades per day fell 3.5 per cent to 244,800.

Despite Ameritrade's higher profit, Toronto-Dominion Bank is expected to see a lower contribution from its 40-per-cent stake in the brokerage because of the stronger Canadian dollar, said Blackmont Capital analyst Brad Smith. While TD Ameritrade's profit was up 13 per cent from a year ago, the portion that hits TD's bottom line will actually fall 13 per cent to $59-million (Canadian). TD Bank is scheduled to release its earnings on Aug. 23.

The hedge funds have accused TD Bank of using its seats on Ameritrade's board of directors to block any possible mergers.

Mr. Moglia reiterated yesterday that the online brokerage industry is delving further into the business of asset gathering, and so the types of takeovers or mergers it might look to do now would be different from a year ago.
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Financial Post, Jonathan Ratner, 19 July 2007

Among the news out with online brokerage TD Ameritrade Holding Corp.’s third quarter earnings, which showed net income rose to US$159-million – its best quarter ever, was Toronto-Dominion Bank’s piece of the action.

TD said it expects the earnings will contribute $59-million to its own third quarter net income.

This was up from $55-million a year earlier, but down from $63-million in the second quarter, Desjardins Securities analyst Michael Goldberg said in a note.

He says TD’s internal allocation of more debt against its Ameritrade investment and a weaker U.S. dollar are to blame. As a result, he thinks Ameritrade’s overall performance was positive.

“AMTD now moves on to the third leg of benefits from its acquisition and integration of Waterhouse, development of the longer term investor business,” Mr. Goldberg said.

He has a “top pick” rating and $79 price target on TD, which reports third quarter results on Aug. 23.

Brad Smith at Blackmont Capital maintained his $73 price target and "hold" rating on TD, while agreeing that the results were solid.

However, he considers news that more investment spending will likely be required to retain Ameritrade's existing client asset base a signal that margin pressures remain a concern.
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Bloomberg, Bradley Keoun, 19 July 2007

TD Ameritrade Holding Corp., the online broker facing shareholder pressure to merge with a rival, boosted profit 14 percent last quarter by reducing costs as customers traded less.

Net income rose to $158.7 million, or 26 cents a share, in the quarter ended June 30, from $139.8 million, or 23 cents, a year earlier, TD Ameritrade said today in a statement. The Omaha, Nebraska-based company was expected to earn 25 cents, the average of 13 analyst estimates compiled by Bloomberg. Revenue climbed less than 1 percent, the slowest in more than two years.

Jana Partners LLC and SAC Capital Advisors LLC, hedge funds with an 8 percent stake in TD Ameritrade, have called for the company to merge with Charles Schwab Corp. or E*Trade Financial Corp. TD Ameritrade Chief Executive Officer Joseph Moglia, who slashed more than $300 million in costs following the company's 2006 purchase of TD Waterhouse USA, has vowed to spend $100 million in the next 15 months to spur growth.

``A mediocre earnings report increases pressure on management to find a merger partner,'' said Patrick O'Shaughnessy, an analyst at Morningstar who gives TD Ameritrade one star, the lowest rating on a scale of five. ``At least they can put the merger with TD Waterhouse behind them, and they have done a pretty good job of managing their expenses.''

Until yesterday, the shares climbed 22 percent this year, the second-best performer in the 12-member Amex Securities Broker-Dealer Index after A.G. Edwards Inc., which is up 34 percent. St. Louis-based A.G. Edwards agreed in May to sell itself to Wachovia Corp.

Revenue growth flagged in part because the 25 percent rise in the Standard & Poor's 500 Index in the past year failed to spark a surge in trading by the company's clients. Commissions and other transaction fees are the company's biggest source of income, followed by interest on loans to customers.

Trading revenue in the quarter fell by 7.2 percent to $197.8 million, TD Ameritrade said. Net interest revenue fell by 30 percent to $138.9 million, while fees on money-market bank accounts almost doubled to $134.6 million.

Clients averaged about 245,000 trades per day, compared with 254,000 last quarter and 253,000 in the third quarter of last year.

Moglia, 58, said today on a conference call with analysts that retail investors ``are not wildly bullish'' in part because they're concerned about rising costs for heating, gasoline and groceries. ``That does have a psychological impact.''

At the end of June, TD Ameritrade held about $297.2 billion of client assets, up 16 percent from a year earlier.

Schwab, the biggest online broker, said earlier this week that second-quarter profit increased 16 percent as $52 million of advertising helped drive the fastest customer-account growth in five years. The San Francisco-based company also said customers traded less, leading to a 6 percent drop in transaction fees. Schwab, which has a mutual-fund arm and bank, relies on trading commissions less than TD Ameritrade does.

Moglia offset slowing revenue by shaving expenses. He shifted TD Waterhouse's 2.2 million customers to TD Ameritrade's trade-processing system in May, completing a step he promised when the merger was announced in mid-2005. TD Ameritrade had been routing TD Waterhouse trades through a clearing system maintained by Automatic Data Processing Inc., under a legacy contract inherited in the merger.

The ``clearing conversion'' aimed to eliminate about $200 million in annual costs, the company said in April.

The $1.6 billion purchase of TD Waterhouse fueled four straight quarters of 60 percent-plus revenue growth for TD Ameritrade. In June, the company said it received a letter from Jana and SAC urging another merger, with Schwab or New York- based E*Trade, the No. 4 broker.

The funds said in the letter that a merger with either of the rivals may lead to as much as $800 million in new revenue and cost savings.

Today's results ``continue to show the need to pursue a strategic combination, given the challenges in growing organically,'' Charles Penner, a New York-based spokesman for Jana, said today in an interview.

Jana and SAC have accused TD Ameritrade of letting its largest shareholder, Toronto-Dominion Bank, wield too much influence over merger discussions. Toronto-Dominion, Canada's third-biggest lender, controls five of TD Ameritrade's 12 board seats. Jana and SAC say a merger might interfere with the Toronto-based bank's U.S. expansion plans.

In July, TD Ameritrade responded to the criticisms by removing Toronto-Dominion's representatives from a committee established to review merger prospects.

Toronto-Dominion has said its representatives on the TD Ameritrade board are acting in the best interest of all shareholders.

On the conference call, Moglia said the company made $8 million of the $100 million new investment in the last quarter, and has budgeted $20 million for the current quarter and each of the following three quarters. Uses include providing training for call-center staffers, who are being asked to promote a broader range of products and services.

``The management team has come to me with individual requests'' for uses of the $100 million, and ``I've allocated probably 85 or 90 percent of that so far,'' Moglia said. ``Frankly the sooner we implement that spend, we think the sooner we're going to get results.''
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Thursday, July 19, 2007

TD Banknorth U$4 Million Lawsuit Settlement Thrown Out by Judge

  
Bloomberg, Sophia Pearson, 19 July 2007

TD Banknorth Inc.'s $4 million settlement of a shareholder suit over a buyout by its parent, Toronto-Dominion Bank, was thrown out by a judge who said the amount should be higher.

The accord is ``insufficient,'' Judge Stephen Lamb wrote in a decision issued today in Delaware Chancery Court in Wilmington. Six investors sued after TD Banknorth said in November that Toronto-Dominion would buy the 41 percent of TD it didn't own for $3.2 billion. Plaintiffs agreed to settle for about $3 million, roughly 3 cents a share, and more than $1 million in legal fees.

``The class members appear to have received insufficient consideration in the form of a token cash increase in merger price, a virtually meaningless change in the calculation of the vote and several proxy disclosures for which the plaintiffs cannot even wholly claim credit,'' Lamb wrote.

The judge's ruling opens the door for a trial. Toronto- Dominion is trying to revive earnings at its slumping U.S. consumer bank. Edmund Clark, chief executive officer of the Toronto-based company, said in November it would focus on making TD Banknorth competitive in three or four years.

Neither TD Banknorth spokesman Jeffrey Nathanson nor plaintiffs' attorney James Notis replied to phone messages seeking comment.

Several Banknorth shareholders objected to the settlement amount. Objectors said plaintiffs' lawyers failed to argue that Toronto-Dominion officials violated a shareholders agreement by initiating the buyout negotiations with Banknorth. Lamb agreed.

Lawyers for the shareholders ``unreasonably'' chose not to pursue viable claims based on the violation of the stockholders agreement in exchange for a meager settlement, Lamb said.

TD Banknorth, based in Portland, Maine, with $1.95 billion in 2006 revenue, has branches in Maine, Massachusetts, New Hampshire, Vermont, Connecticut, New York, New Jersey and Pennsylvania.

Shares of Toronto-Dominion Bank rose 12 cents to C$73.12 today in trading on the Toronto Stock Exchange. They have gained 4.9 percent this year.

The case is In Re: TD Banknorth Inc. Shareholders Litigation, Consolidated CA2557-VCL, Delaware Chancery Court (Wilmington).
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Wednesday, July 18, 2007

UBS Reiterates Its 'Buy' Rating on Scotiabank

  
UBS maintains its 'buy' rating on Bank of Nova Scotia, with a target price of $63.00, based on 13.5x forward earnings, a slight premium to the outlook for the banking group.

The research report noted that due to a broad range of moving parts, there is low visibility into the bank’s near-term international operations; Scotiabank is carrying on the integration of recent acquisitions, which is likely to bear fruit in the upcoming quarters. Scotiabank is focused on enhancing its international presence through acquisitions and has a healthy pipeline, UBS adds.
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Understanding CIBC's Subprime Mortgage Exposure

  
The Globe and Mail, Fabrice Taylor, 18 July 2007

CIBC is having trouble assuaging investors who fear yet another cock-up from the accident-prone bank.

This time it's over its dealings in the U.S. subprime market. Media reports, leaning heavily on hedge fund managers, suggest the bank is whistling its way to a massive haircut on some investments in collateralized debt obligations (CDOs).

Nonsense, says the bank, beyond which it fails to mount a convincing defence.

Truth is, not even the bank knows what's in store for its subprime deals. CDOs are extremely complex to value. The net result for investors, however, is that this might prove to be as much an opportunity as it is a risk.

CDOs are pools of debt, usually junky debt. The CDO issues notes against the debt pool, but the notes are not created equal. The top group, or tranche, has first dibs on the assets and gets paid first. So if the CDO owns subprime mortgages, and, say, 10 per cent of them default, investors in the top tranche are okay.

Those in the bottom tranche are typically wiped out, while those in the middle tranches get burned but keep some of their capital. The higher tranches are usually AAA rated, the lower ones, often called equity tranches, are not rated at all. The interest payments are commensurate with the respective ratings.

By dividing the collateral pie into slices, CDOs turned lousy credit into gold-plated (AAA) bonds. At least on the surface. They also encouraged the U.S. housing bubble by helping supply credit to extremely suspect customers. Like all great financial ideas, they can be, and are, abused - especially when they morph into more complicated versions.

A CDO squared, for example, invests not directly in pools of mortgages or other loans, but rather in certain tranches of other CDOs. For example, a CDO might own the middle tranches of a large number of other CDOs.

These tranches are typically rated A or thereabouts, but again, through the alchemy of risk restructuring, lead becomes gold (well, in this case silver becomes gold.)

The CDO squared can now issue AAA-rated securities on the back of collateral of distinctly lower quality, which in turn rests, ultimately, on the credit-worthiness of Bubba Jones or, failing that, on his Tallahassee home.

It's in such CDOs that CIBC acknowledges an investment. Specifically, in the highest tranche of a vehicle called Tricadia 2006-07 Ltd., though it says it has other subprime investments too. BMO Nesbitt Burns, for instance, says CIBC also invested in Tricadia 2007-2008 Ltd.

Tricadia 2006-2007 invested in other CDOs that ultimately own mortgages originated in 2006 - one of the worst vintages. The bank's investment, it should be noted, is synthetic: that is, it used derivatives to replicate the economic behaviour of such a security. The bank earns small payments - under a million a year by our math - but is on the hook for defaults beyond a certain percentage. The worst-case scenario for Tricadia 2006-2007 is $330-million (U.S.), according to stated records.

But CIBC's Tricadia investments are AAA rated so what's the worry right? Well, it's not that simple.

The first problem is that the tranche CIBC is exposed to may well have not been so safe. Ratings agencies have been downgrading or reassessing tranches of CDOs. Expect more downgrades to come.

According to Bear Stearns, Tricadia's odds of getting kicked down the rating ladder are high. A downgrade might force CIBC to take a charge even if the loan keeps performing (CIBC officials declined to comment on this column).

But of greater concern is a wave of homeowner defaults, which investors appear to be betting on judging from indexes that track the performance of CDO tranches (see the accompanying chart that tracks A-rated tranches of loans originated in 2006). The values have fallen by about quarter.

Ratings agencies and lenders are ratcheting up their predictions for more mortgage defaults. The latest estimates are that around 7 per cent of subprime mortgages will default.

That may not sound like much, but here is why it matters for CIBC.

The highest rated tranche of a CDO might have a 40 per cent cushion beneath it: that is, as long as no more than 4 of every 10 mortgages defaults, the top tranche is fine - and that's an unheard of default rate. But a CDO squared's collateral might have a cushion closer to 10 per cent (remember that its assets are the lower rated tranches of other CDOs).

If defaults hit 7 per cent, then 10 per cent isn't far away. So much for a AAA investment.

One saving grace for the bank is that it's the only investor in some of the CDO tranches, so there's probably no market for them. That means we're depending on CIBC's disclosure and we might not hear all that much about it.

If there are massive defaults though, they aren't likely to bring the bank down. Remember that the Enron settlement - more than $2.4 billion (U.S.) - ended up creating a great opportunity to buy CIBC shares. Look at the charts. That's another way to turn lead into gold.
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Tuesday, July 17, 2007

TD Bank Funds $3.8 Billion in BCE Takeover

  
Bloomberg, Sean B. Pasternak & Frederic Tomesco, 17 July 2007

Toronto-Dominion Bank said it agreed to provide C$3.8 billion ($3.64 billion) in financing for the proposed takeover of BCE Inc. by investors that include the Ontario Teachers' Pension Plan.

Canada's third-biggest bank will lend C$3.3 billion and buy C$500 million in BCE stock, in the largest private-equity financing ever for the Toronto-based company.

Toronto-Dominion joins other lenders including Citigroup Inc. that will provide C$34.3 billion in credit for the world's biggest leveraged buyout. BCE, based in Montreal, is Canada's largest phone company.

``While these commitments are large, they were entered into following the bank's normal processes and are within the risk tolerances provided for in the bank's risk management framework,'' Toronto-Dominion said in a statement today.

The investment group will put up about C$8 billion and borrow the rest for the buyout, Teachers' Senior Vice President Jim Leech said. He declined be more specific or say when regulatory documents would be filed.

``We are still tweaking and fine tuning,'' Leech said in a telephone interview from Toronto today. ``We'll have the final numbers when we file our regulatory documents.''

Under the C$51.7 billion takeover, which includes debt, Teachers' will own 52 percent of BCE, while Providence Equity Partners Inc. will own 32 percent and Madison Dearborn Partners LLC will have 9 percent. The proposed takeover, announced June 30, is expected to close next year.

Toronto-Dominion, which helped advise the Ontario Teachers' plan on the purchase, plans to ``syndicate,'' or distribute the debt and equity to other banks and investors. BCE's financial advisers also included Citigroup, Royal Bank of Scotland Group Plc and Deutsche Bank AG.
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Dow Jones Newswires, 17 July 2007

Toronto Dominion Bank said it has underwritten C$3.3 billion of a C$34.3 billion (US$32.9 billion) credit facility and provided a C$500 million equity bridge facility to a group of institutional investors led by Ontario Teachers' Pension Plan Board in support of their bid to acquire BCE Inc.

The Toronto-based Canadian chartered bank said the commitments "were entered into following the bank's normal credit processes and are within the risk tolerances provided for in the bank's risk management framework."

In the ordinary course, the bank would expect to syndicate these commitments among other financial institutions and investors, it noted.
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The Globe and Mail, Sinclair Stewart & Boyd Erman, 17 July 2007

Toronto-Dominion Bank has agreed to commit about $4-billion in capital to help finance the record takeover of BCE Inc., including purchasing a half-billion dollars worth of equity that will give the bank a 7-per-cent ownership stake in the telecommunications company, according to people familiar with the matter.

These sources said TD offered to put up $500-million for a minority stake in Montreal-based BCE to help Ontario Teachers' Pension Plan and two U.S.-based private equity suitors raise sufficient Canadian equity for their $35-billion takeover bid, which was endorsed by BCE's board late last month.

Teachers, which will own 52 per cent of the equity, has disclosed that U.S.-based Providence Equity Partners and Madison Dearborn Partners will together hold 41 per cent, but it has declined to identify the owner of the remaining 7 per cent.

The plan is for TD, which has $400-billion of assets, to unload its equity stake to other large Canadian investors once the deal is approved.

The bank will likely start feeling out prospective buyers in coming weeks, the sources said.

“It's a very gutsy call,” one person close to the process said of taking on the equity portion.

“Many banks are trying to squash this.”

The arrangement, known as a bridge equity loan, has become an increasingly controversial one in banking circles, with some major firms, like JPMorgan Chase & Co., saying they want to end the practice because the returns rarely justify the amount of risk to which they may be exposed.

The fear is that banks will not be able to sell the equity they purchase to other investors if the market drops, leaving them to keep the investment on their books and face a possible writedown on its value if markets soften.

TD's equity bridge in the BCE deal appears to be the largest yet by a Canadian bank, and sources close to the Teachers consortium said the arrangement was a “critical” component in finalizing the deal, on which TD stands to earn big fees for advisory work and lending. In addition to the equity loan, the bank has $3.5-billion worth of capital commitments, which include long-term debt and credit facilities.

Finding enough Canadian equity was a stumbling block during the BCE auction, given federal rules that cap foreign ownership in telecom companies at 46.7 per cent. TD agreed to step in with an equity commitment for Teachers at a time when rival bidders, including a group led by the Canada Pension Plan Investment Board, appeared to have locked up investment dollars from many of the country's leading pension funds.

The investment by TD comes at a time when the business of doing leveraged buyouts, which has boomed for years, faces headwinds amid reticence on the part of debt investors to buy the bonds needed to finance the debt-heavy purchases.

And while TD has specialized in the telecom business over the years, the results haven't always been pretty: The bank set aside $2.9-billion in 2002 to cover bad loans, many to telecom companies.

After that, the bank shifted its emphasis to retail banking, but in recent years chief executive officer Ed Clark has returned to a greater focus on TD's investment bank.

“Taking down equity of that size when you are a bank focused on retail, that's pretty ballsy,” said a rival Canadian investment banker. “They were saying a few years ago their focus was retail. Now we're seeing them use their capital much more aggressively to support their wholesale side.”

“It will be a giant revenue stream for them if it's all successful,” the banker added.

Still, many firms are leery of equity bridges because, while regular debt bridges are at least secured by assets, equity stakes have last claim on assets.

“Bridge equity is not liquid and there's no clear market in which to price it, so if there are storm clouds brewing you can't blow it out,” said a senior deal maker at a U.S.-based investment bank. “The problem you have with capital markets is the risks increase every day, every hour you hold something.”

Because of that, “there's almost not enough money to pay you for the risk,” the banker said.

The total amount of the equity component in the BCE offer is $7.5-billion, a figure that includes the $2-billion worth of BCE shares that Teachers already owns.

In addition to TD, the lenders providing the $34.35-billion of debt financing are Citigroup Inc., Royal Bank of Scotland and Deutsche Bank, according to documents filed with Canadian regulators.

The figures were blacked out in the documents, but by cutting-and-pasting the redacted section into a fresh word-processing document, it is possible to view the numbers.
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Bloomberg, Caroline Salas and Miles Weiss, 17 July 2007

Goldman Sachs Group Inc., JPMorgan Chase & Co. and the rest of Wall Street are stuck with at least $11 billion of loans and bonds they can't readily sell.

The banks have had to dig into their own pockets to finance parts of at least five leveraged buyouts over the past month because of the worst bear market in high-yield debt in more than two years, data compiled by Bloomberg show.

Bankers, who just a few months ago boasted that demand for high-yield assets was so great that they would have no problem raising debt for a $100 billion LBO, are now paying for their overconfidence. The cost of tying up their own capital may curb earnings and stem the flood of LBOs, which generated a record $8.4 billion in fees during the first half of 2007, according to Brad Hintz, the former chief financial officer at New York-based Lehman Brothers Holdings Inc.

``The private equity firms, being very tough negotiators, are unlikely to let the banks off the hook,'' said Martin Fridson, chief executive officer of high-yield research firm FridsonVision LLC in New York. ``They'll say that's your problem and that's why we're paying you: To take risk.''

As the market began to turn sour last month, Goldman Sachs, Citigroup Inc., Lehman and Wachovia Corp. had to buy $725 million of bonds that Goodlettsville, Tennessee-based Dollar General Corp. was selling to finance Kohlberg Kravis Roberts & Co. purchase of the company for $6.9 billion. All of the securities firms are based in New York, except Wachovia, which is located in Charlotte, North Carolina.

Those bonds are probably worth 94 cents on the dollar, or $43.5 million less than when they were sold on June 28, according to Justin Monteith, an analyst at high-yield research firm KDP Investment Advisors in Montpelier, Vermont. KKR completed the acquisition of Dollar General on July 9.

Bear Stearns Cos. strategists estimate that about $290 billion of deals still need to get funded, including those of Greenwood Village, Colorado-based credit-card processor First Data Corp. and energy company TXU Corp. of Dallas.

The question is ``how much yield are the brokerage firms going to have to eat,'' said Hintz, who is now an analyst at Sanford C. Bernstein & Co. in New York. ``What they've committed to is not current trading rates in the market. If I have a problem it doesn't mean I can't place the problem, but it's going to cause a mark-to-market loss.''

Acquisitions by private equity firms such as New York's KKR and Blackstone Group LP helped push sales of high-yield bonds and loans worldwide up more than 70 percent during the first half of the year to a record $708 billion, according to data compiled by Bloomberg. High-yield, or junk, bonds are those rated below Baa3 by Moody's Investors Service and BBB- by Standard & Poor's.

The investment banking fees generated by LBOs in the first half amounted to almost two-thirds of the $12.8 billion paid by LBO firms to Wall Street in 2006, data compiled by Freeman & Co. and Thomson Financial show. In the race to win deals, the five largest U.S. investment banks more than tripled their lending commitments to non-investment grade borrowers during the past year to $174 billion, according to their regulatory filings.

KKR co-founder Henry Kravis in May called it the ``golden era'' of buyouts at a conference in Halifax, Nova Scotia. The extra yield investors demanded to own junk bonds rather than Treasuries shrank to a record low of 2.41 percentage points in June from the peak of more than 10 percentage points in 2002, according to index data from New York-based Merrill Lynch & Co. The spread has since widened to 3.07 percentage points.

For loans rated four or five levels below investment grade, the spread over the London interbank offered rate shrank to 2.12 percentage points in February from more than 4 percentage points in 2003. It has since widened to 2.72 percentage points.

Some bankers even speculated that $100 billion LBO was possible, a scenario that is now ``definitely'' off the table, said Stephen Antczak, high-yield strategist at UBS AG in Stamford, Connecticut. Wall Street's confidence in its ability to finance just about any deal led buyout firms to remove clauses in their purchase agreements that would allow them to back out if their banks couldn't come up with the financing.

Just three of the 40 biggest pending LBOs have an escape clause that lets the buyer back out if funding can't be arranged, said Mike Belin, U.S. head of equity derivatives strategy at Deutsche Bank AG in New York. A couple of years ago, a majority of deals included a financing contingency, Belin said, based on his research.

``If you were a credit officer or a risk manager who said `No' to virtually anything over the last few years you were wrong,'' Hintz said. ``So did they take it too far? Well, yeah. But that's part of any cycle. The issue is did they take it too far and is it going to hurt their earnings.''

Tribune Co.'s agreement to be bought by billionaire Sam Zell is one of the three acquisitions with an escape clause. Zell or Tribune can back out of the purchase if funding can't be obtained ``on the terms set forth in the financing commitments'' or on similar terms, according to regulatory filings.

Zell agreed to pay $25 million to Tribune, owner of the Los Angeles Times and Chicago Tribune, should the financing fall through. Tribune spokesman Gary Weitman said banks have ``fully committed'' to the deal.

The market for high-yield bonds and junk-rated, or leveraged loans began to crack in June as concerns that LBOs were becoming too risky coincided with a slump in the market for subprime mortgages that caused the near-collapse of two Bear Stearns hedge funds.

Junk bonds lost 1.61 percent last month, the most since March 2005 when General Motors Corp. forecast its biggest quarterly loss since 1992 and the debt lost 2.73 percent, according to Merrill Lynch.

Investors refused to buy bonds to finance purchases of companies including Dollar General and ServiceMaster Co., forcing bankers to either buy the bonds themselves or extend a loan to make up for the securities that weren't sold.

In most deals, investment banks promise to provide loans to the buyer. They then seek other lenders to take pieces of the loans and find buyers for bonds. When buyers vanish, the banks must either buy the bonds themselves or provide a bridge loan to the borrower, tying up capital that would otherwise be used to finance more deals. The banks typically parcel out portions of bridge loans to reduce their risk.

Citigroup, the biggest U.S. bank, reported that its securities and banking division recorded an expense of $286 million in the first quarter to increase loan-loss reserves to account for higher commitments to leveraged transactions and an increase in the average length of loans.

Lehman reported on July 10 that its commitments for ``contingent acquisition facilities'' more than doubled in the quarter ended May 31 to $43.9 billion, exceeding its stock market capitalization of $39.1 billion. Lehman said its commitments contain ``flexible pricing features'' that allow it to charge more if market conditions deteriorate.

Goldman Sachs more than doubled its lending commitments to non-investment grade borrowers to $71.5 billion in the year ended May 31.

Citigroup spokeswoman Danielle Romero-Apsilos, Lehman spokeswoman Tasha Pelio and Goldman Sachs spokesman Michael Duvally, either declined to comment or didn't return phone calls.

JPMorgan failed to sell $1.15 billion of bonds for Memphis, Tennessee-based ServiceMaster on July 3. The banks provided ServiceMaster, the maker of TruGreen and Terminix lawn-care products, with a bridge loan to make up for the failed bond sale. ServiceMaster is being bought by private equity firm Clayton Dubilier & Rice Inc. for $4.7 billion.

KKR and New York-based Clayton Dubilier this month completed their $7.1 billion purchase of Columbia, Maryland-based US Foodservice, a unit of Dutch supermarket company Royal Ahold NV, even though junk bond investors refused to buy $1.55 billion of bonds and $3.37 billion of loans to finance the deal, according to estimates from New York-based Bear Stearns.

Deutsche Bank led the bond offering, which included $1 billion of ``toggle'' bonds that would have allowed US Foodservice to pay interest in either cash or additional debt. KKR and Clayton Dubilier relied on loans to complete the deal, according to S&P's Leveraged Commentary and Data unit.

``Many of these things are beyond our risk desires,'' said Bruce Monrad, who manages $1.5 billion of high-yield bonds at Northeast Investment Management Inc. in Boston.

JPMorgan spokesman Adam Castellani, Deutsche bank spokesman Scott Helfman and Morgan Stanley spokeswoman Jennifer Sala either declined to comment or didn't return calls. All the banks are based in New York, except Deutsche Bank, which is in Frankfurt.

Banks can always sell the debt if demand increases. Meanwhile, they may have to report a loss from the decline in value of their holdings, a process known as marking to market.

Banks could also lose money should they have to offer discounts on loans in order to syndicate the deals, said Tanya Azarchs, a banking industry analyst at New York-based S&P.

``I don't think it's going to cause banks to fail or even lead to downgrades,'' Azarchs said. ``But I do think there will be a little indigestion and lower earnings.''

The biggest concern is ``hung deals,'' where a lender is left holding a large loan to a single borrower, said Azarchs. ``Those traditionally in all the prior credit cycles have caused the greatest amount of grief for the large syndicating banks,'' Azarchs said.

In 1989, First Boston Corp., now part of Credit Suisse, made a bridge loan for a buyout of Ohio Mattress Co., the predecessor to Sealy Corp. The junk bond market collapsed before First Boston could refinance the loan, and the securities firm ended up owning a big stake in the bedding manufacturer.

The deal became known as ``Burning Bed.''

``The thing about this business is memories are two seconds long,'' said James Schell, a private equity attorney in the New York office of Skadden, Arps, Slate, Meagher & Flom LLP.

Banks led by Citigroup committed to extend $37.2 billion in credit to fund the purchase of TXU by a group that included KKR, Fort Worth, Texas-based TPG Inc. and Goldman Sachs's private equity group. The financing will comprise $25.9 billion of term loans and $11.3 billion in an unsecured bridge loan.

Credit Suisse, based in Zurich, is leading banks in the U.S. that have agreed to provide KKR with $16 billion of loans for its $26.1 billion takeover of First Data. The plans include an $8 billion bond sale, which is scheduled for August or September, according to a Banc of America Securities LLC research report.

For firms such as KKR or Blackstone, both based in New York, the tighter credit environment may make their acquisitions less profitable and even change the way they go after future targets. Mark Semer, a spokesman for KKR, declined to comment.

``The underwriters are going to be forced to provide bridge loans and it's getting pretty ugly, but Wall Street deserves to get smacked around a little,'' said William Featherston, managing director in high-yield at J. Giordano Securities LLC in Stamford, Connecticut. ``It's been easy for so long.''
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Monday, July 16, 2007

Preview of Life Insurance Cos Q2 2007 Earnings

  
Scotia Capital, 16 July 2007

Event

• Canadian insurers start reporting Q2/F07 results on July 31. We've released our detailed Insurance Q2/F07 Earnings Preview on July 16.

What It Means

• We believe the Canadian lifecos could beat our EPS estimates this quarter (which are $0.01 below consensus for each lifeco) despite the currency headwind, largely due to very buoyant equity markets (up 17% YOY).

• Going forward we see little likelihood of EPS increases, in fact there could be decreases, as currency continues to be a headwind and equity markets are expected to appreciate only in the mid-single digit range. Exceptions include SLF, where the recently announced funding arrangement and stronger US VA sales levels could add $0.05-$0.07 to 2H/07 EPS and $0.03 in 2008, and GWO, where Putnam financing without common equity issuance could add $0.05-$0.06 to our 2008 estimate (we currently account for 1/2 of this).

The following is an excerpt and a summary from our Insurance Q2/F07 Earnings Preview report released July 16.

• There is a possibility, due to the buoyant equity markets in Q2/F07, that the companies could beat our estimates and consensus despite the currency headwinds. Certainly, currency has been a headwind. The average CAD continues to be particularly strong. In Q2/F07 it is up 3% year-over-year (YOY) and 7% quarter-over-quarter (QOQ) versus the USD, it is up 9% YOY and QOQ versus the ¥, and it is up 5% QOQ but down 6% YOY versus the £. Manulife in particular suffers, and, with 65% of its earnings exposed to the USD and 10% exposed to the ¥, we estimate that YOY foreign exchange changes could take $0.02 to possibly $0.03 out of Q2/07E EPS (the impact is effectively already in our estimates). For Great-West Lifeco and Sun Life the impact is closer to $0.01 (again, the impact is already in our estimates), as both these companies have less exposure to the USD and more exposure to the £, which in fact outpaced the average Q2/F07 CAD on a YOY basis. But we believe the currency headwind could be more than offset by several positives on a YOY basis, namely favourable equity markets, a continued favourable credit environment, and the positive impact of rising long-term interest rates. U.S. and Canadian equity markets are each up 17% YOY (on average) and 5% and 7% QOQ (on average), respectively, well in excess of the 7% annualized rate we assume. This could translate into better-than-expected fee income from wealth management business, better-than-expected net realized gains on assets supporting surplus, and possibly some favourable movement in reserves associated with guarantees on segregated fund/variable annuity business. We estimate the average EPS impact of these stronger-than-expected markets YOY to be $0.02-$0.03 in Q2/F07 for the lifecos (currently not in our estimates), with Sun Life and Industrial-Alliance, each by a small margin, benefiting the most. This benefit more than offsets the negative headwind due to currency.

• But we see little likelihood of any significant increases in EPS estimates going forward. Unless we see something higher than a 7% return on the equity markets going forward (our portfolio strategist suggests just 2%-3% for the S&P/TSX and 6%-7% for the S&P 500), the 3% expected appreciation in the average CAD versus the USD in 2008 over average Q2/F07 levels (as per the most recent Scotia Economics forecast) will continue to put pressure on EPS estimates, especially for Manulife. The pressure is a little less for Great-West Lifeco and Sun Life due to more exposure to the £ (which, as per the most recent Scotia Economics forecast, is expected to be flat versus the CAD through the end of 2008), and less exposure to the USD. That said, the credit environment remains favourable and rising long-term interest rates certainly help more than hurt.

• However, for SLF and GWO we could see increases in EPS estimates. Sun Life, however, is one company for which we expect there is a chance it will come out of the quarter with a lift in EPS estimates, largely due to the recently announced funding arrangement for its U.S. insurance business, and mostly impacting the second half of 2007. Great-West Lifeco is another, where we believe the strong likelihood of funding the Putnam acquisition without issuing common equity could add another $0.02 to 2008E EPS (in addition to $0.03 we have already incorporated).

Great-West Lifeco Inc.

1-Sector Outperform : $40 target, based on 3.0x 6/30/08E BV & 14.1x 2008E EPS

• We are looking for $0.58 per share for Q2/F07, $0.01 per share below consensus. Our 2007 EPS estimate is $2.41, $0.01 ahead of consensus, and our 2008 EPS estimate is $2.75, $0.04 ahead of consensus.

• We look for the Putnam acquisition to close imminently, and financing to be finalized, with no common equity issuance. We believe that financing without common equity will add another $0.02 to 2008E EPS (in addition to $0.03 we have already incorporated).

• Europe should continue to drive growth, helped in part by $10.9 billion brought in-house in February, 2007, from the Equitable Life payout annuity block acquisition.

• Recently completed tuck-in acquisitions in the United States (two 401(k) blocks and managed care blocks, all closed in the last nine months) should start to bear fruit.

• We look for a 6% increase in the dividend.

Industrial-Alliance Insurance and Financial Services Inc.

3-Sector Underperform : $38 target, based on 1.7x 6/30/08E BV & 12.5x '08E EPS

• We are looking for $0.73 per share in Q2/F07, $0.01 below consensus. Our 2007 EPS estimate of $2.96 is $0.01 below consensus, and our 2008 EPS estimate of $3.19 is $0.09 below consensus.

• A significant reduction in new business strain is likely to drive results in Q2/07 (helped in part by a decline in YOY sales), but strain reduction will unlikely be a growth driver in 2008.

• Unless another acquisition is made, we see 2008 EPS growth returning to the 8%-9% range, consistent with the 8% organic growth in 2006 (ex the tax gains) and the expected 10% organic growth in 2007 (ex the tax gains).

• Good chance of a 7%-11% dividend increase.

Manulife Financial Corporation

2-Sector Perform : $43 target, based on 2.5x 6/30/08E BV and 13.9x 2008E EPS

• We are looking for $0.68 per share for Q2/F07, $0.01 per share below consensus. Our 2007 EPS estimate of $2.75 is in line with consensus and our 2008 EPS estimate of $3.06 is $0.05 below consensus.

• We look for 5% earnings growth in the U.S. division (ex foreign exchange) as the U.S. Fixed Products segment finally starts to return to 'guided to' earnings levels.

• New U.S. variable annuity product launch is expected continue to gain traction, but we expect an update on new product launches slated for Q3/F07 in Japan, as well as measures to address the continued slide in U.S. individual insurance sales.

• Share buyback activity appears to have picked up again. Q2/F07 activity was a twice the run rate of prior three quarters. If current pace continues we could $0.02-$0.03 to 2008E EPS.

• We assume the CAD will average US$0.93 in 2008; if it's US$0.95 we will decrease our EPS estimate by $0.05 per share, and if it's US$0.99 we will decrease our estimate by $0.12.

Sun Life Financial Inc.

1-Sector Outperform : $58 target, based on 1.9x 6/30/08E BV & 13.0x 2008E EPS

• We are looking for $0.95 per share for Q2/F07, $0.01 below consensus. Our 2007 EPS estimate of $3.92 is $0.04 below consensus and our 2008 EPS estimate of $4.41 is line with consensus.

• Good likelihood of raising 2007 EPS estimates by $0.05-$0.07 coming out of this quarter due to recently announced funding arrangement, and $0.03 in 2008 due to strength in U.S VA sales.

• We look for a 5%-8% dividend increase, consistent with the company’s practice of increasing the dividend 5%-9% each six months over the last several years.
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Sunday, July 15, 2007

BofA Profit Trails as Citigroup, JPMorgan Go Abroad

  
Bloomberg, Bradley Keoun and Will Edwards, 16 July 2007

Bank of America Corp. does more business in the U.S. than any of its competitors, and that's eroding returns for shareholders of the Charlotte, North Carolina-based company.

Demand for financial services is increasing three times as fast outside the U.S., fueled by companies and investors in Brazil, China, India and Russia. While Bank of America operates in 45 countries, they produce only 13 percent of its revenue. That's puny compared with Citigroup Inc., which derives almost half its sales from abroad and ranks among the biggest banks in Mexico, Poland and South Korea.

The same domestic focus that made Bank of America, Wachovia Corp. and Wells Fargo & Co. the best performing of the biggest U.S. bank stocks during the first half of the decade is working against them now. With Europe and Asia accounting for more than half of the world's economic output and home to six of every 10 millionaires, the banks and securities firms that expanded internationally stand to benefit most.

``Bank of America is largely a play on the U.S. and it's suffering more because the domestic economy has been growing at sub-3 percent,'' said Chris Hagedorn, who helps oversee about $22 billion at Cincinnati-based Fifth Third Asset Management, which owns shares of Citigroup, Bank of America and Wachovia. ``The growth right now is coming internationally.''

Kenneth Lewis, Bank of America's 60-year-old chief executive officer, is unswayed. He says the U.S. represents the best opportunity because it's still the world's single biggest source of banking, brokerage and money-management fees.

``We do better when we play to our strengths, and our strengths are in the U.S.,'' Lewis said in a June 19 interview in New York.

For now, the geographic divide between U.S. banks is growing, and it may widen even further this week when the five largest, Citigroup, Bank of America, JPMorgan Chase & Co., Wachovia and Wells Fargo, report second-quarter results.

Analysts surveyed by Bloomberg estimate that New York-based Citigroup, led by CEO Charles Prince, increased earnings by 7.7 percent, and JPMorgan, which gets a quarter of revenue from outside the U.S., had a 6.4 percent gain. Bank of America may post a 2 percent profit drop, its first decline since 2005, the survey shows.

The situation is already playing out on Wall Street, with Lehman Brothers Holdings Inc. generating almost all of its $1.1 billion increase in second-quarter revenue from international markets. Lehman, the fourth-largest securities firm, said profit increased 27 percent in the three months ended in May.

It was a different story for Bear Stearns Cos., which relied on the U.S. for 87 percent of last year's business. Chief Executive Officer James E. ``Jimmy'' Cayne, who resisted the pressure to expand in investment banking and trading overseas, reported a 10 percent drop in profit as mounting home-loan defaults in the U.S. hurt trading.

Merrill Lynch & Co. shareholders will find out tomorrow how much the world's No. 3 securities firm benefited from its overseas operations, which typically provide 35 percent or more of revenue. The New York-based firm probably will report an 18 percent increase in earnings, the Bloomberg survey shows.

The Boston Consulting Group's ``heat map,'' a color-coded chart showing where financial-services demand is expanding fastest, makes the point graphically. Over on the far right of the page, China's 8.5 percent growth stands out in fiery red. The U.S., where such revenue is rising 2.8 percent a year, sits on the left in an icy blue.

Overall, the pool of fees for everything from investment banking to retail-brokerage services and basic savings accounts will swell by 896 billion euros ($1.2 trillion), or 43 percent, from 2005 to 2015, according to Boston Consulting. About 671 billion euros of the growth will come from abroad.

``Other markets are going to grow faster than the U.S. for the foreseeable future,'' said Michael McKeon, managing partner in the financial services practice of consulting firm Booz Allen Hamilton in New York.

If anything, Bank of America's Lewis is doubling down on the U.S. His agreement to buy ABN Amro Holding NV's Chicago-based LaSalle Bank unit for $21 billion won the backing of the Dutch Supreme Court on July 13. The purchase would bring the bank right up against the federally enforced 10 percent market-share cap on U.S. deposits. The bank currently has almost 6,000 branches in 31 states.

Lewis points to research by McKinsey & Co. and studies by Bank of America that show the U.S. will generate the largest pool of banking fees over the next decade. He predicts that Bank of America can boost earnings per share by 10 percent a year just by gaining a greater share of the U.S. market and making selective investments overseas.

Bank of America became the nation's largest private bank earlier this month with the $3.3 billion acquisition of U.S. Trust Corp. In addition to holding the most U.S. deposits, Bank of America also is the nation's biggest credit-card issuer.

While Bank of America has plans to expand in some developing markets, such as China, it's scaling back operations in others. Last year, the bank swapped its Brazilian unit for a stake in Banco Itau Holding Financiero SA, completing a two-year effort to dispose of assets acquired in the 2004 purchase of FleetBoston Financial Corp.

Lewis says he doesn't like doing business directly anywhere in the world ``where we're 13th.''

Investors have second-guessed Lewis before and lost. When Bank of America agreed to buy FleetBoston in October 2003, its shares tumbled 10 percent. Shareholders rebelled similarly after Lewis proposed buying credit-card issuer MBNA Corp. in June 2005 for 30 percent more than market value. In both cases, Bank of America met or exceeded the cost savings Lewis promised.

In Lewis's first five years as CEO following his promotion in April 2001, Bank of America's stock gained 72 percent. Citigroup's rose 4 percent and JPMorgan's fell 11 percent.

``Up to now you have to give Ken Lewis a lot of credit,'' said Marshall Front, who helps manage about 500,000 Citigroup shares and 300,000 Bank of America shares at Front Barnett Associates in Chicago. ``Our largest holding has been Citigroup, and it hasn't particularly been a good investment.''

The tables have turned during the past year. Bank of America shares advanced 2.5 percent, while Citigroup gained 10 percent and shares of New York-based JPMorgan jumped 22 percent.

Citigroup does business in more than 100 countries, and the $9.2 billion it earned overseas last year exceeded net income at Charlotte-based Wachovia, the fourth-largest U.S. bank.

``When I think about our competition trying to go international, one country at a time, it's not always going to take forever, but it's a very risky strategy because you could happen to be to be in the wrong country at the wrong time,'' CEO Prince said at an investor conference in May.

Prince, 57, spent at least $10 billion in the past eight months on foreign acquisitions. Citigroup bought control of Nikko Cordial Corp., Japan's No. 3 brokerage, and acquired London-based Egg Banking Plc, the world's largest independent online bank. It invested in banks in El Salvador, India and Turkey and agreed to buy another in Taiwan. Citigroup's current expansion plans include doubling branches in Japan to 50, signing up 20,000 customers a month in Russia and building a securities business in China. The company also may purchase 50 percent of Chile's second-biggest bank.

Citigroup is an ``underappreciated global franchise, with first-mover advantage in a lot of developing countries,'' said Hagedorn of Fifth Third. In the U.S., ``banks are looking at 2 percent earnings growth, and that's not terribly exciting.''

Bank of America's overseas strategy has centered on partnerships. Under Lewis, the company has spent almost $5 billion since 2002 taking stakes in China Construction Bank Corp., China's third-biggest bank, and Grupo Financiero Santander Serfin, Mexico's No. 3 bank.

For now, Bank of America is limiting its international expansion mainly to capital markets and credit cards. The company will invest $300 million to $400 million over the next several years to gain a greater share of securities sales and trading in Europe and Asia.

Lewis also wants to sell banking products to credit-card customers in Europe by direct mail. Bank of America's $35 billion purchase of Wilmington, Delaware-based MBNA last year made it a leading credit-card issuer in the U.K., Ireland and Spain.

In the U.S., banks have been squeezed by the so-called flattening yield curve. That's when long-term rates decline and short-term rates increase, narrowing the spread banks earn on the difference between rates on deposits and loans.

Now, with the collapse of the U.S. subprime-mortgage market and the decline in house prices, banks also face bigger losses on home-equity debt and loans to homebuilders, Citigroup analyst Keith Horowitz wrote in a July 10 research note.

Wachovia and San Francisco-based Wells Fargo, the fifth- biggest U.S. bank, both generate less than 5 percent of their revenue from abroad. Wells Fargo Chairman Richard Kovacevich has referred to U.S. states east of the Mississippi River as ``overseas markets.''

Expanding into Europe was easier for Citigroup and JPMorgan in past decades because state-owned banks such as France's Credit Lyonnais SA and Banque Nationale de Paris couldn't keep up with the more nimble Americans, said Giorgio Questa, a finance professor at Cass Business School in London who used to oversee international investment banking at Italy's IMI SpA.

In the securities industry, U.K. brokers were snapped up by U.S. giants such as Merrill, which bought the biggest, Smith New Court, in 1995. Now, ``banks like Bear Stearns, Wachovia and Bank of America are finding entrenched and stiff competition from U.S. banks that were there before,'' Questa said. ``Largely, they have missed the boat.''

That's costing them opportunities to tap into the surge in international demand for financial services. European and Asian companies have accounted for 61 percent of equity-underwriting fees paid to investment banks this year, data compiled by Bloomberg show. In 2000, U.S. companies paid 57 percent.

``You clearly have a much higher growth rate in Asia and in Eastern Europe, compared with the U.S.,'' David Sidwell, chief financial officer at Morgan Stanley, said in a July 12 interview. ``Can you just shift resources out of the U.S. to Asia? The simple answer is no. You need to make sure you're investing in both.''

Bear Stearns, the fifth-biggest Wall Street firm, wants to forge more international partnerships to invest in companies that operate in faster-growing economies, Co-President Alan Schwartz said in March. In March, the company formed a $500 million fund with Huang Guangyu, the richest man in China, to invest in the country's retail industry.

International markets don't come without the kinds of risks Bank of America's Lewis prefers to avoid. Citigroup said it would shut about 80 percent of its consumer-finance branches in Japan earlier this year after the government passed legislation capping interest rates. The company raised its loan-loss reserves in Japan by $375 million and had closure costs of $40 million.

Morgan Stanley, Citigroup and Bank of America all are scheduled to stand trial in coming months for their financing of Parmalat Finanziaria Spa, the Italian dairy company that went bankrupt in 2003 after revealing a 3.95 billion-euro bank account didn't exist. The banks face allegations that they didn't have sufficient internal controls to prevent Parmalat employees from committing fraud.

Goldman CEO Lloyd Blankfein says the cost of staying too close to home may be greater. Developing markets such as Brazil, Russia and China have reached a ``tipping point'' that makes them harder than ever for investment banks to ignore, he said at a conference last month.

``If you forgo the opportunities in emerging markets, you're putting your global franchise at risk,'' Blankfein said. ``Isn't it better to invest in a place where everything is growing at 11 percent than where everything is growing at 2 percent?''
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Thursday, July 12, 2007

Blackmont Capital Comments on Banks' Subprime Exposure

  
Financial Post, Duncan Mavin, 12 July 2007

It can be difficult to discern exactly how Canada’s banks are exposed to the turbulent U.S. sub-prime mortgage market as Blackmont Capital analyst Brad Smith can likely testify after spending the last couple of weeks “Staring into the Structured Finance Labyrinth” to prepare his report of the same title.

Some of the banks may have got involved through the booming global trade in complex credit derivatives called collateralized debt obligations, or CDOs — the market has grown at a compound annual rate of 99% since 2002 and stood at more than US$34-trillion in 2006, says Mr. Smith. CDOs are ultimately tied to mortgage-backed securities, which are securities backed by pools of often sub-prime mortgages.

But finding out who holds these CDOs and how much they hold is not an easy task.

“Disclosure of derivative trading activity has improved greatly in recent years, but remains inadequate for drawing definitive conclusions regarding any given bank’s ultimate exposure to credit derivative trading,” says Mr. Smith.

Fortunately, the Blackmont analyst has done some of the hard work, compiling figures for the Canadian banks where information is available.

Among the conclusions he has been able to draw is that Bank of Nova Scotia has the smallest exposure to credit derivatives, weighted for risk, compared to market capitalization.

Canadian Imperial Bank of Commerce has the highest exposure, almost 6 times the size of Scotiabank’s when compared to market capitalization, according to Mr. Smith’s calculations. “CIBC’s involvement in credit derivative swap trading has ballooned since 2005,” he notes.

It is also worth noting that CIBC issued a press release on Tuesday that played down its exposure to the U.S. sub-prime real estate mortgage market. The bank said its “unhedged” exposure is “well below” a rumoured amount of US$2.6-billion.

CIBC has not confirmed what its actual exposure is.
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Wednesday, July 11, 2007

BMO Agrees to Buy Two Wisconsin Banks

  
Scotia Capital, 11 July 2007

Event

• Bank of Montreal announced July 10 two small acquisitions in Wisconsin for US$327.2 million representing 25.4x LTM earnings.

What It Means

• BMO continues to expand the Harris footprint with small high priced acquisitions with operating challenges. We view these acquisitions as mildly negative given price, low market share, difficult operating environment, execution risk and low expected shareholder return. These acquisitions also reaffirm BMO's statement that Harris is the key growth platform for the bank and it does not intend to sell its U.S. operations.

• In terms of deposit market share, BMO will have the number 9 position in Wisconsin and the number 6 position in Milwaukee, however, combined market share would be a modest 1.5% in Wisconsin and 3% in Milwaukee (as of June 2006).

• BMO is trading at a 5% P/E premium to the bank group on our 2008 earnings estimates with lower than industry average ROE and return on risk-weighted assets.

• Maintain 3-Sector Underperform.

BMO Announces Two Small Acquisitions in Wisconsin - Mildly Negative

• Bank of Montreal (BMO) announced july 10 two small acquisitions in Wisconsin for a combined US$327.2 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 and a combined deposit premium of 19% (26% excluding US$0.5 billion in time deposits at MMBI).

• The bank expects that the acquisitions will exceed the 10% cost of capital. Excluding one-time costs, the transactions are expected to be mildly dilutive in 2007 and mildly accretive in 2008.

• BMO continues to expand the Harris footprint with small high priced acquisitions with operating challenges. We view these acquisitions as mildly negative given price, low market share, difficult operating environment, execution risk and low expected shareholder return. These acquisitions also reaffirm BMO's statement that Harris is the key growth platform for the bank and it does not intend to sell its U.S. operations.

Ozaukee Bank - Strong Brand, Affluent Market

• Ozaukee Bank is primarily a retail bank with 6 full-service and two limited-service locations with a strong brand in the high end area of Ozaukee. The bank has US$694 million in assets and US$561 million in deposits. Ozaukee Bank has 1.42% deposit market share in Milwaukee and 0.54% deposit market share in Wisconsin (as of June 2006).

MMBI - Weak Financial Performance = Potential Opportunity

• Merchants and Manufacturers Bancorporation (MMBI) is a bank holding company dealing primarily in commercial banking with 34 full-service locations and 11 limited-service locations. The bank's earnings have been weak in the past. Currently, MMBI has $1.5 billion in assets and $1.2 billion in deposits. MMBI has deposit market share of 1.58% in Milwaukee and 1.02% in Wisconsin (as of June 2006).

Combined Market Share Modest at 1.5% - 3%

• These acquisitions are BMO's first foray into the state of Wisconsin. The two acquisitions give the bank 40 full-service branches with 33 concentrated in the Milwaukee area. In terms of deposit market share, BMO will have the number 9 position in Wisconsin and the number 6 position in Milwaukee, however, combined market share would be a modest 1.5% in Wisconsin and 3% in Milwaukee (as of June 2006). The transactions are expected to close in late 2007.

Recommendation

• In our comment "BAC Acquires LaSalle - Harris Strategic Options" dated April 24, 2007, we stated that if we were to apply a 30% range deposit premium for Harris the value would be $12 per BMO share, approximately $6 billion or 17% of market capitalization, significantly below earnings contribution of 5%.

• BMO is trading at a 5% P/E premium to the bank group on our 2008 earnings estimates with lower than industry average ROE and return on risk-weighted assets.

• Maintain 3-Sector Underperform.
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The Globe and Mail, Tara Perkins, 11 July 2007

Bank of Montreal has not ruled out making a blockbuster acquisition in the U.S., but none have come its way.

Yesterday, the bank gobbled up two small regional players for nearly $330-million (U.S.), pushing it into Wisconsin for the first time.

"We're always looking at acquisitions, whether they're smaller ones like this or larger ones," Ellen Costello, chief executive officer of BMO's U.S. subsidiary Harris Bankcorp Inc., said in an interview.

Any opportunity would have to meet all of the bank's criteria, including the right price and having a strong cultural fit, she said. No large bank seems to make the cut at the moment.

BMO did take a look at LaSalle Bank, one of its major Chicago-area rivals that is up for grabs. LaSalle, the U.S. bank owned by Dutch giant ABN Amro, is the No. 2 bank in the area, while Harris is No. 3, based on the amount of deposits. LaSalle is in the midst of a takeover battle that will likely see it acquired for more than $20-billion.

Ms. Costello said Harris looks at everything that's available in the market, and noted LaSalle is a well-regarded competitor.

BMO said yesterday it will pay $190-million in stock for Milwaukee-based Ozaukee Bank, which has six full-service branches and $694-million in assets.

It also announced a deal to buy Wisconsin-based Merchants and Manufacturers Bancorporation Inc. for $137.2-million in cash, or $37.30 per share. Merchants and Manufacturers is a holding company that has six bank subsidiaries which together operate 34 full-service locations. Combined, the six subsidiaries have $1.5-billion in assets.

"Merchants and Manufacturers' emphasis on serving small and mid-market commercial customers complements our recent addition of our business banking services in the greater Milwaukee area," Ms. Costello said.

About Ozaukee Bank, she said "when you consider that Ozaukee County has the second-highest median household income in the state, we believe the combined power of our two banks will deliver tremendous results for customers in this market. In particular, we see this as an attractive market for our wealth and business banking capabilities."

UBS analyst Jason Bilodeau said in a note the "synergies are likely to be limited and risks slightly higher for an out-of-market deal, but management suggests each bank is well-positioned in good markets with an attractive deposit base." He said the move suggests BMO is able to speed up its U.S. growth through acquisitions. "Most importantly, we believe this demonstrates that management remains firmly committed to its U.S. retail strategy and will continue growing the platform through organic growth, additional bolt-on acquisitions and, under the right circumstances, potentially larger transactions."

Both deals are expected to close later this year, and are subject to approvals from regulators in the U.S. and Canada as well as the shareholders of the target banks.

Ms. Costello said BMO is still looking for acquisitions. Indiana and Wisconsin are two areas where she sees opportunities. Harris has more than 230 locations in Illinois and Indiana, and aims to bulk up to between 350 and 400 locations across the U.S. Midwest. It has $42-billion (U.S.) in assets and $29-billion (U.S.) in deposits.

• BMO's U.S. presence

Illinois & Indiana

Through its American franchise, Harris Bank, BMO operates more than 230 locations in Illinois and Indiana, with a long-term target of 350 to 400 locations in the U.S. Midwest. Harris has annual revenue of $1.3-billion (U.S.) and is concentrated in the Chicago area, with 9.8 per cent of deposits in the city's banks. Total assets amount to $42-billion and total deposits are $29-billion.

Wisconsin

Ozaukee Bank has six full-service and two limited-service locations in northern Milwaukee. Ozaukee leads other banks in its county with $561-million in deposits and $694-million in assets. Merchants and Manufacturers Bank has 34 full-service and 11 limited-service locations through six subsidiaries in the Milwaukee area. Assets total $1.5-billion and the bank holds $1.2-billion in deposits.
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Financial Post, Duncan Mavin, 11 July 2007

Bank of Montreal has bought two banks in Wisconsin to add to its U.S. operations, showing its ambitions in the Midwest are not dented by the possible intrusion into the region of retail-banking giant Bank of America.

The two deals will cost BMO a combined $340-million in stock and cash and will boost the size of the branch network at BMO's Chicago-based Harris Bank by 16%, or 40 full-service branches and 13 other locations.

The deals announced yesterday for Merchants and Manufacturers Bancorporation Inc. and Ozaukee Bank, both located in the Milwaukee area, will add US$1.75-billion in deposits, bumping Harris's total deposits by 10%.

BMO's first forays into Wisconsin will position Harris as the ninth-largest institution by deposit market share in the state, and the sixth-largest bank by deposit market share in Milwaukee.

There has been some recent speculation the bank's ambitions would be stalled by Bank of America's proposed US$21-billion purchase of LaSalle Bank, which is a significant player in the same "Chicagoland" market as Harris.

LaSalle would add 151 branches to the 56 Bank of America owns in Chicago. A deal, if it goes through, is expected to intensify the already fierce competition in the Chicago banking sector, and some observers had suggested it would also stifle Harris' plans in the region because it could push up the price of smaller, target banks. But Harris's latest purchases appear to show the bank is sticking to its growth plan, said banking analysts.

"We believe [the deals] demonstrate that management remains firmly committed to its U.S. retail strategy and will continue growing the platform through organic growth, additional bolt-on acquisitions and, under the right circumstances, potentially larger transactions," said UBS Investment Research analyst Jason Bilodeau.

"We do not anticipate a material contribution to earnings but do believe that these announcements indicate BMO will continue to focus on growing its U.S. operations through additional acquisitions," said Dundee Securities analyst John Aiken.

Harris Bank chief executive Ellen Costello said competition throughout the mid-west is tough but management is not deterred from making further deals in the region.

Ms. Costello, a former investment banker with years of merger and acquisitions experience, was installed in the Harris hot seat last July.

One of her main tasks is to grow Harris to its stated goal of 350 to 400 locations across the Midwest.

Including yesterday's acquisitions, the Harris network has increased by more than 70 branches, or about a third, since Ms. Costello took over the reins.

UBS's Mr. Bilodeau said the Wisconsin purchases, along with the September 2006 acquisition of First National Bank & Trust for US$290-million, will "be a test of management's ability to accelerate the pace of acquisition growth and to deliver improved operating results."

"Synergies are likely to be limited and risks slightly higher for an out of market deal," he said.
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Financial Post, Duncan Mavin, 10 July 2007

BMO's acquisition of two Wisconsin-based banks to add to its Chicago-based retail banking franchise show that it “will continue to focus on growing its U.S operations through additional acquisitions,” says Dundee Securities analyst John Aiken.

The two banks, Ozaukee Bank and Merchants and Manufacturers Bancorp, will cost BMO a combined $340-million in cash and stock, and add more than US$2-billion in assets, or 10%, to the U.S. growth platform.

BMO’s Harris bank franchise will gain a further 40 full-service branches and 13 other locations and marks the banks entry into Wisconsin. The acquisition grows the total number of Harris Bank branches by 16%.

“It’s a relatively low amount of capital expended to gain access to a third contiguous state for Harris,” says Mr. Aiken. “Each platform allows for additional cross-selling potential,” he adds.

The Dundee analyst says the the outlook on the deals is modestly positive. His 12-month target price for BMO is unchanged at $75.
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Bloomberg, Doug Alexander and Sean B. Pasternak, 10 July 2007

Bank of Montreal, Canada's fourth-largest lender, agreed to buy two Wisconsin banks for $327.2 million, its biggest consumer-banking investment in more than a decade.

Bank of Montreal offered $190 million in stock for Ozaukee Bank, and $137.2 million in cash for Merchants and Manufacturers Bancorporation Inc., the Toronto-based bank said today in statements. The purchases are the first in Wisconsin for Harris Bank, and will increase its U.S. branches by more than a fifth.

``It's demonstrating that they're committed to their U.S. retail strategy,'' said UBS Canada analyst Jason Bilodeau, who rates Bank of Montreal a ``neutral 2'' and doesn't own the stock. ``They've indicated that they want to accelerate the pace of bolt-ons and this may be the first indication of that.''

Bank of Montreal is trying to reverse a slump in U.S. consumer banking, where profit has declined since fiscal 2005. The bank has spent about C$1.5 billion ($1.4 billion) on U.S. banks since 2000 to expand Chicago-based Harris. Ozaukee has eight offices and Merchants has 45, boosting Harris Bank's network to 285 branches in the U.S. Midwest.

Bank of Montreal offered $37.30 a share for Merchants, or 33 percent more than yesterday's closing share price of $28. Stock of the New Berlin, Wisconsin-based bank rose $8.05, or 29 percent, to $36.05 at 3:38 p.m. in over-the-counter trading. Bank of Montreal fell 27 cents to C$69.10 at 4:10 p.m. on the Toronto Stock Exchange.

``What this does for us is add another diversifying element to our footprint in another attractive market,'' Harris Bank Chief Executive Officer Ellen Costello said in an interview. ``This should be evidence that we're serious about growing.''

Merchants has $1.5 billion in assets and $1.2 billion in deposits, with half near Milwaukee. The company had net income of $4 million in 2006, 22 percent less than in 2005.

Ozaukee investors will get about 3 million Bank of Montreal shares as part of the transaction, the bank said. Ozaukee Bank, based in the Milwaukee area, has $694 million in assets and $561 million in deposits.

Chief Executive Officer William Downe, who took over the top job in March, has said that he wants Bank of Montreal to have between 350 and 400 U.S. branches within four years. Last August, the bank promoted Costello to head the U.S. consumer bank to help make acquisitions.

``When Bill Downe was appointed, the U.S. was going to become more important,'' said John Aiken, an analyst at Dundee Securities in Toronto. ``He is an American, and he spent a lot of time down in Chicago, so it stands to reason that this is probably in his comfort zone.''

The takeovers may increase U.S. assets and deposits by about 10 percent, Aiken said today in a note to clients. The acquisitions make Harris the sixth-largest bank for deposits in Milwaukee and ninth in the state, Costello said.

The two acquisitions are the largest consumer-banking investment for Bank of Montreal since its C$378 million purchase of Household Bank in 1996, according to the bank's Web site. In January, Bank of Montreal acquired Indiana's First National Bank & Trust for about C$342 million.

Harris Bank has been ``actively talking'' with other U.S. Midwest banks about takeovers and would consider something larger, Costello said. Harris would consider more takeovers in Illinois and plans to buy more banks or open new branches in Indiana and Wisconsin, she said. Bank of Montreal has ``C$2 billion plus'' in excess cash that could be tapped for acquisitions, she said.

Earnings from U.S. consumer banking, where Bank of Montreal receives less than 5 percent of its annual profit, fell 3.6 percent to C$27 million in the fiscal second quarter, as the Canadian currency surged 6.2 percent relative to the U.S. dollar.

``We've been suffering in the last 18 to 24 months from a slowing real estate market, which has affected us on both the consumer and commercial side,'' Costello said. ``The tactic we've taken is to be really aggressive on managing our costs.''
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