Thursday, January 24, 2008

Analysts Lower Earnings Estimates & Target Prices

RBC Capital Markets, 24 January 2008

Our investment strategy team has been increasingly concerned over the economy and equity markets. If proven right, as they have so far in 2008, these two factors could be material negative earnings drivers for all financial services stocks in Canada, which would add to existing pressure on the conversion of foreign earnings back into Canadian dollars and, for life insurers, low long-term interest rates.

We are lowering our 12-month target prices and earnings estimates to reflect what is fast becoming a difficult macro environment for financial services companies.

We believe that investors in financial services stocks can afford to be patient. We believe that credit quality will deteriorate, uncertainty surrounding the North American economy has risen, equity markets may not be as strong as they have been for the last five years and the potential for negative headlines remains.

We continue to think that Canadian banks and lifecos should manage through a slower economy better than many global peers, that they are financially solid companies, and that they are unlikely to cut dividends. The return from holding these stocks over the next two to three years could be attractive as a result.

We prefer lifecos over banks although our preference is not as strong as it was given declines in long-term bond yields. We believe that the life insurers are less exposed to deteriorating credit quality, and we feel that their exposure to capital markets is lower than for banks. We are less bullish on lifecos versus banks than we were, however, as the significant declines in interest rates and the high Canadian dollar are more negative for them than for banks.

We believe the potential variability around our forecast returns is higher for banks than lifecos. If the US economic issues lead to a Canadian recession, our target prices would likely decline to levels that would suggest negative returns from holding bank shares over the next 12 months. On the other hand, there is more upside to earnings estimates and valuation multiples on banks if the macro environment proves more accommodating than our strategy team expects.
Financial Post, David Pett, 24 January 2008

BMO Capital reduced its earnings forecasts for the bank by 7% Wednesday, telling investors to expect lower trading and capital markets revenues this year alongside higher loan losses.

Analyst Ian de Verteuil said lower expenses will cushion some of the impact but after removing all "unusual items" from his calculations he expects the sector to essentially have no earnings growth in 2008 when compared with 2007. He also said share buybacks are unlikely this year and broadly speaking, all banks are equally affected by his revised forecasts.

"To date, we believe the bulk of the market's concerns have been focused on liquidity pressures and securities valuation," Mr. de Verteuil wrote in a research note.

"There are more challenges ahead, includiing a need for more realistic earnings forecasts (as we have done today), the risk of counterparty failures and the reality of more modest dividend increases and share buybacks.

That said, the analyst believes investors can take comfort in the fact that dividends appear very safe and bank business models remain very defendable.

He maintained his "market perform" rating on the overall sector and reiterated his "outperform" ratings on both TD Bank and National Bank of Canada.
BMO Capital Markets, 23 January 2008

No banker makes a loan if he thinks it will go bad, and no trader puts in a trade that she expects will lose money. That is why bankers, investment bankers and traders aren’t terribly good at predicting loan losses or trading and capital markets revenues. Against this backdrop, and despite the recently stated view by various bank CEOs (that we have little to worry about), we are reducing our earnings forecasts for Canadian banks by 7%.

This incorporates lower trading and capital markets revenues and higher loan losses. Some of the impact of this will be mitigated by lower expenses. We are also assuming that buybacks are virtually non-existent in 2008. All in, after removing “unusual items”, we expect the Canadian bank sector to have essentially no earnings growth in 2008 when compared to 2007.

Our revised forecasts for each bank are shown below. Broadly, all banks are equally affected. As one would expect, the smaller banks, which have less capital markets exposure, have a minor impact. Note we are restricted on CM shares.

We are maintaining our Market Perform rating on the Canadian bank sector. After an extended period of underperformance, the group is certainly more attractive on a relative basis. To date, we believe the bulk of the market’s concerns have been focused on liquidity pressures and securities valuation. There are more challenges ahead, including a need for more realistic earnings forecasts (as we have done today), the risk of counterparty failures and the reality of more modest dividend increases and share buybacks. However, investors should take comfort, as bank dividends appear to be very safe and the business models of Canadian banks remain very defendable.


We are lowering our forecasted bank earnings by $1.6 billion after tax. This reflects $2.5 billion in lower revenues than we had originally forecast and $800 million of higher loan losses. The impact of these two negative headwinds will be offset by $1 billion of lower expenses. We have assumed a 32% tax rate, which also mitigates the impact. Our basic assumption is a material slowdown in economic activity in North America, but no recession in Canada. We are effectively pushing our earnings growth out 12 months (our 2009 forecast is essentially our previous 2008 expectation).

Loan Losses

We are raising our 2008 forecast for loan losses by $800 million from $3.6 billion to $4.4 billion. Our 2009 forecast is increased by $1 billion from $4.4 billion to $5.4 billion. We have assumed the deterioration is principally in the business loan book (about $400 billion) and the non-residential consumer book (about $275 billion) but not in residential mortgages. All in, we note that even with these increases, we are not assuming “recession-type” loan losses. If we did, we would expect a further $2-3 billion of losses, i.e., a further 7% reduction in our earnings forecasts.

This more cautious view appears to be at odds with many bankers who still believe that the environment remains benign and that the specific issues that are developing (e.g., Quebecor World, Ambac, etc.) are isolated. We are simply assuming that the traditional leading indicators (economic activity, unemployment, default rates, etc.) are a relatively good reflection of what happens next. The issue, as we see it, is one of timing – and it is likely that the higher losses are skewed to the second half of 2008.

Trading Revenues

We are cutting our trading revenues forecast for the Canadian banking system to $5 billion from $6 billion. As we show in Chart 1 below, Canadian bank trading revenues have been relatively stable through most of the past six years at about $5.5 billion despite additional capital that has been committed to the business. The reality is that trading revenues today have become more a reflection of the benefits of structuring off-balance sheet vehicles rather than gains or losses on the “good old” swap books.

The relatively poor performance in 2007 included numerous CDO writedowns, so we expect some improvement in 2008. However, we believe with the market volatility (and the general decline in most markets), the odds of a disappointing first half are high. Furthermore, we believe most banks are scaling back capital committed to the business as value-at-risk (VaR) and volatility rise. On a more optimistic point, we note that trading is still a very modest part of overall revenues.

We believe the majority of bank trading operations remain high quality with good diversification and solid profit dynamics. However, volatility is an important element of the business and this has not gone away. Even at revenues of $5 billion annually, the business of facilitating client needs and creating and managing some structure will remain an important part of Canadian banks.

Capital Markets

We have been impressed (and amazed) by the ability of the major players in the Canadian securities marketplace to show consistent growth in profits. The members of the IDA have achieved record profits for the sixth year in a row – an unprecedented performance.

We believe the IDA data excludes most of the trading books of Canadian banks (which are often held in off-shore banking subsidiaries for tax and other reasons) and the traditional corporate loan books. We are assuming that weaker activity in M&A, equity and fixed income underwriting will shave about 20% off of these revenues – down $1 billion off of a base of $6.5 billion.

Wealth Management

The management of Canadians’ wealth (or rather the provision of advice to Canadians to help them manage their own wealth) remains an excellent business for Canadian banks. And banks will likely continue to be relative winners. However, and after several years of strong equity market gains and very strong flows, we believe revenues will be weaker in 2008 than we had previously assumed. We estimate that bank revenues from mutual fund, brokerage (full-service and on-line), private banking and discretionary investment management activities generate about $10 billion of revenues for Canadian banks. All in, we are assuming that revenues will be down 5%, or about $500 million. We note that the effect is less than one might think because many client holdings are not simply equity based, and we are not forecasting net withdrawals.

Bye-Bye Buybacks

We had previously assumed share buybacks of about 1–2% of outstanding stock in 2008 and 2–3% in 2009. We are now assuming no buybacks in 2008 and 1–2% in 2009. Buybacks are additive to EPS because of the low P/E afforded to bank shares. Note that we are considering buybacks not issuance, which is already up meaningfully because of deal activity – TD buying Commerce Bancorp, and Royal’s purchase of RBTT and Alabama National.

What is particularly interesting is that despite comments of confidence in the future by bank CEOs, banks have all but turned off their buyback programs. Specifically, Canadian banks bought back virtually no stock in November and December. A more balanced approach to analyzing buybacks is by considering the six-month rolling average.