Monday, January 21, 2008

RBC CM Assesses Downside Risk of Banks & Life Insurance Cos

RBC Capital Markets, 21 January 2008

Two questions we receive most from investors are: (1) with Canadian bank shares down 24% from their 52 week highs and lifeco shares down 15%, are these levels where the stocks should be bought; and (2) if a recession hits the North America, what kind of downside risk could there be in bank and lifeco stocks.

We would not add to Canadian financial services positions at this time as we see increased downside risk to earnings and the economy, and we do not believe valuations are at "back up the truck" levels. Bank and lifeco stocks may trade higher in a year if the economy avoids a recession, but it is still too early to buy the stocks, in our view.

We believe the next set of earnings will be difficult for lifecos given the high Canadian dollar, shaky equity markets and declining long term interest rates. For banks, net interest income margins are likely to remain pressured this quarter, wealth management and capital market earnings growth may be weaker than in past years and we believe that companies with exposure to CDOs and AAA-rated monolines are at risk of further writedowns. Higher loan losses are expected for those with U.S. exposure in Q1/08, while normalization of loan losses may hit all banks as the year progresses. For banks, we believe that investors default to price to book in times of economic stress, a period in which credit losses rise rapidly and wealth management and capital market earnings become difficult to predict. The banks traded at an average 1.65x book at the last trough (fall of 2002), which coincided with rapidly rising loan losses and difficult equity markets. A decline from current multiples to 1.65x book would suggest 20-25% of downside risk.

Canadian lifecos have not been public for long, but if excluding the period in which they were expected to merge, they have traded at 10.0-14.5x earnings. They are currently trading at 12.0x forward earnings, suggesting 15% downside risk if valuations decline to trough levels. We emphasize P/E instead of P/B since lifecos may be able to post earnings growth close to estimates even if the macro environment worsened given the size of their actuarial reserves. Multiples could decline, however, as the perceived quality of earnings would be negatively impacted in an environment of lower interest rates and weaker equity and credit markets.

We believe the Canadian banks and lifecos are financially solid companies, which are unlikely to cut dividends, have well established franchises and should come out of a recessionary environment better than many global peers. However, there is downside risk to earnings and stock prices if economic news worsens and equity markets continue to decline.