Friday, February 22, 2008

Preview of Banks Q1 2008 Earnings

Scotia Capital, 22 February 2008

Banks Begin Reporting February 27

• Banks begin reporting first quarter earnings, with Laurentian Bank (LB) on February 27, followed by Toronto-Dominion Bank (TD), Canadian Imperial Bank of Commerce (CM) and National Bank (NA) February 28; Royal Bank (RY) February 29; Bank of Montreal (BMO) and Bank of Nova Scotia (BNS) March 4; and Canadian Western (CWB) closing out reporting March 6.

Negative Earnings Momentum - Earnings Remain at High Level

• We expect Q1/08 operating earnings to decline 5% year-over-year and 2% sequentially representing the first YOY decline since the third quarter of 2002. We expect earnings growth to be negatively impacted by net interest margin pressure, weak capital markets revenue and major appreciation in the C$. The impact of higher loan loss provision is expected to be modest.

• The retail net interest margin in the fourth quarter declined to 2.88% or 8 basis points sequentially mainly due to the higher wholesale funding costs due to higher BA costs. BA costs spiked up to 4.86% in the fourth quarter, however they have declined to an average of 4.50% in the first quarter but remain above the 4.34% level of a year earlier. The retail net interest margin in the first quarter of 2007 was 2.99% making year-over-year comparisons difficult. The prime - one-month BA spread narrowed considerably in the fourth quarter to 139 basis points before rebounding in the first quarter to 155. However on a year-over-year basis the wholesale spread is down 12 basis points.

• The Canadian banks were also very aggressive raising $12.4 billion of capital including the CIBC $2.9 billion equity issue. The banks' excess liquidity, capital and major disruptions in credit markets in general are expected to weigh on the banks overall margins.

• Capital markets revenue is also expected to be weak due to a decline in M&A activity and lower retail brokerage commission. First quarter earnings are also expected to be weakened by the 17% YOY appreciation in the C$, reducing the bank groups non C$ net income.

• Despite these challenges the bank group's underlying earnings levels are expected to remain solid with operating ROE of 21%. The weak spots are expected to continue to be mainly CIBC and to a lesser extent BMO who have both pre-announced write-downs. CIBC is expected to record a loss of $2.70 per share for the first quarter with BMO's earnings expected to decline by half for an ROE in the 10% range.

Dividend Increases - Leadership/Confidence?

• There are four banks due to increase dividends this quarter. This is a board decision. However our view is that with solid balance sheets and strong underlying earnings it is important to show market leadership and confidence by continuing the well established dividend pattern. Dividend payout ratios remain low in our view and the modest capital build (for over capitalized institutions) from delaying dividend increases makes no sense unless there is some permanent impairment in the business model which we strongly believe there is not. Hence we expect TD and RY to increase their dividends in the 8% range and we are hopeful that BMO will show confidence in their operating platform by announcing a 4% increase. CIBC possible dividend increase is the most uncertain especially given the recent equity issue. However they too can make a statement.

Grinding Through the Credit Crisis

• The Canadian banks reported solid fourth quarter earnings, with extremely modest writedowns of 1.3% of common equity paling in comparison to global competitors. Return on equity excluding writedowns was an impressive 21.9% in the fourth quarter. Even on a fully loaded basis, including writedowns and excluding VISA gains, ROE was a very respectable 16%.

• However, credit market volatility and the continuous write off announcements by global banks continues to create fear and uneasiness in the market. Market fears have been recently centered on the future of U.S. monoline insurers and the risk of potential counterparty downgrades. The downgrade of ACA, one of the most financially troubled monolines caused CIBC to pre-announce a large $2.5 billion write down for ACA as well as unhedged CDO exposure. The market has also fretted over the impact of further monoline downgrades to AA and the potential for write down requirements by banks rated A. The resolution of the monoline insurance issue seems very much necessary to gaining stability in the credit markets.

• We expect the release of first quarter earnings will increase investors' confidence in the Canadian Banks' balance sheets and earnings power. We expect a strong rebound in earnings momentum in the second half of 2008 and 2009. We expect banks will prove their critics wrong and earn their way through a downturn in a resilient fashion. As fear subsides share prices should move up sharply.

Recommend Aggressively Buying Banks At These Levels

• Banks are currently trading at P/E multiples of 10.9x trailing and 10.6x our 2008 estimates. Banks’ P/E relative to the TSX is 66%, below our target 80%-90% range. The P/E bottom in the Telco & Cable debacle was 10.9x, with the Asia Crisis being 9.0x. It seems that P/E multiples have bottomed in early 2008 at a similar level to Telco & Cable. Following this bottoming in 2002, the P/E multiples ran up to 15.1x. We are looking for a repeat.

• Bank dividend yields relative to 10-year bond yields are at unheard of levels 5.2 standard deviations above the mean. Bank dividend yields relative to the S&P/TSX Index, Pipes & Utilities, Income Trusts and Canadian lifecos are all in the strong buy range.

• We remain overweight the bank group based on high profitability and capital levels, with low relative exposure to high risk assets, diversified revenue mix, reasonable earnings growth outlook, low earnings volatility, ability to increase dividends, and attractive valuation, including extremely high dividend yields, low P/E multiples, and low relative risk. Maintain 1-Sector Outperform on TD and RY based on quality and size of their large retail and wealth management platforms and superior profitability. Maintain 2-Sector Perform on CIBC, CWB, LB and NA with 3-Sector Underperform on BMO.

Exposure to U.S. Monoline Insurers Low - Except CM

• At the end of the fourth quarter the focus on high risk asset exposure shifted from non-bank ABCP and unhedged CDOs with U.S. sub-prime exposure to hedged CDOs and the credit quality of financial insurer counterparties. At fiscal year end, the Canadian banks disclosed their exposure to U.S. monoline insurers and in particular any exposure to counterparties rated less than AAA. Bank exposure to single A counterparties as at October 31, 2007 was $3.5 billion for CM, RY with $240 million, BMO and BNS with $90 million each with TD and NA not having any exposure to U.S. monolines.

• On December 19, 2007, S&P downgraded ACA Capital, thought to be the single A counterparty to CM, RY, and BMO, to CCC, one notch above default. S&P also changed the financial insurer's outlook to CreditWatch Developing reflecting the possibility of an upgrade or further downgrade in the not-too-distant future. Subsequently, CM announced that there is a reasonably high probability that it will incur a large write-down of US$2.0 billion (US$1.3 billion after-tax or $3.85 per share) in Q1/08 as a result of ACA's downgrade and an additional writedown of US$462 million (US$310 million after-tax or $0.90 per share) on its unhedged CDO exposure. We estimate the following potential charges in the first quarter from the downgrade of ACA for the remaining banks to be $100 million or $0.05 per share for RY. BMO pre-announced first quarter write-downs of $490 million on February 18, 2007 which included an ACA write-down of $160 million or $0.21 per share.

• Subsequent to ACA Capital's downgrade, S&P and Moody's have initiated a review of all U.S. monolines. The fear plaguing the market is that the remaining counterparties, including large financial insurers MBIA and Ambac, will be downgraded by Moody's or S&P triggering billions of dollars of losses in the financial system. Although we do acknowledge this as a possibility we believe that capital issues for the monolines will be resolved. In the event of further downgrades we estimate CM's charges could be $2.6 billion or $4.50 per share on notional exposure of $4.5 billion. RY and BMO have $2.2 billion and $135 million in exposure to other monolines which we estimate could result in writedowns of $0.50 per share and $0.10 per share in the remainder of 2008.

Capital Positions Strengthen With Bank New Financings

• During the quarter, banks have been raising capital and building further balance sheet strength. The Canadian banks issued preferred shares, common shares, Euro-bonds and Innovative Tier 1 raising a total of $9.4 billion representing 1.0% of risk-weighted assets. CM, RY and TD have been the most aggressive in raising capital with CM issuing $2.9 billion in common shares, RY issuing $2.1 billion in Euro covered bonds and other debt and TD issuing $1.9 billion in Euro bonds and preferred shares.

• Bank tier 1 ratios should also get a modest boost from new OSFI regulations allowing the amount of preferred shares for inclusion in Tier 1 capital to increase from 25% to 30%.

Retail NIM Expected to Remain Under Pressure

• Retail earnings may come under pressure this quarter as the result of continued net interest margin compression due to higher funding costs. The average BA rate for the quarter was 4.50% down slightly from 4.86% in the previous quarter but up significantly from the average rate of 4.34% a year earlier.

Wealth Management Earnings Expected to Be Weak

• Wealth management earnings are expected to be weak this quarter. Large net redemptions as well as weak equity markets have caused bank assets under management (AUM) to decline 2% from the previous quarter. The TSX declined 10% in Q1/08, declining 5% in January alone, with the S&P 500 declining 11% and the Nasdaq declining 16%. In Q1/08 the mutual fund industry recorded large net LTA redemptions of $4.2 billion versus strong net LTA sales of $8.7 billion a year earlier. In the month of January, which is typically a very strong month for sales due to RRSP deadlines, net LTA redemptions were a record $4.3 billion. Bank net LTA sales were no exception with large net LTA redemptions of $947 million in the first quarter and net LTA redemptions of $1.3 billion in January.

• Money market funds could provide a silver lining for Canadian banks' wealth management earnings. After large net redemption in money market funds following the non-bank ABCP debacle in August 2007, investors have been pouring money into money market funds, particularly bank funds. In the first quarter, the Canadian banks had net sales of money market funds totaling $7.3 billion, more than 80% of industry net sales of money market funds. RY and TD were the main beneficiaries with $4.2 billion and $1.4 billion in money market net sales.

Wholesale Earnings Weak

• Wholesale earnings are expected to be weak this quarter as the result of lower M&A activity, increased wholesale funding costs and volatile capital markets. The value of M&A deals closing in Q1/08 declined 7% from a record quarter a year earlier. Pending deals have declined substantially as well. However, increased IPO activity along with record trading volume could offset the lack of M&A deals. IPO activity increased 50% from a year earlier while trading volume was up 15%.

• The prime-BA spread has declined 11 bp to an average of 155 bp for the first quarter of 2008 from 166 bp a year earlier. The spread has improved slightly from the low of 139 bp in the previous quarter; however, we expect some of the pricing to carryover from the previous quarter.

Loan Losses to Increase in Economic Downturn

• We would expect bank loan loss provisions to continue to remain manageable with historically low earnings sensitivity. LLP increases are expected over the next several years, especially in unsecured personal credit and commercial/small business related to the manufacturing bases in Ontario and Quebec. We believe the banks’ pricing has been relatively thin on unsecured personal credit, and an economic downturn/recession is likely to cause higher losses in this portfolio and a repricing of risk, although very modest compared with what has happened to corporate spreads and sub-prime mortgages. Overall, however, higher loan losses are very manageable given the relatively low sensitivity to credit and record profitability levels. Loan loss provisions are expected to increase 39% in the first quarter to $850 million but this represents a very modest $240 million increase from a year earlier.

Appreciating Canadian Dollar - Difficult YOY Comparison

• The average $C/$US exchange rate in Q1/08 was $1.007 versus $0.863 in the first quarter a year earlier, an increase of 17%. This Q1/08 represents a very difficult year-over-year comparison. In fact we expect difficult year-over-year comparisons until Q3/08 assuming the dollar stabilizes at or near parity. TD, RY and BMO may also have weak year-over-year earnings growth in their U.S. banking divisions. NA is expected to be the least impacted by the appreciation of the Canadian dollar.

Dividend Increases Expected Despite Financial Turmoil

• The banks that are due to increase their dividends this quarter are BMO, CM, RY and TD with expected increases of 4%, 3%, 8% and 9%, respectively. However, CM may decide to defer the dividend increase due to the announced $2.5 billion writedown on its hedged/unhedged CDO exposure and large $2.9 billion equity issue. The bank group’s estimated dividend payout ratio is 44% on our 2008 earnings estimate with TD’s payout ratio a bank group low of 38% and BMO at a high of 49%.

First Quarter Highlights

• Bank of Montreal is expected to report earnings of $1.38 per share versus $1.31 per share a year earlier, an increase of 5% YOY and a decline of 4% sequentially. On February 18, 2008, BMO pre-announced $490 million in charges for Q1/08 including a $160 million write-down on ACA Capital and $175 million on trading and credit-related positions. BMO's pre-announced write-down on SIVs was modest at $25 million. Canadian P&C and Wealth Management earnings growth should be modest with Wholesale extremely weak due to the challenging capital markets environment, with U.S. P&C earnings continuing to underperform. A dividend increase of 4% to $2.92 per share from $2.80 per share is expected.

• Canadian Imperial Bank of Commerce is expected to report operating earnings of $2.05 per share, a decline of 6% YOY and 11% sequential. We expect reported earnings to be a loss of $2.70 per share including a $4.75 per share previously announced writedown on CDOs. Revenue growth is expected to remain a challenge. A modest dividend increase of 3% to $3.60 per share is possible; however CM may opt to defer its dividend increase due to the large writedown and significant equity issue.

• National Bank is expected to report earnings of $1.30 per share in the first quarter, a decline of 9% YOY and a 3% decline from the previous quarter. We do not anticipate a further writedown on NA's non-bank ABCP in Q1/08. We expect year-over-year declines in retail, wealth management and wholesale banking earnings.

• Royal Bank is expected to report earnings of $1.00 per share, a decline of 14% from record high earnings in Q1/07 and a decline of 1% quarter over quarter (QOQ). Solid earnings growth is expected from RY’s Retail and Wealth Management businesses with potential weakness from U.S. and International Banking and RBC Capital Markets due to the appreciation of the Canadian dollar, reduced capital markets activity, and lower trading revenue. A dividend increase of 8% to $2.16 per share from $2.00 per share is expected.

• Toronto-Dominion Bank is expected to report earnings of $1.40 per share, an increase of 1% YOY but flat from the previous quarter. Retail and Wealth Management earnings are expected to continue to drive earnings. We expect wholesale earnings to decline from very high levels in 2007, especially given a more difficult capital market environment. We expect solid operating results going forward from TD Banknorth. TD Ameritrade earnings contributions for Q4/07 are estimated at $0.12 per share versus $0.10 per share in the previous quarter and $0.09 per share a year earlier. We expect TD to increase its dividend 9% to $2.48 per share.

BMO - Pre-Announces First Quarter Write-Downs

• BMO pre-announced writedowns of $550 million ($365 million after-tax or $0.73 per share). The charges relating to BMO Capital Markets totaled $490 million ($325 million after-tax or $0.65 per share) and are as follows: $160 million pre-tax charge for hedges with ACA Capital (BMO has no further exposure to ACA Capital) higher than expected, $175 million pre-tax charge for trading and structured credit-related positions, $130 million pre-tax charge on Apex/Sitka Trust, $25 million pre-tax charge on SIVs. In addition to these charges BMO will increase its general allowance by $60 million ($40 million pre-tax or $0.08 per share) to reflect portfolio growth and risk mitigation.

BMO - Senior Management Changes

• BMO also announced senior management changes effective March 5, 2008. Thomas E. Flynn, acting CFO, will be replacing Chief Risk Officer Bob McGlashan who has retired. Russel C. Robertson, previously Vice-Chairman of Deloitte, will become Interim CFO.Thomas V. Milroy, previously Co-President of BMO Capital Markets has been appointed CEO of BMO Capital Markets replacing Yvan Bourdeau. Yvan Bourdeau will become Vice-Chair of BMO Capital Markets with accountability for account coverage and focus on International objectives. Eric Tripp, Co-President of BMO Capital Markets, will become President of BMO Capital Markets reporting to Thomas Milroy.

BNS to Expand Operations in Guatemala and the Dominican Republic

• On February 4, 2008, BNS announced that it will be expanding its operations in Guatemala and the Dominican Republic. The details of the transactions were not disclosed. Regulatory approval has been received. BNS will acquire Grupo Atlas Cumbres's (GAC) Banco de Antigua in Guatemala with 47 branches and US$82 million in total assets and Banco de Ahorro y Credito Atlas Cumbres with six branches, 35 points of sale and US$29 million total assets.

CM – Senior Management Changes

• On January 7, 2008, CM announced the following changes to senior management: (1) Tom Woods, Chief Financial Officer of CIBC, to become Chief Risk Officer effective immediately (2) David Williamson, former president and CEO of Atlas Cold Storage will to become Chief Financial Officer, effective January 10, 2008 and (3) Richard Nesbitt, former CEO of the TSX Group, will be joining CIBC as CEO of CIBC World Markets, effective February 29, 2008. In addition, Brian Shaw, CEO of CIBC World Markets and Ken Kilgour, Chief Risk Officer will be leaving CIBC.

CM - Pre-Announced First Quarter Write-Downs

• On January 14, 2008, CM pre-announced a $2.5 billion write-down on CDO exposure with a $2.0 billion write-down on its exposure to ACA Capital and an additional $462 million on unhedged CDO exposure.

CM – Raised $2.9B from Equity Issue and Private Placement

• On January 14, 2008, CM announced a new equity issue and private placement of common shares. The share offering was completed on January 24, 2008. Over 21 million shares were issued through the public offering with an additional 2.8 million from an over-allotment option. CM also issued 24 million shares to institutional investors in a private placement. The equity issue raised $2.9 billion.

NA – Investor Day

• On January 30, 2008, National Bank held an Investor Day in Toronto. National Bank unveiled its new bank-wide strategy of becoming a more client centric bank. Management plans to shift the focus from selling products to servicing its clients and taking advantage of cross-selling activities across segments for a bigger share of wallet. NA also provided more granularity on the non-bank ABCP restructuring process.

RY to Acquire Phillips, Hager & North

• On February 21, 2008, RY announced the acquisition of Phillips, Hager & North Investment Management (PH&N) for $1.36 billion to be paid using 27 million share of RY common shares. Purchase price represents 2.0% of $69.2 billion in AUM.

RY to Acquire Ferris, Baker Watts Inc. - U.S. Wealth Management Firm

• Royal Bank announced its intention to acquire Ferris, Baker Watts, a U.S. based wealth management firm. The details of the transaction were not disclosed. The transaction is expected to close by mid 2008. Ferris, Baker Watts is based in Washington D.C. The firm is a full-service broker-dealer and investment banking firm with approximately US$18.5 billion in assets under management.

TD – TD Ameritrade Earnings - Very Strong

• TD Ameritrade (AMTD) reported Q1/08 earnings of US$0.40 per share versus US$0.24 per share in the previous year, above IBES estimates of US$0.39 per share. TD Bank estimated TD Ameritrade’s contribution from this quarter to be C$88 million or C$0.12 per TD share, versus C$0.10 per share in the previous quarter and C$0.09 per share a year earlier.
Bloomberg, Doug Alexander, 21 February 2008

Royal Bank of Canada, Toronto-Dominion Bank and two other Canadian lenders may forego dividend increases this quarter as profits decline, National Bank Financial analyst Robert Sedran said.

Canadian banks typically raise dividends twice a year, meaning Bank of Montreal, Canadian Imperial Bank of Commerce, Royal Bank and Toronto-Dominion are due to boost their payouts, Sedran said. They may postpone increases because average profits before one-time items will probably drop 1.4 percent, he said.

``They are loathe to break that trend, but at the same time the environment has clearly softened,'' Sedran said in an interview today. ``We are assuming they'll take a pause this quarter and would view any increases as a bullish sign.''

Canadian banks, which report fiscal first-quarter earnings starting next week, face slumping profits because a sluggish economy is boosting loan defaults. Writedowns on debt securities linked to the U.S. subprime mortgage market will also erode earnings, he said.

Toronto-Dominion may not raise its dividend because of an ``uncertain environment and a stretched balance sheet'' after taking its TD Banknorth unit in the U.S. private and agreeing to buy Commerce Bancorp Inc., the largest bank based in New Jersey.

A dividend increase isn't likely for Canadian Imperial, which may add more costs to the ``massive writedowns'' already announced for the quarter ended Jan. 31, he said. Canadian Imperial said in January it'll take $2.46 billion in pretax writedowns on investments tied to U.S. subprime mortgages.

``These are not normal times for the bank,'' Sedran said.

Bank of Nova Scotia, the third-biggest bank by assets, and National Bank of Canada, the No. 6 bank, raised dividends in the fourth quarter and aren't expected to raise them this period.

Even if Canada's banks take a pause on dividend increases, they can still meet their targets for payouts this year, Sedran said in a Feb. 13 research note.
RBC Capital Markets, 13 February 2008

• We estimate core EPS growth of 2% on average versus Q1/07. GAAP EPS growth will likely be lower for some banks, particularly CIBC, on expected mark-downs related to US subprime CDOs and hedges with financial guarantors.

• We expect TD Bank and Bank of Montreal to grow EPS at the highest rates. TD's growth will likely be driven by retail growth and lower exposure to wholesale markets. Bank of Montreal should benefit from easy comparisons since it ramped up expenses in Q1/07 to expand its retail sales force and invest in systems in order to improve its retail growth.

• We expect quarterly dividend increases from TD Bank, Royal Bank and Bank of Montreal.

• The health of the US economy may soon impact the Canadian economic outlook, but for now, we should see solid loan growth and domestic credit quality. We expect total credit quality to worsen but it should not be as challenged as it was for the US banks that reported results this past month.

• The prime/BA spread was narrow during parts of the quarter so we expect margin pressure to continue in retail divisions.

• The 10% decline in the TSX from October 31 to January 31 has negative implications for retail wealth management revenues, in our view, although robust trading activity may buffer the impact.

• Basel II regulatory capital standards will be implemented by Canadian banks in Q1/08. We expect that banks will hold less regulatory capital for credit risk, similar capital for market risk and more capital for operational risk. We do not expect overall regulatory capital to change materially for the industry in general.

• Banks will likely disclose more details about their risk exposures than today. We hope there will be more information on financial guarantors and collateral that might offset some of the counterparty risk that has grown substantially for most banks.