Wednesday, June 25, 2008

CIBC & RBC Likely to Increase Markdowns on Hedges with Financial Guarantors

RBC Capital Markets, 25 June 2008

Problems facing financial guarantors worsened recently as rating agencies downgraded several large players.

• We believe further large write-downs are likely as credit default swap spreads have widened considerably since the end of Q2/08.

• Banks have not been valuing their hedges with financial guarantors solely on credit ratings, but have also taken into consideration credit default swap spreads on the financial guarantors in determining valuation allowances on hedges.

• We also expect continued pressure on the valuation of hedged assets, which will increase the exposure to financial guarantors.

CIBC and Royal Bank have the largest exposures to financial guarantors among Canadian banks

• Due to the ratings actions, CDS spread widening and continued pressure on the value of CDOs of RMBS, we are increasing our write-down estimates at CIBC (from $1 billion to $1.5 billion) and Royal Bank (from $0 to $500 million).

• We have summarized our sensitivity analysis on the Tier 1 ratio of CIBC and Royal Bank in this report. We believe that each bank's Tier 1 ratios will remain above 9% using our expected write-down amounts in Q3/08E, and that the banks have enough capital even if we assume the hedges with financial guarantors are worthless.

• The other Canadian banks have much smaller exposures, if any.

Lowering 12-month target price for CIBC and Royal Bank

• We maintain our Underperform rating on CIBC's shares. We have lowered our 12-month target price for CIBC from $64 to $62 per share due to our higher write-down estimate. Our target price is based on a P/BV multiple of 2.0x, versus the current 2.1x multiple, and it implies a P/E on 2009E EPS of 8.4x, whereas the stock currently trades at 8.3x 2008E EPS.

• We maintain our Sector Perform rating on Royal Bank's shares. We have lowered our 12-month target price for Royal Bank from $50 to $49 per share, due to our higher write-down estimate. Our target price is based on a P/BV multiple of 2.3x, versus the current 2.5x multiple, and it implies a P/E on 2009E EPS of 10.8x, whereas the stock currently trades at 10.8x 2008E EPS.
RBC Capital Markets, 24 June 2008

We prefer Manulife's stock ($36.60, Outperform, $41 price target) to Scotiabank's ($48.79, Sector Perform, $49 price target). BNS is not our least favourite bank stock but it shares many similarities with MFC that reduce basis risk. The reasons why we would take money out of Scotiabank and allocate it to Manulife stock are:

• MFC trades at a more attractive valuation relative to historical averages than BNS.

• MFC trades at 11.5x NTM EPS, in line with BNS. Over the last 7 years, MFC has traded at an average premium of 1.4x.

• MFC trades at a 1.3x P/E premium to the lowest valued Canadian lifeco, while BNS trades at a 3.3x premium.

• On a P/B basis, MFC's current 2.2x multiple is in line with its 7-year average, while BNS current 2.7x multiple is higher than its 7-year average of 2.5x.

• We expect greater core EPS growth from MFC in 2008 and 2009 (5% and 13%) than we do for BNS (4% and 2%).

• The macro environment is shifting in a way that advantages MFC.

• The Canadian dollar has settled in a range of about $0.97-$1.03 since mid-November. The rising Canadian dollar had been more negative for MFC than BNS, as it generates 75% of its earnings from outside of Canada versus 45% for BNS.

• The economic and credit quality outlooks continue to deteriorate, which we believe will have a greater negative impact on BNS's loan book than MFC's bond portfolio in 2009. For BNS, we are expecting a 9% earnings growth drag from increasing provisions for credit losses. MFC's investment portfolio has a conservative allocation to riskier bonds (13.8% in BBBs and 2.6% in BBs and below).

• Long term interest rates are up from their lows on rising concerns about inflation. MFC and other insurers benefit from higher interest rates as the duration of their liabilities is longer than that of their assets.

• New business momentum is better at MFC. Sales of insurance products are less dependent on the economy than is loan growth, in our view. We expect loan growth to slow for banks and pressure on retail margins. MFC's Q1/08 value of new business was up 35% YoY, driven by sales of both insurance and wealth management products.

We believe that a pairs trade between MFC and BNS reduces basis risk as these two companies match up well.

• Both companies are best established outside of Canada among their Canadian peers.

• Both management teams are willing to make acquisitions.

• We view both companies as having a "quality" perception among their peers, which should help their stocks in turbulent times.


We have an Outperform rating on Manulife shares as the company has a well-established record of consistent earnings growth and embedded value growth, and has become a world leader among insurers. We believe that Manulife deserves a premium valuation to Canadian financial services companies and life insurers worldwide, based on the company's sales and earnings growth track record, excess capital holdings, growth prospects in Asia, and a lower credit risk profile versus U.S. lifecos and Canadian banks.

• Diversity of operations limits downside earnings risk, in our view, and reserves appear conservative, with large provisions for adverse deviations relative to reserves and a track record of booking experience gains.

• Our 12-month price target of $41 is a combination of our P/B, P/E, and embedded value methodologies. Our P/B target is 2.4x, our target P/E multiple is 12.0x 2009E earnings and our target multiple on embedded value is 1.8x.

We have a Sector Perform rating on Scotiabank shares to reflect our expectations for benign credit deterioration near term, strong domestic retail momentum coming out of Q2/08 results and continuing strong asset growth in international banking, which are offsetting rising loan losses in Mexico, and the negative impact of currency.

• We continue to believe that deterioration in business lending and lower recoveries will lead to a material increase in loan losses in 2009 but to reduce our exposure to the stock today on that basis only is premature in our mind, especially since the retail division is performing well.

• Our 12-month target price of $49 is based on a P/BV multiple of 2.3x, versus the current 2.6x multiple, and it implies a P/E on 2009E EPS of 11.5x, whereas the stock currently trades at 11.8x 2008E EPS.