Tuesday, August 12, 2008

Preview of Banks' Q3 2008 Earnings

BMO Capital Markets, 12 August 2008

We are expecting a better earnings performance than we have seen so far this year when Canadian banks start reporting their third-quarter results at the end of this month. Earnings, inclusive of several large identifiable items, will be down about 20% from year-ago levels but the degree of decline should be far more modest than in the last two quarters (Chart 1).

This quarter, we expect the identifiable charges to include hits at CIBC ($750 million), Royal Bank ($300 million) and TD ($96 million, which was preannounced). The good news is that the bad news isn’t getting worse, and some will argue, is diminishing. Trading revenues, which we believe will include these charges, will be only modestly negative this quarter.

We also have a mixed bag on the “operating front”, but still down about 5%. Domestic Banking should continue to underpin the results with volume growth remaining strong. Spreads are forecast to be stable and expenses will remain well-controlled. On the other hand, Canada’s banks are facing two robust headwinds: loan losses are continuing their inevitable march upward and the low activity levels in Capital Markets have continued for another quarter. We are relatively sure that the loan loss situation will deteriorate and are uncertain on the medium term outlook in Capital Markets. One wonders whether the 2006 and 2007 periods are valid bases for forecasting either of these two variables.

We are maintaining a Market Perform rating on the Canadian bank sector. They have had a nice rebound and now only trail the market by 200 basis points year to date. Were it not for the big move in various individual issues (Potash and RIM), they could be declared winners. We still believe the earnings revisions will be to the downside over the coming year as the Canadian economy slows, operating leverage moderates and loan losses rise. We continue to recommend Scotiabank and National Bank (both rated Outperform) at current levels among the big six Canadian banks.

Loan Losses Should Continue Their Steady Climb Higher

Not surprisingly, we expect to see loan losses continue their concerted upward move in the third quarter. The average bank will see provisions that are 70% higher than a year ago, and three will have doubled. Factors include higher formations, as well as fewer recoveries. As is clear from Chart 2, loan losses are certainly higher than in the past five years but are still meaningfully below 2002 levels. This is despite the fact that the loan book is now 50% bigger than it was then – and with a larger bias to the U.S.

We also expect this quarter to exhibit a more broad-based deterioration in loan losses. To date, BMO, TD and Royal have been the culprits producing two-thirds of system-wide losses on a combined basis. This quarter, we expect Scotia, NA, and possibly CIBC, to show some acceleration in their specific loan losses. We show individual bank loan loss estimates in Table 1, which combine to system-wide provisions of $1.2 billion. Given recent U.S. regulatory filings, there is a real risk that BMO’s losses are higher than we have forecast in this report.

In recent memory, this quarter’s loan loss experience will include the first problem name of real size that runs across several banks, Semgroup Energy Partners, whose primary business is apparently running an oil pipeline. As we have detailed in several comments over the past few weeks, this has the potential to cause a blip in both formations and provisions for BMO, RY and BNS. Whatever the specific outcome regarding this credit, it is hard to believe that the worst of our loan loss problems over the next few quarters will be a pipeline company.

It is always enticing to try to link macro economic performance with loan loss forecasts. Unfortunately, the former is possibly more difficult to predict than the latter. Clearly, Canada in aggregate is slowing down. In addition, we are keenly aware that Canada is becoming (or has always been) a country with significant regional differences. While Alberta continues to do well, central Canada is clearly a concern. We remind investors that banks really want all their clients to “do okay” – if there are some regions doing very well but other areas experiencing a meaningful slowdown, loan losses can still mount. As the old saying goes, it is possible to drown in a river that is on-average, two feet deep.

Net Interest Income Should Continue to Be Robust

If there is one element of the Canadian bank income statement that still remains robust it is Net Interest Income (NII), which makes up close to 50% of total revenue. Several cross currents have affected NII over the past few years. In many ways, the simplest to discuss is loan growth.

Canadian banks have been blessed with outstanding loan growth for several years. Fundamental to this has been consumer demand for loans, which has run in excess of 10% since October 2003 (Chart 3). As if that were not enough, business credit demand accelerated in 2006 (in our opinion largely due to a strengthening Canadian dollar). The last boost to loan growth came from the credit problems in mid 2007 (read ABCP problems), which forced many issuers back onto bank balance sheets.

The recent results are far less impressive. Consumer demand remains good, but business loan growth seems to be slowing quite markedly (as one would expect). All in, we believe that the days of double-digit loan growth are largely behind us. This quarter’s results will probably “book-end” a wonderful period for Canadian Retail Banking.

The benefit of strong loan growth has been diluted by two factors. First, much of the consumer growth has been in residential mortgages, which are being extensively securitized. Effectively, securitization mitigates the growth in mortgage balances given the small NII contribution when the mortgage is not funded on the bank’s balance sheet. However, the bank still retains the client relationship and cross sells other products, ensuring that the volume is still attractive.

The second more material factor is the ongoing spread compression (Chart 4). Competition, loan mix shifts and the lack of core deposit growth are all to blame. The good news is that this seems to be moderating. We are forecasting that in the upcoming quarter, spreads will again be stable – the fourth quarter in a row that there has been relatively little margin pressure.

We actually believe that spreads will start to widen into 2009 as lack of alternatives for business borrowers, and better deposit growth (at least in relation to loan growth) should reverse some of the previous trends. On a short term basis, it is also helpful that Prime-BA spreads have begun to stabilize after tremendous volatility (largely negative) at the end of 2007 and into 2008. When all is said and done, we expect stable spreads in the third quarter.

Domestic Retail – The Goose That Lays the Golden Eggs

With the strong NII performance and good expense control, the domestic retail business should again provide solid underpinning to the results this quarter (actually about 75% of all earnings this quarter). Note this includes both domestic banking and wealth management businesses. The year-over-year increase of 4% is expected to mask that the P&C Banking segment will be up close to 6% while wealth will be down modestly (Table 2).

The reality is that two variables account for the divergent trends across banks. Specifically, we expect RY to be up double-digit on a percentage basis, while CIBC is likely to be flat to nominally lower. The industry heavyweights in domestic banking market share, TD and Royal, will continue to outperform, reflecting the stability of strategy and leadership position. In addition, banks that have a higher proportion of wealth management, BMO and CM, will continue to face more headwinds given the difficult equity market.

Trading and Securities Write-Offs – Anybody’s Guess

The third quarter will be another “dog’s breakfast” quarter for Trading Revenues. We remind investors that this line includes the valuation adjustment needed to deal with all securities held in the “trading books.”

Exclusive of three specific issues, we expect trading revenues to be somewhat disappointing (down 15% compared to a year ago). Inclusive of these, the numbers will be well down from a year ago, but strongly above the second quarter. The three specific items of note relate to: i) TD and its pre-announced $96 million charge for mispriced securities; ii) CIBC and the on-going writedown of its CDO and CLO book, inclusive of insurance valuation adjustment; and iii) Royal Bank and its MBIA and other market charges. The first of these is already quantified so we won’t deal with it in detail; however, the other two warrant some comment.

i) CIBC and the ongoing writedowns: We believe CIBC will take another $750 million pre-tax charge this quarter – almost entirely related to the CDO (RMBS-backed) book. There have been sensationalistic estimates as high as $2 billion of charges at CIBC. This seems too high to us, as we believe the recapitalization of XL and the favourable impact this has had on CDS spreads for several monolines means that there should not be additional material reserve per-dollar of insurance exposure. Unfortunately, with the ABX- AAA Index having declined quite sharply in the quarter, there is more monoline exposure so some incremental reserve is warranted. On the CLO front, we do not have much visibility and expect a further $200 million here (included in the $750 million charge).

ii) Royal and its charges: Royal on the other hand does seem to be more exposed to the ABX than to the CDS of its main insurer, MBIA. As a result, we believe a valuation adjustment of $200 million could be warranted. In addition, we have assumed a $100 million charge to deal with auction rate securities (ARS). We openly acknowledge that this is a shot in the dark – using the comparable numbers for Citigroup, the ARS charge would be three times our estimates. However, we do believe that Royal’s ARS exposure is relatively high quality in nature. Unfortunately, comparative disclosure is poor.

As we have previously said, inclusive of these three identifiable charges we believe that trading revenues will again be negative – though marginally so (Chart 5). We continue to believe it is imprudent to categorize these items as “one-time” in nature, though one can reasonably argue that some of these charges will reverse.

Non-Interest Revenue Will Be Affected by a Weaker Capital Markets Environment

The second quarter was bad enough, but the third quarter has been downright awful for activity levels in capital markets for Canadian investment dealers. Issuance remained reasonable but M&A activity was very weak. This can be partly explained by seasonality – the summer months tend to be slower – and partly by the difficult credit conditions. In Chart 6, we show our estimates for issuance and advisory fees earned by the Big Six banks for the third quarter. We are estimating capital markets revenues will be below last quarter’s levels and well down from the near record levels reported in the same quarter of last year.

Capital Management and Dividends

Economic and liquidity challenges continued to grind the banking system this quarter, forcing banks to exercise ongoing caution in their capital management practices. Debt capital issuance continued to be elevated and share buyback activity remained at a virtual standstill. On the dividend front, Scotia was the only bank to raise its dividend last quarter. Royal, CIBC and BMO have kept their dividends unchanged for the past four quarters, and National for the past three.

Given the confidence expressed by management in its longer term earnings power, we expect Royal to declare a minor dividend increase this quarter (Table 3). National could increase its dividend, but given the fact that the ABCP situation isn’t completely settled, we have assumed that NA’s board will defer a decision at this time. TD could argue for a minor increase but this seems premature given the need to build capital.

Individual Bank Comments

Below are our individual bank forecasts and analysis for the second quarter. In Appendix A we have also included our Preliminary Scorecard, which lists reporting dates and summarizes our more important estimates. We note that the six large Canadian banks will report over a three-day period. Needless to say, the Labour Day weekend, starting the day after TD, Royal and National report, will hopefully provide more “weekend” than “labour”.

Bank of Montreal (August 26) – Continued Headwinds

BMO leads off this compressed earnings season. We are expecting a relatively weak performance from BMO this quarter, with operating earnings roughly flat from last quarter and down 19% from the same quarter of last year. The bank is unlikely to see much momentum from the domestic P&C business although stable spreads and expense control should support the downside. From its FDIC filings, P&C Chicagoland appears to have had an awful quarter due to a significant ramp-up in loan losses. Difficult market conditions should also take some of the shine off of the Private Client segment this quarter.

Capital Markets revenues should be down this quarter, though this is in relation to two relatively strong comparable quarters. Issuance activity remained solid but, with weakness in the metals sector this quarter, advisory fees appear to be quite weak. On the trading side, we are expecting revenues of $75 million, well down from prior quarters.

One area that could help this quarter relates to the steepening yield curve. Traditionally, the bank has benefitted from this because of its U.S. book. So far, there is some evidence from the FDIC filings that this is occurring (it should show up in Harris NA), but there could be some reluctance to taking such risk given the difficulties the bank has experienced in trading.

The focus this quarter for BMO will likely be on credit. For a bank that has the reputation as being a low-risk credit institution, the past two quarters have been quite disappointing and given guidance at the second quarter, the trend remains negative. This quarter, with the banking system solidly into a downward credit cycle, we will be looking to see if BMO closes the negative gap with its peers. A material jump in provisions at Harris is a possibility. The Harris NA filing suggests the reverse could be occurring. We don’t expect material changes to capital or any increase in dividend given the earnings pressures.

Scotiabank (August 26) – Another Workman-Like Quarter

Scotia should report relatively solid results again this quarter. We expect to see some early signs of the credit cycle affecting formations and provisions, but the diversity of the franchise should also be obvious. From our perspective, the real story is the fact that Scotia has side-stepped the major problems in structured credit.

After a solid second quarter, Domestic Banking business should continue to show improving volumes and spreads. The latter should be at odds with its peers i.e. better than a year ago, reflecting lower short-term rates. Expenses should again be well-controlled. We are somewhat concerned that Scotiabank is prepared to consistently pay up for domestic wealth management businesses – whatever the quality or structure of the deal.

International Banking results should continue to show good growth with higher contribution from recent acquisitions. A more relevant comparison is probably versus the second quarter. Mexico’s contribution of $104 million is roughly stable year over year due to well-controlled credit trends.

Not surprisingly, we are expecting a weaker quarter from Scotia Capital, although issuance and advisory activity at the bank appear to have held in better than at other banks. Lower trading revenues and fewer credit recoveries should weigh on earnings. Corporate earnings should be down from year-ago levels, which included high securities gains, but somewhat better than in the second quarter.

Scotia increased its dividend in the last quarter, so we aren’t expecting any change here. Its capital position remains very robust and we expect internal capital generation to offset strong RWA growth. One area of focus this quarter will probably be credit trends. We expect provisioning to continue to rise (roughly double year-ago levels) and hope for more clarity on the bank’s exposure to the auto sector – both via GMAC and other exposures.

CIBC (August 27) – Another Big Charge

Given the moves in various metrics, we expect CIBC to report a $750 million charge this quarter. If there is one positive, it is that the bank looks like it could even avoid a loss this quarter. The reality is that the bank has yet to put this sad chapter behind it and some of these U.S. mortgage assets will likely be worthless, eventually.

We are expecting Retail Markets (which includes wealth management) to be up over last quarter’s disappointing results and roughly stable with last year. The reality is that the bank has had a challenging time delivering good retail results in a very positive banking environment in Canada. Now, with slower loan growth, higher inflation and more difficult equity markets, we find it hard to argue for much growth out of this segment. The trends at First Caribbean also remain difficult.

On the wholesale front, as detailed above, we expect the structured-credit related charges at CIBC to be more manageable this quarter (in the $750 million ballpark and included in Trading Revenues). Outside of this, we expect World Markets to show lower results as M&A activity appears to have been particularly weak for the bank this quarter. Furthermore, there is some chance that with the new executive appointments, additional “restructuring” charges will be needed.

CIBC’s capital position should remain the highest of the banks but decline to just under 10%. The common equity issuance at the beginning of the year combined with the sub-debt issuance this quarter put the bank in a solid capital position. We continue to believe additional common equity issuance will not be needed. Needless to say, a dividend hike is quite unlikely.

Royal Bank (August 28) – Another Noisy Quarter

As in previous quarters, the results from Royal will again be affected by several charges for its involvement in structured credit. We expect an MBIA charge as well as some additional items for ARS. It will also be difficult to isolate the operating performance of RBC Capital Markets as variable compensation could be affected. In our estimate of $300 million pre-tax however, we have assumed no offset from variable compensation and a 20% tax rate.

Canadian Banking results should be good this quarter – probably best in class. We still believe that this unit can produce a double-digit year-over-year increase, reflecting its leadership position and excellent control of expenses. Excluding the loss on the Visa IPO last quarter, growth should be about 6% over the quarter and 13% over the year. Insurance, which will be broken out into a separate segment this quarter, should be stable, as should Wealth Management. The risk to Wealth Management is to the downside, but only modestly so.

International Banking earnings should be around $60 million this quarter, up from a very weak last quarter but well down from the same quarter of last year. Investors should remember that the second quarter included a Visa IPO gain (as opposed to a loss in Canadian Banking). The inclusion of half a quarter of additional RBTT results should be offset by the on-going challenges at Centura.

Investment banking activity levels in the Global Capital Markets business appear to have been relatively steady when compared to last quarter, but well down from a very strong year-ago result. We have assumed $300 million in identifiable charges, which will be included as Trading Revenues. Exclusive of these items, trading revenues should remain good at $500 million.

The Corporate Support line is always difficult (read impossible) to forecast. Items such as Treasury success, securitization revenues and numerous tax items are volatile and can cause major swings. We are expecting Royal to move on dividend this quarter. While there is a good argument to wait another quarter, we perceive a high degree of confidence at the bank that the current problems are manageable, and that 2009 will be quite a bit better. We assume that the bank’s Tier 1 ratio will be stable at 9.5%.

TD Bank (August 28) – Little Left to the Imagination

There will be various cross-currents to TD’s earnings this quarter, but all in all, with AMTD reported and management have provided crisp guidance for the U.S. P&C business, there should be few surprises. The year-over-year decline in reported Cash EPS reflect the outstanding third-quarter wholesale results of a year ago, rather than any fundamental weakness.

Canadian P&C should show solid results. However, there are several headwinds: some weakness in margins, more moderate operating leverage and the continued rise in loan losses associated with VFC and the enlarged credit card book. All in, the year-over-year increase should be at the mid-single-digit percent level. Wealth Management results should be flat with a year ago, but given the volume sensitivity of the direct brokerage in Canada, there is some room for a modest negative surprise.

With regard to the U.S. P&C segment, this will be the first full quarter that TD Bank U.S. (the re-branded Banknorth/Commerce entity) will be included in earnings. As a result, we expect the contribution from this segment to double despite on-going challenges in the U.S. banking system. Simply put, more capital invested has produced a larger contribution rather than any fundamental improvements. Management has reiterated confidence in its forecasts for this segment so we are not anticipating many surprises.

On the wholesale side, we are expecting results to be above last quarter’s weak showing but well down from year-ago levels. One item of note will be the $96 million pre-tax charge related to the mis-pricing of various financial instruments pre-announced by the bank. Outside of this charge, we are expecting trading revenues of $175 million. Even without the $96 million charge, TD Securities will likely be half as profitable as a year ago, reflecting the difficult operating conditions and the strong year-ago performance.

We expect to see progress on the capital front, as management has clearly heard the street concerns on the additional stresses that the U.S. expansion has placed on reported capital ratios. We don’t expect any dividend increase.
RBC Capital Markets, 11 August 2008

We expect another difficult quarter with earnings risk greatest for banks with U.S. exposures, both in banking and capital markets.

• In the near term, National Bank and Scotiabank should be less impacted by U.S. credit quality and capital markets writedowns.

• Until the last quarter, banks had been challenged with weak capital markets and U.S. exposures but there was little sign of deterioration in core Canadian banking businesses. Capital Market and U.S. challenges remain in place, but we expect more issues in the core Canadian business over the next 6 to 12 months with increases in credit losses from low levels, slower loan growth, margin pressure and soft wealth management results.

• We believe that stock price direction will be heavily influenced by the strength of domestic retail banking and wealth management results.

• We estimate core EPS will decline by a median 9% versus Q3/07 driven by higher loan losses and lower capital markets results, and reported EPS will be below core EPS for some banks, due primarily to capital markets-related writedowns.

• We expect Scotiabank to grow core EPS at the highest rate, and CIBC the lowest.

• We do not expect any quarterly dividend increases in Q3/08. Canadian banks have high Tier 1 ratios by both global standards and historical standards, but we do not believe banks are looking to return or deploy that capital quickly. We expect Tier 1 ratios will be at least 9% for all six banks in Q3/08E.

Too early to buy Canadian bank stocks

• We believe it is too early to buy Canadian bank stocks due to our expectation for continued pressure on profitability, the potential for further negative earnings revisions, and valuations that are not overly cheap on a historical basis based on price to book, with the banks trading at a median multiple of 2.0x book versus a trough of 1.65x six years ago when credit and equity markets were weak.

• Near term, investors are likely to be best served holding banks with less exposure to U.S. credit and capital markets, although we do not expect this to be a winning strategy in 2009 as we do not expect Canada's economy to be unscathed by U.S. economic woes.
Financial Post, Jonathan Ratner, 11 August 2008

The risk of future economic weakness has forced Blackmont Capital’s Brad Smith to cut his 2008 and 2009 earnings per share (EPS) estimates and price targets for Canada’s biggest banks. The Big Six domestic banks begin reporting third quarter results on August 26 and the analyst is advising investors to use broader strength in the sector to reposition themselves with exposure to those banks with the strongest capital and best strategy.

“Much of the pending bad news has been well telegraphed already, increasing the probability that bad news, once delivered, could prompt stock rallies such as those observed recently following the release of lower-than-expected loss from a number of global financial service heavyweights...” Mr. Smith said in a research note.

His top picks are Royal Bank and Bank of Nova Scotia, but he downgraded the latter to a “hold” given the positive surprise from its relative share price performance in the past year. Despite the fact that his $50 price target (down from $51) for Scotiabank is unable to support a “buy” recommendation, Mr. Smith continues to think the bank’s earnings and share price potential is better than its domestic peers on average. Its “truly international” retail banking platform and limited exposure to U.S. credit should produce earnings growth outperformance for the foreseeable future, he told clients.

While each of the Big Six had their EPS estimates cut, Toronto-Dominion Bank was the only one that did not see a price target reduction. It remains at $63 per share, while Bank of Montreal falls a dollar to $46, CIBC gets slashed from $74 to $62, National Bank moves from $50 to $46, and Royal falls by $4 to $55. The analyst is concerned about credit risks and capital market pressures they will face in the next 12 to 18 months.

He also said four of the banks are due for a dividend increase and Royal is overdue.

“Failure to raise dividends would in our view signal continued lack of visibility with respect to earnings growth and future capital requirements, which in turn could prove negative for current domestic bank stock valuations,” Mr. Smith said.

In terms of specifics from the banks, BMO’s $10-billion SIV exposure is expected to deteriorate further as a result of widening credit spreads for its assets this quarter.

CIBC may attempt to crystallize its losses through the sale of subprime exposures to third parties as U.S. firms like Merrill Lynch & Co. have done recently, while its writedowns may end up being more aggressive this quarter given that monoline credit spreads on July 30 were similar to levels at the end of April, Mr. Smith noted.

Meanwhile, Royal will likely have mark-to-market losses linked to its monoline hedged subprime exposure, but these are expected to remain manageable.

But like his counterparts, the analyst said credit will be in focus for this round of earnings. He thinks the current credit cycle is in the “very early stages of a cyclical deterioration,” so watch out for a gradual worsening of domestic credit and more deterioration of U.S. loan portfolios. Mr. Smith also sees more upward pressure on credit provision levels, noting that the fiscal first quarter was the first time since early 2003 that Canadian banks as a whole had more in provisions that they wrote off. He suggested that this means they may have to catch up if credit deterioration worsens.