Tuesday, November 11, 2008

Preview of Banks Q4 2008 Earnings

Scotia Capital, 11 November 2008

Banks Begin Reporting November 25

• Banks begin reporting fourth quarter earnings with Bank of Montreal (BMO) on November 25, followed by Bank of Nova Scotia (BNS) on December 2, Canadian Imperial Bank (CM), National Bank (NA), Toronto Dominion (TD) and Canadian Western (CWB) on December 4 with Royal Bank (RY) and Laurentian Bank (LB) closing out reporting on December 5. Scotia Capital's earnings estimates are highlighted in Exhibit 1.

Earnings Resilience in a Difficult Year - Best Banks Globally

• We expect fourth quarter operating earnings to decline a modest 4% YOY and 3% sequentially. We have reduced our fourth quarter earnings estimates (exhibit 3) due to a major sell off in equity markets, weak capital markets revenue and lower expected wholesale net interest margin. An improvement in the retail margin would accelerate positive earnings momentum. We were expecting the banks earnings momentum to turn positive this quarter but it has been pushed out a quarter due to the factors mention above. On a reported basis we expect earnings to be up 5% YOY.

• We also expect the lower C$ to assist book value growth this quarter. Bank book values have been reduced by 15% from 2003 - 2007 due to the appreciation of the C$ and resulting translation loss charged to retained earnings with BNS absorbing a 27% decline followed by RY at 14%. Book values should get a boost this quarter from the significant decline in the Canadian dollar with magnitude depending on hedging.

• Operating ROE is expected to remain strong at 18.6% with the higher ROE banks' profitability continuing in the 20% range.

• We expect dividend increases this quarter from RY, and NA with increases from BMO and CM possible but with much lower probability. TD increased its dividend last quarter.

• We expect mark-to-market writedowns to be modest this quarter given the marks already taken and the possibility banks will have more flexibility in "Determining Fair Value of a Financial Asset When the Market for That Asset is Not Active" (FAS 157-3). Also Canada's Accounting Standards Board (AcSB) has announced amendments to Sections 3855, Financial Instruments-Recognition and Measurement. "The amendments allow entities to move financial assets out of categories that require fair value changes to be recognized immediately in net income."

• The potential writedowns this quarter include the nominal writedowns previously announced by TD and RY. The after-tax writedowns for Canadian Banks we believe peaked in Q1/08 at $2.9 billion (mainly CM), steadily declining in Q2 and Q3 to $1.0 billion. Operating earnings in 2008 are expected to decline 4.8% from 2007 with return on equity of 20.3%. Reported earnings are expected to decline 30% in 2008 mainly due to large writedowns at CIBC.

• In addition to trimming Q4 earnings estimates we are reducing our 2009 estimates by 3% driven by lower earnings expected from wealth management, slightly higher loan loss provisions, and the accelerating economic slowdown. The major wild card with respect to bank earnings, we believe, is the net interest margin, both retail and wholesale. We are assuming a relatively stable retail net interest margin with many cross currents. We are introducing 2010 earnings estimates forecasting a 10% increase despite higher loan loss provisions. We expect earnings momentum to shift to positive in 2009 aided by the lower Canadian dollar and the expected stabilizing to possibly improving retail net interest margin.

• We expect loan losses in 2008 to come in at $4.8 billion or 0.40% of loans which is more than double the 2006 trough of $2.1 billion or 0.22% of loans. Thus 2008 earnings are already partially absorbing the unfolding of the credit cycle. Canadian bank earnings in 2008 have been resilient despite a very difficult market. Cash operating earnings are estimated at $20.1 billion in 2008, flat from the 2007 level. Total writedowns for 2008, assuming modest writedowns in the fourth quarter, would be $6.1 billion with CIBC representing $4.5 billion of this. Thus fully loaded cash earnings for 2008 would be $14.1 billion, the fourth highest in history. Excluding CIBC, writedowns in 2008 for the Canadian Banks are expected to represent only 9% of operating earnings. Modest writedowns, high capital levels, and high profitability translate into Canadian Banks being the "Best Globally".

• We are increasing modestly our 2009 loan loss provision forecast to $5.7 billion or 0.46% from $5.4 billion. We are introducing 2010 loan losses at $6.8 billion or 0.52% of loans.

• Bank share prices have retested lows a number of times this year with the latest being in early October with the major market sell-off (post-Lehman collapse September 14, 2008) as bank P/Es retraced to 8.9x similar to 9.0x on July 15, 2008 (Indy Mac) and 9.4x on March 17, 2008 (Bear Stearns Rescue). The lows tested in 2008 where similar to the low of 9.0x trailing earnings in 1998 with the Asia Crisis but below the 10.9x 2002 Telco/Cable/Power P/E bottom. The banks have since rebounded 9%, with the P/E expanding modestly to 9.8x trailing earnings.

• The bank index has been under pressure most of the year with poor absolute returns with a decline of 17%, with the Royal Bank holding up the best, down 7%. Although absolute returns are disappointing banks' relative performance has improved as the TSX is down 30% with the burst of the commodity bubble.

• The bank dividend yield versus the TSX spiked to 2.6x with the commodity bubble early this year very similar to the 2.8x spike in 2000 reached with the Technology bubble. Interestingly, the three worst years of bank underperformance in the past fifty years was 1979 (commodities- major oil spike), 1999 (Nortel) and 2007 (commodity bubble). The years following, bank stocks went up considerably; up 33% in 1980 and up 39% in 2000. However, with the depth of the financial crisis and degree of investor fear, a rebound of this magnitude doesn't seem plausible for 2008, but we do expect a major rebound to occur in 2009. We believe bank stocks have significant share price upside given the low valuations and the fact that Canadian Banks are proving to be the "Best Globally" in terms of balance sheet strength and profitability. We expect the P/E to expand over the next few years, similarly to the period following the Telco/Cable debacle, when bank P/E multiples expanded to 15.1x from 10.9x.

• Canadian banks are well capitalized, with high-quality balance sheets, diversified revenue mix, solid earnings growth outlook, and low exposure to high-risk assets. We expect banks to be able to grow earnings while absorbing higher credit losses over the next several years. Interestingly banks have recorded strong absolute and relative returns in the face of rising loan loss provisions in each of the past three credit cycles which seems counterintuitive.

• Bank valuations are compelling on both a yield and P/E multiple basis. The bank dividend yield relative to 10-year government bonds is 5.5 standard deviations from the mean. The bank dividend yield relative to the TSX is 0.7 standard deviations above the mean.

• Bank P/E multiples at 9.2x 2009E and 8.3x 2010E are extremely compelling. Bank P/E multiples are 87% relative to the TSX, 58% relative to Pipes & Utilities, 98% relative to Lifecos, and 81% relative to U.S. banks. We believe the banks’ P/E should trade at 80%-90% relative to the market, 110%-115% relative to U.S. banks, and at 100% of Lifecos.

• We continue to recommend overweight bank stocks. We have a 1-Sector Outperform rating on Royal Bank, with 2-Sector Perform ratings on CIBC, TD and NA and 3-Sector Underperform ratings on Bank of Montreal. In terms of the smaller capitalization banks, we maintain a 1-Sector Outperform on CWB and 3-Sector Underperform on Laurentian Bank. Our order of preference has shifted to RY, CWB, CM, NA, TD, BMO, and LB.

• We are reducing our share price target on CWB to $30 per share from $35 per share, due to the major correction in oil prices and the expected growth slowdown in Western Canada. Our other target prices remain unchanged with the bank group target based on 13.8x our 2009 earnings estimates and 12.5x 2010 earnings estimates.

Fourth Quarter Highlights

• In Q4/08 we expect bank group earnings to decline a moderate 4% year over year and 3% sequentially. Year-over-year earnings declines are largely concentrated in BMO and CM, estimated at 20% and 30%, respectively. RY is expected to experience the largest increase in earnings with 5% year-over-year growth. We expect earnings growth for the bank group to turn positive in 2009 based on a lower Canadian dollar, stabilization in the retail net interest margin and potentially improving credit conditions and capital markets in the later half of 2009.

• We expect mark-to-market writedowns to be modest this quarter given the marks already taken and the increased flexibility from FAS 157-3 and amendments to Section 3855 by AcSB. However potential writedowns could be $943 million with the majority of this continuing to come from CIBC. To determine the potential writedowns we looked at the change in CDS spreads during the fourth fiscal quarter for the monoline insurers and the change in the index levels for the ABX -BBB Index (sub-prime proxy) and LCDX Index (CLO proxy) (Exhibit 6). We noticed significant widening of CDS spreads for XL Capital Assurance and FGIC Corp. with only modest widening of spreads for Ambac Assurance and MBIA Insurance Corporation. The ABX - BBB Index was relatively stable with the LCDX Index showing material signs of weakness. The LCDX weakness creates possible writedowns at CIBC given its large CLO portfolio. CIBC potential writedowns are highlighted in Exhibits 8 and 9 (columns 15 and 12, respectively). However the use of FAS 157-3 may not require these writedowns. In any case, the trend of lower potential mark-tomarkets, we believe, remains in tact.

• There is also a potential writedown of identifiable intangibles at TD with respect to its acquisition of Commerce Bancorp (CBH) and the dropping of the Commerce name. TD booked goodwill of $6.1 billion and net identifiable intangibles of $1.2 billion on the acquisition of CBH with some of the intangibles likely related to the name or brand. Thus, a writedown of $300-$400 million (guesstimate) is possible.

• Bank of Montreal is expected to report operating earnings of $1.15 per share versus $1.44 per share a year earlier, a decline of 20% YOY and an increase of 5% sequentially. Canadian P&C earnings growth is expected to be modest, with U.S. P&C earnings continuing to underperform. Wealth Management and Wholesale earnings are expected to be extremely weak due to the challenging capital markets environment. Fiscal 2008 operating earnings are expected to be $4.66 per share, a 19% decline from $5.73 per share a year earlier.

• Canadian Imperial Bank of Commerce is expected to report operating earnings of $1.62 per share, a decline of 30% YOY and 2% sequentially. We expect wholesale earnings to be extremely weak, excluding writedowns, due to the difficult capital markets environment and CM’s shift towards a more risk-averse strategy. Revenue growth is expected to remain a challenge. We estimate CM's potential writedowns this quarter to be $1.2 billion ($780 million or $2.05 per share), however, FAS 157-3 does give the bank some flexibility in determining the appropriate marks and the writedowns may not be required. Fiscal 2008 earnings are expected to decline 22% to $6.90 per share versus $8.88 per share in fiscal 2007.

• National Bank is expected to report operating earnings of $1.35 per share in the fourth quarter, an increase of 1% YOY, but a decline of 11% from the previous quarter. On August 26, 2008, NA announced that it expects to record a gain of $65 million pre-tax ($42M after tax or $0.27 per share) on the sale of a majority stake in Asset Management Finance Corporation (AMF) to Credit Suisse. NA will retain a 10.5% stake in AMF. We expect Retail and Wealth Management earnings to be flat year over year and wholesale banking earnings to be weak. Trading revenue, which has been surprisingly strong, near record levels over the last few quarters, may continue to be supportive to earnings. Fiscal 2008 operating earnings are estimated at $5.74 per share, a 2% increased from $5.65 per share a year earlier.

• Royal Bank is expected to report operating earnings of $1.06 per share, an increase of 5% from a year earlier but a decline of 7% QOQ. Solid earnings growth is expected from RY’s Retail and Insurance platform, despite a projected increase in loan loss provisions. Wealth Management is expected to be weak this quarter due to equity market sell-off. We expect RBC Capital Markets earnings to remain resilient. U.S. & International earnings are expected to remain low due to continued high loan loss provisions. RY pre-announced writedowns of $30 million relating to the repurchase of Auction Rate Securities from the bank's U.S. client accounts. We estimate further writedowns relating to the MBIA downgrade could total $200 million; however, writedowns may not be required under FAS 157-3. Fiscal 2008 operating earnings are expected to increase 3% to $4.35 per share from $4.24 per share in fiscal 2007.

• Toronto-Dominion Bank is expected to report operating earnings of $1.43 per share, an increase of 2% YOY and flat from the previous quarter. TD Ameritrade incurred a $50 million charge to make clients whole in the Primary Fund. The impact of this charge on TD is expected to be $20 million ($13 million after-tax or $0.01 per share). Retail earnings are expected to continue to drive earnings, with wholesale and domestic wealth earnings declining year over year. TDCT earnings are expected to be strong but the superior earnings momentum of the past few years relative to its competitors, we believe, is not sustainable.

• We are nervous about operating results at TD Commerce Bank this quarter given the intense competition for retail deposits, the cost of defending deposit market share, and the potential margin and profitability squeeze. Any loss of deposit market share or margin pressure will not be taken well by the market. There is also a risk of rising credit costs as NY and NJ real estate prices come under pressure and unemployment spreads. It is possible that management earnings guidance for 2009 for CBH is reduced. A writedown of identifiable intangibles related to CBH is also possible. The market, we expect, will also be uncomfortable with a Tier 1 capital ratio of 8% given the global trend to go to 10% aided by government infusion of capital. TD share price could be under pressure in the near term based on a low capital ratio and a softening outlook for CBH. TD Ameritrade's contribution this quarter is expected to be C$60 million or C$0.07 per TD share versus C$0.09 per share in the previous quarter and C$0.10 per share a year earlier. Fiscal 2008 operating earnings are estimated at $5.63 per share, a decline of 2% year over year.
Financial Post, David Pett, 7 November 2008

The outlook for Canadian banks is bad, says Desjardins Securities analyst Michael Goldberg, but it's even worse for other sectors of the country's economy and investors would be wise to add a bank stock or more to their portfolios.

"Expect another challenging quarter as banks begin year-end reporting," the analyst said in a note to clients. "More importantly, we have lowered our fiscal 2008 and fiscal 2009 earnings forecasts to more conservatively reflect recent extraordinary volatility and overwhelming signs of economic weakness."

Mr. Goldberg said banks are unlikely to return to normal earnings power until fiscal 2011, with dividend growth expected to ground almost to a halt.

"We are not expecting dividend increases to be announced by any of the banks with their year-end results; instead we expect more earnings retention in order to strengthen capital." he wrote. Mr. Goldberg expects minimal dividend growth in fiscal 2009 but added dividends are not expected to fall over this period.

Despite this negative view, Mr. Goldberg told clients in a note that banks should be considered a "safe haven" by investors. The analyst said banks stocks trade at a compelling valuation and he believes their superior performance relative to the overall market will continue. He maintained his recommendation to buy bank stocks, with Bank of Nova Scotia and TD Bank noted as his "top picks."