Wednesday, December 10, 2008

RBC CM: Still Too Early to Buy Banks

RBC Capital Markets, 10 December 2008

We continue to believe that it is too early to buy Canadian banks based on: (1) an economic environment that continues to deteriorate rapidly, (2) increased risk over the sustainability of some banks' current dividends and increased risk of equity issues (both of which are a function of the deteriorating economy and continuing capital markets writedowns), a scenario we would have viewed as highly unlikely only a few months ago, (3) our belief that the street needs to lower its profitability estimates (our EPS estimates are currently 7% below the street's) to reflect the rapidly slowing economy and credit/funding markets that remain challenged.

• Valuations have come down for bank stocks but for them to rally on a sustainable basis, we believe that signs of improvement in the banks' fundamental outlook are needed.

• We have gradually increased our loan loss estimates in recent quarters and have consistently reduced our P/BV multiples to reflect a worsening economy. The economy continues to worsen as highlighted by Friday's employment reports in both Canada and the United States. As a result, we have lowered our 12-month target prices again.

The likelihood of capital raises or dividend cuts for Canadian banks has risen in the last months, in our view.

• Q4/08 writedowns have proven larger than we anticipated, which, combined with growth in risk weighted assets that was faster than we were looking for, has led to lower than expected capital ratios.

• TD, Royal Bank and Scotiabank had lower Tier 1 ratios as at Q4/08 although there was no clear outlier as there was before TD raised equity. National Bank and TD had lower tangible equity ratios as at Q4/08.

• Over the next three months, we expect Scotiabank to face the most pressure to raise capital. It has room to issue meaningful amounts of innovative Tier 1 capital (Scotiabank has a tangible common equity ratio at the high end of the peer group) but we do not believe that the market is as liquid as it would be for common equity.

• We believe TD might be pressured to raise capital again if Scotiabank raises equity as it would again find itself as the clear outlier from a capital standpoint.

We expect 2009 earnings per share to again come short of consensus estimates.

• Our current EPS estimates are a median 7% below consensus.

• Directionally, we feel that there is downside risk to our EPS estimates as (1) economic risks have risen, and (2) the risk of equity issues has risen.

• Our 2009 GAAP EPS estimates represent a median 3% increase in profitability compared to a 11% decline in 2008.

• Our core cash EPS represent a median 12% decline in profitability versus a 6% decline in 2008.

• BMO's target price is cut to $35 from $38
• CIBC's target price is cut to $52 from $53
• National Bank's target price is cut to $43 from $46
• Scotiabank's target price is cut to $33 from $36
• TD Bank's target price is cut to $43 from $48
Dow Jones Newswires, 10 Deceber 2008

The likelihood of a Canadian bank cutting its dividend is very slim, BMO Capital Markets says. Dividends survived the 1981-82 and 1990-91 recessions, the collapse of Third World loans and the collapse of commercial real estate. The Big Five - Bank of Montreal (BMO), Toronto-Dominion Bank (TD), Royal Bank of Canada (RY), Bank of Nova Scotia (BNS) and Canadian Imperial Bank of Commerce (CM) - haven't cut dividends since the Great Depression, BMO says. But analysts suggests the banks should reintroduce dividend reinvestment programs (DRIPs), which could generate C$3-4B in common equity, boosting capital levels.

Bank of Nova Scotia (BNS) likely to be next Canadian bank to issue equity, as the banks scramble to get Tier 1 Capital ratios above 10%. Following RBC's (RY) C$2.3B offer, BNS now has lowest ratio of peers. Credit Suisse suggests it needs C$2.3B in common equity to get to 10%, while Toronto- Dominion (TD) needs another C$1.98B even after last week's issue; Bank of Montreal (BMO) needs C$425M and National Bank of Canada (NA.T) needs C$3.27M. CIBC (CM), which raised C$2.9B in January after taking huge charges, remains in top spot with Tier 1 ratio of 10.5%
Financial Post, Eoin Callan And Gary Marr, 10 December 2008

Bay Street's profit margins are starting to come under pressure as official interest rates creep closer to zero, prompting retail banks to change the rules of the game so customers pay more.

While the Bank of Canada yesterday cut interest rates to the lowest level since the 1950s, the country's five big banks indicated they would no longer march in lock step with the central bank.

Instead, Bay Street is keeping the cost of borrowing for consumers more elevated in a bid to protect corporate earnings, passing on only part of the rate cut to customers.

While the decision of Bay Street to pocket part of the Bank of Canada rate cut is seen as good for shareholders and bad for customers, there is less certainty about how it will impact wider demand, partly because there are few historical precedents.

"We just don't have much experience with this," said an official at the Federal Reserve who has studied how financial institutions behave when central banks cut rates close to zero.

The central banker said data were limited, but suggest retail banks remain willing to lend even when official rates fall near zero, as they tend to find ways to protect profit margins on loans.

In normal times, financial institutions do better when the central bank lowers the cost of funds, happily passing on cheaper loan rates to consumers to encourage them to borrow more. But when the official rate starts getting closer to zero, the dynamics start to change, as the prime rate that banks charge customers is pushed nearer to their own cost of funds.

This was key to yesterday's decision by RBC, TD, Scotiabank, BMO and CIBC to cut their prime rate by 50 basis points instead of the full Bank of Canada cut of 75 basis points, according to people in the industry.

Joan Dal Bianco, vice-president of real estate-secured lending with TD Bank, said it would have left the bank without a profit if the full rate cut had been passed on to customers with variable products tied to prime.

"We are still trying to earn something on this stuff. This has been quite the roller-coaster ride and it has not been too hot on the mortgage front. We just can't take on the whole 75-point cut," Ms. Dal Bianco said.

Nancy Hughes-Anthony, head of the Canadian Bankers Association, acknowledged the decision to break step with the Bank of Canada created a public-relations challenge for Bay Street.

But she said: "The banks are still borrowing in a very volatile marketplace. The Bank of Canada rate is only one component of their cost of funding, and while the cost of borrowing in inter-national markets has come down a bit, it is still higher than before the crisis."

John Aiken, an analyst at Dundee Securities, said banks were "starting to see margin compression" as the central bank cut rates to 1.5% from 2.25%, while banks reduced their prime lending rate to 3.5% from 4%.

"The new loans that are being put in the books are arguably at a less profitable rate," he said.

Vince Gaetano, a vice-president with Monster Mortgage, said he expects pressure will start to mount on the banks in the coming weeks to reduce prime further.

"That's what happened the last time they tried to resist rate cuts," he said.

This willingness to pass on rate cuts is critical to determining the ability of the Bank of Canada to stimulate the economy in the midst of a downturn.

The central bank's own research shows "it is the real rate of interest that is most relevant" to the purchasing decisions of households, and that it can "influence demand only to the extent that adjustments to the [official] interest rate feed through to the real interest rate."
Financial Post, Jonathan Ratner, 9 December 2008

When it comes to Tier 1 capital ratios at Canada’s biggest banks, it looks like 10% is the new 9%.

On Monday, Royal Bank announced that it is issuing $2-billion in common equity at $35.25 per share, which represents a 6% discount to its closing price, as well as an over-allotment for maximum proceeds of $2.3-billion. The issue is expected to be approximately 4% dilute to common shareholders.

It will also bring the bank’s Tier 1 capital ratio to 10.1%, up from 9.0% at the end of the fourth quarter as a result of its recently-issued $525-million in preferred shares and this $2.3-billion.

Credit Suisse analyst Jim Bantis expects other banks will follow RBC’s lead, noting a few weeks ago that the Tier 1 capital levels of Canadian banks were among the highest of their global peers at 9.7%. Since then, banks in the United States and Europe have received capital injections via government initiatives and dilutive stock offerings, bringing their Tier 1 ratios into the low double-digits.

“We look for continued balance sheet deleveraging, zero dividend growth and further capital offerings in 2009,” Mr. Bantis told clients.

He noted that RBC management acknowledged that the offering was driven by investor concerns regarding the need for a stronger capital base given the challenges associated with market conditions.
TD Securities, 8 December 2008

The underlying results of Q4/08 were not that bad relative to our expectations for one of the worst quarters in a very long time. However, visibility into 2009 is extremely poor and management teams were universal in their cautious tone on the near-term outlook. As a result we further reduced our 2009 estimates and cut our Target Prices which reflect a wider discount to our estimates of equity fair value.

Fundamentals continue to suggest attractive upside across the group 12-16 months out, but we expect fears/concerns to continue to dominate short-term movements amid broader equity market weakness and volatility. Against that back drop we remain focused on names that we believe have the strongest medium term operating platforms that we want to own for the long term (Scotia) or heavily discounted valuations with fairly clean stories (CIBC).

Q4/08 met expectations by delivering one of the worst quarters the group has reported in a very long time, filled with a number of negative surprises.

As we suspected, the group appears to have used Q4/08 reporting as an opportunity to clean-up their exposures with a range of charges. Further downside risks will remain highly market dependent, and we do expect more, but with the help of new accounting flexibility we believe the acute risk presented by significant and immediate write-downs (i.e. those that would impair the capital structure) is greatly reduced. Ultimately we believe the industry will be in a position to enjoy substantial write-backs.

In terms of operating outlook, the credit cycle remains the dominant theme for the industry and will present a significant headwind for earnings in 2009. We further reduced our estimates across the board coming out of the quarter reflecting even greater conservatism on our outlook for credit costs in 2009. Our outlook is now reflecting a move to levels of credit expense comfortably above historical averages (taking into account today’s higher quality portfolio mix) on the order of 60bp. Where there is meaningful exposure, U.S credit books remain the key concern relative to trends within Canada where exposures appear well managed.

On the basis of our revised earnings expectations, 2008 and 2009 will represent among the two worst years of earnings development the industry has reported since the 1960s (as far back as our data set extends).

It is a long ways out, but we are introducing 2010 numbers driven by our bigger picture views of how the environment will unfold. Simply put, under the expectation that the macro environment will be in recovery and credit cost growth will moderate, the industry should be able to return to modest bottom-line growth.

What we viewed as exceptional capital levels just months ago, now appear very ordinary as a number of financial institutions globally have attracted sizeable capital infusions, including a sizeable portion from their respective governments.

In terms of the regulatory environment, in our discussions we have noted increased comments among senior management regarding the prospect of direct capital investment by the Canadian government (heightened by recent government proposals to allow such flexibility). At this stage, our view is that the discussions reflect an effort to anticipate worst case scenarios and provide solutions proactively. For the most part the banks seem disinclined to accept such investments, but they are also mindful of the competitive reality that has seen many of their global competitors accept similar support.

Valuations have come under material pressure over the past month amid continued concern and weakness in global equity markets. In our view the group is currently trading at material discounts to equity fair values implied by assumptions around long term fundamentals (assuming the world eventually recovers from among the worst economic conditions seen in decades). That said, amid very poor visibility generally and the heightened risk of unforeseen problems within financials we continue to expect volatility near-term.

Against that backdrop, we are focused on names that we believe have the strongest fundamental platforms that are well situated to perform when we eventually make it to the upside of the current downturn. In our view, Scotia is a platform well suited for medium-term growth via their international presence, although they are therefore more exposed to the current downturn.

For a shorter term focus, we highlight CIBC where we believe the model has been materially discounted even based on fairly modest operating results for 2009, there is an attractive dividend yield and the overhang of concerns around the bank’s capital position (relative to risks/exposures) is beginning to fade. We expect additional charges in the coming quarters if credit markets remain under-pressure (on the order of few hundred million) which should be easily tolerated by the bank’s industry leading 10.5% Tier 1 ratio in the context of ongoing earnings generation. With this report we are upgrading CIBC to the Action List.

With this report we have also made additional changes to our Target Price for both BMO and National Bank; reducing both targets to reflect additional conservatism around our valuations (assuming the stocks trade at a wider discount to fair value).

• BMO's target price is cut to $40 from $50
• CIBC's target price is cut to $67 from $76
• National Bank's target price is cut to $50 from $62
• RBC's target price is cut to $40 from $55
• Scotiabank's target price is cut to $45 from $54