Friday, December 11, 2009

Review of Banks' Q4 2009 Earnings

  
Scotia Capital, 14 December 2009

Event

• We are downgrading the Canadian banks to marketweight from overweight due to their strong absolute and relative share price performance in 2009 and increased regulatory/political risk.

• Bank stocks have doubled off their 2009 lows and are up 51% year-to-date outperforming the TSX by 23% thus far in 2009.

Implications

• Banks just finished reporting strong Q4/09 earnings ahead of street expectations, however despite these strong and better-than-expected results bank share prices weakened. We believe this is a reflection of a tired bank rally, guarded management comments, and increased regulatory uncertainty.

• Bank valuations are expected to expand over the next five years; however we believe we are in a consolidation phase with a stalled bank rally in the near term.

• We believe the market needs to see dividend increases to generate further P/E expansion to 14x to 16x as well as a comfort level that the regulator is not going to unnecessarily handicap Canadian banks.

Recommendation

• We recommend a marketweight position for the Canadian banks.

Strong Absolute and Relative Returns

• We are downgrading the Canadian banks to marketweight from overweight due to their strong absolute and relative share price performance in 2009 and increased regulatory/political risk. Bank stocks have doubled off their 2009 lows and are up 51% year-to-date outperforming the TSX by 23% thus far in 2009.

Share Prices Weaken Despite Strong Fourth Quarter Earnings

• Banks just finished reporting strong fourth quarter earnings ahead of Street expectations for the third straight quarter. Earnings continue to be driven by robust wholesale earnings, solid retail and rebounding wealth management. Credit trends are turning positive with lower impaired loan formations and stable loan loss provisions that appear to have peaked. The net interest margin was also stable to improving. ROE was solid at 16.9% on large capital positions with Tier 1 capital at 11.8%. This was the first year-over-year increase in operating earnings (+2%) since the financial crisis began, however despite these strong and better than expected results bank share prices weakened. We believe this is a reflection of a tired bank rally, guarded management comments and increased regulatory uncertainty.

Canadian Banks - Long Term Outperformers

• We continue to view banks as long-term overweight investments given their sound fundamentals and business models and sector structure with a history of generating superior returns. We believe the banks remain poised to continue to generate these superior returns. Bank returns have been nearly double the market's return over the past 40 years with a beta materially less than one. Bank dividends have grown at a 10% CAGR over this time, an enviable record.

Banks Stocks in Consolidation Phase

• Bank valuations are expected to expand over the next five years; however we believe we are in a consolidation phase with a stalled bank rally in the near term. Thus rapid appreciation from these levels is difficult to see given the magnitude of the 2009 rally and the fact that banks appear to have been placed on hold with respect to capital management pending clarity from the regulator. In addition, a sharp acceleration in earnings is not expected until the later part of 2010.

Origin of the Strong Canadian Banking System - Green Paper 1984

• We do not believe it is any one individual or agency that should take credit for the performance of the Canadian banks in this recent financial crisis but rather, we believe, the strength originated from the structure and the foresight launched with the "Green Paper" in 1984. The history of the development of the "Green Paper" is on the OSFI website with the pertinent history section highlighted in Exhibit 16. Canada has to manage its banking success carefully going forward and not squander the opportunity.

Historical Share Price Performance Pattern Points to Consolidation

• Our downgrade to marketweight is also based on bank share price relative performance history. In terms of bank index performance, 2009 thus far is the second best year in history next to 1968 which benefited from the 1967 Bank Act. On a relative performance basis 2009 is the fourth best year since 1967.

• Bank stocks' major outperformance years were 1968, 1971, 1982, 1988 and 1991 which were all followed by neutral to very modest outperformance. The only years where banks outperformed solidly or sustained the major rally was the 1996, 1997 string and through the tech bubble bursting in 2001, 2002 and 2003. Thus it would seem that 2010, or at least the first half, will have muted relative performance unless commodities have a major pullback.

Banks Defer to OSFI - Dividend Increases on Hold - Stalls Bank Rally

• The bank P/E multiple has rallied off of 6x (global financial collapse/systemic risk) to a recent high of 12.6x trailing (current 12.3x). However the P/E rally has stalled, we believe, in the near term due to uncertainty about the timing of dividend increases as the banks appear to have deferred to OSFI as well as a general perceived increase in regulatory and political risk. The risk is that there will be an overreaction which places Canada at a competitive disadvantage or hinders Canadian banks' ability to take advantage of the strength of their banking system and operating platforms.

Dividend Increases to Drive P/E Multiples Higher

• We believe the market needs to see dividend increases to generate further P/E expansion to 14x to 16x as well as a comfort level that the regulator is not going to unnecessarily handicap Canadian banks. Dividend increase expectations have now been pushed back to late 2010. Thus with dividend increases on hold or pushed back several quarters bank share prices are likely to continue to consolidate in the near term.

• We continue to expect strong absolute 12-month returns for the bank group but they will most likely be in the back half. On a medium to longer term basis we expect that dividend increases (when they begin - not if they begin, in our opinion) will be sustainable in the 10% range which will drive P/E multiples towards our fair value range of 16x.
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Financial Post, 14 December 2009

Barclays Capital analyst John Aiken is worried that employee bonuses could weigh on the future profitability of the banks if they continue to rise at historical rates.

In the most recent quarter all of the big banks but National Bank and Bank of Nova Scotia paid out less in variable compensation, but the overall decline is probably a blip rather than a new long-term trend, Mr. Aiken said in a recent note to clients.

In 2009 the big five banks paid out variable compensation of $8.43-billion. That compares to $7.25-billion in 2008 and $8.44-billion in 2007.

As long as profits continue to rise along with bonuses, there is no reason to be concerned. The problem is that they may not. In the face of an uncertain economy and proposed regulatory changes, many analysts worry that bank profitability could take a hit in the coming years. The regulatory front is the top concern, especially regarding ballooning capital levels.

“The market is becoming aware that the vast levels of excess capital carried by the Canadian banks may not be deployed in the near term, particularly as uncertainty exists with pending regulatory changes, Mr. Aiken said.

In a world where banks are required to hold more capital, the bottom line would almost certainly be pushed down. In that context, employee bonuses would become “additional earnings headwinds,” Mr. Aiken said.
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Financial Post, 11 December 2009

The relative share price weakness for National Bank of Canada may be signaling more than just disappointment to its fourth quarter earnings miss.

Given the pronounced decline in the bank’s P/E ratio, Blackmont Capital analyst Brad Smith couldn’t help but look back to September 2007, when National’s collapsing P/E represented either a unique buying opportunity or a valuation that was simply falling to a new level ahead of its larger peers.

That latter theory ended up proving correct as within four months, the Canadian bank index was trading at below 10x trailing P/E.

National saw a similar relative value decline in the fall of 2008, which was again followed by a decline in the bank index P/E, Mr. Smith noted.

The relationship appears to work the other way too as National’s January 2009 P/E expansion preceded the huge sector P/E expansion that has lifted valuations back to pre-credit crisis levels.

“While there can be no assurance that the pattern will again repeat, we would note that as the smallest of the Big Six banks, National’s relative stock illiquidity does favour more exaggerated points of inflection,” the analyst told clients.
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