Friday, March 19, 2010

Review of Banks' Q1 2010 Earnings

Scotia Capital, 19 March 2010

Strong Earnings, Ahead of Market Expectations

• Canadian banks reported another quarter of strong operating results. Bank earnings again exceeded Street expectations for the fourth straight quarter, thus further confirming that the bottom in operating earnings this cycle was Q2/09, which coincided with what we believe was peak quarterly loan loss provisions. Operating earnings this quarter increased 3% year over year (YOY) and 5% quarter over quarter (QOQ).

• Reported earnings this quarter were very much reflective of operating earnings, at only 2% below operating versus 8% below in the previous quarter, further confirming that the bottom of the cycle for reported earnings was Q1/08. Mark-to-market writedowns have generally fully dissipated for this cycle.

• Profitability for the bank group was solid with return on equity (ROE) at 17.4% versus 18.3% a year earlier as financial leverage continues to decline. However, return on risk-weighted assets (RRWA) at 2.12% improved 30 bp YOY based on lower leverage and banks’ active management of risk-weighted assets. Overall profitability, we believe, is high, especially given level of interest rates, low financial leverage, and high level of loan loss provisioning based on the stage in the credit cycle. This quarter earnings level, assuming 30 bp in loan loss provisions, would result in ROE of 19.3% with RRWA of 2.45%.

• First quarter earnings were driven by strong retail banking results, resilient wholesale, modest recovery in wealth management, overall net interest margin (NIM) improvement and lower loan loss provisions.

• Retail banking performance was supported by net interest margin improvement, solid volume growth, and cost control, resulting in very positive operating leverage.

• Wholesale earnings were resilient with strong recovery from TD and CIBC platforms and continued strength at the other banks. Trading revenue held up at historically high levels with capital market revenue solid. Wealth management also showed better results on higher asset levels.

• Credit quality showed further signs of improvement in the quarter, particularly in terms of loan loss provisions (LLPs). LLPs declined 15% QOQ to $2.1 billion in Q1/10, the lowest level since Q4/08. It is becoming more and more evident that LLPs peaked for Canadian banks in Q2/09 at $2,586 million. Bank loan loss provisions’ decline in Q1/10 was earlier in 2010 than expected, although they can still be lumpy. The Credit Cycle unfolds – loan loss provisions peak fiscal 2009 at 80 bp, next trough 2013E/2014E at 20 bp to 25 bp.

• Gross Impaired Loan (GILs) levels remain high; however, the rate of growth has moderated significantly, and appears to be peaking at $17.5 billion or 1.4% of loans.

• GIL formations did show solid improvement, declining 19% in Q1/10 to $4.4 billion, with formations at the lowest level since Q4/08.

• The recovery of the bank group’s net interest margin continued this quarter, providing some follow-through from the reversal that began in the last half of 2009 after an eight-year decline. The banks continue to benefit from the repricing of the loan book and solid growth in personal deposits.

• The bank group’s overall NIM improved 21 bp YOY to 1.92%; however, it declined 1 bp sequentially due primarily to RY’s negative margin impact from repositioning its U.S. securities portfolio and accounting adjustment related to securitization. Notwithstanding RY, the NIM improved sequentially.

• The retail NIM increased 13 bp YOY and 4 bp sequentially to 2.81% – the highest level since Q2/08 but substantially below the level of 3.60% in 2001.

• Bank earnings growth this quarter YOY was led by TD at 26%, followed by BMO, NA, and BNS at 4%, 3%, and 2%, respectively. RY and CM earnings were down YOY with RY considerably lower based on very difficult comps and relatively weak first quarter 2010 earnings.

• In terms of beats this quarter, TD and CM were the leaders with relative stock performance on a short-term trading basis following the earnings; thus, on a trading basis, we expect short term outperformance from TD and CM. In terms of disappointment this quarter, RY earnings were solid but uninspiring.

• The bank group’s strong operating earnings allowed the banks to continue to build capital. Bank dividends remain frozen pending regulatory clarity and/or a nod from the regulator. Banks paid out 47% of operating earnings in the form of common dividends this quarter. Banks continue to generate strong earnings and actively manage risk-weighted assets as a consequence. Tier 1 capital ratios increased 30 bp this quarter to an all-time high of 12.1%.

• The bank group RRWA was 2.12% this quarter, and based on a 47% payout to common shareholders, internally generated capital added 1.1% to capital ratios.

• Bank balance sheets remain high quality with an unrealized security surplus of $3.0 billion versus $2.6 billion in the previous quarter and a deficit of $3.3 billion at the apex of the financial crisis in Q4/08.

Upgrading to Overweight – Overpowering Fundamentals

• We are upgrading the bank group to overweight from market weight due to strength in operating earnings and risk of strong bank rally occurring earlier in 2010 than expected and the fact that the bank group is approaching the high end of its consolidation range that it has built over a healthy four to seven month period. The bank rally in 2009 was stronger than expected and the pending bank rally in 2010 may be earlier than expected.

• Bank fundamentals and earnings strength, we believe, are more than compensating for the regulatory uncertainty that still persists. Also, the market discounted the worst-case scenario from a regulatory perspective early, and is now looking at regulatory risk in a more balanced fashion.

• It appears that bank fundamentals are improving earlier in 2010 than anticipated and capital build is very strong. Strong inflows into the mutual fund industry in February, particularly into balanced funds, is supportive to high dividend yielding stocks, particularly bank stocks.

• We continue to expect a very strong bank rally later in 2010, but bank operating results may accelerate the time line. Also, we are not giving up hope that banks may increase their dividends in the fourth quarter, although at lower rates than operating results would dictate, due to regulatory oversight. We are hopeful that the regulator will be more balanced as the global banking system moves towards some type of normalization.

• Our guess is that systemic risk will be perceived as being lower by year-end, and with strong capital positions, the banks may be allowed to increase dividends, with RY, TD, and NA the most likely, with increases estimated in the 6%-8% range, and BNS and CM less likely, but with modest increases in the in the 4% range possible. BMO’s higher payout ratio may result in delaying an increase for a few quarters. We expect banks to allow their payout ratios to decline modestly in the near to perhaps medium term, depending on calibration from Basel on capital buffers and dividend distribution.

• Interestingly, bank relative share price performance had a distinct seasonal pattern of outperforming in the calendar fourth quarter (19 out of 21 years as at 2000, or 12 straight years) and we were very active with this research in the 1990s. However, the pattern became less predictable post-2000 and was further disrupted by the recent financial crisis. Consequently, it appears the market began to discount, or anticipate, fourth-quarter outperformance, and bank relative outperformance was accelerated to the third quarter. Hence, banks have outperformed in the third calendar quarter since 2000 – seven out of 10 years. Thus, bank share prices may start to discount dividend increases and earnings improvements well prior to calendar fourth quarter.

• We maintain healthy bank share price targets, as we expect P/E multiple expansion to continue off the 2009 lows. We believe bank P/E multiples are poised to again expand towards the 15x-16x range over the next several years based on high profitability and capital, improving fundamentals (including the positive side of the credit cycle), net interest margin stability/expansion, and an economic recovery. Bank dividend yields are attractive and dividend increases, which have stalled in the near term, will be a key catalyst for higher P/E multiples and another solid sustained bank share rally that may have already begun.

• We would recommend moving towards a 30% bank weighting, as YOY earnings growth is expected to increase to 12% in Q2/10, up from 3% this quarter, with the third quarter expected to moderate to 4% (tougher comp), and the fourth quarter expected to increase sharply, up 16% YOY (supportive of dividend increases).

• We have 1-Sector Outperform ratings on TD, RY, and BMO, and 2-Sector Perform ratings on CM, CWB, LB, NA, and BNS. Our order of preference is: TD, RY, BMO, CM, CWB, LB, NA, and BNS. On a trading basis, TD and CM have the strongest positive share price momentum.

First Quarter Highlights

• First quarter operating earnings increased 3% YOY and 5% from the previous quarter, due to lower loan loss provisions, strong Domestic Banking earnings, and resilient wholesale earnings supported by high trading revenue.

• TD, CM, and BMO beat consensus estimates by a wide margin of 20%, 16%, and 10%, respectively, with BNS and NA beating slightly, and RY coming in more or less in line. First quarter earnings were led by TD, with YOY growth of 26% due to stellar wholesale earnings. BMO, NA, and BNS earnings growth was modest YOY, with RY and CM declining.

Domestic Banking & Wealth Management – Strong

• Domestic banking earnings, including wealth management, were very strong at $3.7 billion, up 17% YOY and 12% sequentially. Earnings growth was led by BMO, up 32%, followed by BNS, TD, and RY up 28%, 25%, and 19%, respectively. CM and NA retail earnings continue to disappoint, declining 9% and 3%, respectively, from a year earlier.

Wholesale Banking – Resilient

• Wholesale earnings were resilient at $1.9 billion in the first quarter, increasing 2% QOQ but declining 7% from a near-record quarter a year earlier. Wholesale bank earnings were driven by continued high trading revenue.

• Wholesale earnings represented 34% of total operating earnings from operations in the quarter, with NA having the largest portion of its earnings coming from wholesale at 54%, followed by BMO and BNS at 38%, RY at 37%, CM at 27%, and TD at 26%.

Trading Revenue Solid

• Trading revenue in the first quarter was solid at $2.7 billion, although down from a record $3.4 billion a year earlier and down a modest 6% from the previous quarter. Trading revenue in the first quarter was 12.0% of total revenue, down from the Q4/09 level of 12.9%, but above the five-year average of 9.2%.

Net Interest Margin Continues to Improve

• The banks’ NIM continued to improve this quarter to 1.92%, reinforcing the reversal in the margin trend. The NIM improved 21 bp YOY and declined 1 bp sequentially. The NIM had been declining for eight straight years from the 2.20% level in 2001/2002 before bottoming at 1.70% in Q1/09. The banks’ NIM rebound has been supported by aggressive loan repricing, historically high wholesale spreads (Prime, BAs), a steep yield curve, lower cost of liquidity, a government mortgage securitization program, and improvement in deposit mix with a resurgence in personal deposits. We expect the NIM to continue to improve with controlled interest rate hikes beginning in the second half of 2010. The bank that is expected to benefit the most from rising rates is TD, based on its abundance of low-cost retail deposits (demand and notice).

• The retail NIM also rebounded with a 4 bp improvement sequentially and a 13 bp increase from a year earlier. We expect the retail net interest margin to continue to improve moderately with further loan repricing and favourable loan deposit mix shifts. However, gradually, Bank of Canada interest rate increases will likely provide for a more sustainable increase in the margin.

Mark-to-Market Writedowns Negligible

• Mark-to-market writedowns were a negligible $87 million in the first quarter, the lowest quarterly charge since the credit crisis began. Writedowns this quarter were almost entirely the result of NA’s administrative penalty related to non-bank ABCP. BMO, BNS, and RY did not have any writedowns, and CM and TD had negligible writedowns. Going forward, we expect writedowns to be negligible.

Credit Losses Decline

• Loan loss provisions this quarter were $2.1 billion or 68 bp of loans, down 5% $2.2 billion or 68 bp of loans from a year earlier and down 15% from the previous quarter level of $2.5 billion or 81 bp of loans. LLPs for BMO and RY declined significantly from a year a year earlier, by 22% and 23%, respectively. NA recorded an increase in LLPs of 13%, although loan losses remained at a bank group low of 0.28% of loans. We believe that LLPs have peaked on a quarterly basis and on an annual basis in 2009.

• CM recorded the highest LLP levels this quarter at 79 bp, followed by BMO and TD at 78 bp, RY at 68 bp, BNS at 53 bp, and NA at a bank group low of 28 bp.

• The hot spots were BMO U.S. P&C actual LLPs at 254 bp, Scotia Mexico at 234 bp, RY International/U.S. at 228 bp, and TD U.S. at 143 bp.

• Our 2010 and 2011 LLP forecasts declined to $8,900 million or 70 bp of loans and $7,110 million or 53 bp of loans, respectively, from $9,700 million or 76 bp of loans and $7,410 million or 56 bp of loans, respectively.

Gross Impaired Loan Formations Decline

• Gross impaired loan formations this quarter were $4.4 billion or 0.35% of loans, declining from $5.4 billion or 0.44% of loans in the previous quarter and from $6.0 billion or 0.47% of loans a year earlier. BNS and TD formations remained relatively flat sequentially, while BMO, CM, and RY formations declined 37%, 15%, and 33%, respectively.

Gross Impaired Loans Remain High

• Gross impaired loans for the bank group remained high this quarter at $17.5 billion or 1.41% of loans, largely unchanged from the previous quarter. Gross impaired loans increased for all the banks with the exception of BMO and RY, which had flat gross impaired loans from the previous quarter.

Higher Capital Ratios

• Tier 1 capital ratio for the bank group hit another all-time high of 12.1%, led by CM at 13.0%. The Basel Committee released consultative documents in December 2009 outlining possible changes to the calculation of regulatory capital. Although no potential minimum capital levels were outlined, we expect the minimum Tier 1 ratio will be raised to 8% from the current 7% and that a Tier 1 common ratio will be introduced at 4%. The consultative document was aggressive in nature; however, we expect Canadian banks to fare well versus global banks, given their high current levels of capital, superior business models, and profitability.