Friday, August 27, 2010

RBC Q3 2010 Earnings

  

• BMO cuts price target to C$53 from C$63; rating outperform
• CIBC cuts price target to C$56 from C$62; rating sector performer
• KBW cuts price target by C$2 to C$58; rating outperform
• Macquarie cuts target price to C$56 from C$60; rating neutral
• UBS cuts price target to C$66 from C$68; rating buy
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Scotia Capital, 27 August 2010

Event

• Royal Bank (RY) cash operating earnings declined 28% YOY to $0.87 per share significantly below expectations due to lower-than-expected trading revenue and lower net-interest margin, which offset strong earnings from Canadian Banking and Wealth Management. Operating ROE was 14.8% with RRWA of 1.95%.

Implications

• RBC Capital Markets earnings declined 68% YOY to $202M as trading revenue collapsed. Trading revenue plummeted to $188M from $1,022M in the previous quarter and $1,656M a year earlier. Canadian Banking earnings were strong increasing 14% YOY to $766M.

• We have reduced our 2010 and 2011 earnings estimates to $3.85 per share and $4.40 per share from $4.15 per share and $4.80 per share, respectively, due to lower earnings from wholesale banking, lower economic growth outlook, and moderating net interest margin as the prospect for higher interest rates is delayed.

Recommendation

• We have reduced our one-year share price target to $60 from $68 based on our lower earnings estimates. We maintain our 2-Sector Perform rating.

Canadian Banking Earnings Increase 14%

• Canadian Banking earnings increased 14% to $766 million from $671 million a year earlier, due to solid loan volume and revenue growth and lower LLPs. Canadian Banking average loans and acceptances increased 8% YOY and 2% QOQ.

• Revenue growth was solid at 5.9% although muted by a 1 bp YOY decline in retail net interest margin to 2.70%. Retail NIM declined 6 bp sequentially. Expenses increased 6.3% reflecting higher performance related compensation, higher pension costs, and investment in business growth. Efficiency ratio was flat at 47.3%.

• Loan loss provisions (LLPs) declined 6% to $284 million from $302 million in the previous quarter.

Overall NIM

• The bank's overall net interest margin declined 18 bp from the previous quarter and 35 bp from a year earlier to 2.01%.

RBC Capital Markets Earnings Plummet

• RBC Capital Markets earnings declined 68% YOY and 60% QOQ to $202 million from $622 million a year earlier and $502 million in the previous quarter due to a collapse in trading revenue.

Trading Revenue Collapse

• Trading revenue in RBC Capital Markets plummeted to $188 million versus $1,022 million in the previous quarter and $1,656 million a year earlier. This is the lowest operating trading revenue since the third quarter of 1997. Trading revenue was negatively impacted by losses on MBIA and BOLI and difficult market conditions. The impacts of MBIA and BOLI were a loss of $100 million and $73 million respectively, which negatively impacted earnings by $0.05 per share.

• The major weakness in trading revenue was in interest rate trading, which had a loss of $19 million versus positive $650 million in the previous quarter and $1,056 million a year earlier. The weakness in interest rate trading was centered in the bank's U.K./European trading operations.

• On the conference call, RBC guided that it is reasonable to expect annual trading revenues to be in the $3 billion to $4 billion range.

Wealth Management Earnings Improve

• Wealth Management cash earnings increased 20% to $197 million from $164 million in the previous quarter and increased 10% from $179 million a year earlier.

• Revenues increased 2.6%, with operating expenses increasing 3.7% from a year earlier for negative operating leverage of 1.1%.

• U.S. Wealth Management revenue declined 5%, with Canadian Wealth Management revenue increasing 9% and Global Asset Management revenues increasing 15%.

• Mutual fund revenue increased 7% from a year earlier to $388 million. Mutual Fund assets (IFIC) declined 1% from a year earlier to $101.1 billion, including PH&N.

Insurance

• Insurance earnings were $153 million versus $107 million in the previous quarter and $167 million a year earlier. Strong premiums and solid investment income helped offset higher claims in the quarter.

International Banking Remains in Loss Position

• International Banking continued to report a loss at $52 million versus a loss of $3 million in the previous quarter due to weaker net interest margin, higher LLPs, and operating expenses.

• LLPs were $192 million, up slightly from $185 million in the previous quarter but down from $230 million a year earlier.

• Net interest margin declined 8 bp from a year earlier and 28 bp sequentially to 3.78%.

Capital Markets Revenue Stable

• Capital markets revenue was $608 million versus $565 million in the previous quarter and $636 million a year earlier. Securities brokerage commissions declined 7% to $313 million from $337 million a year earlier, with underwriting and other advisory fees at $295 million, declining by 1%.

Security Gains - Modest Loss

• AFS security gains were a loss of $14 million or $0.01 per share versus a loss of $0.01 per share in the previous quarter and a loss of $0.03 per share a year earlier. Unrealized security surplus was a surplus of $188 million versus a surplus of $125 million in the previous quarter.

Securitization Loss Declines

• Securitization net income impact declined to a loss of $10 million, or $0.00 per share, versus a loss of $55 million, or $0.03 per share, in the previous quarter.

Loan Loss Provisions Decline

• Specific loan loss provisions (LLPs) declined to $432 million or 0.58% of loans from $477 million or 0.67% in the previous quarter and from $709 million or 0.98% of loans a year earlier.

• We have reduced our 2010 LLP estimate to $1,850 million or 0.63% of loans from $2,000 million or 0.69% of loans, due to lower-than-expected loan loss provisions in the third quarter. Our 2011 LLP estimate is reduced to $1,600 million or 0.53% of loans from $1,800 million or 0.59% of loans.

Gross Impaired Loan Formations Decline Modestly

• Gross impaired loans were unchanged at $5,020 million or 1.69% of loans versus $5,064 million or 1.74% of loans in the previous quarter. Net impaired loans were flat at $1,841 million, or 0.62% of loans, versus $1,841 million, or 0.63% of loans, in the previous quarter.

• Gross impaired loan formations declined to $868 million from $1,131 million in the previous quarter. Net impaired loan formations increased slightly to $519 million from $475 million in the previous quarter.

• Average loan and acceptances increased 3% YOY and 2% QOQ. International Banking average loans and acceptances declined 13% YOY and were flat QOQ. RBC Capital Markets average loans and acceptances declined 19% YOY but increased 1% QOQ.

Tier 1 Ratio 12.9%

• Tier 1 capital declined to 12.9% from 13.4% in the previous quarter due to higher risk-weighted assets.

• Risk-weighted assets increased 4% sequentially and 6% YOY to $258.8 billion. Market-at-risk assets increased 55% YOY and 21% QOQ to $27.3 billion. The common equity to risk-weighted assets (CE/RWA) ratio was 13.0% versus 13.3% in the previous quarter and 12.8% a year earlier.
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National Bank Q3 2010 Earnings

  

• BMO raises target price to C$71 from C$70; rating outperform
• Canaccord Genuity raises price target to C$69 from C$68
• Credit Suisse raises target price to C$69 from C$68
• Macquarie cuts price to C$67 from C$68; rating neutral
• RBC raises price target to C$74 from C$71; rating sector perform.
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Scotia Capital, 27 August 2010

Event

• NA reported a 12% decline in operating EPS to $1.57, above expectations. Earnings were better than expected due to very strong retail earnings, which increased 15% sequentially, high security gains, and lower loan loss provisions at 18 bp, which offset the weak results from Financial Markets (significant decline in trading revenue).

Implications

• Retail earnings increased 32% YOY and 15% QOQ to $162M. Retail earnings were driven by revenue (increased 6% YOY) and volume growth, a decline in LLPs, and controlled expenses (flat YOY).

• Financial Markets earnings declined 42% YOY to $98M due to a collapse in trading revenue. Trading revenue was $89M, down from $168M a year earlier and $150M in the previous quarter.

Recommendation

• We are increasing our 2010E EPS to $6.25 from $6.15 due to the beat this quarter. However, we are reducing our 2011E EPS to $6.80 from $6.90 due to a lower economic growth outlook and moderating net interest margin as the prospect for higher interest rates is delayed. Our one-year share price target is unchanged at $70. We maintain our 2-Sector Perform rating.
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Canadian Banks Confident Ahead of New Basel Rules

  
Thomson Reuters, 27 August 2010

Canada's banks appear set to handily absorb stiffer global capital and liquidity rules being developed by the Basel banking committee, meaning they could soon begin raising dividends and making acquisitions.

While the new regulations won't be released until November, the CEOs of Canada's big six banks have begun speaking more confidently about their ability to adopt the rules, which will redefine how much capital banks have to hold on their balance sheets.

"Based on what we know and the work we've done to date, we're well positioned on both an absolute and relative basis, to adopt the new rules," Bank of Montreal Chief Executive Bill Downe said on a conference call after the bank released its quarterly earnings this week.

Louis Vachon, CEO of smaller rival National Bank of Canada went a step further in terms of specifics, predicting that the rules will reduce National's Tier 1 capital ratio by 2.5 percentage points, a level that would still leave the lender well capitalized on a historical basis.

"Suffice it to say, that our level of comfort over the last few months has increased significantly," Vachon said.

The language marks a shift from the cautious tone of previous commentary on the Basel III rules, which are being developed to help avoid another banking crisis.

The uncertainty has prompted Canada's bank regulator -- the Office of the Superintendent of Financial Institutions -- to put a moratorium on big capital outlays such as dividend hikes and sizable acquisitions until the new rules become clear.

But the banks' confidence has been helped by signs the new rules may not be as strict as some had worried.

Last month, the Basel committee scaled back some of the toughest proposals, particularly those concerning the definition of Tier 1 capital, which is a key measure of a bank's stability.

The CEOs have also likely taken comfort from the robust levels of capital that Canadian banks have built up over the past year, as they have essentially stockpiled profits.

National's Tier 1 ratio was 13 percent on July 31, well above its normal 9 to 11 percent range and easily capable of withstanding a 2.5 percentage-point hit. A level of 10 percent is well above most global peers.

BMO's ratio was 13.55 percent, while Canadian Imperial Bank of Commerce was at 14.2 percent. Royal Bank of Canada, the country's largest bank, had a ratio of 12.9 percent.

Toronto-Dominion Bank and Bank of Nova Scotia will report their quarterly results next week.

The increasing comfort with the regulatory changes has bank CEOs looking past the November G20 meeting in Seoul, when the rules are expected to be released.

"I think that capital allocation becomes the story in 2011," said John Aiken, an analyst at Barclays Capital.

National Bank's Vachon noted that the bank's dividend payout ratio -- the level of earnings committed to the dividend -- was at the bottom end of its normal range.

"I think it's quite clear what our next step would be," he said.

National, TD, Royal, and Scotiabank are expected to be quick off the mark with dividend hikes, while BMO and CIBC could wait a few quarters.

Acquisitions are also expected, as the banks struggle to grow revenues in the crowded Canadian bank space. The lingering effects of the financial crisis have left attractively priced targets in the United States and Europe, observers say.

"I think all of them are likely to really monitor where else they can use their capital," said Juliette John, portfolio manager at Bissett Investment Management in Calgary.

RBC, for instance, has signaled it is looking to expand its wealth management operations in Europe, while TD has been adding to its retail banking presence on the U.S. East Coast.

BMO's Downe also flagged M&A as a possible focus, pointing to Federal Deposit Insurance Corp-assisted deals in the U.S. Midwest, where BMO already has an established presence with its Harris Bank unit.

"I think there should be some opportunity there," he said.

"BMO views the current environment as an opportunity to strategically expand our U.S. footprint.
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Thursday, August 26, 2010

CIBC Q3 2010 Earnings

  
Scotia Capital, 26 August 2010

Event

• CIBC (CM) reported an increase in cash operating earnings of 22% YOY to $1.66 per share beating expectations due to surprisingly strong trading revenue/wholesale earnings and slightly higher security gains. Operating ROE was 21.5% with RRWA of 2.39%.

Implications

• Wholesale Banking operating earnings declined 33% YOY to $123 million, but remained surprisingly strong against $134 million in the previous quarter due to resilient trading revenue (lower exposure to fixed income trading).

• CIBC Retail Markets earnings increased 40% YoY and 23% QoQ to $604 million. Retail earnings were boosted by treasury allocation and lower loan losses.

Recommendation

• We have increased our 2010 earnings estimate to $6.40 per share from $6.15 per share due to the beat this quarter and solid retail banking results. Our 2011 earnings estimate remains unchanged at $7.00 per share. Our one-year share price target is unchanged at $80 per share. We maintain our 2-Sector Perform rating.

Items of Note

• Reported cash earnings were $1.55 per share, including net one-time charges of $0.11 per share. One-time items included a loss of $138 million ($96 million after-tax or $0.25 per share) on structured credit run-off activities and a reversal of $76 million ($53 million after tax or $0.14 per share) of general provisions.

Retail Markets Earnings Improve

• Earnings at CIBC Retail Markets were $604 million, an increase of 40% year over year, which were boosted by treasury allocation and lower loan losses. Other Retail Markets revenue (assisted by treasury allocation) was $40 million versus a loss of $54 million the previous quarter, representing a positive $94 million sequential swing in revenue (after-tax $64 million or $0.16 per share).

• Specific LLPs declined to $304 million from $417 million a year earlier and from $334 million in the previous quarter.

• Retail Markets revenue increased 6.6% with non-interest expense increasing 3.2% for positive operating leverage of 3.4%. Wealth Management revenue increased 6%, with FirstCaribbean revenue declining 17%. Wealth Management and FirstCaribbean represented 14% and 6% of Retail Markets revenue, respectively.

• Average loans & acceptances increased 4% YOY and 2% QOQ to $215.2 billion.

• Deposit and payment fees declined 3% year over year to $194 million. Card fees were $72 million compared with $83 million in the previous quarter and $80 million a year earlier.

• Mutual fund revenue, which is contained in Wealth Management revenue, increased 13% from a year earlier to $188 million. Mutual fund assets (IFIC) increased 7.6% YOY to $46.2 billion. Investment management and custodian fees increased 14% from a year earlier to $117 million.

Canadian Retail NIM Declines Sequentially

• Retail net interest margin (NIM) declined 1 bp sequentially but increased 2 bp from a year earlier to 2.79% (as a percentage of average loans and acceptances).

Overall Net Interest Margin

• The overall bank net interest margin declined 7 bp sequentially but improved 7 bp from a year earlier to 2.05%.

CIBC Wholesale Banking

• CIBC Wholesale Banking operating earnings were surprisingly strong at $123 million (excluding structured credit run-off) due to resilient trading revenue. This compares to $185 million a year earlier and $134 million in the previous quarter. Corporate and investment banking revenue declined to $146 million from $232 million a year earlier but increased from $132 million the previous quarter.

Underlying Trading Revenue Surprisingly Resilient

• Trading revenue (excluding structured credit run-off) was very strong given the difficult trading environment particularly in fixed income. Trading revenue actually increased sequentially to $181 million versus $150 million in the previous quarter although declined from $219 million a year earlier. Interest rate trading was surprisingly resilient at $41 million versus $60 million in the previous quarter and $81 million a year earlier.

Capital Markets Revenue Stable

• Capital markets revenue was $216 million versus $207 million in the previous quarter and $254 million a year earlier.

• Underwriting and advisory fees were $108 million, increasing 24% from $87 million the previous quarter but declining 18% from $132 million a year earlier.

Security Gains High

• Security gains (AFS/FVO) included in operating earnings were $52 million or $0.09 per share versus $37 million or $0.06 per share in the previous quarter and $32 million or $0.05 per share a year earlier.

• The security surplus increased to $629 million from a surplus of $386 million in the previous quarter and a surplus of $270 million a year earlier.

Corporate and Other Business Segment

• The corporate and other segment recorded a loss of $37 million versus a loss of $16 million in the previous quarter and a loss of $52 million a year earlier.

Higher Securitization Net Income

• Securitization revenue increased in Q3/10 to $150 million from $120 million in the previous quarter and from $113 million a year earlier. The net income statement securitization impact was a gain of $48 million in Q3/10 versus a loss of $7 million in Q2/10, representing a positive swing of $0.09 per share sequentially.

Loan Loss Provisions Decline

• Specific LLPs declined to $297 million or 0.64% of loans versus $316 million or 0.71% of loans in the previous quarter and from $422 million or 0.97% of loans a year earlier. Retail LLPs were $304 million, with wholesale LLPs at $29 million, and the corporate segment recording a $36 million recovery (excluding $76 million release of general allowance).

• Our 2010 and 2011 LLP estimates are unchanged at $1,300 million or 0.70% of loans and $1,000 million or 0.52% of loans, respectively.

Impaired Loans Increase Slightly

• Gross impaired loans increased slightly to $2,042 million or 1.10% of loans in the quarter versus $1,968 million in the previous quarter and $1,668 million a year earlier. Net impaired loans were $5 million versus negative $102 million in the previous quarter and negative $312 million a year earlier.

• Gross impaired loan formations declined to $557 million this quarter from $566 million in the previous quarter and from $967 million a year earlier.

Tier 1 Ratio 14.2%

• Tier 1 ratio increased to 14.2% from 13.7% in the previous quarter and 12.0% a year earlier. The common equity to risk-weighted assets (CE/RWA) ratio was 11.4% compared with 10.8% in the previous quarter and 9.2% a year earlier.

• Total risk-weighted assets declined 1% sequentially and 7% YOY to $107.2 billion, while market-at-risk assets increased 5% sequentially and 18% YOY to $2.0 billion.
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Wednesday, August 25, 2010

BMO Q3 2010 Earnings

  
Scotia Capital, 25 August 2010

Event

• BMO cash operating EPS increased 9% to $1.14, below our estimate of $1.20 and consensus of $1.21. Earnings were lower-than-expected due to extremely weak trading revenue and lower security gains, partially offset by lower than expected LLPs. Operating ROE was 13.9%.

Implications

• Positives for the quarter were credit and strong operating results in core businesses: P&C Canada and Wealth Management (excl. insurance).

• P&C Canada earnings were strong at $428M, up 17% YOY with retail NIM increasing 9 bp YOY and 5 bp QOQ. BMO Capital Markets hit a cyclical low due to extremely weak trading revenue. Trading revenue fell to $145M from $410M in Q2/10.

Recommendation

• We have reduced our 2010E and 2011E EPS to $4.75 and $5.20 from $4.85 and $5.60, due to continued low capital market activity, weak trading revenue, lower economic growth outlook, and expected persistence of low interest rates. Our one-year share price target is unchanged at $70.

• We maintain our 1-SO rating based on continued leverage to recovery in Canadian retail franchise and expected improvement in U.S. banking operations.

P&C Canada Earnings Increase 17%

• P&C Canada earnings increased 17% from a year earlier to $428 million, driven by an improvement in the retail net interest margin (NIM), strong operating leverage, and solid loan volume growth.

• Retail net interest margin improved 9 bp from a year earlier and 5 bp sequentially to 2.96%.

• P&C Canada revenue growth was very strong at 9.3%, with expenses increasing 3.8% for strong operating leverage of 5.5%.

• Loan growth was 5.9% with personal loan growth strong at 16% and mortgage loan balances increasing only 1% due to run-off of broker channel loans. Personal deposits were down 1% from a year earlier, with market share declining due to a highly competitive environment. The productivity ratio was 51.1% versus 53.8% a year earlier.

P&C U.S. Net Loss on Actual Loss Experience Basis

• P&C U.S. cash earnings declined 31% YOY to $45 million (using expected loan loss provisions) from $65 million a year earlier. If we use actual loan loss provisions of $103 million versus $31 million expected loan losses, P&C U.S. earnings would have been a loss of $4 million versus a loss of $9 million a year earlier.

• The P&C U.S. retail NIM improved 59 bp YOY and 15 bp sequentially to 3.70%.

Overall Net Interest Margin Flat

• The bank’s overall net interest margin on average earning assets was flat sequentially and up 14 bp YOY to 1.88%.

Private Client Group Earnings Strong Excluding Insurance

• Private Client Group (PCG) earnings in Q3 declined 5% YOY and 8% sequentially to $109 million. PCG earnings included $34 million from insurance versus $67 million a year earlier. Excluding insurance, PCG earnings were $74 million, increasing 61% YOY.

• Mutual fund revenue improved 17% YOY to $139 million. Mutual fund assets under management (as reported by IFIC) increased 8% YOY to $35.1 billion.

BMO Capital Markets Earnings - Cyclical Low

• BMO Capital Markets earnings were very weak, declining 58% YOY and 50% QOQ to $131 million from $310 million a year earlier and $260 million in Q2/10, respectively due to extremely weak trading revenue. Average loans & acceptances declined 26% YOY to $24.3 billion.

Trading Revenue Declines 64%

• Trading revenue declined 64% to $145 million versus $410 million in the previous quarter and $407 million a year earlier, the lowest level since Q2/08 and Q4/06. The major weakness in trading revenue was concentrated in interest rate products which declined to $20 million from $225 million in the previous quarter and $288 million a year earlier. Equity trading revenue declined to $91 million in the quarter from $107 million in Q2/10 but increased from $87 million a year earlier. FX trading revenue declined to $62 million versus $69 million in the previous quarter and $85 million a year earlier. Trading revenue declined to 5.0% of revenue from 13.7% a year earlier.

Capital Markets Revenue Stable

• Capital markets revenue was $349 million versus $358 million in the previous quarter and $341 million a year earlier. Underwriting and advisory fees declined 10% YOY to $91 million, while securities commissions and fees increased 8% to $258 million.

Security Gains Negligible

• Security gains recorded in the quarter were $9 million or $0.01 per share versus $0.07 per share in the previous quarter and a loss of $0.01 per share a year earlier. Unrealized security surplus increased to $767 million from $378 million in the previous quarter and $381 million a year earlier.

Loan Loss Provisions Decline More Than Expected

• Specific loan loss provisions (LLPs) were below expectations at $214 million or 0.49% of loans, declining from $249 million or 0.60% of loans in the previous quarter and from $357 million or 0.82% of loans a year earlier.

• The lower-than-expected loan losses were due to a recovery at BMO Capital Markets and lower commercial LLPs in P&C Canada.

• We are reducing our 2010 and 2011 LLP forecast to $1,040 million or 0.59% of loans and $900 million or 0.48% of loans, from $1,100 million or 0.63% of loans and $1,000 million or 0.53% of loans, respectively, to reflect the improving credit trends.

Impaired Loans Decline

• Gross impaired loan (GIL) formations declined to $242 million from $366 million (excluding acquisitions) in the previous quarter. Including acquisitions, GILs declined to $132 million from $803 million the previous quarter. Net impaired loan (NIL) formations declined slightly to $113 million from $124 million in the previous quarter, excluding the impact of acquisitions.

• GILs declined in the quarter to $3.1 billion or 1.80% of loans. Net impaired loans were $1.2 billion or 0.72% of loans.

• The coverage ratio (Allowance for Credit Losses as a percentage of GILs) improved to 60% versus 55% in the previous quarter, but declined slightly from 62% a year earlier.

Capital Ratios Strong

• Tier 1 Capital increased to 13.5% from 13.3% in the previous quarter due to a 2% sequential decline in risk-weighted assets (RWA) and internal capital build. Tier 1 Capital was 11.7% a year earlier. Tangible common equity to RWA was extremely high at 10.4%.

• RWA declined 9% YOY and 2% quarter over quarter to $156.6 billion. Market-at-risk assets declined 24% YOY to $5.5 billion.

• The total capital ratio was strong at 16.1% at the end of the quarter versus 15.7% in the previous quarter and 14.3% a year earlier.
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Thursday, August 19, 2010

Credit Suisse: Revenue Growth to Slow for Banks

  
Credit Suisse, 19 August 2010

As Canadian bank earnings/returns on equity (ROE) benefit from declining credit charges, slowing revenue growth represents a headwind.

We forecast provisions for credit losses (PCLs) to decline 35% and 36% in 2010 and 2011, respectively, providing a substantial boost to group profitability. However, as this earnings/ROE driver loses momentum, the onus falls on revenue growth to drive the bottom line. On this front, we believe: (1) domestic retail lending is poised to slow; (2) wholesale revenues are falling as trading revenues normalize; and (3) competitive forces will restrict margins. Given our cautious outlook on the revenue front, we are forecasting the pace of group ROE expansion to fall to 37 basis points in 2012 from 61 basis points in 2010.

Capital regulation, capital management and (potentially) economic stability represent the most important near-term stock drivers. Uncertainty toward the regulatory capital landscape represents an overhang for the sector. Clarity should come at the end of 2010, allowing banks to revisit capital-management programs. We forecast the group to have $28 billion of excess capital by the end of fiscal 2012 under Basel III and our sector 2011 estimated dividend payout ratio is 44%. This cushioning should allow banks to raise dividends over the next 12 months.

A bias toward banks with significant foreign operations is counter intuitive given the strength of the Canadian economy. Our rationale is that top-line growth in Canada is slowing, while foreign activities are either tied to secular growth trends or are underappreciated by the Street.

Stock selection favors a basket of growth potential and defense. Our stock selection emphasizes: (1) relative growth positioning; (2) dividend growth potential; (3) relative valuation; (4) revenue mix tilted toward P&C [personal and commercial] banking; and (5) excess capital and/or deployment opportunities.

We've assigned Outperform ratings to the Bank of Nova Scotia (BNS) and Toronto-Dominion Bank (TD), as they play well into our offensive themes of growth positioning and capital-deployment opportunities, while also offering a favorable mix of personal and commercial-banking revenue.

We also rate National Bank of Canada as Outperform, as it screens well against our criteria of dividend growth and relative valuation.

We are Neutral on Bank of Montreal (BMO), Canadian Imperial Bank of Commerce (CM) and Royal Bank of Canada (RY).
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Thursday, August 12, 2010

Preview of Banks' Q3 2010 Earnings

  
Scotia Capital, 12 August 2010

Banks Begin Reporting Third Quarter Earnings August 24 - Uninspiring

• Banks begin reporting third quarter earnings with Bank of Montreal (BMO) on August 24, followed by Canadian Imperial Bank of Commerce (CM) on August 25, Royal Bank (RY) and National Bank (NA) on August 26, Bank of Nova Scotia (BNS) on August 31, Canadian Western (CWB) on September 1 (after market close), with Toronto Dominion (TD) and Laurentian Bank (LB) closing out reporting on September 2.

• Our earnings estimates are highlighted in Exhibit 1, consensus earnings estimates in Exhibit 2, and conference call information in Exhibit 3.

Third Quarter Earnings - Momentum Stalls

• We expect third quarter operating earnings to decline 1% year over year (YOY) and be flat from the previous quarter. Bank earnings momentum is expected to stall in the third quarter as improvement in credit costs (loan loss provisions expected to decline 24% YOY) and retail net interest margin improvement is being offset by perhaps a cyclical low in the banks' wholesale business, driven by an expected nearly 50% decline in trading and 20% decline in capital markets revenue, as well as higher short-term wholesale funding costs (BAs up 26 bp YOY) and 9% appreciation YOY in the C$.

• We are trimming our Q3 earnings estimates by $0.04/$0.05 per share for RY, NA, and TD mainly due to lower trading revenue expectations.

• RY and NA are expected to record the weakest earnings momentum of the bank group this quarter with declines of 17% and 16% YOY, respectively, due to tough comps and higher trading revenue reliance. BMO and CM are expected to have the highest earnings momentum of the major banks with growth in earnings of 14% and 10% YOY due to lower bases a year earlier and some recovery in their underlying businesses. CWB earnings are expected to be up 21% YOY due to significant recovery in their net interest margin.

• Bank profitability this quarter is expected to remain solid, although with a lower return on equity at 16.4% (Exhibit 8) due to expected wholesale banking weakness and deleveraging. However on RRWA, profitability is trending at near record levels of 2.14% (Exhibit 9).

• Bank earnings have beaten Street expectations for most of fiscal 2009 and the first quarter of 2010, with Q2/10 earnings the first quarter since the earnings recovery began in which banks did not exceed expectations, as heightened expectations were greeted by softer capital markets, a stalled net interest margin (NIM), and negative earnings impact from a strong C$. Impressive retail and wealth management earnings were the main drivers in the second quarter.

• Third quarter earnings are expected to be uninspiring with no growth, although earnings levels remain respectable, especially given the very difficult quarter expected from wholesale banking. We expect the earnings trend to resume its positive track, perhaps as early as Q4/10 after pausing with a relatively weak Q2 and Q3E negatively impacted by the economic and sovereign debt uncertainty.

• Quarterly earnings variables (Exhibits 4 & 5) remain mixed this quarter with positives such as wider mortgage-treasury spreads, credit trends, higher retail spreads offset by negatives such as flatter yield curve, lower wholesale spreads, higher short-term funding costs, lower trading volume, weak equity and fixed income underwriting, and no growth in mutual fund assets.

• We expect retail bank earnings to remain strong although growth is expected to begin to slow as volume growth moderates from a very strong pace (off cycle) and net interest margin improvement may begin to moderate. Wealth management earnings growth is also expected to moderate due to lack of sustained asset growth. Wholesale earnings could be at a cyclical low this quarter as trading revenue is expected to decline 46% YOY and 23% sequentially (Exhibit 5, row #24), with underwriting and advisory revenue down 20% YOY and 6% sequentially (Exhibit 4, row #33).

• We expect trading revenue to decline to $1.9 billion in the third quarter versus $2.5 billion in the previous quarter and $3.6 billion a year earlier. Loan loss provisions are expected to be $1.9 billion in the third quarter, similar to the previous quarter but down from $2.5 billion a year earlier. Loan loss provisions in the second quarter were 61 bp and are expected to decline to less than 30 bp through the cycle. However, loan loss provisions can be lumpy on the descent.

• The one trend that remains solidly intact is balance sheets continuing to strengthen. We expect capital levels to continue to build based on internally generated capital and management of risk-weighted assets. Balance sheet strength and solid earnings are expected to lead to the resumption of dividend growth.

Basel Rules Less Onerous - Uncertainty on Details to be Resolved by Year-End

• The Basel Committee on Banking Supervision on July 26 reached a broad agreement on the overall design of the capital and liquidity reform package (see July 28, 2010 Daily Edge note titled "Euro Crisis/Partial Reality Check for Basel - Tone Improves - Positive for Canadian Banks"). The agreement in general seems to be more balanced and constructive than the December 2009 document. Capital definitions have been eased and liquidity design softened with transition time frames extended. We estimate that the July agreement increases bank capital by 100 bp versus Basel's December 2009 consultative document. The July agreement is positive and the tone has improved; however, calibration risk and uncertainty will likely persist until the detailed rules are released later this year

Valuations Attractive - High Dividend Yield - Low P/E Multiples - Building Base

• Bank valuations remain very attractive with a dividend yield of 4.0%, which is 135% of the 10-year bond yield and 166% of the TSX dividend yield versus historical means of 59% and 145%, respectively. Bank earnings yield relative to corporate bond yields is 187% versus the historical mean of 131%.

• Bank P/E multiples, we believe, are attractive at 10.7x 2011 earnings estimates and are poised for expansion. Bank P/E multiples, we believe, have formed a base and support at 12x, which we expect to expand to the 15x-16x range, similar to the post-2002 cyclical recovery. The resumption of dividend growth is expected to be the catalyst for higher P/E multiples.

Major Bank Stock Rally Pending - Maintain Overweight

• We continue to recommend an overweight position in bank stocks as they grind out some outperformance with a modest 1% increase versus a 1% decline for the TSX as well as higher return of 1.6% from dividends.

• Bank share price performance has been muted in the past quarter based on sluggish earnings, concerns about the economic recovery, nervousness about sovereign debt, and regulatory uncertainty (slight relief with July Basel agreement).

• We continue to believe that a key catalyst for a sustained rally in bank stocks and higher P/E multiples are dividend increases. The first prospect for a dividend increase is expected to arise with the banks' release of Q4 earnings late November/early December. The timing of dividend increases is dependent on Basel capital ratio details due out later this year and OSFI consent.

• We are hopeful that the overreaction stage fraught with noise and drama from politicians and regulators will subside and banks will increase dividends with the release of fourth quarter earnings, significantly improving investor sentiment. Thus, we believe a major bank stock rally is pending.

• We have 1-Sector Outperform ratings on TD, CWB, BNS, BMO, and 2-Sector Perform ratings on CM, LB, RY and NA. Our order of preference is: TD, CWB, BNS, BMO, CM, LB, RY, and NA.
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Thursday, August 05, 2010

Manulife Q2 2010 Earnings

  
Citigroup Global Markets, 5 August 2010

2Q10 a miss – Operating EPS of (C$1.36) compared unfavorably to 2Q09 EPS of C$1.09, and was well below our estimate of $0.00 and FC of (C$0.62). While disappointing, we did not find much during our initial review of the results with respect to business line performance that came as a surprise in terms of sales or underwriting trends. But, Canadian GAAP incorporates a more mark-to-market present valuation of liabilities which dictates the present value of the impact of equity market or long-term interest rate movements flow through earnings much more rapidly than U.S. GAAP. While this results in the book value of Canadian life insurers being closer to their underlying “economic” value, it can also cause considerably greater swings in quarter-to-quarter earnings. For MFC in 2Q10 the cost of the decline in global equity markets was (C$1.7B) plus continued low interest rates cost added a charge of (C$1.5B). Absent these, along with a couple of other minor items, and normalized adjusted operating earnings were $658M or about $0.37/share; down modestly from their adjusted level of $0.42 in 1Q10.

Capital remains an issue – Although Manulife’s statutory MCCSR (Minimum Continuing Capital and Surplus Requirements) ratio of 221% at 2Q10 was still strong, it did decline from 250% in 1Q10. In light of management’s acknowledgment on the earnings call that charges from its annual actuarial assumption review in 3Q10 may exceed C$1 billion, we expect that MCCSR will fall further. The pending 3Q10 charges came on top of the (C$2.4B) net loss for 2Q10 and because of this, we continue to anticipate a common equity raise in the C$1.5B – C$2.0B range by YE10. The pricing mistakes made on variable annuities, secondary guarantee universal life (SGUL) and individual long-term care (LTC) at Manulife’s U.S. John Hancock operations will materially depress overall corporate ROE for decades to come. The cost of fully reserving for what we estimate are roughly US$35 billion of largely un-hedged variable annuities written in 2005-07 with generous living benefits, along with the $18.2B of reserves backing LTC and an estimated $15 billion of reserves behind SGUL will be very painful. But, we believe Manulife’s CEO Don Guloien is moving towards finally stepping up to do so in order to allow his company to begin to move forward from the legacy issues he was left by his predecessor. All three of these lines are also candidates to be put into run-off and we would note rival Sun Life, as part of its 2Q10 results, announced it had formally exited SGUL. At 2Q10, MFC had $32.3B in capital and in the last 12 months has raised $3.5B of new capital split between $2.5B of common equity and $1.0B of Tier 1 notes. The company maintained its $0.13 quarterly dividend and we do not believe it is at risk.

Expect another difficult quarter in 3Q10/4Q10 – Management could not provide an estimate of what the charge in 3Q10 would be as part of its annual actuarial assumption review. Instead they guided for a “material charge” which we believe help to spook the market and precipitate the approx. 15% sell-off in the shares. We believe it will be at least as big as the 3Q09 C$783M after-tax charge experienced from changes to actuarial morbidity and policyholder lapse assumptions. If this wasn’t enough, the pending adoption by Canadian life insurers of phase 1 of International Financial Reporting Standards (IFRS) is likely to bring with it several billion dollars worth of additional charges. Most notable of this will be a material impairment of the company’s C$7.2B goodwill asset that equaled 25.9% of equity at 2Q10. However, unlike Sun Life that was able to offer some insight as to what the accounting impact of the transition costs to IFRS would be, Manulife CFO Michael Bell was considerably less precise when asked on the earnings call.

Regulatory update - As announced by Office of the Superintendent of Financial Institutions (OSFI) on July 28/10, existing capital requirements related to new (but not in-force) segregated fund/VA business written starting in 2011 will change.

VA hedging remains a primary valuation risk issue – It was clear again from today’s call that Manulife’s CEO Mr. Guloien plans to continue what is largely his company’s very large un-hedged investment in equity markets. While he stated that by YE12 he intends to hedge or reinsure at least 70% of the company’s VA guarantees vs. 51% as at 2Q10, it was clear no formal program for averagingin has been adopted. Rather it will continue to be done on an “ad-hoc” basis with management essentially hoping equity markets cooperate and rise. Mr. Guloien anticipates this will reduce the company’s equity market sensitivity by 15% relative to June 30/10 but we would point out the hedge program will continue to largely avoid addressing the deeply in the money 2005-07 vintages whose estimated US$35 billion of guarantees appear to us to be over 35% in the money. And, per the step-up features on these contracts, their guaranteed amount will continue to rise at a minimum rate of 5% net of fees annually.

Sales results mixed:

Insurance –On a constant currency basis sales were up 9% to $648M. Asian insurance sales were driven by 41% upside in Japan to US$117M, a 36% rise in Hong Kong to US$45M, and 41% growth in China & Taiwan to US$27M. In Canada, individual insurance and affinity sales grew 12% to $73M but consistent with peers, group benefits declined 20% to $70M. US life sales fell 9% to US$154M following the steep price increases in term and guaranteed universal life products. LTC sales jumped 72% to US$62M, reflecting good gains in group sales.

Wealth management - Sales excl. VA rose 12% Y-O-Y to $7.1B, led by 19% upside in Hong Kong to US$175M, Other Asia increase of 35% to US$520M, and new products launched in Japan. In Canada, mutual fund deposits jumped 175% to $297M and MFC bank sales rose 6% to $1.1B. But, consistent with peers, this was offset by a 37% drop in fixed products to $247M and 51% decline in group retirement sales to $175M. Similarly, in the US, mutual fund sales rose 51% to US$2.4B, and retirement plan services rose 24% to a record $1.1B, driven by the acquisition of larger cases, improved markets and expanded distribution relationships.

Investment strategy

Our Buy/Medium Risk (1M) rating on the shares of Manulife reflects our view that despite near term challenges including the risk of another common equity raise it continues to be one the premier global life insurance franchises. That said, the combination of weak risk management poor product pricing discipline over the past few years along with rising investment losses has measurably weakened its financial condition. However, we believe CEO Don Guloien is committed to putting MFC’s problems at its troubled U.S. John Hancock operations behind it once and for all.

We also have growing confidence MFC is beginning to regain its former sales momentum led by its high growth Asian businesses. An important factor behind our upgrade is recent management changes and our belief these reflect that CEO Don Guloien is finally getting a full handle on the significant product pricing and risk management mistakes made in the U.S. In our view the issue for MFC is not regulatory capital, but rather the economic cost of the VA and UL pricing mistakes made in the U.S. We expect these will limit the company’s long-term earnings growth rate and ROE to somewhere in the 12%-13% range for each. That said we believe its Asian operations offer superior growth potential and expect them to play a steadily rising role in future earnings growth and possible M&A.

Valuation

When deriving valuations for life insurers, we primarily utilize a peer comparison of P/B regressed against ROE. In support of this we also use a relative P/E assessment, sum-of-the-parts analysis and PV of excess returns. To arrive at our C$22/US$21 target price for Manulife’s shares we performed a P/B vs. ROE regression for a peer group of North American life insurers. We adjusted this to allow for the historical 10%-15% premium Canadian life insurers have traded above their U.S. peers which we attribute to differences in accounting. Longer-term we look for ROE to stabilize in the 12%-14% range and EPS growth to be 10%-12%.

Price-to-book value – Our target price was established using a 1.4x P/BV multiple of projected year-end 2010 book value of C$15.97. While above the level inferred by our industry price/book versus ROE regression model based on a 2010 projected ROE of 7.6%, it factors in what we forecast will be a significant 60-70 bps annual improvement over the next two years. This compares to an average for the large-cap peer group of 1.03x and range of 0.64x–2.1x, with ROEs of 9.2%-27.9%.

Relative P/E – Our target price utilizes a multiple of 18.3x our 2010E of C$1.20 and 11.0x our 2011E of C$2.00. This compares to the 2010 peer average of 9.0x and range of 7.6x-10.8x and 2011 average and range of 7.9x and 6.6x-8.7x.

PV of Excess returns – Infers share value of C$22.76.

Risks

We rate Manulife Financial as Medium Risk for several reasons. The first is liability risk related to variable annuities, no-lapse and individual long-term care. These products were significantly under-priced industry wide by insurers and MFC was a leading writer of each of them. Along with the Japanese VA line they may all require further reserve strengthening. A second risk factor is interest rates. We estimate over half of earnings come from individual life insurance products and are meaningfully impacted by the level of long-term interest rates. Management est. a 100bps upward shift in rates would benefit capital by C$1.6B while a similar drop would reduce it by C$2.2B. A third risk factor relates to the general account long term investment portfolio that equaled C$188.3B at 1Q10. While we consider it conservative with only 4% held in bonds rated below investment grade, its sheer size means it is not immune to the general credit environment. A fourth factor is earnings sensitivity to equity market movements. These impact fees generated off segregated and mutual fund AUM which totaled C$194.1B and C$36.8B, respectively, at 1Q10. Management est. an immediate 10% equity market drop would reduce capital by C$1.2B. A final risk factor is currency as over half of earnings originate outside of Canada, primarily the U.S., and are influenced by changes to the Cdn/$ exchange rate. Our forecasts assume an exchange rate of 0.96x. If any of these factors has a greater/lesser impact than predicted, the shares could have difficulty achieving our target price or could exceed it.
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