RBC Capital Q4 2005 Cdn Insurance Earnings Preview

Highlights

• Expecting Double-Digit EPS Growth. We expect a positive tone on the Q4 results, buoyed by strong momentum in wealth management products. MFC and IAG should lead Q4 with approximately 23% and 18% EPS growth, respectively. We are above consensus for GWO and MFC, and marginally below consensus for SLF.

• Wealth Momentum Rising. MFC and IAG are growing domestic wealth sales well above industry averages – growth rates for SLF and GWO have lagged just slightly. In the U.S. and Asia, MFC continues to show sales growth at the top end of industry ranges. Central to our positive investment thesis is that surging wealth sales will have a positive near-term impact on margins and EPS revisions.

• Q4 Life Sales Seasonally Strong. Life sales typically bulge 15% to 20% QoQ in the year-end sales season. In domestic life, GWO sales may be strongest given: (i) the increasing popularity of the whole life product where GWO excels; and (ii) continued success by Canada Life in the independent channels. In the U.S., both MFC and SLF carried excellent momentum into Q4 – we look for big results there.

• U$ Translation Headwind Abating? After a benign Q3/05 and now just -4% erosion YoY in Q4/05, the impact of the declining U$ was just half the average run rate of the past couple of years. This is most favourable for MFC and SLF, but less so in the near term at GWO, which is still adjusting from hedged to unhedged.

• Sales Mix, Excess Capital and Higher Dividend. As the product mix shifts to less capital-intensive wealth products, capital generation by the lifecos should accelerate, in our view, boosting dividend growth. We factor 14% to 18% growth rates in 2006/2007. This quarter, we are looking for a 13% increase at MFC, and 6% at SLF.

• Time to Reload on Lifecos with Rates Rising. Lifecos are trading at 103% of the banks on forward P/E, well below their typical relative valuation of 114%, depressed by low interest rates. However, interest rates have started to move off their lows, relieving spread compression broadly. Also, insurers have adjusted crediting rates down to much lower levels, reflecting the new interest rate reality, resulting in improved spreads on new and renewal business. The stage is now set for improvement in earnings performance and valuation.

• Manulife remains Top Pick. We believe MFC is positioned to continue gaining ground in the U.S. high-net-worth life and annuity markets, capitalizing on the early distribution success through the newly acquired John Hancock channels.

Favourable Year-End Outlook

We expect a positive tone on the Q4 results, buoyed by strong momentum in wealth products. Manulife and IAG should lead Q4 with approximately 23% and 18% EPS growth, respectively. We are above consensus for both MFC and GWO, and while we are below consensus for Sun Life, it is only marginally.

MFC and IAG are growing domestic wealth sales well above industry averages – growth rates for Sun and GWO have lagged just slightly. In the U.S. and Asia, MFC continues to show sales growth at the top end of industry ranges. Central to our positive investment thesis is the view that surging wealth sales will have a positive near-term impact on margins and EPS revisions.

Life sales typically bulge 15% to 20% QoQ in the year-end sales season. In domestic life, GWO sales may be strongest given: (i) the increasing popularity of the whole life product where GWO excels; and (ii) continued success by Canada Life in the independent channels. In the U.S., both MFC and Sun carried excellent momentum into Q4, so we look for big results there.

After a benign Q3/05 and now just -4% erosion YoY in Q4/05, the impact of the declining USD was just half the average run rate of the past couple of years. This development is most favourable for MFC and SLF – less so in the near term at GWO, which is still adjusting from hedged to unhedged. On average, the Canadian dollar appreciated by $0.05 relative to the U.S. dollar in Q4/05. We estimate that quarterly EPS will be negatively impacted by $0.02 to 0.03 for Manulife, and by $0.01 to $0.02 for Sun Life compared to last year. Great-West Lifeco’s earnings are protected by currency hedges on the euro (87% hedged at CAD/EUR1.61) and the U.S. dollar (100% hedged at CAD/USD1.34), but due to the reduced CAD/USD hedge rate from $1.58 last year, the year-on-year impact on GWO’s quarterly EPS is projected at $0.01 to $0.02. There is no currency impact on Industrial Alliance.

As the sales mix shifts to less capital-intensive wealth products, capital generation at the lifecos should accelerate, in our view, boosting dividend growth. We have factored growth rates of 14% to 18% in 2006/2007. This quarter, we are looking for a 13% increase at MFC and 6% at SLF.

Lifecos are trading at 103% of the banks on forward P/E, well below their typical relative valuation of 114%, depressed by low interest rates. However, interest rates have started to move off their lows, relieving spread compression broadly. Also, insurers have adjusted crediting rates down to much lower levels, reflecting the new interest rate reality, resulting in improved spreads on new and renewal business. The stage is now set for improvement in earnings performance and valuation.

Canadian Life Insurers – A Positive Investment Thesis

Product mix shift to wealth management should drive more capital-efficient earnings growth. Robust wealth management sales are the most encouraging lead indicator of near-term earnings growth, for two reasons. First, the wealth management products have the earliest profit emergence of all lifeco businesses, with fee income recognized immediately on customer deposits. By contrast, life insurance sales typically do not generate profit in the early years post-sale, as profit is held back, should experience differ from actuarial projections. Second, the wealth divisions now account for increasing proportions of overall lifeco business, now at roughly one-third of the whole.

Life insurance sales were increasingly disappointing in 2005 on tepid interest rates and buyer fatigue after the sustained rebound in strength in 2003-2004. A slightly higher interest rate would be ideal for another rebound in protection sales. Regardless, the powerful top four Canadian publicly traded lifecos have had better sales growth than the broad sector average through this lull across North America. With sales heavily skewed to wealth products in the current cycle, we expect that overall net income growth will track above long-term average growth rates and market expectations.

Another positive by-product of the wealth-rich sales mix is more efficient regulatory capital usage. Wealth products attract much lower regulatory capital requirements than life insurance policies, so we also anticipate above-average dividend payout growth in this cycle.

Manulife, Sun Life have flexibility to raise dividends. With payout ratios on trailing earnings in the low 30% range, plenty of excess capital and an oft-stated commitment to return capital to shareholders, both Manulife and Sun Life have both the flexibility and willingness to increase dividends. Great-West has traditionally been a strong yield play, but it now has less room to manoeuvre than in the past, with low excess capital and challenged earnings growth over the next year. It is, however, a clear beneficiary in the longer term of any favourable adjustments to dividendtaxation policies. IAG has already earmarked its excess capital for the CFI acquisition, and also consequently falls into the category of long-term beneficiary of any proposed changes to dividend taxation.

Lifeco valuation more attractive than banks. Canadian lifeco valuations have expanded a full multiple point in the last three months, now trading at 13.9x consensus forward earnings – this represents a break-out from the 11x to 13.5x range since spring 2002, when Canadian government 10-year bond yields fell below 5%. Despite the strong price performance, lifecos continue to trade at only a 3% premium to the banks (as has been the case through much of the year), and well below the 14% premium since demutualization. We expect lifecos to outperform the banks in a modestly rising interest rate environment.

Manulife remains Top Pick. We believe the earnings momentum and valuation outlook for insurers remains positive. We believe MFC is positioned to continue gaining ground in the U.S. high-net-worth life and annuity markets, particularly capitalizing on the early distribution success through the newly acquired John Hancock channels. We also expect continued success in Asian markets, where the focus on wealth products is also showing tangible gains in select markets (Japan, Hong Kong and Singapore), particularly as more bancassurance business models develop across the Asia platform, including in Hong Kong. Finally, while not expected to be significantly profitable in the near future, MFC’s rapid but disciplined Chinese city build-out should start attracting value as one of the best-developed foreign lifeco platforms in that country.

Sector Price Performance and Valuation

Canadian lifecos outperformed in Q4, and in line for 2005. Canadian lifecos advanced 9% in Q4 to lead comparable financial indexes, and were well ahead of the TSX Composite and S&P500 at 2% each. For the year, the Canadian lifecos finished up 20%, in line with the Canadian banks, U.S. lifecos and the TSX Composite. Manulife was the top-performing lifeco for the second consecutive quarter, up 10% in Q4 and 23% in 2005 to lead the group.

Trading at a 3% premium to the banks. The Canadian lifecos are trading at 13.9x consensus forward earnings, above the 13.3x average since demutualization. The lifecos are trading at a 3% premium to the Canadian banks, still below the average premium of 14% since demutualization.

We find a strong negative correlation between lifeco forward P/Es and 10-year bond yields, but the relationship breaks down at yields below 5¼%, we believe due in part to spread compression on fixed rate products. Historical data show that lifeco valuations are capped at 14.5x forward earnings for 10-year yields below 5¼% – current 10-year rates are at 4.15% in Canada and 4.51% in the U.S. We see expansion of relative P/E from the current 103% towards 115%, and see movement to levels above 15x forward P/E with yields between 5.25% and 6.00%. Every 10% expansion in the lifeco-bank relative valuation from current levels adds 1.3 multiple points to the lifecos.

In our view, the dampening effect of persistently low interest rates (just now breaking higher) on lifeco product spreads and ROE, combined with the Canadian banks’ higher relative dividend yield and lower USD exposure has kept lifeco relative P/E valuation at bay. Looking forward, we envision stabilization of both interest rates and USD volatility as catalysts for recovery in EPS and ROE, leading to revaluation of the lifeco sector. This is already underway, with lifecos having moved to a 3% premium to the banks, up from par at October 2005 month-end.

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TD Firmly Rooted in Old America

TD's U.S. strategy focuses on historic New England with an eye on Manhattan

The Toronto Star, Stuart Laidlaw, 30 January 2006

New York —Toronto Dominion Bank's first foray into Manhattan retail banking is more of a happy accident than the kind of bold initiative on which its U.S. captain has built his name, but that could soon change.

The bank has an ideal location — in world-famous Rockefeller Center, a mecca for tourists and locals alike — but the cramped branch's rec-room-style wood panelling and brass trim suggest a bank that's not quite keeping up with its flashy and stylistic competitors across Midtown.

"Their branches are old, they're tired," Mark Fitzgibbon, a bank analyst with Sandler O'Neill & Partners says in an interview at his Manhattan office.

"They've got a lot of work to do fixing them up."

Bear Stearns & Co. Ltd. bank analyst Salvatore DiMartino works just around the corner from the Hudson United Bank that has become the latest in the TD family.

"It's a fixer-upper," he says, choosing his words carefully during an interview in his Madison Avenue office.

Maine-based TD Banknorth, 51 per cent owned by Toronto Dominion, picked up the branch and another one near Wall Street as part of a $1.9 billion (U.S.) deal to buy Hudson that closes tomorrow. Hudson got the branches in an earlier deal.

By purchasing Hudson, Banknorth, a top New England lender, enters greater New York for the first time, giving it access to a rich market of 19 million people.

"There's not 19 million people in the whole rest of our franchise," Banknorth chief executive Bill Ryan told the Toronto Star in an interview earlier this month.

"I just want to get my hands on that."

Based in Portland, Maine, Ryan is starting to feel hemmed in after more than two-dozen deals in 15 years across the U.S. Northeast, having achieved a 20 per cent share in several markets. As a result, Ryan says he may start facing resistance from regulators in New England if he keeps buying banks there.

"The feds wouldn't allow it," he said of the Federal Reserve Bank, which must approve U.S. bank mergers.

And so he looked south to Hudson and its 204 branches concentrated in New York's suburbs, much as parent TD looked south in 2004 when it paid $3.8 billion for a majority stake in Banknorth as a domestic ban on bank mergers hampered growth at home.

In Banknorth's case, moving south put it in the world's premier banking market, and raises the possibility that Ryan might be able to make his long hoped-for assault on Manhattan. In an interview with the Star, however, Ryan said any such move beyond his two small branches there is still a few years off.

For now, he said, the real prize is in the suburbs.

"Our strategy initially is to go into suburbs where everybody lives. We did this in Boston, and it worked very well."

While Banknorth has become a major player in the Boston banking market, including paying between $5 million and $6 million to rename the Boston Bruins' home arena TD Banknorth Garden, the bank has remained largely in the suburbs.

It's a strategy both Fitzgibbon and DiMartino, like most analysts, say has worked well for Banknorth, which attracted TD as a suitor two years ago because of its track record buying underperforming rural and suburban banks and turning them around.

"They like to be in rural areas and the suburbs where the competition is a little less intense," Fitzgibbon says.

But the realities of suburban New York banking may force Banknorth to consider breaking with past practice, making the move into the highly competitive Manhattan market sooner than might otherwise be the case.

DiMartino points to suburban rivals such as his own bank, North Fork Bank, which have moved aggressively into Manhattan to provide better service to commuter clients demanding a branch near their work, as well as their homes.

"They may find they have to get into Manhattan," DiMartino says of Banknorth.

But before he makes that kind of jump, Ryan says he wants to know if he can run the same sort of community bank he has in the suburbs, with long hours, branches open Saturday and Sunday and an emphasis on the consumer.

In the city, the native New Yorker says, banking is much more commercial.

"That market is different from everything else we are doing. If we have to change the way we do business, I don't think we should" increase the bank's presence in Manhattan, he says.

Such a move could effectively leave him running two banks — one suburban and one big city, he says.

"I don't think it will work."

That puts Banknorth at something of a crossroads — trying to decide whether to keep buying banks in New York suburbs, and even follow the I-95 Interstate south into new territory, or take the Holland Tunnel from New Jersey into Manhattan, following the pattern set by competitors such as North Fork.

"The way this really works in the future is probably to just get to know the New York bankers pretty well and see who is really a good operator and maybe at a later date try to buy that bank," says Ryan, who says he admires the success North Fork has had in his hometown market.

Based on Long Island with no branches in Manhattan until just a couple of years ago, North Fork now has more than 20 branches in the Big Apple, including one on Madison Avenue that DiMartino at Bear Stearns says he uses at least as much as his home branch in the Whitestone area of Queens.

Before that branch opened, DiMartino says banking was starting to get inconvenient.

"If I wanted to do my family's banking, it had to be on weekends," he says.

Now, he can just pop into the branch down the street on his lunch hour, leaving his weekends free. He says Hudson may face pressure to offer similar convenience.

"Retail banking is all about marketing," he says. "The products and services they offer are not all that different."

In such an environment, he says, little things such as branch location and convenience can make the difference in attracting new customers. He confesses, for example, that he chose his bank for one simple reason: drive-through tellers along his morning commute.

"It's the easiest thing, you don't have to get out of the car."

For Ryan, the city is still a prize worth pursuing, but not just yet. There are still a lot of suburban banks to be bought first, and a lot of learning to be done about banking in the New York area.

With the Hudson deal, besides the two Manhattan branches, Banknorth will also pick up several branches in Philadelphia, the fifth-largest city in the United States.

"Philly is really the first time we are going into a big city, so that experience will help us and tell us that we can gain experience quicker to go into the city based on our Philly experience," Ryan says.

"Or maybe our Philly experience will tell us to go slower."

With only 1 per cent of the market share in the greater New York area, Ryan says Banknorth still has plenty of room to grow in the region before it worries about where to go next.

"I think we should wear out our welcome in the Northeast and get everything done there and create a really solid company and then say okay, now let's continue to expand the geography," he says.

"This is our first acquisition in the metro New York area. It shouldn't be our last."

But he and his executives have also said that before moving into Manhattan, the bank could bypass the city and keep going south — to the suburbs of Baltimore and Washington, D.C., in the next few years.

Banknorth chief operating officer Peter Verrill told an analysts' conference in New York in late November that the bank could be in the suburbs of Washington, D.C., in five years and to Florida within a decade.

"We are looking at ranges a lot larger than we have in the past," he said.

In an interview, Ryan said such expansion would likely not be on his watch, which is expected to last only a few more years. For now, he says, he will focus on getting as many of those 19 million people living in and around New York coming to his bank.

"I am going to concentrate on the metro New York area, Massachusetts and Connecticut. Those are the areas where I think we have the best opportunity to buy other banks and expand our franchise."

His successor, however, can expect to find that the same pressures that New York analysts say might eventually push the bank into Manhattan — consumer demand for convenience — will one day make it necessary for Banknorth to move into the U.S. South, he says.

"There are so many people in the Northeast that live in Florida in the wintertime," Ryan says. "At some point, there will be so many of them that we'll just say, look, we've got to be there."

But he soon returns to thoughts of his home market, and all the suburban New York banks waiting to be bought, saying there's still much work to be done in the North.

"I don't want to pass up all the opportunities in banks we know, that we are familiar with, that we feel comfortable with, to do something in Florida."

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RBC Capital Research on TD Bank

Event

TD Ameritrade deal closes and Ameritrade reports Q1/F06 result.

Investment Opinion

• TD Vends Waterhouse (TWE) for 32.5% of Ameritrade (AMTD). Concurrent with AMTD’s Q1 report and board meeting, TD’s Waterhouse becomes part of TD Ameritrade. Over the course of the next three years, TD will now aim to pick up another 7.4% of AMTD outstanding in the open market to raise its stake to targeted 39.9%.

• EPS Accretion in Target Range Despite Buy-Up & USD Challenges. Management estimates EPS accretion should range from 4-7¢ for ’06 and from 19-25¢ in ’07 – the range reflects the low/high ownership post-close ‘buy-up’ outcomes. The original deal accretion targets, set June’05, were 8¢ in ’06, and 25¢ in ’07, both assumed full 39.9% ownership by TD and a stronger USD at 1.25. Since, revised higher synergy benefits should offset the lower USD and lower average expected ownership in the early stages of the deal. We do expect TD will aim for at least 37.5% ownership toward the end of 2006, to secure its 5th board seat and retain maximum management involvement at AMTD.

• AMTD’s Q1/F06 Meets Consensus Comfortably. AMTD reported US$0.21 EPS, which excl. 1¢ derivative adjustments, was US$0.22. AMTD also absorbed 3¢ in pre-deal closing costs, so the pre-closing underlying EPS was above the reported level. Q2/F06 momentum in early January is strong – trades/day are tracking up ~30% at both AMTD and TWE from the prior quarter average. Leverage to earnings at AMTD is ~1:1 with changes in trade volume.

• Synergy Target Boosted 17%. Management raised its target revenue synergy by 50% to US$300MM, adding 17% to total integration benefit expected. Since deal announcement date in June, 6 central bank rate hikes have improved the free balance revenue opportunity.

• Attractive Valuation. Our price target of $70 is set at 14x our $5.00 estimate, roughly the mid-point of our 2006 and 2007 estimates of $4.68 and $5.30, respectively. We have rolled forward our estimate period to help reflect a full year of earnings from each recent acquisition (AMTD and HU). Our premium target P/E reflects TD’s leading domestic franchise, management that we rate as peerless and the unique structure for growth in the U.S., yet TD trades at a sector-neutral 13x our ’06 estimates. Our investment thesis is that consensus estimates are low and overly discount (i) organic growth, which we believe should be above 10%, and (ii) EPS accretion on the Ameritrade and Hudson United transactions, particularly for 2007 where we are $0.30 or 4% above the 10% consensus growth rate.

TD Closes Ameritrade Deal Amid Strong Fundamentals, Though Challenges Persist

TD Ameritrade fundamentals are improving rapidly as (i) higher interest rates boost the free balances revenue (up 50% since the March quarter) and (ii) trades/day activity regains momentum. Since the deal was announced in June 2005, Ameritrade’s run-rate revenue is up 19%. Management has also increased their estimate for anticipated revenue synergy by 50% from US$100 million to $300 million.

Mitigating these improving fundamentals are two factors; (i) the falling USD, and; (ii) TD’s uncertain ownership level. On the USD, management is now using a 1.15 USD/CAD assumption in their outlook, below our 1.20 assumed, and the original deal level of 1.25.

On the Ameritrade ownership front, TD's financial ability to buy additional Ameritrade stock in the open market and achieve its 37.5% ownership threshold by year-end is strong. With over 10% Tier 1 capital, even post-closing the BNK-HU and AMTD deals, and with TD generating in excess of CAD$2 billion in free capital per year, we do not anticipate any financial constraint. Timing is uncertain though, as this will likely depend on market pricing. The good news is that AMTD is a very liquid stock, recently for example, trading 10 million shares/day. TD is aiming to acquire 24 million shares in the open market and would need an estimated ~CAD$550-600 million to get to 37.5%.

EPS Sensitivity to Varying AMTD Ownership. In 2006, roughly $0.03 of total $0.07-$0.08 modeled accretion is lost if ownership stays at 32.5%, 7.4% below the intended 39.9% final ownership outcome. We see a mid-range outcome as probable for ’06 average, but compared to the bank’s overall EPS, expected to run in the $4.60-4.70 range, variability around this number is just not an overly material issue.

In 2007, the 7% difference in ownership would generate a $0.06 EPS shortfall, from $0.25 to only $0.19. We view this latter ownership outcome at the low end of the range as unlikely, as we believe TD CEO Ed Clark is motivated to NOT lose TD its 5th board seat at Ameritrade, which would be triggered by a less-than-37.5% ownership level.

EPS Sensitivity to Trade Activity. A 30% lift in trade activity, given the industry’s and AMTD’s huge fixed cost leverage, would generate a similar 33% improvement in EPS, as we infer from management’s published sensitivity analysis, the latter well-supported by AMTD’s history as well as internal modeling capability. This would flow through to the $0.25 accretion bumping it to ~$0.33 (or works $0.19 EPS accretion, at lower ownership assumption, back up to $0.25).

Investment Thesis. We continue to believe the interesting aspect of the TD story lies in 2007, where our cash EPS estimate is $0.25 or ~5% above consensus.

In 2007, we do factor $0.25 EPS accretion from the Ameritrade position, assuming ~37.5% ownership. We also add another $0.10-0.12 from the Banknorth acquisition of Hudson United. Backing a range of $0.31 to $0.37 EPS accretion numbers out of consensus EPS, we see the consensus using 2-4% organic EPS growth compared to our 10% assumption. In our view, the difference is reflected in our 5% higher EPS estimate.

In summary, although the timing on realization of both the AMTD and HU deals has been pushed out into 2007, the fundamentals, particularly for AMTD, keep getting better. Trading at a sector-neutral multiple, we believe these circumstances constitute a good buying opportunity.

Hudson United Acquisition Closing

On January 11, 2006, shareholders of Banknorth and Hudson United (HU) approved the transaction with 99% and 98%, respectively, in favour. The deal has cleared all regulatory hurdles and is now slated for closing on January 31, 2006, with full systems conversion in May 2006. The deal was originally expected to be US$0.02 dilutive to EPS at the Banknorth consolidated level, but with the lag between closing and conversion, management now expects a further US$0.02 dilution for a total of US$0.04/share this year. At the TD level, the BNK-HU deal should be neutral to cash EPS in 2006, and $0.12 accretive in 2007.

Earnings Outlook

Our EPS estimates factor the following segmented earnings growth assumptions: (i) P&C at 15% in 2006, and 12% in 2007 (P&C earnings grew by 16-18% in each of the last three years); (ii) wholesale at 5% in each of 2006 and 2007 (in line with management’s aspirations, but in our view, somewhat beatable); (iii) wealth (excludes TD Ameritrade) at 20% in 2006, 15% in 2007 (earnings for this business includes retail mutual funds and brokerage, growing contribution at 20-30% in the last several quarters). For Banknorth, we are incorporating the estimates of our U.S. Bank Team (James Ackor) – factoring additive earnings from the Hudson United transaction, and for Ameritrade, roughly using mid-points of management projections.

Valuation

Our price target of $70 is set at 14x our $5.00 estimate, roughly the mid-point of our 2006 and 2007 estimates of $4.68 and $5.30, respectively. We have rolled forward our estimate period to help reflect a full year of earnings from each recent acquisition (AMTD and HU). Our premium target P/E reflects TD’s leading domestic franchise, management that we rate as peerless and the unique structure for growth in the U.S., yet TD trades at a sector-neutral 13x our ’06 estimates. Our investment thesis is that consensus estimates are low and overly discount (i) organic growth, which we believe should be above 10%, and (ii) EPS accretion on the Ameritrade and Hudson United transactions, particularly for 2007 where we are $0.30 or 4% above the 10% consensus growth rate. Risks to our outlook include (i) further USD weakness and (ii) deal integration disappointment.

Price Target Impediments

The primary risks to our price target are integration foul-ups and/or follow-on deal reinvestment risk. Potential for a unique earnings shortfall as distinct from normal systemic sector risk centres on (i) the BNK-Hudson United integration and (ii) TD Ameritrade deal risk. In our view, maintaining continuity of the BNK management team is also paramount to successful U.S. expansion, and this team has been together for fifteen years now. For its part, TD management has an excellent track record for major acquisitions, both with TD Canada Trust and previous trust deals, as well as numerous TD Waterhouse acquisitions (all cross-border).

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Scotia Capital Research on TD Bank

TD Bank • Rating: 1-Sector Outperform • Risk Ranking: Low
Target 1-Yr: $75.00 ROR 1-Yr: 25.7% • 2-Yr: $85.00 2-Yr: 44.9%
Valuation: 16.3x 2006 cash earnings estimate
Est. NTM Div. $1.74 • Div. (Current) $1.68

Event

• Toronto-Dominion Bank (TD) announced the completion of its sale of TD Waterhouse USA to Ameritrade (AMTD) and the acquisition of 100% of AMTD's Canadian brokerage operations.
• TD will realize a gain on sale of approximately C$1.5 billion or C$2.11 per share in Q1 2006.
• TD Ameritrade has increased the expected gross synergies by US$100 million to US$678 million due to higher expected revenue synergies.

What It Means

• We continue to view the transaction as extremely positive as TD Ameritrade enhances its strategic positioning in the discount brokerage industry in the U.S., creates substantial synergies, is accretive to earnings and provides a strong platform for growth.
• TD Ameritrade is expected to be accretive to TD earnings by C$0.04 per share to C$0.07 per share in 2006 and by C$0.19 per share to C$0.25 per share in 2007.
• Maintain 1-Sector Outperform on TD based on strong Canadian retail and wealth management platform, Ameritrade value-add, high ROE and capital, and discount to bank P/E multiple.

TD Ameritrade Merger Complete

TD Bank to Realize Gain on Transaction of C$1.5 Billion in Q1/06

• TD Bank (TD) announced the completion of its sale of TD Waterhouse USA (TDW) to Ameritrade (AMTD) and the acquisition of 100% of AMTD's Canadian brokerage operations.
• TD currently owns 32.5% of the new company, TD Ameritrade, and will realize a gain of C$1.5 billion or C$2.11 per share in Q1 2006.
• Ameritrade paid a US$6 per share special cash dividend to its shareholders prior to close of the TD Ameritrade transaction.

Estimated Gross Synergies at US$678 Million

• TD Ameritrade has increased the expected gross synergies by US$100 million to US$678 million due to higher expected revenue synergies.
• The US$678 million in synergies is comprised of US$300 million in revenue enhancements, and US$378 million from reduced fixed costs and advertising expenses (eliminating 59% of TD Waterhouse expenses). TD Ameritrade expects to reduce its fixed costs to US$333 million from the current level of US$661 million by the quarter end September 2007.
• TD Ameritrade expects the acquisition to be accretive within twelve months and to realize the synergies within eighteen months. Assuming TD Ameritrade will achieve full benefit of the expected synergies, the new company would have annual revenues in excess of US$2 billion and pre-tax margins of approximately 56% by fiscal year 2007.

TD Current Ownership at 32.5% - 5 Board Seats

• TD currently owns 32.5% of TD Ameritrade and has five seats on the Board of Directors of the new company, with Ed Clark as Vice Chairman of the Board. Unless TD increases its ownership to 37.5% within one year, they would lose one board seat. TD has the option of increasing its ownership of TD Ameritrade to 39.9%. TD's ownership will be capped at 39.9% for three years and at 45% from years four to ten.

TD Ameritrade Earnings Guidance for 2006 and 2007

• TD Ameritrade provided new EPS guidance for the next two fiscal years. For 2006, EPS estimates range from US$0.82 per share to US$1.00 per share. EPS estimates for 2007 range from US$1.03 per share to US$1.27 per share, respectively. IBES mean estimates currently are US$0.92 per share for 2006 and US$1.26 per share for 2007 (up from previous 2007 mean estimate of US$1.17 per share).

Earnings Accretion to TD Bank

• Earnings accretion for TD is estimated at C$0.04 per share in 2006 and C$0.19 per share in 2007, based on TD's 32.5% ownership of TD Ameritrade. If TD increases its ownership to 39.9%, expected earnings accretion would increase to C$0.07 per share in 2006 and C$0.25 per share in 2007.
• Our 2006 and 2007 estimates for TD Bank are unchanged at C$4.60 per share and C$5.10 per share, respectively.
• We are maintaining a conservative earnings accretion estimate for TD at C$0.04 per share in 2006 and C$0.17 per share in 2007 based on a 32.5% ownership and a Canadian dollar at US$0.90 in 2007. We have built in an $0.08 per share cushion that could be realized with TD's increased ownership to 39.9%.

Maintain 1-Sector Outperform on TD Bank

• The TD Ameritrade merger brings together two highly complementary businesses. Ameritrade's strength lies in its on-line brokerage business catering mainly to the active trader while TD Waterhouse U.S.A. is more focused on providing investment advice and solutions to longer term investors through its branches and network of independent investment advisors.
• We continue to view the transaction as extremely positive as TD Ameritrade enhances its strategic positioning in the discount brokerage industry in the U.S., creates substantial synergies, is accretive to earnings and provides a strong platform for growth.
• We believe that TD Ameritrade, in addition to TD Banknorth's personal and commercial banking operations, will strengthen TD's brand name in the United States. Furthermore, the TD Ameritrade and Hudson United transactions will increase TD's proforma net tangible common equity ratio to 8.5% (Q4/05 ratio was 7.4%).
• Maintain 1-Sector Outperform on TD bank based on strong Canadian retail and wealth management platform, Ameritrade value-add, high ROE and capital, and discount to bank P/E multiple.

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FBR's Comment on TD Ameritrade

Friedman Billings Ramsey, Michael Parker & Matt J. Snowling, CFA, CPA, 27 January 2006

WE ARE DOWNGRADING TD Ameritrade to Market Perform from Outperform. We believe much of the near-term upside is now priced in the stock.

We are lowering our 12-month price target by $1 to $21, or 16 times our revised fiscal 2007 estimate.

[Ameritrade Holding closed the acquisition of Toronto Dominion's TD Waterhouse unit on Wednesday, forming TD Ameritrade.]

Along with the release of fiscal first-quarter operating results this morning, TD Ameritrade provided guidance for 2007 and details into the upcoming integration. While the company increased their revenue expectations, the high end of guidance came in below our expectations.

Ameritrade reported operating earnings of 22 cents per share for the quarter, in line with consensus and a penny shy of our estimate, excluding a one-time charge of one cent associated with Knight Capital Group forward contracts. Results included $18 million of nonrecurring charges related to the deal.

Management increased revenue synergies by $100 million to $300 million, yet the pick up is mainly attributable to the passive catalyst of favorable short-term rates. Management expects to realize the remaining $378 million of costs over the next 18 months, with much of that back-end weighted.

Ameritrade updated guidance for fiscal 2006 to earnings per share in the range from 82 cents to $1.00, and expects fiscal 2007 earnings in the range from $1.03 to $1.27.

To reflect the delay in synergy realization and further dilution of options from the special dividend, we are lowering our fiscal 2007 estimate by five cents to $1.30.

Additionally, while management tends to err on the conservative side, the company faces a challenging integration, possible pricing pressure on commissions, and fewer benefits from interest rates over the next several quarters.

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Prem Watsa & Fairfax Financial

The Globe and Mail, John Daly, 26 January 2006

In this war, there are no prisoners, no truces, no neutral parties. Few companies inspire deeper loyalty—and more bitter vitriol—than Fairfax Financial Holdings Inc., the largest Canadian-based property and casualty (P&C) insurance company. One camp, including a handful of shareholders who control the majority of Fairfax's shares, sees company founder, chairman and CEO Prem Watsa as a Canadian version of investing god Warren Buffett. But for his critics, including the short sellers who've been locked in trench warfare with Fairfax for years, Watsa is far short of a god. To them, he can do nothing right.

The battle has been largely waged out of the public eye because Watsa has always shunned media interviews, preferring to let Fairfax's financial results do the talking. Until now, that is. Why the change of heart? Jovial and relaxed as he sits in Fairfax's boardroom in downtown Toronto, Watsa tries to shrug off the question: "Once in 20 years. Hey, you just got lucky."

The reality, however, is that Watsa has some explaining to do. Company shares, which traded on the Toronto Stock Exchange as low as $3 in 1985, soared to peaks of $600 in 1998 and 1999. Since then, their value has deteriorated to around $175 lately as Fairfax has been battered on virtually all sides—by the shorts, by staggering claims costs from 9/11 and a wave of natural disasters, by volatile North American stock markets and by lingering hangovers from the company's ambitious acquisitions in the late 1990s.

There's more. The shorts have been almost gleeful lately as Fairfax has been swept up in the U.S. imbroglio over complex arrangements known as "finite reinsurance." Last March, the scandal felled Hank Greenberg, the chairman and CEO of American International Group Inc. (AIG), the world's largest insurance company. Now Fairfax is being probed by Washington's Securities and Exchange Commission (SEC) and investigators with the U.S. Justice Department.

Watsa insists that Fairfax's financial dealings have always been impeccably honest and fully disclosed in its annual reports and regulatory filings. Indeed, dozens of companies are also being probed in the wake of the AIG storm—Fairfax may just have been caught up in a police sweep.

Still, given Watsa's background, it's a strange turn of fate that he would end up being automatically associated in investors' and analysts' minds with the fallen titan of the North American insurance business. But then, the previous twinning—with Buffett—was pretty unlikely too.

Watsa was born in 1950 in Hyderabad, India's fifth-largest city. The place is known for its mosques and temples, but Watsa was raised an Anglican. In a cheery and nasal voice, with inflections that are part East Indian, part anglophile and part Bay Street jock talk, Watsa speaks warmly about his religious feelings. "In my story, there are tons of fortunate instances," he says. "I happen to have a spiritual faith, so I feel I'm blessed. Very hugely blessed."

Watsa's father, orphaned as a toddler, was a self-made man who became principal of a school that Watsa describes as "the equivalent of Upper Canada College." Watsa was good at chemistry, "so my dad said I should do engineering." He graduated from the Indian Institute of Technology in 1972 with a bachelor's degree in chemical engineering. He met his wife-to-be, Nalini, while he was there, but he didn't actually like his courses much. Business was far more intriguing, so he enrolled at the Indian Institute of Management.

But another paternal intervention precluded his completion of the program. Watsa's older brother, David, had settled in London, Ontario. Their father figured prospects were limited in India, so he told Prem that he, too, should go to Canada. Watsa arrived in London in 1972 and enrolled in the MBA program at the city's University of Western Ontario. Watsa recalls joking with the dean of UWO's Richard Ivey School of Business in 1999, before accepting an award for business leadership: "I didn't come here because the school was good. I came here because this was the only place I could afford to go."

Watsa rented a room in his brother's house, and helped put himself through school by selling air conditioners and furnaces door to door. When he went looking for work after graduating in 1974, Watsa experienced one of those "fortunate instances." Three other candidates didn't show up for their interviews for an investment analyst job at Confederation Life. Watsa got the nod. At Confed, Watsa says he had his "road to Damascus moment"—his first boss, John Watson, handed him Benjamin Graham's The Intelligent Investor, a classic of value investing, the doctrine that urges investors to look for signs of underlying value in companies, rather than chasing after rapid growth.

Confed would eventually collapse because of disastrous speculation in real estate, and was liquidated in 1994. But in the 1970s, it was a solid insurer. Soon after arriving, Watsa was managing a portfolio of Canadian stocks. His value-investing discipline was put to the test during the oil and gas boom in the late 1970s and early 1980s. The value principle said: Stay out. "You had Dome Petroleum and all sorts of oil speculations, perhaps not unlike what we have today," says Watsa. "So we underperformed for about 18 months to two years." But then the energy bubble burst and Dome went bust.

At Confed, Watsa began his practice of collecting investing colleagues: Five Confed alumni are still with him today. In 1983, Watsa moved to Gardiner Watson, a Toronto boutique investment firm. There he met one of the most improbable investment managers ever, and one of the most talented: Francis Chou. At the time, Chou, another immigrant from India, was a solder-wielding Bell Canada technician who'd earned his Chartered Financial Analyst designation in his spare time. He was introduced to Watsa by one of the firm's branch managers. "I was never more impressed in a 45-minute meeting than I was with Francis," says Watsa.

Chou is now a vice-president at Fairfax. However, he's best known to investors for his own line of Chou Funds, which Watsa helped him launch in 1984. In 2004, Chou won a Canadian Investment Award as mutual fund manager of the decade. To preclude the possibility of conflicts of interest, Chou collects no salary at Fairfax, but he still has company shares he bought in the early days at around $3.25 apiece.

Soon after meeting Chou in 1984, Watsa left Gardiner Watson to found his own pension-fund management firm, Hamblin Watsa Investment Counsel, along with a former boss from Confed, Tony Hamblin, and a handful of others. They began with just $30,000 of their own money. It took Watsa almost a year to get their first client, Pratt & Whitney.

They quickly landed nine more, and Hamblin Watsa went on to become a permanent part of the Fairfax group. Watsa might have happily remained a pension manager but for Chou. He had planted a key concept in Watsa's head: that of float. "Francis tells me: Do you know how [Warren Buffett's] Berkshire Hathaway made money? And Henry Singleton's Teledyne? And Larry Tisch?" Those value-investing legends ran companies that generated lots of cash every year—pools of cash that have to be invested. If invested wisely, that investment portfolio can generate huge profits.

To that end, Buffett had started acquiring P&C insurers in the 1960s. In 1980, Watsa began making the pilgrimage to Berkshire's annual meeting in Omaha, where 20,000 acolytes now gather each year in search of homespun wisdom from Buffett.

In 1985, Watsa found a P&C of his own to buy: Markel Financial Holdings, a Canadian-based specialist in trucking insurance. Controlled by the Virginia-based Markel family, it was virtually bankrupt. But Watsa figured it just needed a capital injection. He hit it off with Steven Markel, who is still a friend. In 1987, Watsa reorganized the company and renamed it Fairfax, short for fair, friendly acquisitions.

Although Watsa says he "didn't have a clue" at the start how huge Fairfax would get, the Markel acquisition set a pattern for astonishing expansion in the late 1980s and early 1990s. Fairfax bought up beat-up P&Cs on the cheap, and turned them around by improving their core operations and by generating more profits from their investment portfolio. By 1993, Fairfax had over $1 billion in assets.

Watsa will also tell you—and tell you again and again—that as Fairfax has looked for opportunities from year to year, it has remained true to a set of 15 "guiding principles" listed in its annual report. The most important of these is to build shareholder value over the long term. There is even a specific target: a 15% annual return on shareholders' equity.

To stay focused on the long term, Fairfax says it will "always be a very small holding company and not an operating company." There are just 30 employees at head office in Toronto, although the operating divisions employ almost 8,000.

Watsa says that maintaining focus also requires that one person has to have a controlling interest—namely Prem Watsa. His 10-for-1 multiple voting shares give him just over 50% ownership. "I put the group together," he says, "so I had control from that day onwards." And, at 55, he has no plans to give it up or retire any time soon. "I love what I do," he says. "I'm planning to be there for another 10 years at least. Another 20, to be exact."

Of course, multiple voting shares start red flags waving in the good-governance camp, as does combining the chairman and CEO's office. Ditto for boards that are small and populated partly by insiders—like Fairfax's, which consists of just Watsa and five other directors, one being his friend Robbert Hartog. But some of Fairfax's major shareholders prefer a company controlled by a strong guiding force. "I love Frank Stronach. I know he pays himself too much. And l love Gerry Schwartz. These guys are business guys," says Wade Burton, a portfolio manager at Peter Cundill & Associates. "Prem made this thing survive."

Companies run in imperial fashion can work fine, of course. Unless the leader bites off more than he can chew.

In 1998, it looked like Watsa and Fairfax could do no wrong. The company's revenues had tripled in the previous four years alone, and the share price had soared, even after Fairfax issued millions of new shares at prices as high as $500. Watsa had steadfastly maintained his media blackout, which in some eyes made him principled, and which added to his mystique. Chief financial officer Greg Taylor, who has been with Fairfax since 2002, was working for Merrill Lynch Canada during those heady days. "I remember reading the brokerage reports on [Fairfax], and the targets were $800 a share," he says.

Then came two huge U.S. acquisitions that again more than doubled the size of Fairfax. The first was Crum & Forster, a poorly performing division of Xerox that Fairfax bought for $565 million (U.S.) in August, 1998. The second was TIG Holdings of New York, which Fairfax bought in April, 1999, for $847 million (U.S.).

Both acquisitions soon went off the rails. As it turned out, 1997 proved to be the beginning of a four-year stretch of so-called soft pricing in the P&C and reinsurance business. The industry tends to go in cycles: During the soft portion, companies compete hard, often by taking on riskier business. But then they're jolted back to reality by a disaster, and premium rates harden—they shoot up.

So long as the insurer survives the claims hit. Like many other P&Cs, Fairfax staggered after the 9/11 catastrophe. The company posted its first annual loss ever: $346 million. The following year, it had to put much of TIG into "runoff." In this industry practice, a company or unit stops writing new business and, it's hoped, has enough reserves left to pay out any remaining claims.

Crum & Forster's troubles were exposed by its combined ratio, the standard measure of an insurer's operating performance. Basically, the combined ratio is the claims paid during the year, net of reinsurance, plus the company's operating expenses, including commissions and administrative costs, all divided by the premium income the company earns that year. If the ratio is greater than 100%, the company is losing money on operations. In 2001, Crum & Forster's combined ratio shot up to 131%, helping to push the average ratio for Fairfax as a whole to 121%. Matters improved in 2002, however, with Crum & Forster's combined ratio declining to 108% and Fairfax as a whole working its way down to 102%.

But Fairfax was soon hit from other directions. In December, 2002, the company listed its shares on the New York Stock Exchange. That made sense for a company whose business was increasingly U.S.-based and that needed access to capital from American investors. (In 2003, Fairfax also switched to reporting its results in U.S. dollars.) But the NYSE listing also brought increased scrutiny from merciless American analysts and short sellers. Some of them immediately jumped on Fairfax.

In January, 2003, the Memphis-based brokerage Morgan Keegan & Co. Inc. released a scathing report that circulated quickly on investor websites. It argued that Fairfax's reserves against future insurance claims were deficient by $5 billion (U.S.). The NYSE was closed for Martin Luther King Day when this broadside was fired, but in Toronto, Fairfax shares plunged to $57 within three hours, a 40% drop. Watsa quickly released a statement refuting the report; the shares rebounded and closed at $85.

Two weeks later, Morgan Keegan lowered its estimate of Fairfax's reserve deficiency to $3 billion (U.S.). But the company still disputed that figure, and went on what, for Fairfax, was a PR offensive: Watsa actually talked to Forbes magazine, and committed himself to answering questions from analysts in quarterly conference calls.

In its rebuttal volley, Fairfax charged that short sellers were trying to manipulate its stock. Short sellers attempt to profit from share price declines by "borrowing" stock. The lender may be a brokerage or a shareholder, and typically takes a commission. The short sells the stock, hoping a wave of selling will drive down the price so he can purchase shares later at lower prices. The short returns the shares to the lender once he's taken a profit. Naturally, the shorts try hard to talk the stock price down. Morgan Keegan analyst John Gwynn, one of the authors of the damning report, responded angrily to Fairfax's accusation. "We're not in cahoots with the shorts," he said.

Analysts tend to be just as sharply divided on Fairfax as long and short investors are. No surprise, then, that the company has had more spats with analysts and bond-rating agencies over the past three years. In March, 2003, Fitch Ratings downgraded some of Fairfax's debt to junk status. Fairfax cut off Fitch from the standard private analyst briefings given by Fairfax executives. Throughout 2003 and 2004, Fitch argued that Fairfax was perilously short of cash at the holding-company level. Last September, however, Fitch took Fairfax's ratings off negative credit watch, noting that cash pressures had eased, although Fairfax's $2.2 billion (U.S.) in long-term debt was still high in relation to its earnings.

The shorts, meanwhile, haven't given an inch. Soon after Fairfax debuted on the NYSE, the total number of shares sold short swelled to two million, and it's stayed around there ever since. "We think this is a zero," veteran New York short seller Jim Chanos, President of Kynikos Associates, declared of Fairfax last summer. Other short sellers conform to the more shadowy stereotype, badmouthing the company behind the scenes. "I don't exist," says one, who nonetheless asserts that Fairfax is a huge debacle.

Fairfax has about 18 million shares outstanding, but long-term allies, including firms controlled by value-investing legends Mason Hawkins of Memphis and Peter Cundill of Vancouver, own the majority of them. Even these stalwarts are getting frustrated by the relentless attacks from the shorts. "It bothers me quite huge," says Wade Burton of Peter Cundill & Associates. A few years ago, Burton didn't mind if the shorts drove down Fairfax's price temporarily—it gave him a chance to buy more of the stock cheaply. "Now I'm prepared for that opportunity to go away," he says.

The so-called public float of shares is thin. Fairfax's allies argue that the thin float makes it easier for shorts to move the share price—more than $10 in a day on occasion. But the shorts retort that it's tough to find shares to borrow, which means it can cost them the equivalent of 40% interest.

As technical as the issues around Fairfax are, they boil down to one big question: Is the company in better or worse shape now than it was three years ago, when it was lambasted by Morgan Keegan?

Watsa likes to point to combined ratios as signs of improved performance. Take Northbridge Financial Inc., Canada's largest commercial P&C insurer. Its combined ratio was 88% for 2004. OdysseyRe, Fairfax's global reinsurance arm, came in at 98%. Fairfax as a whole averaged 98% as well. Of course, the combined ratio doesn't reflect any earnings on Fairfax's investment portfolio. The past five years have been "tough, tough, tough" for operations, Watsa concedes. "But peel the onion: Crum & Forster is looking good, OdysseyRe is looking good, Northbridge is looking good."

Morgan Keegan's Gwynn and other critics argue that many of the operational problems haven't been resolved at all. Gwynn says Watsa was hell-bent on acquiring more float in the late 1990s, and he didn't look closely enough at the problems on the books of Crum & Forster and TIG. Since then, says Gwynn, Fairfax has merely dumped much of TIG's problems into its sizable runoff operations. "The stabilization never occurred," he says. "Once you have a crappy book of business in the property-casualty business, it's a crappy book of business that you own forever." (That's a positively polite criticism compared to what gets thrown Fairfax's way in on-line investor forums such as Yahoo Finance, stocklemon and onelimestreet.)

Watsa rejects the charge that he bought indiscriminately to accumulate investable assets. He says he drove hard bargains by negotiating directly with the vendors, rather than participating in inflation-prone auctions. And he points out that he paid substantially less than book value. The goal in all of Fairfax's acquisitions, he adds, is to generate long-term returns from investments and operations. "The combination of those two has made money for our shareholders," he says.

Indeed: Despite the recent reversals, Fairfax's 20-year record is formidable: from $17 million (Canadian) in annual revenue in 1985 to $5.8 billion (U.S.) in 2004 (making Fairfax the 31st-largest publicly traded North American insurer). Average annual return on shareholders' equity has been about 15%.

Still, runoff operations remain a nagging cash drain on Fairfax. The company has been anticipating that it would lose about $100 million (U.S.) a year for several years, excluding unusual items. But there have been a lot of those items lately. In 2004, run-off losses totalled $194 million (U.S.). And in the third quarter of last year alone, they hit $181 million (U.S.). "A runoff book of property-casualty insurance is almost, by definition, an extremely difficult proposition. You have no cash inflow and all cash outflows—claims," says Gwynn. "That's usually what catches with an under-reserved company. That's what I think is gonna happen here."

Watsa admits that putting much of TIG's operations into runoff "was a tough decision for us." But he says part of the reason for the big cash drain since then is that the runoff group is settling remaining claims quickly and efficiently. "When we put it in runoff, [there were] 55,000 claims," says Watsa. "Today, it's 15,000. It's a dull roar. It's almost over."

In the third quarter of last year, however, Fairfax was slammed by Hurricanes Katrina and Rita, and it posted a $220-million (U.S.) quarterly loss. But the impact of the hurricanes could be short-lived. And with that factor excluded, Fairfax says it would have made $91 million (U.S.). The hurricanes have also prompted big regional price increases, with some premium rates tripling.

To get through the tough period, Fairfax has also raised cash by selling new shares, $300 million (U.S.) worth in December, 2004, and the same amount last October. That Fairfax needed the money showed it's been under strain. That it was able to raise it, particularly right after last year's hurricanes, showed it still has support in the market. "The third quarter served as a real-world 'field test' of the financial strength of Fairfax, a test the company comfortably passed," says Mark Dwelle, an equity analyst with Ferris, Baker Watts, Inc., a Washington, D.C.-based investment bank that has long rated Fairfax a "buy."

Well, yes, it passed, but not without a lot of bobbing and weaving. The major buyers of those Fairfax issues were firms controlled by Hawkins and Cundill, and Steve Markel's Markel Corp., which bought $100 million (U.S.) worth in December 2004. As with several other issues in recent years, Fairfax also had to sell shares at less than book value. Yet P&Cs trade on average at a premium to book value. What's more, selling for less violates one of Warren Buffett's guiding principles: "We will issue common stock only when we receive as much in business value as we give."

The runoffs, the hurricanes, the money-raising moves—presumably, all of these have been digested by the market. So, one answer to the question of whether Fairfax is better off than in 2003 is simply the price of its shares: At around $175 on the TSX lately, the price is a far cry from the glory days, though it's more than double the $85 close on Martin Luther King Day in January, 2003. But there is one factor on which the jury is definitely still out: the complicated, topsy-turvy world of finite reinsurance.

Ever since Morgan Keegan's report in January, 2003, John Gwynn and other critical analysts have honed in on the second-largest single asset on Fairfax's balance sheet, an item called amounts "recoverable from reinsurer." That is money Fairfax expects to collect from reinsurers. As of last September 30, those recoverables were $7.6 billion (U.S.). By industry standards, that's very high—28% of Fairfax's assets, and more than double Fairfax's shareholders' equity of $3 billion (U.S.).

It's routine for P&Cs to buy reinsurance from other companies. But Gwynn and other critical analysts have long argued that Fairfax's recoverables are "soft" assets. Some of the reinsurers may be troubled, they argue, and may not be willing or able to pay the full amounts.

Regulators can also be suspicious of "finite re." A highly simplified example shows why. Suppose that an insurer is worried that it may have to pay out more in claims over the next several years than it had anticipated because courts are awarding higher settlements in, say, environmental cases. The insurer estimates the amount will be $1 billion. If it chooses to keep the risk itself, it must set aside $1 billion in reserves now. Instead, however, it could purchase a limited, or finite, amount of reinsurance (rather than unlimited protection). The reinsurer is then responsible for up to $1 billion worth of claims. The insurer agrees to pay a premium of, say, $520 million for the coverage.

If the reinsurer doesn't have to pay out the $1 billion within 10 years, for instance, and earns more than 7% by investing the money, it will earn a profit. Meanwhile, the insurer gets benefits on its financial statements. Yes, the insurer's revenue drops by $520 million, which, technically, is premium revenue "ceded" to the reinsurer. But the insurer is off the hook for $1 billion in claims, so its net income for the year is $480 million more than it would have been. The capital on its balance sheet is also $480 million more.

Two other wrinkles: Suppose the events covered by the insurer's original policies have already happened but it appears the claims costs may yet escalate. (This is the case with decades-old asbestos claims, for example.) And suppose the insurer hangs on to the $520 million, and instead guarantees the reinsurer a 7% return.

Such arrangements are controversial. Unless there's a transfer of a meaningful amount of risk to the reinsurer, the arrangement looks an awful lot like a loan rather than an asset, albeit one that improves the insurer's balance sheet immediately. Gwynn says finite re is like "cocaine"—it can provide a quick fix. In Canada and the United States, the regulators' test for legitimate risk transfer is a greater-than-10% chance of a greater-than-10% loss for the insurer.

Although the above example is simplified, it has similarities to a controversial arrangement Fairfax made in 1999, after it bought TIG. Fairfax turned around and bought $1 billion (U.S.) worth of coverage from a subsidiary of Swiss Re of Zurich. The coverage was against "adverse development" on all of Fairfax's subsidiary business written before 1999, including TIG.

Watsa and Fairfax CFO Taylor say the Swiss Re "cover" and their other finite reinsurance arrangements are entirely legitimate risk transfers, and in keeping with one of Fairfax's fundamental guiding principles: "We always look at opportunities but emphasize downside protection and look for ways to minimize loss of capital."

As for the SEC and U.S. Justice Department investigations into finite reinsurance, Watsa and Taylor can't comment on any specifics. But they point out that Fairfax's numbers are reviewed by its own actuaries and accountants, as well as by external auditors, ratings agencies and government regulators.

Ground zero in the industry investigation is AIG. In November, 2004, AIG agreed to pay a $126-million (U.S.) fine to settle an allegation that, as a reinsurer, it helped Pittsburgh-based PNC Financial Services polish its books. The firing of company founder Hank Greenberg came four months later, after the company's board reviewed a suspicious 2000 transaction with Warren Buffett's General Re Corp.

New York State Attorney General Eliot Spitzer then filed a civil suit accusing Greenberg of using fraudulent finite reinsurance contracts to understate AIG's liabilities and overstate its profits. By industry standards, Fairfax is a relatively heavy user of finite re, so it was a logical target in the U.S. regulators' sweeping investigations of so-called non-traditional insurance and reinsurance products. Thus Fairfax's announcement last fall that it was also being probed by the SEC and officials with the U.S. Justice Department.

The adverse publicity from the AIG case is a danger for Fairfax. At the end of March, 2005, Merrill Lynch Canada analyst Brad Smith downgraded Fairfax's shares to a "sell" rating—and caused the share price to dip by more than 10% within a week—by saying the negative stories and the investigations may prompt some reinsurers to get out of the business. If that happens, Fairfax will be squeezed.

Any take on Fairfax has to consider Watsa's personality as well as the numbers that surrounds him. Even some of his critics concede it would be out of character for him to misuse finite reinsurance. He's a straight arrow who is dedicated to Fairfax. "More than 99%" of his net worth is tied up in the company, he says, and he collects a meagre salary by CEO standards: $600,000. He and Nalini do live in Toronto's tony Rosedale neighbourhood, but theirs is a relatively modest house.

The couple has three children, all in their 20s: Ben, an investment banker in New York; Christine, an investment analyst; and Stephanie, who recently earned a BA in business and marketing. "First of all, I told them, 'You can't get into Fairfax,'" Watsa says with a smile. "'You'd never get a sense of accomplishment. They'd always say it was your dad.'"

Apart from family, the biggest influence in Watsa's life, as both a friend and business adviser, is mutual fund legend Sir John Templeton, now 93 years old. Watsa keeps a bust of Templeton in Fairfax's boardroom, and visits him at least once a year at his home in the Bahamas. "What I always liked about him was that he had a spiritual bent to his personality, and to his work," says Watsa. "He's a wonderful guy. Just a really wise man."

In his spare time, Watsa has helped Toronto's St. Paul's Anglican Church and the Hospital for Sick Children greatly in recent years by running their investment committees. He took up golf about 10 years ago, but has not joined any of the city's fusty established clubs, opting instead for the Devil's Pulpit in Caledon, where he also has a country home.

Of course, whether or not the head guy's a straight arrow, it would be irresponsible to speculate on the guilt or innocence of a company that is merely under investigation by regulators. But analysts do have to construct risk scenarios. One of them is Mark Dwelle of Ferris, Baker Watts. U.S. regulators often file civil suits in complex financial cases, rather than serving harder-to-prove criminal charges. "This seems to be the way these things have been resolved," says Dwelle. "The litigator says, 'We're gonna look at it like this, and if you want to go to trial to try to defend this arcane, esoteric product, you can do that. Or you can settle for X.' "

"Everybody chooses to settle for X," says Dwelle.

Just about the only thing that Fairfax's supporters and critics agree on are the investing abilities of Watsa and his team. The return on Fairfax's portfolio often bounces up and down from year to year. But the yearly average from 1985 to 2004 was a healthy 9.5%.

Yet Watsa's ultra-cautious value investing discipline has held back Fairfax's returns lately. Even when stocks are at their most alluring, Fairfax never puts more than 25% of its money in equities, and lately it's been a lot less. The company had actually started reducing the percentage of stocks in its portfolio by 1995, even though the Dow Jones Industrial Average would go on to more than double its value, before peaking in early 2000. By then, Watsa was sure the markets had gone mad—how else to explain Yahoo trading at 1,425 times earnings in 1999?

So Fairfax has kept most of its portfolio in bonds. But analysts and economists say the upside on bonds now looks limited. Meanwhile, the NYSE and the TSX have climbed back to near-record or record heights. No matter to Watsa: Last September 30, the end of Fairfax's third quarter, its portfolio consisted of $4.4 billion (U.S.) in cash, $8.3 billion (U.S.) in bonds and preferred shares, and just $2.6 billion worth of equities. As a result, Fairfax earned 9.1% over the preceding 12 months, including paper gains and losses.

As with insurance operations, Watsa says one of Fairfax's main objectives with investments is protecting itself from catastrophes. "If there's a big drop in the stock market, if the economy weakens, sort of a 1-in-50- or 1-in-100-year event, we protect ourselves on the investment side from that," he says.

Spoken as only a diehard conservative investor can. For a sunny forecast from Watsa, one has to turn the subject to the only sort of event that will bring the long war with the shorts to an end.

"Once we perform, once we make a lot of dough, believe me, the stock's going up."

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US’s Biggest Banks Decelerate

The Economist, 24 January 2006

Perhaps banks really believe that bolstering earnings through temporary fixes is a good strategy, a kind of show of effort, even if it is not particularly effective in convincing the market that they run promising businesses. Over the past week, America’s three biggest banks—Citigroup, J.P. Morgan Chase and Bank of America (BofA)—reported earnings that looked good at first glance, only to sag under scrutiny.

BofA was the most brazen of the three, trumpeting its “record” results for 2005 in the headlines of a press release packed with a long list of achievements. Investors skipped the headline and the hype, focusing instead on the sequential decline in quarterly results and the bank’s cost of financing—hitherto low, but set to rise now that its merger with MBNA, a credit card issuer, has been completed. Sober comments by Al de Molina, BofA’s chief financial officer, on January 23rd were well received, in a sober sort of way: growth, he acknowledged, is slowing. To their credit, Morgan and Citi did not bother to hype results that on the surface were quite good but substantially bolstered by clearly disclosed special items. That spared them from the sniggers directed at BofA but nonetheless led to some selling of their shares.

More than one-quarter of Citi’s and Morgan’s fourth-quarter earnings stemmed from the sale of an asset: in Citi’s case, a gain recorded on the swap of its asset-management business for the brokerage offices of Legg Mason; in Morgan’s case, the disposal of BrownCo, a quirky discount broker (it doesn’t even provide quotes) beloved of experienced traders. Morgan and Citi also benefited from the recovery of money previously put aside for litigation and the release of some loan reserves.

Optimists might see these tweaks as demonstrating the virtues of large banks: they seem to have all sorts of hidden wealth to extract when they need it; and a reduction in money set aside for bad loans and litigation suggests that conditions are getting better, not worse. Furthermore, in the interest of efficiency, Morgan is shedding all sorts of duplicative property inherited from one of the many banks subsumed during its acquisitive history. Citi’s recent disposals have ranged from the obvious (its headquarters) to the obscure (an Indian software company). No one outside its executive suite has a clear picture of how many assets it might still have stashed away.

In a manner of speaking, BofA disposed of assets too, by shedding excess potential customers over the past year. This was part of its effort to stay below the 10% ceiling on any one bank’s share of American deposits, until after its merger with MBNA was approved by regulators. It achieved this, according to Charles Peabody, an analyst at Portales Partners, by paying an unusually low rate on deposits, thus minimising growth.

Sceptics shudder, believing that at best, these techniques are deceptive; and that at worst, they amount to the sale of seed corn, reducing future returns. Once they are stripped out, earnings have been sluggish. “Where’s the forward momentum?” asks David Hendler, an analyst at CreditSights, an independent research firm. Reversing strategy is costly. BofA, for example, will soon be paying more for money (to attract customers ensconced elsewhere) and doing so at a time when it would really like a flood of new funds to feed the credit-card business of MBNA.

Morgan has done a particularly good job of controlling expenses, but at some cost. A tough line on bonuses recently prompted many valuable employees to prepare their resumes. It is only belatedly spending money to rejuvenate a retail branch network that for years suffered from underinvestment. And, like BofA, it had poor results from trading. Perhaps it should be spending more. Tellingly, shares of all of these banks sell at a discount to the rest of the stockmarket, notwithstanding their demonstrated resilience recently in surviving a recession and a deluge of litigation, as well as benign economic conditions that should augur well for future returns.

Conveniently, the banks provided two external villains for their troubles which have the virtue of being plausible and temporary. The first, a recent change in bankruptcy law, encouraged people heavily in debt to file last year, thus pushing up defaults; the second is a closing of the gap between long- and short-term interest rates that undermined banks’ classic formula—take short-term money cheaply from depositors and lend it for the long-term, pocketing the spread.

Theoretically, neither of these problems is much to worry about. A one-time surge in bankruptcy should mean that the weakest debtors have now been dispensed with, so that defaults will be even lower in the future. Rates for lending in the distant future should return to being higher than those for the short term. And all of these banks are more balanced in their operations than they were not long ago. BofA has a nationwide franchise. Morgan was probably thrilled to see revenues surge from equity underwriting and merger advisory work, both fields it has long tried to break into. Citi has an oddly stunted retail franchise in America, but its vast international operations did well. None of these banks is suffering.

And yet, something is missing. Mr Peabody speculates it may be that the real cost of the financial industry’s various scandals was not in the initial fines or the distraction of litigation, but rather in blunting the banks’ aggression. Big banks may be nicer than ever—cutting the absurd range of fees for overdrafts or bounced checks or other routine matters, and holding themselves back from controversial trades—but as a result seeing smaller returns. This is plausible but of course impossible to know. Every bank has taken pains to change how it is run. Last year one of the big fears was “headline risk”, meaning being on the front page for doing something wrong. They have now got themselves off the front page, but perhaps in doing so have lost some of their bite.

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Scotia Capital Research on Cdn Insurance

Q4 2005 Earnings Preview

• Despite stretched valuations, the sector’s defensive characteristics provide support in uncertain markets – we continue to recommend market weight. As we approach the Q4/05 earnings season, we find the group’s valuation relative to the market at four-year highs, and, perhaps more importantly, stretched versus other financials, namely Canadian banks and U.S. lifecos. Simply said, financials appear expensive relative to the market, and Canadian lifecos appear to be a little expensive relative to other financials. However, in our opinion, the Canadian lifeco sector’s defensive characteristics, specifically a consistent track record of negligible earnings surprises and significant excess capital positions that allow for share buybacks and dividend increases, do warrant a valuation premium, especially in these uncertain markets. Thus, despite the stretched valuations, we maintain our market weight recommendation.

• Multiple relative to market continues to expand – unlikely to participate in any market rally, but excellent defensive characteristics. The Canadian lifecos’ forward multiple, currently at 13.6x, has climbed 8% over the last three months and has increased nearly 10% over the last 18 months, despite a 5% reduction in forward multiples for both the S&P 500 and the S&P/TSX over the same time. Relative to the S&P 500, the Canadian lifeco forward multiple is now 85% of the S&P 500 forward multiple (up from 83% three months ago), or nearly two standard deviations above its historical 68% mean, the highest premium relative to the market in the last three years. With this sort of valuation premium, we would not expect the Canadian lifecos to significantly participate in a market rally, just as premium valuations were essentially the reason the Canadian lifecos did not broadly participate in the market rally of the fourth quarter of 2004. However, we believe the defensive qualities of the Canadian lifeco group, namely reasonable earnings visibility (we expect 12% EPS growth in 2005 and 11% growth in 2006 and 2007) and exceptional excess capital positions (both to buy back stock and increase dividends), will provide support in uncertain markets. As such, we continue to recommend market weight in the sector, despite the stretched valuations.

• Valuation relative to U.S. lifecos continues to expand – makes sector look expensive relative to U.S. peers but also makes U.S. acquisitions more appealing. The premium to the U.S. lifecos (on a forward P/E basis) has modestly increased over the last three months to 9% from 8%, and Canadian lifecos still trade above the three-year mean of a 5% premium. When you combine these valuation premiums to the U.S. lifecos with increasing levels of excess capital, and a more favourable Canadian currency, we have to believe the Canadian lifecos will look to the highly fragmented U.S. market to make what we consider to be reasonably accretive acquisitions. We expect acquisition activity to increase in 2006, as we believe the big players will continue to take advantage of low debt financing rates to acquire, and sub-scale players will look to rationalize or specialize.

• Valuation relative to Canadian banks – 5% premium versus 2% three-year mean – suggests banks may be slightly more attractive. The Canadian lifecos have modestly outperfomed the Canadian banks over the last three months (by about 3%), as the Canadian lifeco premium to the banks climbed from 1% (below the 2% mean) to 5%. Three months prior to that, the banks outperformed the lifecos by 4%, as the lifeco premium fell from a 7% premium to a 1% premium. We believe a modest premium over historical levels would be justified, assuming long-term interest rates rise and the yield curve remains somewhat flat, which is traditionally an environment less punitive to lifecos than to banks. However, given the uncertainty over the likelihood of a long-term rate rising scenario actually happening (we note consensus has been wrong on this scenario for the past two years), the modest premium is by far not a given. A scenario whereby long-term rates continue to decline will be more punitive to the lifecos than the banks, in our opinion. Given this uncertainty, we believe the current valuation premium may not be entirely justified.

• Fundamentals remain steady – but we point to a couple of items that may cause some concern. Despite the stretched valuations relative to the market, fundamentals remain steady for the group, with ROEs modestly climbing, excess capital positions growing, and targeted dividend payout ratios rising.

• Low long-term interest rates and a flattening yield curve – Industrial-Alliance the most at risk. Long-term rates continue to slide, especially in Canada. With liabilities longer than assets, a declining long-term interest rate scenario can pose significant reinvestment risk to the lifecos. While the reinvestment risk is by far the largest risk in a declining long-term and flattening yield curve environment, a flattening yield curve not only increases the likelihood of increased surrenders on savings-type products (along with associated disintermediation risks), but may also diminish the competitive advantage that the longer investing lifecos have over the banks in attracting sales of short-term asset accumulation-type products. We estimate that a 100 basis point (bp) parallel decline in the yield curve over 2004 year-end levels (and deemed to be permanent for the purposes of reserving) results in a 6% decline in earnings for Sun Life, a 10% decline in earnings for Great-West Lifeco, a 14% decline in earnings for Manulife, and almost a 30% decline in earnings for Industrial-Alliance, all other things equal. Canadian long-term rates have declined 80 bp over 2004 year-end levels, whereas U.S. long-term rates have declined only 20 bp over 2004 year-end levels. Interest rate risk for Great-West Lifeco, Sun Life, and Manulife is much more U.S. related than Canadian related, whereas it is 100% Canadian related for Industrial-Alliance. As such, we remain cautious on Industrial-Alliance as long-term Canadas continue to fall.

• Credit cycle takes a turn for the worse – Manulife the most at risk. Times are good now, but if credit spreads were to widen and the incidence of bond defaults increases, Canadian lifecos’ earnings could suffer. Manulife has the highest exposure of below-investment grade bonds for the group (6% of Manulife’s bond portfolio is below investment grade, as opposed to 3% for Sun Life, 1% for Great-West Lifeco, and 0% for Industrial-Alliance). In terms of exposure to GM and Ford bonds, Sun Life is at $0.80 per share and Great-West Lifeco is at $0.27 per share (as at Q4/04, the latest data we have available), with Manulife at $0.56 per share (as at Q1/05, the latest available). Manulife claims that 95% of its exposure to Ford and GM bonds is secured.

• Equity markets slowing – Sun Life the most at risk. 2005 saw average levels for the S&P 500 up 8% (in line with company and our expectations), and average levels for the TSX up 18% (above expectations). A sizeable portion of the equity market-related earnings for the lifecos is derived from U.S. equity markets (especially in the case of Sun Life with MFS), and if markets were to slide, we could see downward EPS adjustments for 2006. For the purposes of pricing and reserving for segregated fund guarantees, we believe that most lifecos assume 7%-8% annual appreciation in equity markets. While recent trends in equity markets are encouraging, we estimate that if markets declined 10% from current levels over the next two months and then remained flat throughout the remainder of 2006, we could expect EPS estimates for 2006 to decline by 2% in the case of Great-West Lifeco, 3% in the case of Manulife, and 4% in the case of Sun Life, assuming all else remains the same.

• Strengthening Canadian dollar versus the U.S. dollar – Manulife the most at risk. Our EPS estimates assume an average exchange rate of $1.16 (C$/US$) for 2006, with no currency hedging for Manulife and Sun Life and a currency hedge for Great-West Lifeco in line with our average rate. Each 5% movement in our estimate is worth about $0.05 per share for Great-West Lifeco (or 2% of 2006E EPS), $0.17 per share for Manulife (or 4% of 2006E EPS), and $0.06 per share for Sun Life (or 2% of 2006E EPS). As Manulife’s U.S. owners (nearly 50% of the shareholder base) would obviously see their stock benefit from an appreciating Canadian dollar, we believe any perceived impact on Manulife’s share price due to an appreciating Canadian dollar may not be so dramatic.

Canadian P&C insurers – Canadian auto continues to pace ahead of industry norms, but we do not expect impact of hurricanes to result in significant increase in Canadian commercial insurance pricing.

• The profitability of Canadian auto insurance continues to pace well ahead of industry norms due to the sustained effectiveness of automobile reforms and continued low frequency levels. We get the impression from management at ING Canada that this trend will continue through 2006. The U.S. non-standard auto market (a significant portion of Kingsway’s business) remains very competitive and perhaps somewhat irrational, as niche players have gained market share. It remains to be seen as to whether the impact of more expensive reinsurance (in light of the hurricanes) will introduce an element of rationality to the market, an obvious positive for Kingsway. However, should this market become more rational, we would expect large traditional players (State Farm, Geico, Progressive) to no longer “hold back the reins” and re-enter the non-standard market as well, thus increasing competition.

• With the 2005 hurricanes removing US$40 billion to US$60 billion from the balance sheets of insurers worldwide, market conditions for commercial players should improve in 2006, especially for those companies writing U.S. coastal coverages. We are somewhat cautious as to the hurricane impact for our players, especially lower-rated direct commercial players (such as Northbridge) with very limited U.S. coastal business. We believe the magnitude of price increases in the January renewal season is up for debate, and we believe the higher leverage to any significant improving pricing trends lies with the reinsurers and the highrated direct writers. We will continue to revisit our view as January renewals are finalized.

Great-West Lifeco Inc.
2-Sector Perform – $33 one-year target, based on 2.9x 12/31/06E BV and 13.1x 07E EPS
• We are in line with consensus for Q4/05 and $0.03 per share below consensus for 2006. We do not expect a significantly beneficial currency hedge for 2006
• European segment (24% of bottom line), up 27% year-to-date 2005, should continue to show double-digit growth – with further support in 2006 from the recently announced acquisition in the payout annuity market in Britain (closed Q4/05).
• We look for good cost control and good sales growth in Canada (45% of bottom line).
• Possible 8%-10% dividend increase.

Industrial-Alliance Insurance and Financial Services Inc.
2-Sector Perform – $33 one-year target, based on 1.75x 12/31/06E BV and 11.8x 07E EPS
• We are in line with consensus for Q4/05 and $0.04 per share below consensus for 2006.
• Expect to see a modest rebound in individual insurance sales.
• We will carefully monitor interest rate risk.

Manulife Financial Inc.
1-Sector Outperform – $76 one-year target, based on 2.3x 12/31/06E BV and 13.8x 07E EPS
• We are $0.02 per share above consensus for Q4/05 and $0.01 per share above consensus for 2006.
• John Hancock integration is essentially done – U.S. protection segment and U.S. annuity segments should continue to build on recent sales momentum.
• We will pay close attention to the credit risk profile, but expect the improvement in quality we saw in Q3/05 to continue.
• Possible 10%-15% dividend increase.

Sun Life Financial Inc.
2-Sector Perform – $50 one-year target, based on 1.85x 12/31/06E BV and 12.7x 07E EPS
• We are in line with consensus for Q4/05 and $0.06 per share below consensus for 2006.
• A “show me” story – we will closely monitor much-needed progress in organic sales growth.
• Spread improvement in U.S. fixed annuity block should continue in Q4/05 as the company’s “mismatch” assumption is proving to be profitable.
• Possible 8% dividend increase.

Fairfax Financial Holdings Limited
2-Sector Perform – US$184 one-year target, based on 1.0x 12/31/06E BV
• Hurricane Wilma wipes out any gains in the quarter.
• Lots of “noise” surrounding subpoenas but no new news.
• Runoff segment remains under the radar screen.

ING Canada Inc.
2-Sector Perform – $56 one-year target, based on 2.3x 12/31/06E BV
• A good chance the company could exceed consensus with another excellent quarter of underwriting profitability – we forecast a combined ratio of 87%, not as good as the exceptionally strong 83% in Q3/05.

Kingsway Financial Services Inc.
2-Sector Perform – $27 one-year target, based on 1.4x 12/31/06E BV
• We look for a steady quarter in line with consensus, with no significant prior period reserve development and a combined ratio in the 97% range.
• We look for an update regarding the impact of the company’s recent agreement with Robert Plan (a non-standard business partner focusing on New York and New Jersey).
• Last quarter the company reports in Canadian dollars; going forward the company will report in U.S. dollars.

Northbridge Financial Corporation
3-Sector Underperform – $35 one-year target, based on 1.5x 12/31/06E BV
• Hurricane Wilma to negatively impact the quarter by $0.24 per share.
• While underwriting profitability should remain better than the historical average, revenue is expected to continue to decline. • Will the post-hurricane environment be significantly more favourable? We remain sceptical.

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RBC Capital Markets Comments on Cdn Banks & Insurance

RBC Capital Markets, 23 January 2006

Stock Prices – What Happened Last Week?

Canadian lifecos were down 3.4% last week amid weakness across North American financials - in the U.S., banks and lifeco’s both dipped 3.6%. Canadian banks fared best, down only 1.3%. BMO pulled back a sharper-than-average 3.3% after a very strong prior week, up 4.7%. BMO and CIBC remain super-sensitive to election news, which appears to be veering to a minority and negative for their merger outlook.

BMO and CIBC are both up ~5% relative to the peers year to-date largely on prospective merger potential driven by the election outlook. With a minority looking most likely, we would look at trades favouring fundamentals at TD and RY again, where wealth management leverage is strongest.

Higher short-term rates have been pushing up Prime and this has been favourable for TD and RY’s lending spreads.

In 2005, the banks were up 20.9%, driven by large increases for Royal Bank (41.3%), TD (22.5%) and NA (21.7%). The banks finished the year just ahead of the lifecos, which were up 20.0%, led by MFC (up 23.2%) and SLF (up 16.4%).



Valuation Update – Lifeco Valuation on the Move

Prefer Lifecos Over Banks in Rising Rates. Canadian lifeco valuations have expanded a full multiple point in the last 3 months, now trading at 13.9x consensus forward earnings - this represents a break-out from the 11-13.5x range since Spring 2002, when Canadian government 10-year bond yields fell below 5%. Despite the strong price performance, lifecos continue to trade at only a 3% premium to the banks (as has been the case through much of the year), and well below the 14% premium since demutualization. We expect lifecos to outperform the banks in a modestly rising interest rate environment.

For banks specifically, there is no longer a cushion between the banks’ consensus forward P/E of 13.5x and our regression forecast of 13.4x at the current yield of 4.01%. However, the banks would lose a P/E multiple for every 50 bps increase in the 10-year Canada yield.

Bank Rank Notes

Ameritrade Reports Q4/05 on Jan 25th. AMTD reports Q4/05 earnings on January 25th, with consensus expectations at US$0.22/share – positive results would be a catalyst for TD, pending 40% owners of this market leader. Schwab (SCHW) reported Q4 results of US$0.14/share last week (in line with the street) on a strong quarter of trading. The TD-AMTD deal is scheduled to close on January 24th, with a special dividend payment of US$6/share the same day to shareholders on record Jan 17th (TD not included).

Federal Election and Bank Mergers. The outcome of today’s Canadian federal elections has implications for merger bank mergers with a minority likely perpetuating the Status Quo ‘limbo’. A surprise majority would probably add upwards of 5% for BMO or CIBC, though we would be very cautious chasing the merger story. In our view, bank mergers would remain a very long-probability – the incentive for a new majority ruling party championing the bank merger is very low, particularly early in their new mandate. We would factor less than 10% probability that mergers happen in the next 12 months. And a minority government, on the other hand, would be even less likely to move ahead on bank merger policy.

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BMO's Position on FMF Fiasco

Financial Post, Barry Critchley, 20 January 2006

Officially the Bank of Montreal has made no comment on the FMF Capital Group debacle, a U.S. sub-prime mortgage lender that came to Canada, raised $197.5-million from retail investors and less than eight months later suspended distributions.

The units -- which cost $10 when issued in the initial public offering via a deal led by BMO Nesbitt Burns and which never traded at issue price -- now change hands at around 60 cents.

The bank has decided that saying nothing is the best approach. It adopted "my lips are sealed" approach when FMF suspended distributions -- "we don't talk about our clients" and followed a similar line when a class-action lawsuit was filed a few weeks later. Then it said that "we can't comment given that the matter is before the courts."

But the bank -- clearly a takeover target if the new government allows bank mergers -- does take an interest in what's going on -- and what's written. A while back, a spokesperson asked this columnist whether he owned any FMF units. Given that this is a family newspaper, we skip the full reply. (For the record, journalists do have a code of investing conduct.)

But the question seems to be part of a BMO trend: Try and deflect the blame for what appears to be a monstrous lack of due diligence on its part. (The analogy isn't perfect but if a new car performed as badly as FMF, then the manufacturer's warranty would kick in.)

The bank has adopted "don't blame us'' approach in its correspondence with brokers who have written seeking answers.

In recent correspondence it said the following: "It is the responsibility of each investment advisor to review the risks of an investment and determine whether it is suitable for his or her clients."

That approach didn't sit too well with some brokers, including a former BMO Nesbitt broker.

"I find it of interest that the firm seems to be holding the brokers [its IAs] totally responsible for recommending this to clients," he said.

"How can an IA no matter how bright and experienced, be able to critically analyze each new issue over a couple of days when the corporate finance group comprising an army of specialists has been working with the corporate client for weeks and months and then promotes this to the IAs in its roadshows?" There seems to be a huge imbalance here, noted the broker.

Of course the bank has a ready answer: "BMO Nesbitt Burns and its employees conducted themselves appropriately and in accordance with applicable professional standards."

While BMO has made no public comment on the class action lawsuit, a lot has happened.

- The firm has hired Winston & Strawn, an international law firm that's home to 875 lawyers. That firm wasn't chosen at random. It acted for BMO in its successful defence of a Bre-X class action lawsuit filed in the U.S. In turn, W&S has hired a Michigan litigation firm of Young & Susser.

- The six underwriters on the FMF issue are divided into two camps. Four firms have opted to use Winston & Strawn while two -- Canaccord Capital and Blackmont Capital -- have retained Foley & Lardner.

- BDO Seidman, FMF's auditor, has hired Dickinson Wright, a Detroit-based law firm. BMOs approach of late stands in contrast to what it said when FMF closed its deal.

Back then it said the following: "Ultimately investors were attracted to FMF Capital's strong and predictable revenue and cash flow, a compelling strategy for future growth and a dynamic and committed management team with a proven track record of success."

And for good measure the bank added that "we were delighted to lead this successful offering for FMF Capital, the first financial services company to go public through a cross-border income-participating securities transaction."

BMO and Manulife BMO's approach is in contrast to what Manulife did last year when it faced a situation with some of its clients who bought Portus hedge funds. With chief executive Dominic D'Allesandro calling the shots, the insurer decided to make its clients whole. The result: The matter has been settled.

Manulife's action and BMO's non-actions came up in a recent conversation with a senior Manulife executive. This executive opined that if a lawyer gave D'Alessandro the same view that is being given to Comper, "he wouldn't be working here anymore. Dominic would have told him that he was fired."

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BMO Appoints Downe as COO

The Globe and Mail, Sinclair Stewart, 20 January 2006

Bill Downe may have been unveiled as the heir apparent to Bank of Montreal chief executive officer Tony Comper, but that doesn't mean he has to move back to Canada. Well, at least not for another year.

The long-time BMO executive was promoted to chief operating officer of the bank yesterday, and handed responsibility for all of its main business lines, including retail banking, wealth management, the U.S. Harris Bank subsidiary, and investment banking arm BMO Nesbitt Burns Inc.

Mr. Downe, an Ontario native who now makes his home in Chicago, will also become the only second-in-command at a Big Five Canadian bank who does not live in the country.

"Where people physically reside is less important than it was 30 years ago," Mr. Comper said. "Bill spends four days a week here."

That could soon change, if Mr. Comper steps down as expected in the spring of 2007, when he turns 62. According to the Bank Act, bank CEOs must be Canadian residents, meaning Mr. Downe will have to move home if he gets the top job.

"I tend to be very close to the front lines," he said in an interview yesterday.

"I spend a lot of time in Canada. I think it will be necessary to split my time."

Mr. Downe, a corporate banker for many years before ascending to head of BMO Nesbitt Burns in 2001, said he will focus particularly on getting out "in the field" with the bank's domestic retail operations. He has been in charge of BMO's U.S. banking operation, including its retail branch network, since 2002.

BMO's board has been working increasingly on succession over the past 18 months, and much of the next year will be devoted to easing the transition. People familiar with the bank don't expect any sudden shifts in its low-risk strategy if Mr. Downe eventually takes the reins.

"Why would you change when you have a functioning corporate culture that has no problems?" one industry analyst asked.

Certainly, Mr. Comper and his likely successor share similar styles. Both favour a patient growth strategy, and both have a low tolerance for risk in corporate lending. Neither is particularly flashy, either. Mr. Downe, for example, drives a 15-year-old Mercedes-Benz -- not for the cachet, as one person explained, but because it still runs.

With the business groups reporting to someone else, Mr. Comper said he will devote more time to acquisition possibilities, particularly around BMO's Harris franchise.

"I put a lot of my energy into looking at expansion in the United States and I'm going to put much more of my time into that [now]," he said. If the Conservative Party unseats the ruling Liberals in next week's federal election, as is widely expected, Mr. Comper may also have time to dust off the bank's abandoned merger plans with Bank of Nova Scotia and reconsider his options. As one of the smallest of Canada's banks, and the one with the most established U.S. foothold, BMO would be the most sought-after target in any potential merger scenario.

As part of the executive shuffle at BMO yesterday, Yvan Bourdeau was promoted to CEO and head of investment banking at BMO Nesbitt Burns, where he was formerly president. Tom Milroy and Eric Tripp were named co-presidents of the unit. Chief financial officer Karen Maidment, meanwhile, will continue to report directly to Mr. Comper, and has added chief administrative officer to her title.

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