03 March 2006

National Bank Upgraded at TD Newcrest

TD Newcrest, 3 March 2006


NA reported a strong quarter, with diluted EPS of $1.26, above our estimate of $1.23 and consensus of $1.18. The better than expected result was driven by strong numbers from the beta-sensitive businesses, particularly retail brokerage, mutual funds, trading and merchant banking gains.


Positive. We are raising our 2006 EPS estimate to $5.05 from $4.95 and our 2007 EPS estimate to $5.60 from $5.40. We are upgrading our recommendation on the stock to a BUY from a Hold with a new target price of $71.00 from $63.00. We are also adding the stock to our Action List. Although we believe that the bank will continue to show above average quarterly volatility in its beta-sensitive businesses quarter over quarter, we believe that the yearly trend, business mix and good fundamentals will allow the bank to continue growing earnings at above average rates.


Stronger than expected wealth management: Wealth management reported earnings of $38 million in the quarter compared to $26 million in both Q4/05 and Q1/05. The discrepancy from our $29 million estimate was driven by very strong revenues from three subdivisions; retail brokerage ($141 million from $138 in Q4/05), mutual funds ($49 million from $46 million in Q4/05) and trust ($24 million from $21 million in Q4/05). Expenses were also down sequentially in all three divisions as operational efficiencies are taking hold. The tax rate also played a significant part in the division reporting better than expected results. The effective tax rate was 32.2% this quarter relative to 42.6% in Q4/05. Management explained that the wealth management segment is composed of many different divisions, with each having its own tax structure, and that in Q4/05 a higher proportion of income came from one of the higher taxed operations. Management is guiding for a run rate of about 33% for the division; however, we prefer to remain conservative given the spike seen in Q4/04 and are using an average rate of 36% over the next two years. As anticipated, assets under administration were up solidly 2.3% quarter over quarter and 19.1% year over year, while assets under management were up 6.5% quarter over quarter and 17.1% year over year.

Strong capital markets performance: Wholesale net income jumped to $82 million (we expected $67 million)compared to $49 million in Q4/05 and $76 million in Q1/05. Trading revenues were up 8.4% sequentially and 15.4% year over year. Equity trading performed well with revenues of $70 million versus $43 million in Q4/05 and $58 million in Q1/05. Both commodities & foreign exchange and fixed income & and money markets revenues were down sequentially. Securities gains were $42 million this quarter compared to $7 million in Q4/05 and $35 million in Q1/05; the sequential increase was expected as the bank had previously mentioned that it would return to more historical rates of gain realizations (roughly in the mid 30s). What was unexpected; however, was the flat expenses, since the majority of the securities gains were realized in the merchant bank, which is not as sensitive to performance related compensation. As expected, new issues and underwriting revenues were down sequentially, which gives us confidence that overall wholesale revenues can remain strong even though trading revenues might not hold up to current levels in coming quarters. Management’s focus on stabilizing revenues through diversification across business lines appears to work well; however, on a quarterly basis it generates volatility in earnings.

Satisfactory retail results: The P&C division reported net income of $114 million compared to $110 million in Q4/05 and $112 million in Q1/05. Asset growth continued its impressive trend with average loans and BAs up 2% quarter over quarter and 9% year over year. Management now says that almost 60% of the new loan growth emanates from the partnership agreements while the rest is generated through HELOCs. The net interest margin (NIM) was down to 2.89% from 2.90% in Q4/05 and 3.02% in Q1/05. The slight sequential deterioration in NIM was expected as loans generated through the partnership agreements are usually made to high net worth individuals and are generally well collateralized, thus earning lower spreads. Also, management mentioned that spreads on mortgages are continuing to compress due to competitive pressure. Although deposit spreads are improving as interest rates rise, we expect NIM to continue trending lower in the short term as partnership loans grow. PCLs for the division were down to $31 million from $38 million in Q4/05. We believe that quarterly PCLs will trend higher throughout 2006, but will remain below $40 million.

Capital management: The bank maintained its Tier 1 ratio at 9.5% in Q1/06, inline with 9.6% in both Q4/05 and Q1/05. The bank repurchased 1.8 million shares this quarter and signaled its intention to continue to be opportunistic on repurchases throughout the year.


Given NA’s excellent beta-sensitive earnings growth and solid fundamentals in retail banking, we believe that it deserves to be valued at least at par with BMO and CM.

Justification of Target Price

Our $71.00 NA target price is a product of adding 50% of the $63.84 value derived from our 2007 P/E valuation of 12.0 times to 50% of the $67.20 value derived from our 2007 price-to-book valuation of 2.4 times, to which we add 8% to account for the probable change to the dividend tax legislation.

Key Risks to Target Price

We believe that the four key valuation risks specific to NA that may prevent the stock from attaining our target price are: a) Unfavorable interest rate movements; b) Quebec sovereignty (we view this with a low probability); c) Lack of scale and financial flexibility; and d) Irrational pricing behavior from non public competitor Desjardins.

Investment Conclusion

NA currently trades at a P/E discount to its peers of 1.5 times 2006 EPS estimates. We believe this discount is unwarranted and that NA should trade at much closer to par to its peers. We believe the bank’s dynamic betasensitive operations, dominant position in Quebec, growing source of partnership loans and no exposure to USD earnings, provide investors an excellent growth platform. The political winds come and go, but for the time being we are hopeful that the growing support of the Conservative Party within the province will mute separatist sympathy. We rate the stock a BUY, with a new 12-month target price of $71.00.