26 May 2006

National Bank Q2 2006 Earnings

TD Newcrest, 26 May 2006


National Bank of Canada reported a solid quarter, with core diluted EPS of $1.23 (excluding a gain on sale relating to shareholder management activities), in line with our estimate and above consensus of $1.19. EPS was down from $1.26 last quarter, but up from $1.08 in Q2/05. Wealth management operations drove the quarterly results, particularly mutual funds and segregated management. Management also increased the dividend to $0.50 (from $0.48).


Neutral. We are maintaining our 2006 and 2007 EPS estimates, our $71.00 target price and Action List BUY recommendation on the stock.


Wealth management results were strong. Net income of $42 million (or $37 million excluding the gain on sale of shareholder management activities), was comparable with $38 million in Q1/06 and up from $30 million in Q2/05.

Year over year revenue growth was driven by momentum in brokerage, mutual funds, and segregated & private investment management divisions. Expenses were controlled at $165 million, up from $155 million last quarter and $160 million a year ago. We also highlight total bank assets under administration rose 13% to $189 billion, and assets under management increased 16% to $40 billion year over year.

Retail results were solid, with net income of $111 million, down slightly from $114 million last quarter (principally due to fewer days in the quarter), and up from $105 million a year ago. Earnings were driven by volume growth year over year, with revenues up in retail banking, insurance and credit cards. Net interest margins were 2.86%, down 3 bps sequentially (less than the decline reported by some of the banks competitors to date) and 11 bps from Q2/05 (which we also note is partially attributable to higher volumes of lower margin partnership loans, which have high collateral values). Asset growth was strong, with average loans and BA’s of $46 billion, up 2% sequentially and 9% year over year, and management commented that approximately 70% of this increase YTD was from loan growth through partnership agreements.

Financial Market earnings declined as expected, with net income of $59 million, down from an exceptionally high $82 million in Q1/06 and flat with $61 million a year ago. Sequentially, much of the decline can be attributed to lower trading revenues of $83 million (down from $90 million in Q1/06), and lower investment gains which were $31 million versus $42 million last quarter (more consistent with average gains of approximately $35 million). Expense control was good, with expenses declining to $142 million, from $151 million in Q1/06 and $150 million a year ago, although the reduction was not enough to offset the decline in revenues. We do highlight the significant increase in average loans and BA’s to $14 billion, up 10% sequentially and 56% year over year, with approximately $1 billion attributable to increased corporate lending and the remainder trading activities.

Credit remained strong, with PCL’s of $22 million, up slightly from $17 million last quarter and $18 million a year ago. Gross impaired loans remained low, declining to $242 million from $260 million at January 31, 2006, and formations were only $3 million, down from $15 million in Q1/06 and flat with $1 million a year ago.

Tier 1 capital declined to 9.1% (at the lower end of the bank group) from 9.5% at January 31, 2005, and the bank repurchased 2.7 million shares during the quarter. An innovative capital issuance is expected to prop the ratio up 47 bps next quarter.


NA is currently trading at 10.9 times estimated 2007 earnings, versus the rest of the peer group, which is trading at 12.0 times 2007 earnings. We are forecasting EPS growth of 11% and 12% in 2006 and 2007 respectively, and given NA’s relatively relative earnings prospects, we believe that it should at least trade at par with the group.

Justification of Target Price

Our $71.00 NA target price is a product of adding 50% of the $71.11 value derived from our 2007 P/E valuation of 13.4 times to 50% of the $71.28 value derived from our 2007 price-to-book valuation of 2.6 times.

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 reported solid Q2/06 results, and our earnings projections for 2006 and 2007 assume above average growth for the bank. Trading at 10.6 times estimated 2007 earnings, the bank is trading at a 1.4 times discount to the bank group, which we believe is unwarranted given its better growth prospects.

In our opinion the bank will continue to benefit from a dominant market position in Quebec, expansion of its partnership loan program, minimal US$ exposure and strong beta-sensitive operations. We continue to rate the stock an Action List BUY, with a $71.00 target price.