Scotia Capital, 18 May 2006
Earnings Growth 11% YOY - Led by RY and TD
• Our second quarter earnings estimates are highlighted in Exhibit 1. Second quarter bank earnings are expected to be up 11% year over year but down 5.4% sequentially from a very strong first quarter. RY and TD are expected to lead in earnings growth at 15% and 13%, respectively, driven by the strength of their retail and wealth management platforms as well as their insurance businesses.
• Profitability is expected to continue to run at historical highs on very large capital positions. Return on equity is expected to remain high at 19.5%.
• Retail banking earnings are expected to be solid with continued strong volume growth, cost control and a stable net interest margin although the second quarter has fewer days which trims earnings 1% - 2% versus the first quarter.
• Wealth management earnings are also expected to be strong although only three banks disclose these earnings on a separate basis. Bank mutual assets grew 20% year over year and banks captured 51% of total industry net sales during the fiscal second quarter. RY, TD and BMO have been the dominate players in mutual funds.
• Wholesale banking earnings are expected to be supported by strong capital markets revenue given the sequential increase in the number and size of equity underwritings. Fees from new equity issues are estimated to have increased 70% sequentially in the second quarter with RY and BMO experiencing the largest increases. Trading revenue is expected to be strong with S&P/TSX average daily trading volumes up 13% and trading values up 10% quarter over quarter. However, trading revenues are expected to be weaker than the record first quarter levels.
• Consensus earnings estimates and share price targets are highlighted in Exhibit 3.
Interest Rates and Retail Net Interest Margin
• The prime rate increased 50 basis points (bp) in fiscal Q2/06 following a 50 bp increase in fiscal Q1/06. (Exhibit 12) Short term interest rates have now increased 150 bp or 35% in 9 months. While these increases in short term rates are positive for compression reversal , the retail net interest margin, which was stable in Q1 (Exhibit 9), has yet to show any real improvement on the back of these rate hikes due in part to the 120 day rate guarantees on mortgages, lag impact, and competition.
• We expect retail net interest margin to remain stable in Q2/06 with margin expansion being pushed out until rates stabilize which is expected over the next six to twelve months.
Appreciation of CAD Reduces Bank Book Values by 7% - Fiscal 2003-2005
• The appreciation of the CAD against the USD has been a drag on the banks' foreign currency earnings which are mainly in U.S. dollars, with the exception of BNS (which has material earnings in Pesos and Caribbean currencies).
• In addition, the bank group's book value has been reduced as the banks have incurred foreign exchange translation losses on their net foreign currency investments. Translation losses for the banks from fiscal 2003 to 2005 totalled $18.2 billion. However, the banks hedge their foreign currency investments to varying degrees with the book value impact reduced to $6.3 billion through hedging, net of taxes. Thus, the appreciation of the CAD in fiscal 2003 through fiscal 2005 reduced banks' common shareholders equity or book value by $6.3 billion or 7%, with BNS absorbing the largest impact with a 13% reduction in book value (Exhibit 17).
• National Bank has 95% of its businesses and activities in CAD thus foreign exchange translation losses are not material. The most aggressive bank in hedging its foreign currency investments appears to be CIBC with hedges offsetting more than 90% of its translation losses.
• BMO, RY, and TD's hedging activities have offset approximately 65% of translation losses with BNS at the lower end at 45%. Hedging activity at BNS is less due to the difficulty and impracticality of hedging some Caribbean (soft) currencies as opposed to the USD.
• In the first quarter of 2006 foreign exchange translation losses net of hedging and taxes were $670 million, a further 0.8% reduction in book value based on 3.8% appreciation (spot) in the CAD. The CAD has appreciated a further 1.9% in Q2/06 with a guesstimate of a further $300 million reduction in book value CAD Appreciation Strongest in Fiscal 2003
• The major CAD appreciation (spot) actually occurred in fiscal 2003 with an 18% increase, with fiscal 2004 at 8%, and fiscal 2005 a modest 3%. However the CAD has increased momentum versus the USD appreciating 7% in the first six months of fiscal 2006 as at April 30, 2006.
• If the CAD was to appreciate to par with the USD this would represent a further 10% appreciation from the current exchange rate. Thus, it would appear that the major appreciation of the CAD has already occurred.
Earnings Sensitivity to Appreciation in CAD
• In fiscal Q2/06, the CAD appreciated 1.5% (based on average exchange rates, which are used to translate net income). Assuming no hedging, the impact on second quarter earnings is estimated from a negative 0.07% for National Bank to a negative 0.6% for Scotia (Exhibit 20)
• The negative impact in fiscal Q3/06 is expected to be greater as the CAD has already appreciated $0.03 to $0.04 or 3.5% - 4.0% from the Q2/06 average exchange rate.
• On an annual basis, the negative impact on earnings of a $0.05 appreciation in the CAD, assuming no hedging, is estimated at 2.3% for BNS, 1.8% for CM, 1.6% for BMO, 1.4% for RY, 1.3% for TD, and 0.3% at NA (Exhibit 21). The actual impact is expected to be less as some banks do hedge their foreign currency earnings.
Dividend Increases Expected from BNS and NA
• We expect BNS and NA to announce dividend increases in the 5% to 7% range (Exhibit 5). This follows on dividend increases by RY, BMO, and TD of 12.5%, 8.2%, and 4.8%, respectively, in the first quarter.
• Bank of Montreal is expected to report $1.20 per share, an 11% YOY increase. We expect the bank will be challenged to repeat the record level of trading revenue it recorded in the first quarter. BMO's retail NIM declined 12 bp in Q1/06 and we expect continued weakness relative to the bank group. BMO appears to be positioned for declining as opposed to increasing interest rates which could have a negative impact on its NIM in the quarter. BMO appears to be the only bank with this interest rate positioning. We expect stronger equity underwriting revenues while Harris earnings growth is expected to remain sluggish and further hampered by the strong CAD.
• Bank of Nova Scotia is expected to report $0.80 per share, a 5% increase YOY. A strong Canadian dollar will continue to mute the bank's earnings growth from Mexico and the Caribbean. Retail NIM at BNS declined 11 bp in the first quarter although the overall net interest margin was stable. The bank cited transfer pricing as the reason for the weak retail NIM performance. The sharp rise in interest rates magnified the impact of the banks' transfer pricing mechanism. The banks' smaller wealth management platform will hurt its relative earnings momentum versus RY and TD. A large unrealized security surplus provides for sustainable security gains. A dividend increase of 5.6% to $1.52 per share is expected.
• Canadian Imperial Bank is expected to report $1.55 per share, a 10% increase from a year earlier. The bank was well positioned for rising interest rates in Q1 and benefited probably the most of any bank. The bank is also well positioned going into Q2. CIBC enjoyed accelerated cost saves in Q1 that are unlikely to be fully available in Q2 and loan loss provisions may rise again. CIBC's equity underwriting was strong in the quarter.
• National Bank is expected to report earnings of $1.17 per share, an 8% increase from a year earlier. The bank needs to continue to generate strong trading and capital markets revenue. The bank was reliant on high security gain levels in Q1. Retail bank performance was disappointing in Q1 due to higher costs. Wealth management earnings should remain very strong. A dividend increase of 6.3% to $2.04 per share is expected.
• Royal Bank is expected to report $0.80 per share, a 15% YOY increase. Retail and wealth management earnings are expected to remain solid, supported by strong insurance earnings and equity underwriting revenue.
• Toronto Dominion Bank is expected to report $1.13 per share, a 13% YOY increase. Retail and wealth management earnings at TD are expected to remain the earnings drivers, supported by strong insurance earnings. TD Ameritrade (strong) and TD Banknorth (weak) contributed approximately $0.06 per share and $0.09 per share, respectively to TD's Q2/06 earnings.
Recent Events
BMO - Robert Pearce Resigns
• On May 8th, BMO announced the resignation of Robert Pearce, head of Canadian Personal and Commercial Banking. Bill Downe, COO of BMO, will lead the group until a replacement is found.
BNS - Investments in Latin America and Acquisition of Maple Trust
• On March 9th, BNS completed the purchase of two Peruvian banks - Banco Wiese Sudameris (BWS) and Banco Sudamericano (BSA) - for a total investment of C$390
million. BNS intends to merge the two to form the third largest bank in Peru.
• On April 3rd, BNS closed the deal to buy Maple Trust Company, the mortgage lending business of Maple Financial Group.
• On April 18th, BNS announced the acquisition of Citibank's retail banking operations in the Dominican Republic.
• It was reported on May 10th that BNS was in discussions to buy a stake in Shenzhen Commerical Bank of China.
CM - Acquires Majority Stake in FirstCaribbean International Bank
• On March 13th, CM announced that it intends to acquire an additional 43.7% ownership stake in FirstCaribbean International Bank (FCIB) from Barclays Bank PLC for a total ownership stake of 87.4%. FCIB has branches and banking centres in 17 countries across the Caribbean with its strongest presence in Bahamas, Barbados, and Cayman Islands. The transaction is valued at US$1.08 billion or US$1.62 per share.
TD - Increases Ownership of TD Ameritrade to 37.5% from 32.5% at Deal Close - Retains Board Seat
• TD Bank continued to invest in its two main U.S. businesses TD Ameritrade (AMTD) and TD Banknorth (BNK) in the second quarter.
• TD invested a further US$263 million in AMTD, purchasing 12.9 million shares at an average price of US$20.42 per share and increasing its ownership to 34.6% from 33.4%. Subsequent to the second quarter (ending April 30th) TD invested a further US$326 million (as at May 15) purchasing 17.4 million shares at an average share price of US$18.70 per share, increasing its ownership to 37.5%.
• TD Bank announced February 22, 2006 that it intends to purchase up to 15 million or 2.5% of AMTD stock by August 15, 2006 and that it aims to own 37.5% of AMTD by January 2007. TD has already purchased, as at May 15, 2006, 30.3 million shares since closing for US$589 million or US$19.43 per share. This brings its ownership up to 37.5%, well ahead of January 2007, which allows it to keep the one board seat.
• TD's cost base for AMTD is estimated at US$15.42 per share with the current AMTD share price of US$16.57 or 7.5% higher than TD's cost base.
TD - Modest Additional Investment in TD Banknorth
• TD's additional investment in BNK was modest in the second quarter at US$23.3 million or 762 thousand shares at an average price of US$30.58 per share increasing its ownership in BNK to 55.8% from 53.5%, aided by BNK net repurchases of 8.2 million shares of its own stock.
• On April 13th, BNK announced the acquisition of Interchange Financial Services Corp of New Jersey for US$480.6 million cash. The deal is to be financed mainly through the sale of 13 million BNK common shares to TD Bank.
• As at May 15th, TD had acquired 99.99% of the outstanding common shares of non-prime automotive financing company, VFC Inc.
Strong Fundamentals - Remain Overweight
• We believe bank fundamentals remain strong with low balance sheet risk, high capital levels, strong asset quality, record profitability, and historically low earnings volatility.
• Bank stock valuations remain attractive although not as compelling as they have been. Banks are trading at a low (based on fundamentals) 13.2 times our 2006 earnings estimates with a bank dividend yields relative to bonds (Exhibit 24), equity markets (Exhibit 25), income trusts (Exhibit 28) and pipes and utilities (Exhibit 26) all in the Buy range although not at the previous extreme discounts.
• Solid earnings growth outlook and double digit dividend growth expected for the next three to five years bodes well for continued appreciation in bank share prices.
• We reiterate our Overweight Banks recommendation based on attractive valuation, strong fundamentals, and low relative low risk.
• Maintain 1-Sector Outperform ratings on TD, RY and LB, and 2-Sector Perform ratings on BNS, CWB, and NA, with 3-Sector Underperform ratings on BMO and CM.
• We continue to expect TD and RY to move to 10% to 15% P/E premiums to the bank group with CM and BMO declining to 10% discounts based on relative fundamentals.
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Earnings Growth 11% YOY - Led by RY and TD
• Our second quarter earnings estimates are highlighted in Exhibit 1. Second quarter bank earnings are expected to be up 11% year over year but down 5.4% sequentially from a very strong first quarter. RY and TD are expected to lead in earnings growth at 15% and 13%, respectively, driven by the strength of their retail and wealth management platforms as well as their insurance businesses.
• Profitability is expected to continue to run at historical highs on very large capital positions. Return on equity is expected to remain high at 19.5%.
• Retail banking earnings are expected to be solid with continued strong volume growth, cost control and a stable net interest margin although the second quarter has fewer days which trims earnings 1% - 2% versus the first quarter.
• Wealth management earnings are also expected to be strong although only three banks disclose these earnings on a separate basis. Bank mutual assets grew 20% year over year and banks captured 51% of total industry net sales during the fiscal second quarter. RY, TD and BMO have been the dominate players in mutual funds.
• Wholesale banking earnings are expected to be supported by strong capital markets revenue given the sequential increase in the number and size of equity underwritings. Fees from new equity issues are estimated to have increased 70% sequentially in the second quarter with RY and BMO experiencing the largest increases. Trading revenue is expected to be strong with S&P/TSX average daily trading volumes up 13% and trading values up 10% quarter over quarter. However, trading revenues are expected to be weaker than the record first quarter levels.
• Consensus earnings estimates and share price targets are highlighted in Exhibit 3.
Interest Rates and Retail Net Interest Margin
• The prime rate increased 50 basis points (bp) in fiscal Q2/06 following a 50 bp increase in fiscal Q1/06. (Exhibit 12) Short term interest rates have now increased 150 bp or 35% in 9 months. While these increases in short term rates are positive for compression reversal , the retail net interest margin, which was stable in Q1 (Exhibit 9), has yet to show any real improvement on the back of these rate hikes due in part to the 120 day rate guarantees on mortgages, lag impact, and competition.
• We expect retail net interest margin to remain stable in Q2/06 with margin expansion being pushed out until rates stabilize which is expected over the next six to twelve months.
Appreciation of CAD Reduces Bank Book Values by 7% - Fiscal 2003-2005
• The appreciation of the CAD against the USD has been a drag on the banks' foreign currency earnings which are mainly in U.S. dollars, with the exception of BNS (which has material earnings in Pesos and Caribbean currencies).
• In addition, the bank group's book value has been reduced as the banks have incurred foreign exchange translation losses on their net foreign currency investments. Translation losses for the banks from fiscal 2003 to 2005 totalled $18.2 billion. However, the banks hedge their foreign currency investments to varying degrees with the book value impact reduced to $6.3 billion through hedging, net of taxes. Thus, the appreciation of the CAD in fiscal 2003 through fiscal 2005 reduced banks' common shareholders equity or book value by $6.3 billion or 7%, with BNS absorbing the largest impact with a 13% reduction in book value (Exhibit 17).
• National Bank has 95% of its businesses and activities in CAD thus foreign exchange translation losses are not material. The most aggressive bank in hedging its foreign currency investments appears to be CIBC with hedges offsetting more than 90% of its translation losses.
• BMO, RY, and TD's hedging activities have offset approximately 65% of translation losses with BNS at the lower end at 45%. Hedging activity at BNS is less due to the difficulty and impracticality of hedging some Caribbean (soft) currencies as opposed to the USD.
• In the first quarter of 2006 foreign exchange translation losses net of hedging and taxes were $670 million, a further 0.8% reduction in book value based on 3.8% appreciation (spot) in the CAD. The CAD has appreciated a further 1.9% in Q2/06 with a guesstimate of a further $300 million reduction in book value CAD Appreciation Strongest in Fiscal 2003
• The major CAD appreciation (spot) actually occurred in fiscal 2003 with an 18% increase, with fiscal 2004 at 8%, and fiscal 2005 a modest 3%. However the CAD has increased momentum versus the USD appreciating 7% in the first six months of fiscal 2006 as at April 30, 2006.
• If the CAD was to appreciate to par with the USD this would represent a further 10% appreciation from the current exchange rate. Thus, it would appear that the major appreciation of the CAD has already occurred.
Earnings Sensitivity to Appreciation in CAD
• In fiscal Q2/06, the CAD appreciated 1.5% (based on average exchange rates, which are used to translate net income). Assuming no hedging, the impact on second quarter earnings is estimated from a negative 0.07% for National Bank to a negative 0.6% for Scotia (Exhibit 20)
• The negative impact in fiscal Q3/06 is expected to be greater as the CAD has already appreciated $0.03 to $0.04 or 3.5% - 4.0% from the Q2/06 average exchange rate.
• On an annual basis, the negative impact on earnings of a $0.05 appreciation in the CAD, assuming no hedging, is estimated at 2.3% for BNS, 1.8% for CM, 1.6% for BMO, 1.4% for RY, 1.3% for TD, and 0.3% at NA (Exhibit 21). The actual impact is expected to be less as some banks do hedge their foreign currency earnings.
Dividend Increases Expected from BNS and NA
• We expect BNS and NA to announce dividend increases in the 5% to 7% range (Exhibit 5). This follows on dividend increases by RY, BMO, and TD of 12.5%, 8.2%, and 4.8%, respectively, in the first quarter.
• Bank of Montreal is expected to report $1.20 per share, an 11% YOY increase. We expect the bank will be challenged to repeat the record level of trading revenue it recorded in the first quarter. BMO's retail NIM declined 12 bp in Q1/06 and we expect continued weakness relative to the bank group. BMO appears to be positioned for declining as opposed to increasing interest rates which could have a negative impact on its NIM in the quarter. BMO appears to be the only bank with this interest rate positioning. We expect stronger equity underwriting revenues while Harris earnings growth is expected to remain sluggish and further hampered by the strong CAD.
• Bank of Nova Scotia is expected to report $0.80 per share, a 5% increase YOY. A strong Canadian dollar will continue to mute the bank's earnings growth from Mexico and the Caribbean. Retail NIM at BNS declined 11 bp in the first quarter although the overall net interest margin was stable. The bank cited transfer pricing as the reason for the weak retail NIM performance. The sharp rise in interest rates magnified the impact of the banks' transfer pricing mechanism. The banks' smaller wealth management platform will hurt its relative earnings momentum versus RY and TD. A large unrealized security surplus provides for sustainable security gains. A dividend increase of 5.6% to $1.52 per share is expected.
• Canadian Imperial Bank is expected to report $1.55 per share, a 10% increase from a year earlier. The bank was well positioned for rising interest rates in Q1 and benefited probably the most of any bank. The bank is also well positioned going into Q2. CIBC enjoyed accelerated cost saves in Q1 that are unlikely to be fully available in Q2 and loan loss provisions may rise again. CIBC's equity underwriting was strong in the quarter.
• National Bank is expected to report earnings of $1.17 per share, an 8% increase from a year earlier. The bank needs to continue to generate strong trading and capital markets revenue. The bank was reliant on high security gain levels in Q1. Retail bank performance was disappointing in Q1 due to higher costs. Wealth management earnings should remain very strong. A dividend increase of 6.3% to $2.04 per share is expected.
• Royal Bank is expected to report $0.80 per share, a 15% YOY increase. Retail and wealth management earnings are expected to remain solid, supported by strong insurance earnings and equity underwriting revenue.
• Toronto Dominion Bank is expected to report $1.13 per share, a 13% YOY increase. Retail and wealth management earnings at TD are expected to remain the earnings drivers, supported by strong insurance earnings. TD Ameritrade (strong) and TD Banknorth (weak) contributed approximately $0.06 per share and $0.09 per share, respectively to TD's Q2/06 earnings.
Recent Events
BMO - Robert Pearce Resigns
• On May 8th, BMO announced the resignation of Robert Pearce, head of Canadian Personal and Commercial Banking. Bill Downe, COO of BMO, will lead the group until a replacement is found.
BNS - Investments in Latin America and Acquisition of Maple Trust
• On March 9th, BNS completed the purchase of two Peruvian banks - Banco Wiese Sudameris (BWS) and Banco Sudamericano (BSA) - for a total investment of C$390
million. BNS intends to merge the two to form the third largest bank in Peru.
• On April 3rd, BNS closed the deal to buy Maple Trust Company, the mortgage lending business of Maple Financial Group.
• On April 18th, BNS announced the acquisition of Citibank's retail banking operations in the Dominican Republic.
• It was reported on May 10th that BNS was in discussions to buy a stake in Shenzhen Commerical Bank of China.
CM - Acquires Majority Stake in FirstCaribbean International Bank
• On March 13th, CM announced that it intends to acquire an additional 43.7% ownership stake in FirstCaribbean International Bank (FCIB) from Barclays Bank PLC for a total ownership stake of 87.4%. FCIB has branches and banking centres in 17 countries across the Caribbean with its strongest presence in Bahamas, Barbados, and Cayman Islands. The transaction is valued at US$1.08 billion or US$1.62 per share.
TD - Increases Ownership of TD Ameritrade to 37.5% from 32.5% at Deal Close - Retains Board Seat
• TD Bank continued to invest in its two main U.S. businesses TD Ameritrade (AMTD) and TD Banknorth (BNK) in the second quarter.
• TD invested a further US$263 million in AMTD, purchasing 12.9 million shares at an average price of US$20.42 per share and increasing its ownership to 34.6% from 33.4%. Subsequent to the second quarter (ending April 30th) TD invested a further US$326 million (as at May 15) purchasing 17.4 million shares at an average share price of US$18.70 per share, increasing its ownership to 37.5%.
• TD Bank announced February 22, 2006 that it intends to purchase up to 15 million or 2.5% of AMTD stock by August 15, 2006 and that it aims to own 37.5% of AMTD by January 2007. TD has already purchased, as at May 15, 2006, 30.3 million shares since closing for US$589 million or US$19.43 per share. This brings its ownership up to 37.5%, well ahead of January 2007, which allows it to keep the one board seat.
• TD's cost base for AMTD is estimated at US$15.42 per share with the current AMTD share price of US$16.57 or 7.5% higher than TD's cost base.
TD - Modest Additional Investment in TD Banknorth
• TD's additional investment in BNK was modest in the second quarter at US$23.3 million or 762 thousand shares at an average price of US$30.58 per share increasing its ownership in BNK to 55.8% from 53.5%, aided by BNK net repurchases of 8.2 million shares of its own stock.
• On April 13th, BNK announced the acquisition of Interchange Financial Services Corp of New Jersey for US$480.6 million cash. The deal is to be financed mainly through the sale of 13 million BNK common shares to TD Bank.
• As at May 15th, TD had acquired 99.99% of the outstanding common shares of non-prime automotive financing company, VFC Inc.
Strong Fundamentals - Remain Overweight
• We believe bank fundamentals remain strong with low balance sheet risk, high capital levels, strong asset quality, record profitability, and historically low earnings volatility.
• Bank stock valuations remain attractive although not as compelling as they have been. Banks are trading at a low (based on fundamentals) 13.2 times our 2006 earnings estimates with a bank dividend yields relative to bonds (Exhibit 24), equity markets (Exhibit 25), income trusts (Exhibit 28) and pipes and utilities (Exhibit 26) all in the Buy range although not at the previous extreme discounts.
• Solid earnings growth outlook and double digit dividend growth expected for the next three to five years bodes well for continued appreciation in bank share prices.
• We reiterate our Overweight Banks recommendation based on attractive valuation, strong fundamentals, and low relative low risk.
• Maintain 1-Sector Outperform ratings on TD, RY and LB, and 2-Sector Perform ratings on BNS, CWB, and NA, with 3-Sector Underperform ratings on BMO and CM.
• We continue to expect TD and RY to move to 10% to 15% P/E premiums to the bank group with CM and BMO declining to 10% discounts based on relative fundamentals.
