Scotia Capital, 21 June 2006
Bank Valuation Compelling Historic Low Beta Reiterate Overweight Banks
Event
• Banks reported better-than-expected second quarter earnings with growth of 16% year-over-year. Bank earnings resilience and momentum has exceeded market expectations for the past three years.
• Second quarter earnings were led by RY with 24% earnings growth followed by BMO 16%, and NA 14%. TD and CM lagged the bank group with earnings growth of 9% and 10%, respectively. TD and CM earnings reflect weak wholesale banking results with CM further suffering from revenue erosion.
What It Means
• Bank valuations are now compelling as opposed to attractive on a yield basis versus bonds, pipes & utilities and income trusts after the recent correction.
• Bank P/E multiples peaked in February at 15.1x trailing and now have retraced to 13.1x. One year betas for banks are at historical lows of 0.39.
• Reiterate 1-Sector Outperform on RY and 3-Sector Underperform on BMO and CM.
• Reiterate Overweight Banks recommendation based on superior dividend growth, strong fundamentals, compelling valuation, and low relative risk.
Banks Second Quarter Overview
Earnings Resilience
Second Quarter Earnings Yield 16% Growth
• Banks reported better-than-expected second quarter earnings with growth of 16% year-overyear. Bank earnings resilience and momentum have exceeded market expectations for the past three years.
• Second quarter earnings were led by Royal Bank (RY) with 24% earnings growth followed by Bank of Montreal (BMO) 16%, and National Bank (NA) 14%. Toronto-Dominion Bank (TD) and Canadian Imperial Bank (CM) lagged the bank group with earnings growth of 9% and 10%, respectively. TD and CM lower earnings growth reflects weak wholesale banking results with CM further suffering from revenue erosion.
• In terms of the small capitalization banks, Laurentian Bank's (LB) earnings continue to recover, increasing 35% with Canadian Western Bank's (CWB) earnings growth of 33% led by loan and deposit growth of over 20%.
• Second quarter earnings performance was driven by strong growth from wealth management and wholesale banking with solid retail bank earnings. Retail volume growth and cost containment offset a weaker retail net interest margin. The banks’ retail net interest margins (NIM) weakened a moderate 3 basis points (bp) in the quarter. Royal Bank (RY) reported the strongest NIM with a 3 bp expansion.
Retail and Wealth Management – Earnings Growth Solid
• Domestic retail and wealth management earnings were solid in the quarter, with a growth rate of 10%. RY was by far the outperformer with a 16% growth rate. TD, NA, and BMO reported solid year-over-year growth in the 8%-10% range, with CM trailing at 7%.
• Retail net interest margin weakened 3 bp in the quarter. BMO and CM had NIM declines of 5 bp, NA and TD had 3 bp declines. RY recorded the best margin performance with a 3 bp increase.
Retail Volume Growth Strong
• Retail earnings moderated slightly due to declining net interest margins and aggressive pricing. Retail loan volume growth remained strong at 8% with personal deposit balances up 3%. Retail productivity improved considerably across the group, especially at RY, and BMO.
Wealth Management - Important Earnings Driver
• Wealth management continued to be the major earnings driver in the second quarter. Unfortunately, only three banks (BMO, NA, and TD) currently segment these earnings. RY stopped reporting this business separately in Q1/05, CM in Q4/05, and BNS has never disclosed this breakdown.
• Earnings growth from domestic wealth management at BMO (excluding U.S. segment results), TD, and NA was solid at 31%, 28%, and 23%, respectively. Domestic wealth management revenue growth was strong at RY at 20%, TD at 17%, BMO at 13%, and NA at 7%.
• Mutual fund revenue for the bank group was up 19% year over year with 36% growth at RY, 19% at BMO, 14% at NA, and 12% at CM. We believe wealth management is a major contributor to the strength of RY’s underlying earnings.
International Banking
• Grupo Scotiabank (formerly Inverlat) contributed $124 million or $0.13 per share in Q2, an increase of 46% from $85 million or $0.09 per share a year earlier. Overall, international represented 32% of Scotiabank's total cash earnings in the quarter.
Wholesale Banking Earnings
Strong at RY and BMO; TD and CM Underperform
• Wholesale earnings for the bank group increased 18% year over year with RY up 49%, and BMO up 44%. Wholesale earnings declined 3% at NA, 15% at TD, and 21% at CM.
• Wholesale banking earnings were very strong in the quarter at RY and BMO with strong trading revenues, strong underwriting (BMO) and M&A activity (RY), and lower effective tax rates.
• TDSI wholesale banking performance was weak with earnings declining 15% YOY and 30% sequentially. If security gains were excluded, TD's wholesale earnings would have declined 40% sequentially. Trading revenue was particularly weak at TD, declining 21% from a year earlier versus an increase of 28% for the other major banks, due in part to losses associated with TD's exiting its global structured products business.
• CIBC World Markets earnings declined 21% YOY and 7% sequentially due to revenue erosion. Underwriting and advisory fees declined 30% YOY.
Trading Revenue Strength Indicator High - 114%
• Trading revenue for the bank group was $1,547 million, up 16% year over year. The trading revenue strength indicator (Exhibit 3, Column 10) was strong at 114% of the average of the past eight quarters led by RY at 137% followed by BMO at 123%. RY experienced record trading revenue growth of 42% year over year, while TD lagged significantly with a 21% decline in trading revenue. Excluding TD's results, trading revenue was up 28% YOY for the bank group.
Capital Markets Revenue Strength Indicator 102%
• Capital markets revenue was $2,162 million, up 5% sequentially and flat year over year. The capital markets revenue strength indictor (Exhibit 3, Column 11) was neutral at 102% with RY and BMO at 114% and TD trailing at 85%. BMO led the bank group with a 16% sequential and 8% year over year increase in capital market revenue with RY experiencing 15% growth sequentially and 6% YOY. CM lagged significantly, down 10% QOQ and 15% YOY.
Loan Loss Provisions Stable and Low
• Loan loss provisions (LLPs) remain low, as they have retreated to lower levels than anticipated by the market, and we expect them to remain lower for longer than market expectations. LLPs were $486 million in the quarter, up 11% from a year earlier but still benign at 0.21% of loans.
• In terms of the individual banks, BNS recorded the best LLP performance at 7 bps, followed by BMO and NA both at 18 bps and TD at 19 bps. CM LLPs remain high at 46 bps given its large credit card portfolio and large unsecured personal loan portfolio.
• We have reduced our loan loss provisions estimate to $2.1 billion in 2006 from $2.4 billion versus $2.1 billion in 2005, at a very modest 23 bp loss level. The reduction in our loan loss provisions forecast in 2006 is based on lower than expected LLPs driven by continued recoveries in the second quarter with consumer loan loss provisions remaining stable. Our 2007 LLP forecast is also relatively benign at $2.9 billion or 0.29% of loans.
Excellent Profitability – RRWA – ROE
• The bank group reported the second strongest quarter in history (behind Q1/06) in terms of profitability, with return on risk-weighted assets (RRWA) of 2.05%, and only the third quarter ever to be over 2.00%.
• TD holds a substantial lead in terms of profitability based on this measure with RRWA of 2.34%, followed by RY at 2.25% and BMO the laggard at 1.71%. We believe that TD’s and RY’s retail and wealth management platforms provide a competitive advantage, which is reflected in their higher profitability. However, we believe that TD's profitability is more at risk due to heavy reliance on TDCT and the disappointing performance in its wholesale operation and earnings weakness at TD Banknorth.
• Return on equity for the bank group in the second quarter was strong at 21.6% on extremely high capital levels. RY led the bank group in ROE at 23.3% with CM ROE of 24.3% aided by additional leverage. RY's ROE was supported by strong results across all business lines.
Earnings Growth Forecast for 2006 Bumped to 11.5% from 10.4%
• Our earnings growth forecast for 2006 increased to 11.5% from 10.4% due to the stronger than expected results reported in the second quarter.
• Bank earnings growth has been more resilient than market expectations for the past three years, with growth of 21% in 2003, and 16% in both 2004 and 2005. Earnings growth is expected to slow in 2007 to 10%.
Dividend Increases Continue – BMO Raises Target Payout Ratio
• Our longer-term outlook is for earnings growth in the high single-digit/low double-digit range, with dividend growth in the low to mid-teen levels, and with the dividend payout ratio expected to expand towards 50% as per our thesis in Four Decades of Dividend Growth published in March 2002.
• Dividend increases remain frequent and consistent. Banks have consistently increased their dividends every second quarter since the beginning of 2003, increasing 163% since the beginning of 2000.
• Dividend increases continued this quarter with increases from BMO, NA, and CM of 17%, 8%, 4%, and 3%, respectively. BMO also announced an increase in its target payout ratio range to 45%-55% from 35%-45%. The banks' dividend payout ratios on our 2006 estimates remain relatively low at 43%.
Bank Valuation Now Compelling Versus Attractive
• Bank valuations are now compelling as opposed to attractive on a yield basis after the recent correction.
• Bank dividend yield relative to 10-year bonds has increased to 2.9 standard deviations above the mean, versus 1.9 earlier in the year (Exhibit 14).
• Reversion to the mean on this measure would require a 47% increase in the bank index, or a 6.6% 10-year bond yield versus the current bond yield of 4.5%, without factoring in expected bank dividend increases.
• Bank valuation is now much more attractive versus Pipes and Utilities and Income Trusts as they are now back to the Strong Buy range. The relative yield of Banks versus Pipes and Utilities is now at 87% or 1.9 standard deviations above the mean, retracing from a recent low of 78% or 1.0 standard deviations above the mean in March. The relative yield of Banks versus Income Trusts is now at 50% or 1.8 standard deviations above the mean, retracing from a recent low of 45% or 1.4 standard deviations above the mean in October of 2005, and nearing its high of 51%.
• Reversion to the mean with respect to bank dividend yields relative to pipes & utilities, the S&P/TSX, and income trusts would suggest an increase in the bank index of 28%, 37%, and 41%, respectively.
Bank P/E Multiples Retrace From High of 15.1x
• The Bank P/E multiple peaked in February at 15.1x on a 12-month trailing basis and since then has retraced to current level of 13.1x. In general, the banks have been building a base in the 14x-15x range over the past three years. The bank group P/E multiple’s most recent high was in early 1998 in the 16x-17x range, aided by bank merger speculation. We continue to forecast the P/E expansion to the 16x range, with the recent decline in P/E multiples due, we believe, to the overall equity market correction.
Bank Betas at Historical Lows
• The one year average bank beta is now 0.39 compared with a three year average bank beta of 0.47 and a five year average bank beta of 0.81.
Strong Fundamentals, Attractive Valuation
Maintain Overweight Recommendation
• We continue to view bank fundamentals as the strongest in history, with record profitability and capital, high asset quality, low financial and earnings leverage to credit, diversified revenue mix, and low earnings volatility.
Recommendations - Recent Changes
TD Downgrade
• We maintain our 1-Sector Outperform rating on RY, 2-Sector Perform ratings on NA, CWB, LB, and TD, and 3-Sector Underperform ratings on BMO and CM.
• Also on June 14, we downgraded TD to 2-Sector Perform from 1-Sector Outperform based on disappointing performance in the bank's wholesale operations, continued earnings weakness at TD Banknorth, and the risk of a deceleration in relative earnings growth at TDCT led by a slowdown in insurance revenue growth.
• We maintain a 1-Sector Outperform rating on RY which has the strongest retail and wealth management operating platform and a solid wholesale banking business. We continue to expect stronger relative earnings momentum from this bank, as well as relative P/E multiple expansion.
• We downgraded LB to 2-Sector Perform from 1-Sector Outperform on June 3 based on our view that the pace of earnings recovery is now slowing and earnings growth, though still on track, is expected to take longer to achieve. Maintain 2-Sector Perform ratings on NA and CWB.
• We maintain 3-Sector Underperform ratings on BMO and CM based on lower profitability and no meaningful valuation discount and, in the case of CM, continued
concerns about revenue erosion and weakening of its competitive position in its major business lines.
• Our 12-month bank share price targets for BMO, CM, CWB, LB, NA, RY, and TD are $72, $55, $45, $36, $72, $58, and $70 per share, respectively.
• Our 12-month target for the bank index is 24,700 based on a target P/E multiple of 15.5x our 2006 or 14.1x our 2007 earnings estimates, for a total expected return of 25%.
• Maintain Overweight Banks recommendation based on superior dividend growth, strong fundamentals, compelling valuation, and low relative risk.
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Bank Valuation Compelling Historic Low Beta Reiterate Overweight Banks
Event
• Banks reported better-than-expected second quarter earnings with growth of 16% year-over-year. Bank earnings resilience and momentum has exceeded market expectations for the past three years.
• Second quarter earnings were led by RY with 24% earnings growth followed by BMO 16%, and NA 14%. TD and CM lagged the bank group with earnings growth of 9% and 10%, respectively. TD and CM earnings reflect weak wholesale banking results with CM further suffering from revenue erosion.
What It Means
• Bank valuations are now compelling as opposed to attractive on a yield basis versus bonds, pipes & utilities and income trusts after the recent correction.
• Bank P/E multiples peaked in February at 15.1x trailing and now have retraced to 13.1x. One year betas for banks are at historical lows of 0.39.
• Reiterate 1-Sector Outperform on RY and 3-Sector Underperform on BMO and CM.
• Reiterate Overweight Banks recommendation based on superior dividend growth, strong fundamentals, compelling valuation, and low relative risk.
Banks Second Quarter Overview
Earnings Resilience
Second Quarter Earnings Yield 16% Growth
• Banks reported better-than-expected second quarter earnings with growth of 16% year-overyear. Bank earnings resilience and momentum have exceeded market expectations for the past three years.
• Second quarter earnings were led by Royal Bank (RY) with 24% earnings growth followed by Bank of Montreal (BMO) 16%, and National Bank (NA) 14%. Toronto-Dominion Bank (TD) and Canadian Imperial Bank (CM) lagged the bank group with earnings growth of 9% and 10%, respectively. TD and CM lower earnings growth reflects weak wholesale banking results with CM further suffering from revenue erosion.
• In terms of the small capitalization banks, Laurentian Bank's (LB) earnings continue to recover, increasing 35% with Canadian Western Bank's (CWB) earnings growth of 33% led by loan and deposit growth of over 20%.
• Second quarter earnings performance was driven by strong growth from wealth management and wholesale banking with solid retail bank earnings. Retail volume growth and cost containment offset a weaker retail net interest margin. The banks’ retail net interest margins (NIM) weakened a moderate 3 basis points (bp) in the quarter. Royal Bank (RY) reported the strongest NIM with a 3 bp expansion.
Retail and Wealth Management – Earnings Growth Solid
• Domestic retail and wealth management earnings were solid in the quarter, with a growth rate of 10%. RY was by far the outperformer with a 16% growth rate. TD, NA, and BMO reported solid year-over-year growth in the 8%-10% range, with CM trailing at 7%.
• Retail net interest margin weakened 3 bp in the quarter. BMO and CM had NIM declines of 5 bp, NA and TD had 3 bp declines. RY recorded the best margin performance with a 3 bp increase.
Retail Volume Growth Strong
• Retail earnings moderated slightly due to declining net interest margins and aggressive pricing. Retail loan volume growth remained strong at 8% with personal deposit balances up 3%. Retail productivity improved considerably across the group, especially at RY, and BMO.
Wealth Management - Important Earnings Driver
• Wealth management continued to be the major earnings driver in the second quarter. Unfortunately, only three banks (BMO, NA, and TD) currently segment these earnings. RY stopped reporting this business separately in Q1/05, CM in Q4/05, and BNS has never disclosed this breakdown.
• Earnings growth from domestic wealth management at BMO (excluding U.S. segment results), TD, and NA was solid at 31%, 28%, and 23%, respectively. Domestic wealth management revenue growth was strong at RY at 20%, TD at 17%, BMO at 13%, and NA at 7%.
• Mutual fund revenue for the bank group was up 19% year over year with 36% growth at RY, 19% at BMO, 14% at NA, and 12% at CM. We believe wealth management is a major contributor to the strength of RY’s underlying earnings.
International Banking
• Grupo Scotiabank (formerly Inverlat) contributed $124 million or $0.13 per share in Q2, an increase of 46% from $85 million or $0.09 per share a year earlier. Overall, international represented 32% of Scotiabank's total cash earnings in the quarter.
Wholesale Banking Earnings
Strong at RY and BMO; TD and CM Underperform
• Wholesale earnings for the bank group increased 18% year over year with RY up 49%, and BMO up 44%. Wholesale earnings declined 3% at NA, 15% at TD, and 21% at CM.
• Wholesale banking earnings were very strong in the quarter at RY and BMO with strong trading revenues, strong underwriting (BMO) and M&A activity (RY), and lower effective tax rates.
• TDSI wholesale banking performance was weak with earnings declining 15% YOY and 30% sequentially. If security gains were excluded, TD's wholesale earnings would have declined 40% sequentially. Trading revenue was particularly weak at TD, declining 21% from a year earlier versus an increase of 28% for the other major banks, due in part to losses associated with TD's exiting its global structured products business.
• CIBC World Markets earnings declined 21% YOY and 7% sequentially due to revenue erosion. Underwriting and advisory fees declined 30% YOY.
Trading Revenue Strength Indicator High - 114%
• Trading revenue for the bank group was $1,547 million, up 16% year over year. The trading revenue strength indicator (Exhibit 3, Column 10) was strong at 114% of the average of the past eight quarters led by RY at 137% followed by BMO at 123%. RY experienced record trading revenue growth of 42% year over year, while TD lagged significantly with a 21% decline in trading revenue. Excluding TD's results, trading revenue was up 28% YOY for the bank group.
Capital Markets Revenue Strength Indicator 102%
• Capital markets revenue was $2,162 million, up 5% sequentially and flat year over year. The capital markets revenue strength indictor (Exhibit 3, Column 11) was neutral at 102% with RY and BMO at 114% and TD trailing at 85%. BMO led the bank group with a 16% sequential and 8% year over year increase in capital market revenue with RY experiencing 15% growth sequentially and 6% YOY. CM lagged significantly, down 10% QOQ and 15% YOY.
Loan Loss Provisions Stable and Low
• Loan loss provisions (LLPs) remain low, as they have retreated to lower levels than anticipated by the market, and we expect them to remain lower for longer than market expectations. LLPs were $486 million in the quarter, up 11% from a year earlier but still benign at 0.21% of loans.
• In terms of the individual banks, BNS recorded the best LLP performance at 7 bps, followed by BMO and NA both at 18 bps and TD at 19 bps. CM LLPs remain high at 46 bps given its large credit card portfolio and large unsecured personal loan portfolio.
• We have reduced our loan loss provisions estimate to $2.1 billion in 2006 from $2.4 billion versus $2.1 billion in 2005, at a very modest 23 bp loss level. The reduction in our loan loss provisions forecast in 2006 is based on lower than expected LLPs driven by continued recoveries in the second quarter with consumer loan loss provisions remaining stable. Our 2007 LLP forecast is also relatively benign at $2.9 billion or 0.29% of loans.
Excellent Profitability – RRWA – ROE
• The bank group reported the second strongest quarter in history (behind Q1/06) in terms of profitability, with return on risk-weighted assets (RRWA) of 2.05%, and only the third quarter ever to be over 2.00%.
• TD holds a substantial lead in terms of profitability based on this measure with RRWA of 2.34%, followed by RY at 2.25% and BMO the laggard at 1.71%. We believe that TD’s and RY’s retail and wealth management platforms provide a competitive advantage, which is reflected in their higher profitability. However, we believe that TD's profitability is more at risk due to heavy reliance on TDCT and the disappointing performance in its wholesale operation and earnings weakness at TD Banknorth.
• Return on equity for the bank group in the second quarter was strong at 21.6% on extremely high capital levels. RY led the bank group in ROE at 23.3% with CM ROE of 24.3% aided by additional leverage. RY's ROE was supported by strong results across all business lines.
Earnings Growth Forecast for 2006 Bumped to 11.5% from 10.4%
• Our earnings growth forecast for 2006 increased to 11.5% from 10.4% due to the stronger than expected results reported in the second quarter.
• Bank earnings growth has been more resilient than market expectations for the past three years, with growth of 21% in 2003, and 16% in both 2004 and 2005. Earnings growth is expected to slow in 2007 to 10%.
Dividend Increases Continue – BMO Raises Target Payout Ratio
• Our longer-term outlook is for earnings growth in the high single-digit/low double-digit range, with dividend growth in the low to mid-teen levels, and with the dividend payout ratio expected to expand towards 50% as per our thesis in Four Decades of Dividend Growth published in March 2002.
• Dividend increases remain frequent and consistent. Banks have consistently increased their dividends every second quarter since the beginning of 2003, increasing 163% since the beginning of 2000.
• Dividend increases continued this quarter with increases from BMO, NA, and CM of 17%, 8%, 4%, and 3%, respectively. BMO also announced an increase in its target payout ratio range to 45%-55% from 35%-45%. The banks' dividend payout ratios on our 2006 estimates remain relatively low at 43%.
Bank Valuation Now Compelling Versus Attractive
• Bank valuations are now compelling as opposed to attractive on a yield basis after the recent correction.
• Bank dividend yield relative to 10-year bonds has increased to 2.9 standard deviations above the mean, versus 1.9 earlier in the year (Exhibit 14).
• Reversion to the mean on this measure would require a 47% increase in the bank index, or a 6.6% 10-year bond yield versus the current bond yield of 4.5%, without factoring in expected bank dividend increases.
• Bank valuation is now much more attractive versus Pipes and Utilities and Income Trusts as they are now back to the Strong Buy range. The relative yield of Banks versus Pipes and Utilities is now at 87% or 1.9 standard deviations above the mean, retracing from a recent low of 78% or 1.0 standard deviations above the mean in March. The relative yield of Banks versus Income Trusts is now at 50% or 1.8 standard deviations above the mean, retracing from a recent low of 45% or 1.4 standard deviations above the mean in October of 2005, and nearing its high of 51%.
• Reversion to the mean with respect to bank dividend yields relative to pipes & utilities, the S&P/TSX, and income trusts would suggest an increase in the bank index of 28%, 37%, and 41%, respectively.
Bank P/E Multiples Retrace From High of 15.1x
• The Bank P/E multiple peaked in February at 15.1x on a 12-month trailing basis and since then has retraced to current level of 13.1x. In general, the banks have been building a base in the 14x-15x range over the past three years. The bank group P/E multiple’s most recent high was in early 1998 in the 16x-17x range, aided by bank merger speculation. We continue to forecast the P/E expansion to the 16x range, with the recent decline in P/E multiples due, we believe, to the overall equity market correction.
Bank Betas at Historical Lows
• The one year average bank beta is now 0.39 compared with a three year average bank beta of 0.47 and a five year average bank beta of 0.81.
Strong Fundamentals, Attractive Valuation
Maintain Overweight Recommendation
• We continue to view bank fundamentals as the strongest in history, with record profitability and capital, high asset quality, low financial and earnings leverage to credit, diversified revenue mix, and low earnings volatility.
Recommendations - Recent Changes
TD Downgrade
• We maintain our 1-Sector Outperform rating on RY, 2-Sector Perform ratings on NA, CWB, LB, and TD, and 3-Sector Underperform ratings on BMO and CM.
• Also on June 14, we downgraded TD to 2-Sector Perform from 1-Sector Outperform based on disappointing performance in the bank's wholesale operations, continued earnings weakness at TD Banknorth, and the risk of a deceleration in relative earnings growth at TDCT led by a slowdown in insurance revenue growth.
• We maintain a 1-Sector Outperform rating on RY which has the strongest retail and wealth management operating platform and a solid wholesale banking business. We continue to expect stronger relative earnings momentum from this bank, as well as relative P/E multiple expansion.
• We downgraded LB to 2-Sector Perform from 1-Sector Outperform on June 3 based on our view that the pace of earnings recovery is now slowing and earnings growth, though still on track, is expected to take longer to achieve. Maintain 2-Sector Perform ratings on NA and CWB.
• We maintain 3-Sector Underperform ratings on BMO and CM based on lower profitability and no meaningful valuation discount and, in the case of CM, continued
concerns about revenue erosion and weakening of its competitive position in its major business lines.
• Our 12-month bank share price targets for BMO, CM, CWB, LB, NA, RY, and TD are $72, $55, $45, $36, $72, $58, and $70 per share, respectively.
• Our 12-month target for the bank index is 24,700 based on a target P/E multiple of 15.5x our 2006 or 14.1x our 2007 earnings estimates, for a total expected return of 25%.
• Maintain Overweight Banks recommendation based on superior dividend growth, strong fundamentals, compelling valuation, and low relative risk.
