Scotia Capital, 10 August 2006
Banks Begin Reporting August 22
• Banks begin reporting third quarter earnings with Bank of Montreal (BMO) on August 22, followed by Toronto-Dominion Bank (TD) on August 24, Royal Bank (RY) on August 25, Bank of Nova Scotia (BNS) on August 29, National Bank (NA) and Canadian Imperial Bank (CM) on August 31, Laurentian Bank (LB) on September 6, and Canadian Western closing out reporting on September 7.
Earnings Growth 10% YOY – Led by BNS and RY
• Our third quarter earnings estimates are highlighted in Exhibit 1. Third quarter bank earnings are expected to be up 9.7% year over year but down 1.3% sequentially. BNS and RY are expected to lead in earnings growth at 12% and 11%, respectively. RY earnings growth is expected to be driven by the strength of retail and wealth management platforms and continued strong performance from Global Capital Markets. BNS earnings are expected to be driven by International operations although the Peso weakened significantly in the quarter.
• Profitability is expected to continue to run at historical highs on very large capital positions. Return on equity is expected to be 19.8%.
• Retail banking earnings are expected to be solid, although we expect some slowing in earnings growth as loan growth slows over the next year driven by weaker real estate markets, and margin expansion is delayed until interest rate levels stabilize. Short term interest rates have now risen 175 basis points or 42% in the past year. The increase in prime rate has relieved margin pressure created by the prime rate deposit cost (floor) squeeze however the rate of the increases as well as competition has delayed actual margin expansion.
• Wealth management earnings are also expected to continue to be buoyant although only three banks disclose these earnings on a separate basis. Bank average mutual fund assets are up 15% year over year and flat QOQ.
• Wholesale banking earnings are expected to weaken modestly from the extremely high levels of the first half of the year. Trading is expected to be solid although weaker than first half and equity underwriting is also expected to be very weak with M&A mixed. Equity trading volumes declined 18% QOQ but are up 33% YOY. New equity issues declined both 34% YOY and QOQ with secondary financing also declining sharply at 40% QOQ and 19% YOY. In terms of M&A, Closed/Pending Value is up substantially both YOY and QOQ. CDN M&A Closed Deals Value is up 21% QOQ but down 49% YOY.
Interest Rates and Retail Net Interest Margin
• The prime rate increased 25 basis points (bp) in fiscal Q3/06 following a 50 bp increase in each of the previous three quarters. Short-term interest rates have now increased 175 bp or 42% in twelve months. The Bank of Canada left the overnight rate unchanged at its last announcement date, July 11. The increases in short-term rates we believe are positive for compression reversal, stabilizing the margin descent. However, the retail net interest margin (NIM) has yet to show any real improvement from these rate hikes due in part to interest rate guarantees on mortgages, lag impact, and competition.
• We expect retail net interest margin to remain stable in Q3/06, with margin expansion being pushed out until rates stabilize, which is expected over the next six to 12 months.
Dividend Increase Candidates RY and TD
• The likely candidates for dividend increases this quarter are RY and TD, with dividend increases in the 7% to 8% range expected. This follows dividend increases announced in the previous quarter Q2/06 by BMO, BNS, NA, and CM of 17%, 8.3%, 4.2%, and 2.9%, respectively. The bank group's dividend payout ratio on our 2006 earnings estimates is 43% with BMO a high of 51% with TD, NA and RY the low at 39%, 40% and 42% respectively.
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 stocks are underperforming the Resource led TSX year to date with a flat bank index versus a 7% gain for the overall market. The bank group betas have declined to 0.39 versus a 5 year beta of 0.8.
• Banks are trading at a low 11.9x our 2007 earnings estimates, with bank dividend yields relative to bonds, equity markets, income trusts, and pipelines and utilities all in the Strong Buy range.
• Canadian Banks' P/E premium to the major U.S. banks has declined from the 10% - 15% range to nominal. Canadian banks are at a 15% P/E multiple discount to U.S. Regional Banks. U.S. yield curve is now inverted.
• Solid earnings growth outlook and double-digit dividend growth expected for the next three to five years bodes well for resumption of bank share price appreciation.
• We reiterate our Overweight Banks recommendation, based on attractive valuation, strong fundamentals, and low relative risk.
• We maintain 1-Sector Outperform ratings on RY and BNS, 2-Sector Perform ratings on NA, CWB, LB and TD with 3-Sector Underperform ratings on BMO and CM.
Recent Events
BMO – Frank Techar Appointed Head of Canadian Retail Banking
• On June 6, BMO announced the appointment of Frank Techar as President and CEO, Personal and Commercial Banking Canada, effective July 1, 2006. This position was formerly held by Rob Pearce. Mr Techar had headed BMO's P&C Banking in the U.S. since 2002 as President and CEO of Harris Bankcorp.
• On July 19, BMO announced the appointment of Ellen Costello as CEO of Harris Bankcorp. She replaces Frank Techar who was recently made President and CEO, Personal and Commercial Banking in Canada. Ms Costello had previously held the position of Vice-Chair and Head, BMO Capital Markets, New York.
• On August 3, BMO announced its intention to acquire bcpbank Canada, a full-service chartered bank owned by Millennium bcp of Lisbon, Portugal for $41 million. Bcpbank Canada has a network of eight retail bank branches, seven of which are located in the Greater Toronto Area.
BNS – Costa Rican Acquisition
• On June 13, BNS announced that it would acquire Corporacion Interfin, parent of Banco Interfin, the largest private bank in Costa Rica, for Cdn $330 million. BNS intends to merge its existing operations with Interfin. The transaction is expected to close in August 2006.
CM – Global Crossing Lawsuit
• There was an action filed in New York on June 20 to add additional CIBC affiliates and other third party defendants to the claims originally filed in 2004 seeking $2 billion in profits from alleged insider trading with respect to Global Crossing. CIBC has said that the action contains no new claims against CIBC. CIBC filed to dismiss these claims in January of 2006 which is still pending.
NA – Louis Vachon Appointed COO
• On July 27, NA announced the appointment of Louis Vachon as COO of the company. Prior to this appointment, Louis Vachon was Senior Vice-President, Chairman and Chief Executive Officer of National Bank Financial Group.
TD – TD Banknorth and TD Ameritrade Earnings
• TD Banknorth (BNK) reported Q2/06 cash operating earnings of US$0.56 per share, versus US$0.55 per share in the previous quarter and US$0.63 per share a year earlier. Consensus was US$0.55 per share for the quarter. The operating contribution of BNK to TD Bank (TD) is estimated at C$0.09 per share versus C$0.08 per share last quarter and C$0.10 per share a year earlier
• TD Ameritrade (AMTD-NASDAQ) reported Q3/06 earnings of US$0.23 per share, versus IBES estimate of US$0.22 per share. At its current ownership level of 39.8%, the contribution to TD Bank (TD-T) is estimated at C$0.08 per share.
• On August 3, TD Ameritrade announced a share repurchase program of up to 12 million shares, or 2 percent of its shares outstanding.
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Banks Begin Reporting August 22
• Banks begin reporting third quarter earnings with Bank of Montreal (BMO) on August 22, followed by Toronto-Dominion Bank (TD) on August 24, Royal Bank (RY) on August 25, Bank of Nova Scotia (BNS) on August 29, National Bank (NA) and Canadian Imperial Bank (CM) on August 31, Laurentian Bank (LB) on September 6, and Canadian Western closing out reporting on September 7.
Earnings Growth 10% YOY – Led by BNS and RY
• Our third quarter earnings estimates are highlighted in Exhibit 1. Third quarter bank earnings are expected to be up 9.7% year over year but down 1.3% sequentially. BNS and RY are expected to lead in earnings growth at 12% and 11%, respectively. RY earnings growth is expected to be driven by the strength of retail and wealth management platforms and continued strong performance from Global Capital Markets. BNS earnings are expected to be driven by International operations although the Peso weakened significantly in the quarter.
• Profitability is expected to continue to run at historical highs on very large capital positions. Return on equity is expected to be 19.8%.
• Retail banking earnings are expected to be solid, although we expect some slowing in earnings growth as loan growth slows over the next year driven by weaker real estate markets, and margin expansion is delayed until interest rate levels stabilize. Short term interest rates have now risen 175 basis points or 42% in the past year. The increase in prime rate has relieved margin pressure created by the prime rate deposit cost (floor) squeeze however the rate of the increases as well as competition has delayed actual margin expansion.
• Wealth management earnings are also expected to continue to be buoyant although only three banks disclose these earnings on a separate basis. Bank average mutual fund assets are up 15% year over year and flat QOQ.
• Wholesale banking earnings are expected to weaken modestly from the extremely high levels of the first half of the year. Trading is expected to be solid although weaker than first half and equity underwriting is also expected to be very weak with M&A mixed. Equity trading volumes declined 18% QOQ but are up 33% YOY. New equity issues declined both 34% YOY and QOQ with secondary financing also declining sharply at 40% QOQ and 19% YOY. In terms of M&A, Closed/Pending Value is up substantially both YOY and QOQ. CDN M&A Closed Deals Value is up 21% QOQ but down 49% YOY.
Interest Rates and Retail Net Interest Margin
• The prime rate increased 25 basis points (bp) in fiscal Q3/06 following a 50 bp increase in each of the previous three quarters. Short-term interest rates have now increased 175 bp or 42% in twelve months. The Bank of Canada left the overnight rate unchanged at its last announcement date, July 11. The increases in short-term rates we believe are positive for compression reversal, stabilizing the margin descent. However, the retail net interest margin (NIM) has yet to show any real improvement from these rate hikes due in part to interest rate guarantees on mortgages, lag impact, and competition.
• We expect retail net interest margin to remain stable in Q3/06, with margin expansion being pushed out until rates stabilize, which is expected over the next six to 12 months.
Dividend Increase Candidates RY and TD
• The likely candidates for dividend increases this quarter are RY and TD, with dividend increases in the 7% to 8% range expected. This follows dividend increases announced in the previous quarter Q2/06 by BMO, BNS, NA, and CM of 17%, 8.3%, 4.2%, and 2.9%, respectively. The bank group's dividend payout ratio on our 2006 earnings estimates is 43% with BMO a high of 51% with TD, NA and RY the low at 39%, 40% and 42% respectively.
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 stocks are underperforming the Resource led TSX year to date with a flat bank index versus a 7% gain for the overall market. The bank group betas have declined to 0.39 versus a 5 year beta of 0.8.
• Banks are trading at a low 11.9x our 2007 earnings estimates, with bank dividend yields relative to bonds, equity markets, income trusts, and pipelines and utilities all in the Strong Buy range.
• Canadian Banks' P/E premium to the major U.S. banks has declined from the 10% - 15% range to nominal. Canadian banks are at a 15% P/E multiple discount to U.S. Regional Banks. U.S. yield curve is now inverted.
• Solid earnings growth outlook and double-digit dividend growth expected for the next three to five years bodes well for resumption of bank share price appreciation.
• We reiterate our Overweight Banks recommendation, based on attractive valuation, strong fundamentals, and low relative risk.
• We maintain 1-Sector Outperform ratings on RY and BNS, 2-Sector Perform ratings on NA, CWB, LB and TD with 3-Sector Underperform ratings on BMO and CM.
Recent Events
BMO – Frank Techar Appointed Head of Canadian Retail Banking
• On June 6, BMO announced the appointment of Frank Techar as President and CEO, Personal and Commercial Banking Canada, effective July 1, 2006. This position was formerly held by Rob Pearce. Mr Techar had headed BMO's P&C Banking in the U.S. since 2002 as President and CEO of Harris Bankcorp.
• On July 19, BMO announced the appointment of Ellen Costello as CEO of Harris Bankcorp. She replaces Frank Techar who was recently made President and CEO, Personal and Commercial Banking in Canada. Ms Costello had previously held the position of Vice-Chair and Head, BMO Capital Markets, New York.
• On August 3, BMO announced its intention to acquire bcpbank Canada, a full-service chartered bank owned by Millennium bcp of Lisbon, Portugal for $41 million. Bcpbank Canada has a network of eight retail bank branches, seven of which are located in the Greater Toronto Area.
BNS – Costa Rican Acquisition
• On June 13, BNS announced that it would acquire Corporacion Interfin, parent of Banco Interfin, the largest private bank in Costa Rica, for Cdn $330 million. BNS intends to merge its existing operations with Interfin. The transaction is expected to close in August 2006.
CM – Global Crossing Lawsuit
• There was an action filed in New York on June 20 to add additional CIBC affiliates and other third party defendants to the claims originally filed in 2004 seeking $2 billion in profits from alleged insider trading with respect to Global Crossing. CIBC has said that the action contains no new claims against CIBC. CIBC filed to dismiss these claims in January of 2006 which is still pending.
NA – Louis Vachon Appointed COO
• On July 27, NA announced the appointment of Louis Vachon as COO of the company. Prior to this appointment, Louis Vachon was Senior Vice-President, Chairman and Chief Executive Officer of National Bank Financial Group.
TD – TD Banknorth and TD Ameritrade Earnings
• TD Banknorth (BNK) reported Q2/06 cash operating earnings of US$0.56 per share, versus US$0.55 per share in the previous quarter and US$0.63 per share a year earlier. Consensus was US$0.55 per share for the quarter. The operating contribution of BNK to TD Bank (TD) is estimated at C$0.09 per share versus C$0.08 per share last quarter and C$0.10 per share a year earlier
• TD Ameritrade (AMTD-NASDAQ) reported Q3/06 earnings of US$0.23 per share, versus IBES estimate of US$0.22 per share. At its current ownership level of 39.8%, the contribution to TD Bank (TD-T) is estimated at C$0.08 per share.
• On August 3, TD Ameritrade announced a share repurchase program of up to 12 million shares, or 2 percent of its shares outstanding.
