RBC Capital Markets, 7 September 2006
Valuation and Recommendation
Canadian banks trade at 12.7x estimated forward earnings – a compelling valuation given the excellent EPS growth, ROE, credit and capitalization. Our Sector Overweight recommendation reflects solid industry fundamentals and factors a 13x forward price/earnings (P/E) target multiple, supported by our valuation model and assuming a 4.25% domestic 10-year bond yield. Risks to our outlook include: (i) higher-thanexpected inflation and interest rates, and/or (ii) sharply rising impaired loan balances.
• Higher Estimates & Price Targets. We raised our 2006 and 2007 cash EPS estimates by an average of 1.5% and price targets by an average of 2%. The biggest change was a 9% reduction in estimated loan losses for 2007, effectively extending out our view of the credit (again). Impaired loans hit another record low and reserve coverage another high. We also tweaked retail net interest margin upwards.
• Focus Buy on TD. Given its discounted valuation, attractive business mix and excellent track record for growth, we think TD is the best choice for total return over the next 12 months. TD just beat consensus expectations cleanly. We are noting a positive inflection in the earnings of TD’s U.S. subsidiaries, which in our view is a key catalyst.
• Q3/06 Better Than Judged. Given all the pre-reporting hype, it was not surprising that investors judged this quarter’s results as disappointing. Most bank stocks traded down after reporting their results, TD being the notable exception. And this despite large positive EPS variances at most as investors interpreted Q3/06 results as lacking in quality. Upon closer examination, we think these results were much better than judged, and the current price levels will prove to be a great buying opportunity.
• Big Growth, Anyway You Measure It. In our view, even the most conservative interpretation of Q3/06 results would be they were collectively in line with expectations. Reported EPS was 10% above consensus and normalized, EPS was still ~5.5% ahead. Looking at growth, average reported EPS was up 18% year over year, still an impressive 15.8% normalized. RY’s normalized EPS growth of 25% led while CIBC, up 1% was lagged.
• Underlying EPS Analysis Favourable to RY, BNS. Our unique “underlying” EPS growth analysis (excludes the estimated impact of trading, securities gains and credit losses) shows the group generated 11% sustainable earnings growth year over year, matching the average of the last six quarters. By this measure, RY was indicated growing EPS at 22%, double the group average, while NA and CIBC are lagging. BNS is in the leadership position when measured in constant currency, up 24%.
• Positive Domestic Retail Operating Leverage. The difference in year-over-year growth between retail revenue and expenses remained positive. TD was strongest at +5.7% while BNS was the only bank with negative operating leverage. Overall, the group averaged 13.1% year-over-year growth in retail & wealth earnings this quarter. TD excelled, up 22% year over year, while BNS clearly lagged. Domestic retail revenue growth re-accelerated in Q3/06, assisted by improved product spreads.
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Valuation and Recommendation
Canadian banks trade at 12.7x estimated forward earnings – a compelling valuation given the excellent EPS growth, ROE, credit and capitalization. Our Sector Overweight recommendation reflects solid industry fundamentals and factors a 13x forward price/earnings (P/E) target multiple, supported by our valuation model and assuming a 4.25% domestic 10-year bond yield. Risks to our outlook include: (i) higher-thanexpected inflation and interest rates, and/or (ii) sharply rising impaired loan balances.
• Higher Estimates & Price Targets. We raised our 2006 and 2007 cash EPS estimates by an average of 1.5% and price targets by an average of 2%. The biggest change was a 9% reduction in estimated loan losses for 2007, effectively extending out our view of the credit (again). Impaired loans hit another record low and reserve coverage another high. We also tweaked retail net interest margin upwards.
• Focus Buy on TD. Given its discounted valuation, attractive business mix and excellent track record for growth, we think TD is the best choice for total return over the next 12 months. TD just beat consensus expectations cleanly. We are noting a positive inflection in the earnings of TD’s U.S. subsidiaries, which in our view is a key catalyst.
• Q3/06 Better Than Judged. Given all the pre-reporting hype, it was not surprising that investors judged this quarter’s results as disappointing. Most bank stocks traded down after reporting their results, TD being the notable exception. And this despite large positive EPS variances at most as investors interpreted Q3/06 results as lacking in quality. Upon closer examination, we think these results were much better than judged, and the current price levels will prove to be a great buying opportunity.
• Big Growth, Anyway You Measure It. In our view, even the most conservative interpretation of Q3/06 results would be they were collectively in line with expectations. Reported EPS was 10% above consensus and normalized, EPS was still ~5.5% ahead. Looking at growth, average reported EPS was up 18% year over year, still an impressive 15.8% normalized. RY’s normalized EPS growth of 25% led while CIBC, up 1% was lagged.
• Underlying EPS Analysis Favourable to RY, BNS. Our unique “underlying” EPS growth analysis (excludes the estimated impact of trading, securities gains and credit losses) shows the group generated 11% sustainable earnings growth year over year, matching the average of the last six quarters. By this measure, RY was indicated growing EPS at 22%, double the group average, while NA and CIBC are lagging. BNS is in the leadership position when measured in constant currency, up 24%.
• Positive Domestic Retail Operating Leverage. The difference in year-over-year growth between retail revenue and expenses remained positive. TD was strongest at +5.7% while BNS was the only bank with negative operating leverage. Overall, the group averaged 13.1% year-over-year growth in retail & wealth earnings this quarter. TD excelled, up 22% year over year, while BNS clearly lagged. Domestic retail revenue growth re-accelerated in Q3/06, assisted by improved product spreads.
