01 November 2006

Potential Impact of Trust Tax on Financials

Dow Jones Newswires, Monica Gutschi, 1 November 2006

Banks and life insurers are likely to reap the biggest benefit from the Canadian government's move to tax income-trust distributions.

With dividend yields of 3.2%, the financial-services companies will become attractive alternatives for investors seeking income who pull funds out of the beleaguered income-trust sector, analysts said Wednesday.

"We believe that banks will be net beneficiaries from the plan to tax trusts," BMO Capital Markets analyst Ian de Verteuil said in a morning note. "Banks have solid business models, high yields and excellent balance sheets."

The only potential negative for the banking sector from the announcement by Canadian Finance Minister Jim Flaherty is that their wholesale divisions have reaped underwriting fees from the flurry of Canadian corporations that have converted to income trusts. As well, analysts noted that many of the bank's wealth-management units offer retail funds that hold income trusts, and those are likely to see their assets under management fall.

But Andre-Philippe Hardy of Merrill Lynch estimated that underwriting revenue related to income trusts represents at most 2% of the banks' total revenue. As well, he suggested that Canadian wealth-management earnings are only about 10-15% of the banks' earnings, and are diversified across many businesses.

BMO's de Verteuil said the overall hit to banks could be 5% of quarterly earnings, although that would be offset over time by higher fees.

Canadian Imperial Bank of Commerce and Royal Bank of Canada have been the most active banks in the income-trust sector and have very large wealth-management franchises, so could have the highest earnings risk, de Verteuil noted.

However, "any short-term negative earnings effect will be more than offset by the higher relative attractiveness of bank shares overall," he wrote.

Mario Mendonca of Genuity Capital Markets noted the growth rate in dividends of most Canadian banks this year is 18%, exceeding the core rate of earnings growth of 14%.

Additionally, he noted average dividend yields of the eight largest banks "compares favorably" to the 4% yield on the Canadian government's 10-year bond.

Mendonca also said the country's six largest banks are trading below their March 2006 record highs, and well below their peaks versus the U.S. banks, setting them up for multiple expansion.

He noted the banks enjoyed a "strong run" after the previous Canadian government proposed a dividend tax cut last year.

Life insurance companies, such as Manulife Financial Corp., Sun Life Financial Inc. and Great-West Lifeco, should be least affected, Merrill Lynch's Hardy said. They are "less reliant on Canadian equity markets" and typically perform best in weaker equity markets, especially Great-West, "which should be helped by its industry-high dividend yield."
RBC Capital Markets, 1 November 2006

We are watching for good flow into the Canadian large cap financials, which are defensive, liquid and non-trusts. If only half of the $40B in market capitalization that our income trust group muse may be erased flows into large cap financials, the Financial sector could be up 6%. Fundamental valuation could support such a move as the banks are currently trading at ~12.8x our forward EPS estimates (13.0x consensus) and should be trading closer to 13.4x, given the current 4% 10 year GoC bond yield.

We believe Manulife and BNS could benefit the most from the announcement, with a favourable mention to BMO.

Considerations: There are 4 considerations in examining potential stock performance:

(i) Who has income trust exposure? Only one large cap financial is directly exposed. Sun Life own 35% of CI, which represents effectively ~5% of SLF’s market cap or $4/share. So a 20% hit to CI would imply an 80-cent hit to SLF value.

(ii) Who has the most CAD exposure? If the CAD goes into a weakening trend, we should focus on those Financials most insulated from the CAD weakness. RBC’s Global F/X Strategy group is now looking for technical targets of 1.14 (medium-term) and 1.17 (long-term). Those stocks most insulated would be Manulife (with only 22% of earnings in CAD) and BNS (with only 55% of earnings derived domestically). Least attractive if the CAD takes a header would be IAG among the lifecos, and National Bank and CIBC among banks.

(iii) Who has the most domestic wealth management exposure? The stock most insulated from CAD domestic wealth would be Manulife (5-6% of earnings only). The other three lifecos would be roughly equally impacted (at over 20%) though SLF would be the most high profile with CI and McLean Budden. Among banks, BNS is least exposed to domestic wealth.

(iv) Who has the highest dividend yield? The banks are yielding 3.2% with ~40% payouts, where BMO has the highest dividend yield among the big six at 3.6% and a payout ratio above 50%.
BMO Capital Markets, 1 November 2006

We believe that banks will be net beneficiaries from the plan to tax trusts. Banks have solid business models, high yields (3.2%) and excellent balance sheets. Compared to the rest of the market, banks should be relative winners from good funds flow out of trusts. Overall though, there could be some short-term earnings hit from the reduced investment banking activity levels by trusts and from the potential hit to mutual funds overall. We would broadly estimate that, all other things being equal, the hit could be 5% to quarterly earnings. Over the medium term, banks will offset this by other fees as corporate and retail clients react to the changes. In our opinion, any short-term negative earnings effect will be more than offset by the higher relative attractiveness of bank shares overall. Having said that, there could be some differentiation among the banks. We believe that CIBC and RY which has been more active in the trust sector and have very large wealth management franchises, could be singled out as having more ‘earnings at risk’ than their peers, while TD and BNS which have less exposure to investment banking, should be relative winners within the group. BMO and NA are probably somewhere in the middle. We continue to recommend bank shares overall, and this decision reduces the attractiveness of trusts vis-à-vis banks.