The Globe and Mail, Andrew Willis, 21 February 2007
As Toronto-Dominion Bank kicks off the big bank's quarterly financial reporting Thursday, the experts all agree the sector will continue to report fabulous profits from the retail branch networks.
The question analysts are asking is whether there are any surprises, good or bad, coming from the rest of the banks' operations that might move stocks one way or another.
With the exception of Canadian Imperial Bank of Commerce, where the share price has been rising steadily for eight months, bank stocks have gone sideways for the past three months. The domestic banking index up just 1.1-per-cent in the past quarter. However, the banks have been stellar performers over the past three years on the back of strong retail profits, and now command price-to-earnings multiples superior to those of U.S. and European peers.
“We remain steadfast in our view that the valuation premium of the Canadian banks is warranted,” said Credit Suisse analyst James Bantis in a report this week. He said: “Domestic retail earnings will once again underpin the earnings growth story in 2007.”
Beyond their retail operations, analysts see three major areas where the domestic banks could shock investors, for better or worse: provisions for bad loans, investment banking results and cost cutting.
The banks have enjoyed several years of minimal loan losses on the back of strong economic growth, and analysts forecast the good times to come to an end, with a fall in corporate credit quality. However, the banks proved better lenders than expected in 2006, with lower loan loss provisions than the analysts predicted. UBS Securities analyst Jason Bilodeau said in a report this week; “We expect the credit environment to slip. However, we expect the deterioration to be modest ... credit trends could come in slightly better than expected.”
On the investment banking front, there has been much hand-wringing on Bay Street over the federal government's decision to shut down the income trust market, a source of lucrative underwriting revenues for the Canadian bank-owned dealers for the past five years. But brokerage executives privately play down the potential for lost profits, because domestic underwriting has become an increasingly small component of most dealers' revenues.
“The cool-down in the income trust market is likely to have a marginal and we expect fleeting impact,” said Mr. Bilodeau. “We expect fairly healthy trading/capital markets fee revenue.”
When it comes to actually running the business, Bank of Montreal is the latest player to take an axe to costs, announcing up to 1,000 layoffs last month. Other banks may also announce initiatives aimed at boosting efficiency, as Mr. Bilodeau said: “With a slower top-line environment emerging, cost control/cutting efforts will be increasingly important to delivering bottom-line results.”
Three banks — TD, Royal Bank of Canada and CIBC — are expected to increase their quarterly dividends when they report results, with the bump forecast to be between 8 per cent and 12 per cent.
Here is what analysts are looking for at each of the six big banks: TD Bank reports Thursday and the consensus forecast from analysts has the bank earning $1.27 a share for the three months ended Jan 31. Domestic retail profits are expected to slow slightly from last year's heady 22-per-cent clip, but still grow at a double-digit pace.
National Bank reports on March 1 and is expected to post $1.31 per share profit. Investors will be looking for some sense of strategic direction from newly-named chief executive officer Louis Vachon.
Bank of Montreal reports March 1 and while the consensus earnings forecast is $1.29, the estimates range widely after a disappointing finish to 2006. Analysts will be trying to determine whether the bank is beginning to regain market share in domestic retail banking while at the same time bringing down costs.
CIBC also reports March 1 and is expected to earn $1.94. The bank picked up retail market share in 2006 and analysts will want to see whether this growth continues; CIBC may also announce a stock split.
Royal Bank reports on March 2, and is expected to earn 98 cents a share. The largest domestic branch network was also the fastest growing in 2006, and there are expectations that RBC's retail profit growth will slow to the industry's pace.
Bank of Nova Scotia is up to bat on March 6 and is expected to earn 94 cents a share. International expansion was the biggest driver of growth last year, and that's expected to continue. Analysts would like to see Scotiabank's domestic retail network gain market share on rivals.
As Toronto-Dominion Bank kicks off the big bank's quarterly financial reporting Thursday, the experts all agree the sector will continue to report fabulous profits from the retail branch networks.
The question analysts are asking is whether there are any surprises, good or bad, coming from the rest of the banks' operations that might move stocks one way or another.
With the exception of Canadian Imperial Bank of Commerce, where the share price has been rising steadily for eight months, bank stocks have gone sideways for the past three months. The domestic banking index up just 1.1-per-cent in the past quarter. However, the banks have been stellar performers over the past three years on the back of strong retail profits, and now command price-to-earnings multiples superior to those of U.S. and European peers.
“We remain steadfast in our view that the valuation premium of the Canadian banks is warranted,” said Credit Suisse analyst James Bantis in a report this week. He said: “Domestic retail earnings will once again underpin the earnings growth story in 2007.”
Beyond their retail operations, analysts see three major areas where the domestic banks could shock investors, for better or worse: provisions for bad loans, investment banking results and cost cutting.
The banks have enjoyed several years of minimal loan losses on the back of strong economic growth, and analysts forecast the good times to come to an end, with a fall in corporate credit quality. However, the banks proved better lenders than expected in 2006, with lower loan loss provisions than the analysts predicted. UBS Securities analyst Jason Bilodeau said in a report this week; “We expect the credit environment to slip. However, we expect the deterioration to be modest ... credit trends could come in slightly better than expected.”
On the investment banking front, there has been much hand-wringing on Bay Street over the federal government's decision to shut down the income trust market, a source of lucrative underwriting revenues for the Canadian bank-owned dealers for the past five years. But brokerage executives privately play down the potential for lost profits, because domestic underwriting has become an increasingly small component of most dealers' revenues.
“The cool-down in the income trust market is likely to have a marginal and we expect fleeting impact,” said Mr. Bilodeau. “We expect fairly healthy trading/capital markets fee revenue.”
When it comes to actually running the business, Bank of Montreal is the latest player to take an axe to costs, announcing up to 1,000 layoffs last month. Other banks may also announce initiatives aimed at boosting efficiency, as Mr. Bilodeau said: “With a slower top-line environment emerging, cost control/cutting efforts will be increasingly important to delivering bottom-line results.”
Three banks — TD, Royal Bank of Canada and CIBC — are expected to increase their quarterly dividends when they report results, with the bump forecast to be between 8 per cent and 12 per cent.
Here is what analysts are looking for at each of the six big banks: TD Bank reports Thursday and the consensus forecast from analysts has the bank earning $1.27 a share for the three months ended Jan 31. Domestic retail profits are expected to slow slightly from last year's heady 22-per-cent clip, but still grow at a double-digit pace.
National Bank reports on March 1 and is expected to post $1.31 per share profit. Investors will be looking for some sense of strategic direction from newly-named chief executive officer Louis Vachon.
Bank of Montreal reports March 1 and while the consensus earnings forecast is $1.29, the estimates range widely after a disappointing finish to 2006. Analysts will be trying to determine whether the bank is beginning to regain market share in domestic retail banking while at the same time bringing down costs.
CIBC also reports March 1 and is expected to earn $1.94. The bank picked up retail market share in 2006 and analysts will want to see whether this growth continues; CIBC may also announce a stock split.
Royal Bank reports on March 2, and is expected to earn 98 cents a share. The largest domestic branch network was also the fastest growing in 2006, and there are expectations that RBC's retail profit growth will slow to the industry's pace.
Bank of Nova Scotia is up to bat on March 6 and is expected to earn 94 cents a share. International expansion was the biggest driver of growth last year, and that's expected to continue. Analysts would like to see Scotiabank's domestic retail network gain market share on rivals.
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Scotia Capital, 19 February 2007
Overview
• Banks begin reporting first quarter earnings February 22. We are looking for continued earnings resilience with growth expected at 11%. RY is rated 1-Sector Outperform. Maintain Overweight recommendation.
Banks Begin Reporting February 22
• Banks begin reporting first quarter earnings, with Toronto-Dominion Bank (TD) on February 22, followed by Laurentian Bank (LB) February 27; Bank of Montreal (BMO), Canadian Imperial Bank of Commerce (CM), and National Bank (NA) March 1; Royal Bank (RY) March 2; Bank of Nova Scotia (BNS) March 6; and Canadian Western (CWB) closing out reporting March 8. Scotia Capital’s earnings estimates are highlighted in Exhibit 1, consensus earnings estimates/target prices in Exhibit 3, conference call information in Exhibit 4, and dividend increases and trends in Exhibit 7.
Q1 Earnings Growth Forecast 11%
• We expect first quarter earnings for the bank group to increase 11% year over year and 2% sequentially. Earnings growth is expected to continue to be driven by wealth management, with solid earnings from retail and wholesale. Loan loss provisions are expected to remain at low levels. We expect LLPs to increase 28% to $662 million but remain at extremely low levels at 0.28% of loans. We believe loan loss provisions troughed in 2006 at 0.22% of loans.
• CM and RY are expected to lead in earnings growth at 20%, 13% and 12%, respectively. CM earnings growth continues to be driven by cost cutting and a relatively low earnings base. Revenue performance is expected to remain weak. RY earnings growth is expected to be driven by the strength of retail and wealth management platforms. Bank group profitability is expected to continue to run at historical highs on very large capital positions with return on equity of 21.2%.
• Wealth management earnings are expected to continue to be strong, although only three banks disclose these earnings on a separate basis, with RY recently announcing that it will segment its wealth management earnings beginning Q2/07. Bank average mutual fund assets are up 16% from a year earlier and 6% sequentially. The banks continue to dominate mutual fund sales; particularly RY and TD, with market share of long-term asset net sales at 20% and 16%, respectively, during the quarter.
• Retail banking earnings are expected to remain solid, although we expect some slowing in earnings growth in 2007 and 2008 as loan growth slows due to the weakening real estate markets. The major question is to what degree net interest margin expansion may offset the lower volume growth. The prime rate has increased 175 basis points or 41% in the past two years, with Q4/06 the first quarter in a year with no rate hike. We believe the stability of the prime rate at these higher levels will be positive for margin expansion and could be the source of a positive earnings surprise from the bank group. An improving retail margin could boost earnings growth to the 12% range in 2007, representing the third straight year of positive earnings surprises.
• Wholesale banking earnings are expected to remain solid, supported by strong revenue and cost containment offset by modestly higher loan losses due to lower loan loss recoveries, although LLPs are expected to remain at negligible levels. The wholesale net interest spread was solid in the quarter at 166 bp, up 5 bp from a year earlier and down 1 bp sequentially.
• Capital markets activity remained relatively strong in Q1, with TSX trading volume up 14% year over year and 15% sequentially. IPO dollar value increased sequentially by 45% but declined 3% from a year earlier. M&A activity continued to be very strong, up 13% sequentially and more than double from a year earlier. Bond yields backed up in Q1 in both Canada and the U.S. by 15 bp and 21 bp, respectively.
• Other earnings factors in the quarter are that stock-based compensation is expected to be up due to the 7% increase in bank share prices during the quarter. The Canadian dollar weakened 3.1% in the quarter sequentially against the U.S. dollar and 3.1% against the peso.
Dividend Increase expected from CM, RY, and TD
• Dividend increase candidates this quarter are CM, RY, and TD, with dividend increases expected to be in the 7% to 14% range (Exhibit 7). This follows dividend increases announced in the previous quarter by BMO, BNS, and NA of 5%, 8%, and 8%, respectively.
• The bank group’s dividend payout ratio on our 2007 earnings estimates is 41% and 38% on our 2008 earnings estimates, with BMO at a high of 49% and CM and NA at the low end at 35% and 37%, respectively. We continue to expect bank dividend payout ratios to drift towards 50%.
Stock Split likely for CM
• CM is the most likely candidate for a stock split given its share price levels. BMO, NA and TD are also stock split candidates over the next year. This follows stock splits by CWB in December 2006, RY in March 2006, and BNS in March 2004.
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 slightly underperforming the TSX early in the year (year to date as at February 15, 2007), with the bank index unchanged versus 3% gain for the overall market. Banks are trading at a low 13.4x our 2007 earnings estimates, with bank dividend yields relative to bonds (Exhibit 12), equity markets (Exhibit 13), pipelines and utilities (Exhibit 14) and income trusts (Exhibit 15) all in the Strong Buy range. Reversion to the mean would result in the bank index increasing on a relative basis by 41%, 34%, 35%, and 17% versus the bonds, equity markets, pipes & utilities, and income trusts.
• Canadian banks are trading at a 5% premium to the major U.S. banks and an 18% discount to U.S. regional Banks. The Canadian Banks premium, we believe, is fully supported by the respective government bond yields and lower earnings risk in the Canadian Banks, higher profitability, and stronger capital positions.
• We reiterate our Overweight Banks recommendation, based on attractive valuation, strong fundamentals, and low relative risk. We maintain a 1-Sector Outperform ratings on RY 2-Sector Perform ratings on CM, CWB, LB, and TD, with 3-Sector Underperform ratings on BMO and NA. We continue to have no sells in the bank group on an absolute return basis.
First Quarter Highlights
• Bank of Montreal is expected to report earnings of $1.28 per share, an 8% YOY increase and a decline of 3% sequentially. Earlier this month, BMO announced a restructuring charge for Q1 of $0.18 per share; therefore, reported earnings are expected to be $1.10 per share.
• Canadian Imperial Bank of Commerce is expected to report $1.95 per share, an increase of 20% YOY and a decline of 3% sequentially. Earnings are expected to be supported be strong M&A revenue. CM has been very successful at cost reduction and has significantly reduced the risk in its retail loan portfolio. However, revenue and market share weakness is its biggest challenge. A dividend increase of 14% to $3.20 per share is expected and a 2-for-1 stock split. This dividend increase would bring CM’s payout ratio to 40% on our 2007 earnings estimates, the low end of its target payout ratio range of 40%-50%.
• National Bank is expected to report $1.34 per share in the first quarter, an increase of 6% YOY and 2% sequentially. Wealth management earnings should remain solid. We remain concerned about the bank’s reliance on security gains and trading revenue over the past several quarters for earnings growth.
• Royal Bank is expected to report $0.99 per share, an increase of 13% YOY and 2% QOQ. Retail and wealth management earnings are expected to remain solid with overall earnings quality high. A dividend increase of 8% to $1.72 per share is expected.
• Toronto-Dominion Bank is expected to report $1.25 per share, an increase of 9% YOY and 4% QOQ. Retail earnings are expected to continue to be the earnings driver, with the U.S. platforms a drag on earnings growth. TD Ameritrade earnings contributions for Q1/07 are estimated at $0.09 per share versus $0.07 per share in the previous quarter, with TD Banknorth earnings of $0.09 per share, unchanged from the previous quarter. A dividend increase of 6 % to $2.04 per share is expected for TD.
BMO - Restructuring Charge
• On January 31, 2007, BMO announced a restructuring charge of $135 million ($88 million after tax or $0.18 per share). Approximately 1,000 jobs will be cut in an attempt to rejuvenate earnings and achieve financial targets in 2007. BMO stated that the cost savings will be invested in front-line sales and service in order to improve its retail operations, which have been a drag on earnings in recent quarters.
BNS Acquires Travelers Leasing Corporation
• On November 14, 2006, Scotiabank announced the acquisition of Travelers Leasing Corporation (TLC), a leading Canadian automobile financing company. The terms of the transaction were not disclosed. TLC is based in British Columbia and currently has $255 million in loans under management. The transaction closed February 15, 2007.
NA - New CEO
• On January 11, 2007, NA announced that Louis Vachon, the current Chief Operating Officer, will become the new Chief Executive Officer, effective June 1, 2007. Real Raymond, the current CEO, will serve as a part-time Special Advisor after May 31, 2007.
CM Completes FirstCaribbean Transaction
• On December 22, 2006, CM completed the US$1.1 billion purchase of Barclays’ 43.7% interest in FirstCaribbean, increasing its ownership to 87.4%. CM and Barclays merged operations in 2002 to create FirstCaribbean, of which each party owned 43.7%. Subsequent to acquiring Barclays’ stake, CM extended an offer to all remaining shareholders, acquiring an additional 4.1% of shares for total ownership of 91.5% as at January 30, 2007. This transaction is expected to be dilutive to cash EPS by C$0.01 in 2007. As a result of the FirstCaribbean acquisition, Tier 1 capital ratio is expected to decline to 9.9% from 10.4% in Q1 with tangible common equity declining to 7.0% from 7.7%.
RY - To Report Wealth Management Segment Earnings
• RY announced on February 7, 2006, that beginning in Q2/07 it will report financial results for its Wealth Management segment. We expect this would be positive for the bank, given RY’s significant Wealth Management business and the overall impact of Wealth Management earnings, which carry a higher P/E multiple than other business segments.
TD Banknorth Buy In
• On November 21, 2006, TD announced that it would acquire the remaining 41% stake in TD Banknorth for US$32.33 per BNK share or US$3.2 billion (C$3.6 billion) in an all-cash offer. The transaction will be financed by $3.0 billion, primarily of subordinated debt. The transaction is expected to be accretive to TD by $0.05 per share in 2007 and $0.16 per share in 2008. Closing is expected for March or April 2007.
TD - TD Ameritrade and TD Banknorth Earnings
• TD Ameritrade (AMTD) reported Q1/07 cash earnings of US$0.24 per share, up 14% from US$0.22 per share a year earlier, versus the IBES estimate of US$0.20 per share. At its current ownership level of 39.8%, the contribution to TD would be C$64 million or C$0.09 per share.
• TD Banknorth (BNK) reported Q4/06 cash earnings of US$0.51 per share, a decline of 18% from US$0.62 per share a year earlier and in line with IBES estimate of US$0.51 per share. TD indicated that BNK’s contribution this quarter would be C$64 million or C$0.09 per share.
Overview
• Banks begin reporting first quarter earnings February 22. We are looking for continued earnings resilience with growth expected at 11%. RY is rated 1-Sector Outperform. Maintain Overweight recommendation.
Banks Begin Reporting February 22
• Banks begin reporting first quarter earnings, with Toronto-Dominion Bank (TD) on February 22, followed by Laurentian Bank (LB) February 27; Bank of Montreal (BMO), Canadian Imperial Bank of Commerce (CM), and National Bank (NA) March 1; Royal Bank (RY) March 2; Bank of Nova Scotia (BNS) March 6; and Canadian Western (CWB) closing out reporting March 8. Scotia Capital’s earnings estimates are highlighted in Exhibit 1, consensus earnings estimates/target prices in Exhibit 3, conference call information in Exhibit 4, and dividend increases and trends in Exhibit 7.
Q1 Earnings Growth Forecast 11%
• We expect first quarter earnings for the bank group to increase 11% year over year and 2% sequentially. Earnings growth is expected to continue to be driven by wealth management, with solid earnings from retail and wholesale. Loan loss provisions are expected to remain at low levels. We expect LLPs to increase 28% to $662 million but remain at extremely low levels at 0.28% of loans. We believe loan loss provisions troughed in 2006 at 0.22% of loans.
• CM and RY are expected to lead in earnings growth at 20%, 13% and 12%, respectively. CM earnings growth continues to be driven by cost cutting and a relatively low earnings base. Revenue performance is expected to remain weak. RY earnings growth is expected to be driven by the strength of retail and wealth management platforms. Bank group profitability is expected to continue to run at historical highs on very large capital positions with return on equity of 21.2%.
• Wealth management earnings are expected to continue to be strong, although only three banks disclose these earnings on a separate basis, with RY recently announcing that it will segment its wealth management earnings beginning Q2/07. Bank average mutual fund assets are up 16% from a year earlier and 6% sequentially. The banks continue to dominate mutual fund sales; particularly RY and TD, with market share of long-term asset net sales at 20% and 16%, respectively, during the quarter.
• Retail banking earnings are expected to remain solid, although we expect some slowing in earnings growth in 2007 and 2008 as loan growth slows due to the weakening real estate markets. The major question is to what degree net interest margin expansion may offset the lower volume growth. The prime rate has increased 175 basis points or 41% in the past two years, with Q4/06 the first quarter in a year with no rate hike. We believe the stability of the prime rate at these higher levels will be positive for margin expansion and could be the source of a positive earnings surprise from the bank group. An improving retail margin could boost earnings growth to the 12% range in 2007, representing the third straight year of positive earnings surprises.
• Wholesale banking earnings are expected to remain solid, supported by strong revenue and cost containment offset by modestly higher loan losses due to lower loan loss recoveries, although LLPs are expected to remain at negligible levels. The wholesale net interest spread was solid in the quarter at 166 bp, up 5 bp from a year earlier and down 1 bp sequentially.
• Capital markets activity remained relatively strong in Q1, with TSX trading volume up 14% year over year and 15% sequentially. IPO dollar value increased sequentially by 45% but declined 3% from a year earlier. M&A activity continued to be very strong, up 13% sequentially and more than double from a year earlier. Bond yields backed up in Q1 in both Canada and the U.S. by 15 bp and 21 bp, respectively.
• Other earnings factors in the quarter are that stock-based compensation is expected to be up due to the 7% increase in bank share prices during the quarter. The Canadian dollar weakened 3.1% in the quarter sequentially against the U.S. dollar and 3.1% against the peso.
Dividend Increase expected from CM, RY, and TD
• Dividend increase candidates this quarter are CM, RY, and TD, with dividend increases expected to be in the 7% to 14% range (Exhibit 7). This follows dividend increases announced in the previous quarter by BMO, BNS, and NA of 5%, 8%, and 8%, respectively.
• The bank group’s dividend payout ratio on our 2007 earnings estimates is 41% and 38% on our 2008 earnings estimates, with BMO at a high of 49% and CM and NA at the low end at 35% and 37%, respectively. We continue to expect bank dividend payout ratios to drift towards 50%.
Stock Split likely for CM
• CM is the most likely candidate for a stock split given its share price levels. BMO, NA and TD are also stock split candidates over the next year. This follows stock splits by CWB in December 2006, RY in March 2006, and BNS in March 2004.
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 slightly underperforming the TSX early in the year (year to date as at February 15, 2007), with the bank index unchanged versus 3% gain for the overall market. Banks are trading at a low 13.4x our 2007 earnings estimates, with bank dividend yields relative to bonds (Exhibit 12), equity markets (Exhibit 13), pipelines and utilities (Exhibit 14) and income trusts (Exhibit 15) all in the Strong Buy range. Reversion to the mean would result in the bank index increasing on a relative basis by 41%, 34%, 35%, and 17% versus the bonds, equity markets, pipes & utilities, and income trusts.
• Canadian banks are trading at a 5% premium to the major U.S. banks and an 18% discount to U.S. regional Banks. The Canadian Banks premium, we believe, is fully supported by the respective government bond yields and lower earnings risk in the Canadian Banks, higher profitability, and stronger capital positions.
• We reiterate our Overweight Banks recommendation, based on attractive valuation, strong fundamentals, and low relative risk. We maintain a 1-Sector Outperform ratings on RY 2-Sector Perform ratings on CM, CWB, LB, and TD, with 3-Sector Underperform ratings on BMO and NA. We continue to have no sells in the bank group on an absolute return basis.
First Quarter Highlights
• Bank of Montreal is expected to report earnings of $1.28 per share, an 8% YOY increase and a decline of 3% sequentially. Earlier this month, BMO announced a restructuring charge for Q1 of $0.18 per share; therefore, reported earnings are expected to be $1.10 per share.
• Canadian Imperial Bank of Commerce is expected to report $1.95 per share, an increase of 20% YOY and a decline of 3% sequentially. Earnings are expected to be supported be strong M&A revenue. CM has been very successful at cost reduction and has significantly reduced the risk in its retail loan portfolio. However, revenue and market share weakness is its biggest challenge. A dividend increase of 14% to $3.20 per share is expected and a 2-for-1 stock split. This dividend increase would bring CM’s payout ratio to 40% on our 2007 earnings estimates, the low end of its target payout ratio range of 40%-50%.
• National Bank is expected to report $1.34 per share in the first quarter, an increase of 6% YOY and 2% sequentially. Wealth management earnings should remain solid. We remain concerned about the bank’s reliance on security gains and trading revenue over the past several quarters for earnings growth.
• Royal Bank is expected to report $0.99 per share, an increase of 13% YOY and 2% QOQ. Retail and wealth management earnings are expected to remain solid with overall earnings quality high. A dividend increase of 8% to $1.72 per share is expected.
• Toronto-Dominion Bank is expected to report $1.25 per share, an increase of 9% YOY and 4% QOQ. Retail earnings are expected to continue to be the earnings driver, with the U.S. platforms a drag on earnings growth. TD Ameritrade earnings contributions for Q1/07 are estimated at $0.09 per share versus $0.07 per share in the previous quarter, with TD Banknorth earnings of $0.09 per share, unchanged from the previous quarter. A dividend increase of 6 % to $2.04 per share is expected for TD.
BMO - Restructuring Charge
• On January 31, 2007, BMO announced a restructuring charge of $135 million ($88 million after tax or $0.18 per share). Approximately 1,000 jobs will be cut in an attempt to rejuvenate earnings and achieve financial targets in 2007. BMO stated that the cost savings will be invested in front-line sales and service in order to improve its retail operations, which have been a drag on earnings in recent quarters.
BNS Acquires Travelers Leasing Corporation
• On November 14, 2006, Scotiabank announced the acquisition of Travelers Leasing Corporation (TLC), a leading Canadian automobile financing company. The terms of the transaction were not disclosed. TLC is based in British Columbia and currently has $255 million in loans under management. The transaction closed February 15, 2007.
NA - New CEO
• On January 11, 2007, NA announced that Louis Vachon, the current Chief Operating Officer, will become the new Chief Executive Officer, effective June 1, 2007. Real Raymond, the current CEO, will serve as a part-time Special Advisor after May 31, 2007.
CM Completes FirstCaribbean Transaction
• On December 22, 2006, CM completed the US$1.1 billion purchase of Barclays’ 43.7% interest in FirstCaribbean, increasing its ownership to 87.4%. CM and Barclays merged operations in 2002 to create FirstCaribbean, of which each party owned 43.7%. Subsequent to acquiring Barclays’ stake, CM extended an offer to all remaining shareholders, acquiring an additional 4.1% of shares for total ownership of 91.5% as at January 30, 2007. This transaction is expected to be dilutive to cash EPS by C$0.01 in 2007. As a result of the FirstCaribbean acquisition, Tier 1 capital ratio is expected to decline to 9.9% from 10.4% in Q1 with tangible common equity declining to 7.0% from 7.7%.
RY - To Report Wealth Management Segment Earnings
• RY announced on February 7, 2006, that beginning in Q2/07 it will report financial results for its Wealth Management segment. We expect this would be positive for the bank, given RY’s significant Wealth Management business and the overall impact of Wealth Management earnings, which carry a higher P/E multiple than other business segments.
TD Banknorth Buy In
• On November 21, 2006, TD announced that it would acquire the remaining 41% stake in TD Banknorth for US$32.33 per BNK share or US$3.2 billion (C$3.6 billion) in an all-cash offer. The transaction will be financed by $3.0 billion, primarily of subordinated debt. The transaction is expected to be accretive to TD by $0.05 per share in 2007 and $0.16 per share in 2008. Closing is expected for March or April 2007.
TD - TD Ameritrade and TD Banknorth Earnings
• TD Ameritrade (AMTD) reported Q1/07 cash earnings of US$0.24 per share, up 14% from US$0.22 per share a year earlier, versus the IBES estimate of US$0.20 per share. At its current ownership level of 39.8%, the contribution to TD would be C$64 million or C$0.09 per share.
• TD Banknorth (BNK) reported Q4/06 cash earnings of US$0.51 per share, a decline of 18% from US$0.62 per share a year earlier and in line with IBES estimate of US$0.51 per share. TD indicated that BNK’s contribution this quarter would be C$64 million or C$0.09 per share.
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BMO Capital Markets, 13 February 2007
Spreads - Consistent Signs That They Will Be Stable
Core Personal and Commercial Bank spreads have been under pressure for several years (see Chart 1), reflecting a material shift in business mix from high spread business loans to low spread residential mortgage loans. The majority of this mix shift has now run its course. Better demand for business borrowing plus some moderation in the demand for mortgage credit have resulted in stable loan mix and should ensure stable spreads.
Of course, other variables- Prime-BA spreads, absolute levels of interest rates and general competitive conditions- are also important in impacting spreads, but are far less material. The good news is that these secondary factors have generally been quite supportive. Prime-BA spreads broadly give us insight into the margins achieved on retail loans that are funded by wholesale money. With the well-telegraphed increase in the Bank Rate through most of 2006, wholesale markets anticipated the rate changes, which caused periodic compression of Prime-BA spreads. The good news is that in the past two quarters, a less well-defined trend in rates has made for modestly wider retail-wholesale spreads. As we show in Table 1, average Prime-BA spreads have been 169-170 basis points in the past two quarters.
While the rises in the Prime Rate temporarily hurt Prime-BA spreads, the good news is that it did take some pressure off deposit pricing. Remember that banks have a certain amount of 'free float' where there is either zero or minimal interest rates. These deposits are part of the funding mix for Prime-priced loans. All in, therefore, a higher Prime Rate is beneficial to margins.
Another variable that is somewhat positive is competitive conditions. Though there still remains a plethora of competitors who are prepared to undercut bank pricing (both on the deposit and loan side of the balance sheet), the highest profile competitor in High-Interest Savings accounts, ING Bank, continues to struggle with a flat yield curve that has compressed its spreads. We believe that there is a bit more sanity to the market now, and that most of the damage has already been done. At this stage, new entrants such as Altamira and Dundee seem to be more of a threat to ING than to banks themselves.
Loan Growth - More of the Same
We continue to be pleasantly surprised by the strength of loan growth in Canada. Overall loan growth, inclusive of consumer and business credit, grew at about 12% in November and December (see Chart 2). Although this is the slowest pace in the past year, it is still more than adequate to allow banks to show operating leverage and solid net interest income growth.
Despite the recent strength, it is not lost on us that loan growth is likely to slow in 2007. We forecast overall loan growth in 2007 of 7%, implying a relatively mundane outlook for growth in the second half of the year. Essentially, we believe that continued strength in business borrowing (driven by a relatively strong dollar, which creates tougher operating conditions for businesses and increases the appeal of additional investment in fixed assets) will not be enough to offset a slowdown in the consumer in later this year.
Trading Revenues - Seasonal Strength May Offset Low Volatility
Trading revenues in the second half of 2006 were certainly weaker than expected, reflecting the seasonal weakness in the business and the record low volatility in several markets. Volatility has remained very low and, as such, we would expect trading books to perform a bit better than in the fourth quarter, but below the performance of the first quarter of 2006.
We continue to grapple with the increased capital committed by most banks (but particularly Royal Bank) to trading because the increased capital has yet to produce any meaningful increase in trading revenues. Furthermore, this has occurred in an environment where VaR (which is mathematically affected by volatility) hasn’t moved much. Taken together, we believe that trading revenues, which are relatively unchanged in the past four years, could actually move meaningfully higher in the medium term.
Capital Markets - Little Impact from the Income Trust Fallout
Bank stocks really do climb a 'wall of worry.' With the decision to tax trusts, several parties highlighted the risk to bank earnings from lower capital markets activity levels. We believe that the banks will again show this quarter that their investment dealers are nothing if not resourceful (no pun intended).
We believe the revenues from M&A and underwriting will be as good this quarter as they have been anytime in the past year. Of course, the big driver has been M&A activity with numerous high profile deals, including Falconbridge, Glamis and Summit, over the past six months. We see little reason to forecast any slowdown given the tremendous liquidity, high interest by private equity buyers and an entire trust sector that probably needs to restructure in the next three to four years. This quarter, it appears as if TD, CIBC, and Scotia have all had comparatively strong performances.
Dividend Activity - A Hat Trick of Increases
We expect dividend increases from TD, CM, and RY this quarter (see Table 2). The most meaningful will be CIBC, which has telegraphed a review of its dividend and buyback policies. With the successful completion of the FCIB deal, the bank now has relatively good visibility on its capital needs. We expect a 10%-plus increase in dividend, a reinstatement of its share buyback program and a stock split (either 2:1 or 3:1). There is also a case to be made for an increase in the target payout range- though this is more of a possibility than a likely event.
Royal and TD are also both expected to increase dividends, despite the fact that the two continue to be at other ends of the payout spectrum. TD remains quite conservative and is far more cautious on dividend increases, while Royal is more focused on rewarding investors today with a 10% dividend increase. The reality is that the former is run by a CEO who is more cautious on the future than the latter. Over the past few years, TD has de-risked and has been preparing for a weaker environment (complete with greater risk premiums). On the other hand, Royal Bank has bet that the environment would hold together well and this bet has clearly paid dividends (both figuratively and literally) for RY shareholders. Of course, the reality is that success of either path will be clear only in the next down-cycle.
Other Items
New Accounting Rules: The bane of all analysts’ existence, new accounting rules, will be in full view this quarter. Starting this quarter, the CICA will require banks to adopt the U.S.-style 'other comprehensive income' (OCI) for establishing a market value for financial instruments (largely all assets other than loans and fixed assets).
This will create a transitional bump to OCI for banks with large unrealized securities gains (BNS and TD). It is unclear whether the market will include these taxed gains in book value and the calculation of ROE. We still expect banks to disclose the income statement impact of gains or losses in each quarter (at least for the banks that have done this in the past).
Tax Rate: We expect tax rates to be relatively comparable in 2007, exclusive with the few one-time items at CIBC, TD, and BMO. We continue to be surprised by the degree of success the industry has had in getting tax rates down to the mid-20% range (on a TEB basis). To date there is little sign that much will change on this front, but this remains one area where there is exogenous risk.
Loan Losses: No news is generally good news in the world of credit. We expect a modest uptick in loan losses, largely driven by fewer reversals rather than a fundamental deterioration in the loan book.
Individual Company Comments
• TD Bank - Retail and Wealth Management Continue to Drive Earnings
TD Bank reports earnings on Thursday, February 22nd, a full week ahead of the next bank, so its results will set the tone for investor perception on industry-wide trends. The bottom line improvements at TD (i.e. EPS increase) will likely be somewhat mundane but the fundamentals should be quite robust. We should note that the year-ago quarter was inflated by the large AMTD gain on dilution.
The core Personal and Commercial Banking business should continue to perform well with year-over-year growth of about 10%, reflecting strong volume growth and stable margins. Loan losses may continue to track modestly higher as the VFC book continues to mature. Given the material number of branch openings late in 2006, expense growth should moderate the strong revenue performance.
Both TD Ameritrade and TD Banknorth have pre-announced results that will add $64 million each to TD overall. This is the last quarter when the year-over-year comparison is affected by the timing of the Waterhouse-Ameritrade deal and it is appropriate that AMTD is beginning to show some operating leverage to TD’s earnings. The Wealth Business (domestic full-service, mutual funds and discount brokerage) should show a material quarter-over-quarter improvement for seasonal reasons.
TD Securities should have another solid quarter. Indeed, given the strong performance by the dealer at the end of the calendar year and with the seasonal strength of the trading business, there is potential for a very strong quarter. On the other hand, the reality is that volatility has remained low and TD Securities may take the opportunity to heavy up on accruals this early in the year. Our forecast of over $150 million of earnings is toward the higher end of the annual guidance.
The Corporate segment, after a fourth quarter that saw tax refunds and high levels of securitizations generate an unusual profit, should be back to a more normal run rate of a slight loss.
There will be several 'non-income statement' issues that will be noteworthy this quarter. We expect to see a solid dividend increase, to $0.51 from $0.48. CEO, Ed Clark, recently said that he would consider materially higher dividends if the bank was not growing meaningfully, so we don’t expect any change in target payout ratio. In addition, the hedge transaction that allowed the bank to get its ownership interest in AMTD to 45% will use up some capital. Overall, we expect the growth in retained earnings will mitigate some of this effect, and we believe that Tier 1 will be modestly lower. ROE and book value may be impacted by the creation of an OCI account.
• CIBC - Another Quarter of Upside Potential
After the strong results last quarter, CIBC has certainly begun to attract more fans. We believe that there is still some potential for further earnings revisions. Furthermore, the First Caribbean deal has now closed, so there is far more urgency for the dividend and the buyback issues to be addressed. Bottom line: it is hard to see much other than good news this quarter. The only issue is whether the CIBC results can gain any traction on a day in which two other banks report.
On the retail side, the bank appeared to have turned the corner in the middle of 2006. We believe that the combination of stable market share, tight control of expenses and reductions in loan losses argues for continued earnings momentum. Indeed, we would not be surprised to see CIBC have some of the better retail year-over-year trends in the first half of 2007.
CIBC World Markets also looks set for a solid quarter. Strong revenue in M&A and underwriting should offset a difficult comparison in trading, where the year-ago and linked quarter results were very robust. All in, we expect the dealer to continue to earn in the $125-175 million range. We also note that the first quarter of last year did see a somewhat elevated tax rate at World Markets, so this will help somewhat in the comparisons with last year.
Loan losses should continue to be well managed, with declining losses in the retail book offsetting higher levels in the corporate book. While there are still no obvious problems in the loan book generally, it is hard not to expect lower levels of reversals during 2007.
Like TD, there will be some focus on balance sheet strength, buybacks and share repurchases. The FCIB deal closed in late December and will take Tier 1 down from the 10.4% level at year-end. Despite this, a figure of around 9.0% seems reasonable at the end of the first quarter. We note that there were more FCIB shares tended by the minority to the follow-up bid than we had expected, so there will be slightly more leverage added in the quarter. The good news is that the acquisition will be slightly more accretive than we had forecast.
The buyback/dividend issue will be more important matter for investors. We assume an 11% increase in the dividend and a re-initiation of the buyback program. We would be surprised if CIBC was aggressive in the latter, at this stage- since the shares are at all-time highs, and the valuation is comparable to its peers. What is most likely is a commitment to ongoing regular dividend increases and gradual buybacks. We believe that there could be some opportunities for incremental capital deployment in the Caribbean, but this will obviously be opportunistically driven.
On a more superficial perspective, CIBC could easily announce a two-for-one, or even potentially a three-for-one, stock split.
• BMO - Earnings Are Important, So Is the Source of Earnings
Exclusive of the pre-announced restructuring charge of $88 million (after tax), we believe that BMO will show healthy year-over-year improvements at the domestic P&C business compared with the weak first quarter of 2006. In addition, the bank’s tax rate, which declined through all of 2006, should also provide some year-over-year momentum.
In Canada, the P&C business should continue to benefit from the re-pricing of the mortgage book that started in the middle of 2006. As such, we expect year-over-year and quarter-over-quarter margin improvement. In the U.S., we expect to see some moderation in expense growth (which dogged the bank in the fourth quarter) and stable margins.
The Investment Banking Group should perform in line with year-ago results, but well ahead of the weak fourth quarter. Reported trading revenues (which are distorted by technical factors) were particularly weak in the fourth quarter and we expect to see a more normal trading level of about $150 million. On the other hand, the capital markets business did appear to be slightly weaker. Private Client should report another solid result.
The Corporate Segment, which includes the 'true-up' of expected loan losses charged to the operating segments, continues to be quite volatile. This segment should include the $88 million restructuring charge this quarter. Furthermore, the progress on tax is most apparent in this reporting segment. Specifically, we expect the tax rate (TEB) to be lower than year-ago levels but above the level in the fourth quarter.
If we are wrong on loan losses, the variation is likely to be to the downside (i.e. losses will be lower and earnings will be positively affected). Having said that, with the ACL down to $153 million at year-end, it is hard to bet too much on reversals in the coming quarters.
We don’t expect any change in dividend (given the move last quarter) and buyback activity remains relatively predictable. Tier 1, which is strong, should strengthen modestly this quarter, barring a sharp rise in risk-weighted assets.
All in all, the negative sentiment on BMO does bear considering. As such, earnings surprises on the upside will be disproportionately important. We believe, however, that if earnings surprises come from tax rate reductions, unusually low loan losses or trading, the market is unlikely to be substantially impressed.
In addition, progress on expenses will be hard to rationalize given the 'one-time' charge this quarter.
• National Bank - Wholesale Strength Continues
National Bank is the third bank to report on March 1st, which will be the busiest day of this quarter’s reporting cycle. The wholesale business should continue to deliver solid results with trading and securities gains representing a meaningful part of earnings.
We expect both Wealth Management and Personal and Commercial (P&C) Bank to deliver reasonable year-over-year improvement. The Wealth Management business did underperform somewhat in the fourth quarter due to higher expenses, and we expect to see better comparative results this quarter. The P&C bank should continue to produce solid year-over-year growth and some good news is possible on spreads generally.
Financial Markets is likely to be below both the year-ago and linked quarter results. We expect a strong, though not outstanding, trading quarter, and underwriting and M&A do not yet appear to have turned as yet. Having said that, expenses should be well controlled. Over the past couple of years, the earnings surprises have broadly come from this segment, but to date the market has been reluctant to pay much for this outperformance. The loss in the corporate segment a year ago resulted from unusually low securitization revenues and we believe a more 'normal' result of a small loss is likely.
The other area of concern this quarter has been on credit, and questions on whether the Quebec economy is being disproportionately affected by the strong Canadian dollar. We expect National to earn through higher loan losses this quarter, but expect a moderation in the rate of impaired loan formation. With the dividend increase last quarter, we also don’t expect much new on this front, though the less aggressive buyback activity in the past six months does suggest more focus on dividends at the expense of buybacks.
• Royal Bank - More of the Same, Great Results
On Friday, March 2nd, Royal will likely report a continuation of the strong trends that have allowed the bank to outperform over the past two years. Furthermore, the bank has continued to aggressively increase its dividend to match earnings growth, and this quarter should be no exception, with a 10% increase in the dividend expected.
The Canadian Personal and Business segment will show strong year-over-year gains driven by continued strength in volumes, stable margins and good expense control (see Table 7). It is also noteworthy that the year-ago quarter did include some headwinds on insurance, so a more relevant year-over-year growth rate is closer to 13%.
In the U.S. and International segment, we expect to see continued solid improvements. We believe that Centura is performing relatively well and that the ongoing investment in Global Private Banking is producing good returns. We note that the regulated U.S. bank did take a securities loss this quarter, so this may create some headwind, depending on translation adjustments. As was the case for the Canadian segment, we note that the year ago quarter was somewhat weaker than we had expected, so the year-over-year results are above average.
It is always difficult to get a good read on RBC Capital Markets. It is clear that the bank showed its 'stripes' in the domestic market in 2006, but, as importantly, the dealer continued the build-out of its global aspirations with strong performance in several of its chosen niches. We expect trading to remain strong (though not as good as the blow-out results of the second and third quarters of 2006) and the advisory business to be quite robust. We do forecast minor loan losses this quarter compared to net reversal and recoveries in all of 2006. All in, we expect modestly lower contribution from this segment this quarter. The corporate segment, which includes the TEB adjustment for tax, should be closer to breakeven this quarter, after two comparable quarters when taxes and hedging gains bolstered results. Tier 1 should remain quite stable in the 9.5-10% range with high ROE funding strong RWA growth. As we have already mentioned, a $0.04 increase in the quarterly dividend is likely.
It is also possible that the Royal will move its 'targeted' payout range higher to 45-55% to mimic BMO.
Royal will restate its segmented disclosures in the second quarter to isolate a global wealth management business line. While this will create havoc with investor models, it is hard not to be positive on the incremental disclosure.
• Scotiabank - International Strength to Offset Weakness in Domestic
As is often the case, the big bank reporting seasons end with Scotiabank reporting results- this time on Tuesday, March 6th.
We believe that the continued strength in International will offset what will be relatively weak trends in domestic Retail and Wealth. All in, this should be another solid quarter from a well diversified franchise.
In the Domestic Banking segment (both P&C Banking and Wealth Management), year-over-year comparisons are made easier by a relatively weak base (see Table 8). 2006 saw virtually no growth compared to 2005. Spreads should bottom out and loan growth (partially driven by the Maple and Travelers deals) should be good. Loan losses, which were unusually low in the fourth quarter in Commercial, are likely to moderate.
International should produce a very solid quarter. Mexico continues to benefit from good volume growth, and the acquisitions in Peru and Costa Rica will ensure strong year-over-year earnings trends. Loan losses, which are volatile, should be somewhat higher than those in the fourth quarter, and should mitigate some of the core improvements.
Scotia Capital, like TD and CIBC, appears to have had a solid quarter on the M&A and underwriting front. Trading should be down from year-ago record levels, but with good expense control and the benefi t of loan growth on the NII line, contribution is expected to be relatively stable. One other variable of focus will be loan losses, which returned to positive territory in the fourth quarter. We don’t expect much movement either way this quarter. The Corporate segment, which included the benefit of a reversal of general allowance in the fourth quarter, should be back to a more normal result.
Two very positive elements of the Scotiabank story include the depth of unrealized securities and the strength of its capital position. Specifically, we expect that quarterly realized securities gains should be $90 million, plus or minus $20 million, and that the Tier 1 will remain above 10%. With a hefty dividend increase last quarter, we do not expect any material change in the short term.
Note that the accounting change discussed earlier will result in an 'other comprehensive income' gain of over $700 million. This could impact reported book value and ROE, but we expect it to be largely ignored.
Spreads - Consistent Signs That They Will Be Stable
Core Personal and Commercial Bank spreads have been under pressure for several years (see Chart 1), reflecting a material shift in business mix from high spread business loans to low spread residential mortgage loans. The majority of this mix shift has now run its course. Better demand for business borrowing plus some moderation in the demand for mortgage credit have resulted in stable loan mix and should ensure stable spreads.
Of course, other variables- Prime-BA spreads, absolute levels of interest rates and general competitive conditions- are also important in impacting spreads, but are far less material. The good news is that these secondary factors have generally been quite supportive. Prime-BA spreads broadly give us insight into the margins achieved on retail loans that are funded by wholesale money. With the well-telegraphed increase in the Bank Rate through most of 2006, wholesale markets anticipated the rate changes, which caused periodic compression of Prime-BA spreads. The good news is that in the past two quarters, a less well-defined trend in rates has made for modestly wider retail-wholesale spreads. As we show in Table 1, average Prime-BA spreads have been 169-170 basis points in the past two quarters.
While the rises in the Prime Rate temporarily hurt Prime-BA spreads, the good news is that it did take some pressure off deposit pricing. Remember that banks have a certain amount of 'free float' where there is either zero or minimal interest rates. These deposits are part of the funding mix for Prime-priced loans. All in, therefore, a higher Prime Rate is beneficial to margins.
Another variable that is somewhat positive is competitive conditions. Though there still remains a plethora of competitors who are prepared to undercut bank pricing (both on the deposit and loan side of the balance sheet), the highest profile competitor in High-Interest Savings accounts, ING Bank, continues to struggle with a flat yield curve that has compressed its spreads. We believe that there is a bit more sanity to the market now, and that most of the damage has already been done. At this stage, new entrants such as Altamira and Dundee seem to be more of a threat to ING than to banks themselves.
Loan Growth - More of the Same
We continue to be pleasantly surprised by the strength of loan growth in Canada. Overall loan growth, inclusive of consumer and business credit, grew at about 12% in November and December (see Chart 2). Although this is the slowest pace in the past year, it is still more than adequate to allow banks to show operating leverage and solid net interest income growth.
Despite the recent strength, it is not lost on us that loan growth is likely to slow in 2007. We forecast overall loan growth in 2007 of 7%, implying a relatively mundane outlook for growth in the second half of the year. Essentially, we believe that continued strength in business borrowing (driven by a relatively strong dollar, which creates tougher operating conditions for businesses and increases the appeal of additional investment in fixed assets) will not be enough to offset a slowdown in the consumer in later this year.
Trading Revenues - Seasonal Strength May Offset Low Volatility
Trading revenues in the second half of 2006 were certainly weaker than expected, reflecting the seasonal weakness in the business and the record low volatility in several markets. Volatility has remained very low and, as such, we would expect trading books to perform a bit better than in the fourth quarter, but below the performance of the first quarter of 2006.
We continue to grapple with the increased capital committed by most banks (but particularly Royal Bank) to trading because the increased capital has yet to produce any meaningful increase in trading revenues. Furthermore, this has occurred in an environment where VaR (which is mathematically affected by volatility) hasn’t moved much. Taken together, we believe that trading revenues, which are relatively unchanged in the past four years, could actually move meaningfully higher in the medium term.
Capital Markets - Little Impact from the Income Trust Fallout
Bank stocks really do climb a 'wall of worry.' With the decision to tax trusts, several parties highlighted the risk to bank earnings from lower capital markets activity levels. We believe that the banks will again show this quarter that their investment dealers are nothing if not resourceful (no pun intended).
We believe the revenues from M&A and underwriting will be as good this quarter as they have been anytime in the past year. Of course, the big driver has been M&A activity with numerous high profile deals, including Falconbridge, Glamis and Summit, over the past six months. We see little reason to forecast any slowdown given the tremendous liquidity, high interest by private equity buyers and an entire trust sector that probably needs to restructure in the next three to four years. This quarter, it appears as if TD, CIBC, and Scotia have all had comparatively strong performances.
Dividend Activity - A Hat Trick of Increases
We expect dividend increases from TD, CM, and RY this quarter (see Table 2). The most meaningful will be CIBC, which has telegraphed a review of its dividend and buyback policies. With the successful completion of the FCIB deal, the bank now has relatively good visibility on its capital needs. We expect a 10%-plus increase in dividend, a reinstatement of its share buyback program and a stock split (either 2:1 or 3:1). There is also a case to be made for an increase in the target payout range- though this is more of a possibility than a likely event.
Royal and TD are also both expected to increase dividends, despite the fact that the two continue to be at other ends of the payout spectrum. TD remains quite conservative and is far more cautious on dividend increases, while Royal is more focused on rewarding investors today with a 10% dividend increase. The reality is that the former is run by a CEO who is more cautious on the future than the latter. Over the past few years, TD has de-risked and has been preparing for a weaker environment (complete with greater risk premiums). On the other hand, Royal Bank has bet that the environment would hold together well and this bet has clearly paid dividends (both figuratively and literally) for RY shareholders. Of course, the reality is that success of either path will be clear only in the next down-cycle.
Other Items
New Accounting Rules: The bane of all analysts’ existence, new accounting rules, will be in full view this quarter. Starting this quarter, the CICA will require banks to adopt the U.S.-style 'other comprehensive income' (OCI) for establishing a market value for financial instruments (largely all assets other than loans and fixed assets).
This will create a transitional bump to OCI for banks with large unrealized securities gains (BNS and TD). It is unclear whether the market will include these taxed gains in book value and the calculation of ROE. We still expect banks to disclose the income statement impact of gains or losses in each quarter (at least for the banks that have done this in the past).
Tax Rate: We expect tax rates to be relatively comparable in 2007, exclusive with the few one-time items at CIBC, TD, and BMO. We continue to be surprised by the degree of success the industry has had in getting tax rates down to the mid-20% range (on a TEB basis). To date there is little sign that much will change on this front, but this remains one area where there is exogenous risk.
Loan Losses: No news is generally good news in the world of credit. We expect a modest uptick in loan losses, largely driven by fewer reversals rather than a fundamental deterioration in the loan book.
Individual Company Comments
• TD Bank - Retail and Wealth Management Continue to Drive Earnings
TD Bank reports earnings on Thursday, February 22nd, a full week ahead of the next bank, so its results will set the tone for investor perception on industry-wide trends. The bottom line improvements at TD (i.e. EPS increase) will likely be somewhat mundane but the fundamentals should be quite robust. We should note that the year-ago quarter was inflated by the large AMTD gain on dilution.
The core Personal and Commercial Banking business should continue to perform well with year-over-year growth of about 10%, reflecting strong volume growth and stable margins. Loan losses may continue to track modestly higher as the VFC book continues to mature. Given the material number of branch openings late in 2006, expense growth should moderate the strong revenue performance.
Both TD Ameritrade and TD Banknorth have pre-announced results that will add $64 million each to TD overall. This is the last quarter when the year-over-year comparison is affected by the timing of the Waterhouse-Ameritrade deal and it is appropriate that AMTD is beginning to show some operating leverage to TD’s earnings. The Wealth Business (domestic full-service, mutual funds and discount brokerage) should show a material quarter-over-quarter improvement for seasonal reasons.
TD Securities should have another solid quarter. Indeed, given the strong performance by the dealer at the end of the calendar year and with the seasonal strength of the trading business, there is potential for a very strong quarter. On the other hand, the reality is that volatility has remained low and TD Securities may take the opportunity to heavy up on accruals this early in the year. Our forecast of over $150 million of earnings is toward the higher end of the annual guidance.
The Corporate segment, after a fourth quarter that saw tax refunds and high levels of securitizations generate an unusual profit, should be back to a more normal run rate of a slight loss.
There will be several 'non-income statement' issues that will be noteworthy this quarter. We expect to see a solid dividend increase, to $0.51 from $0.48. CEO, Ed Clark, recently said that he would consider materially higher dividends if the bank was not growing meaningfully, so we don’t expect any change in target payout ratio. In addition, the hedge transaction that allowed the bank to get its ownership interest in AMTD to 45% will use up some capital. Overall, we expect the growth in retained earnings will mitigate some of this effect, and we believe that Tier 1 will be modestly lower. ROE and book value may be impacted by the creation of an OCI account.
• CIBC - Another Quarter of Upside Potential
After the strong results last quarter, CIBC has certainly begun to attract more fans. We believe that there is still some potential for further earnings revisions. Furthermore, the First Caribbean deal has now closed, so there is far more urgency for the dividend and the buyback issues to be addressed. Bottom line: it is hard to see much other than good news this quarter. The only issue is whether the CIBC results can gain any traction on a day in which two other banks report.
On the retail side, the bank appeared to have turned the corner in the middle of 2006. We believe that the combination of stable market share, tight control of expenses and reductions in loan losses argues for continued earnings momentum. Indeed, we would not be surprised to see CIBC have some of the better retail year-over-year trends in the first half of 2007.
CIBC World Markets also looks set for a solid quarter. Strong revenue in M&A and underwriting should offset a difficult comparison in trading, where the year-ago and linked quarter results were very robust. All in, we expect the dealer to continue to earn in the $125-175 million range. We also note that the first quarter of last year did see a somewhat elevated tax rate at World Markets, so this will help somewhat in the comparisons with last year.
Loan losses should continue to be well managed, with declining losses in the retail book offsetting higher levels in the corporate book. While there are still no obvious problems in the loan book generally, it is hard not to expect lower levels of reversals during 2007.
Like TD, there will be some focus on balance sheet strength, buybacks and share repurchases. The FCIB deal closed in late December and will take Tier 1 down from the 10.4% level at year-end. Despite this, a figure of around 9.0% seems reasonable at the end of the first quarter. We note that there were more FCIB shares tended by the minority to the follow-up bid than we had expected, so there will be slightly more leverage added in the quarter. The good news is that the acquisition will be slightly more accretive than we had forecast.
The buyback/dividend issue will be more important matter for investors. We assume an 11% increase in the dividend and a re-initiation of the buyback program. We would be surprised if CIBC was aggressive in the latter, at this stage- since the shares are at all-time highs, and the valuation is comparable to its peers. What is most likely is a commitment to ongoing regular dividend increases and gradual buybacks. We believe that there could be some opportunities for incremental capital deployment in the Caribbean, but this will obviously be opportunistically driven.
On a more superficial perspective, CIBC could easily announce a two-for-one, or even potentially a three-for-one, stock split.
• BMO - Earnings Are Important, So Is the Source of Earnings
Exclusive of the pre-announced restructuring charge of $88 million (after tax), we believe that BMO will show healthy year-over-year improvements at the domestic P&C business compared with the weak first quarter of 2006. In addition, the bank’s tax rate, which declined through all of 2006, should also provide some year-over-year momentum.
In Canada, the P&C business should continue to benefit from the re-pricing of the mortgage book that started in the middle of 2006. As such, we expect year-over-year and quarter-over-quarter margin improvement. In the U.S., we expect to see some moderation in expense growth (which dogged the bank in the fourth quarter) and stable margins.
The Investment Banking Group should perform in line with year-ago results, but well ahead of the weak fourth quarter. Reported trading revenues (which are distorted by technical factors) were particularly weak in the fourth quarter and we expect to see a more normal trading level of about $150 million. On the other hand, the capital markets business did appear to be slightly weaker. Private Client should report another solid result.
The Corporate Segment, which includes the 'true-up' of expected loan losses charged to the operating segments, continues to be quite volatile. This segment should include the $88 million restructuring charge this quarter. Furthermore, the progress on tax is most apparent in this reporting segment. Specifically, we expect the tax rate (TEB) to be lower than year-ago levels but above the level in the fourth quarter.
If we are wrong on loan losses, the variation is likely to be to the downside (i.e. losses will be lower and earnings will be positively affected). Having said that, with the ACL down to $153 million at year-end, it is hard to bet too much on reversals in the coming quarters.
We don’t expect any change in dividend (given the move last quarter) and buyback activity remains relatively predictable. Tier 1, which is strong, should strengthen modestly this quarter, barring a sharp rise in risk-weighted assets.
All in all, the negative sentiment on BMO does bear considering. As such, earnings surprises on the upside will be disproportionately important. We believe, however, that if earnings surprises come from tax rate reductions, unusually low loan losses or trading, the market is unlikely to be substantially impressed.
In addition, progress on expenses will be hard to rationalize given the 'one-time' charge this quarter.
• National Bank - Wholesale Strength Continues
National Bank is the third bank to report on March 1st, which will be the busiest day of this quarter’s reporting cycle. The wholesale business should continue to deliver solid results with trading and securities gains representing a meaningful part of earnings.
We expect both Wealth Management and Personal and Commercial (P&C) Bank to deliver reasonable year-over-year improvement. The Wealth Management business did underperform somewhat in the fourth quarter due to higher expenses, and we expect to see better comparative results this quarter. The P&C bank should continue to produce solid year-over-year growth and some good news is possible on spreads generally.
Financial Markets is likely to be below both the year-ago and linked quarter results. We expect a strong, though not outstanding, trading quarter, and underwriting and M&A do not yet appear to have turned as yet. Having said that, expenses should be well controlled. Over the past couple of years, the earnings surprises have broadly come from this segment, but to date the market has been reluctant to pay much for this outperformance. The loss in the corporate segment a year ago resulted from unusually low securitization revenues and we believe a more 'normal' result of a small loss is likely.
The other area of concern this quarter has been on credit, and questions on whether the Quebec economy is being disproportionately affected by the strong Canadian dollar. We expect National to earn through higher loan losses this quarter, but expect a moderation in the rate of impaired loan formation. With the dividend increase last quarter, we also don’t expect much new on this front, though the less aggressive buyback activity in the past six months does suggest more focus on dividends at the expense of buybacks.
• Royal Bank - More of the Same, Great Results
On Friday, March 2nd, Royal will likely report a continuation of the strong trends that have allowed the bank to outperform over the past two years. Furthermore, the bank has continued to aggressively increase its dividend to match earnings growth, and this quarter should be no exception, with a 10% increase in the dividend expected.
The Canadian Personal and Business segment will show strong year-over-year gains driven by continued strength in volumes, stable margins and good expense control (see Table 7). It is also noteworthy that the year-ago quarter did include some headwinds on insurance, so a more relevant year-over-year growth rate is closer to 13%.
In the U.S. and International segment, we expect to see continued solid improvements. We believe that Centura is performing relatively well and that the ongoing investment in Global Private Banking is producing good returns. We note that the regulated U.S. bank did take a securities loss this quarter, so this may create some headwind, depending on translation adjustments. As was the case for the Canadian segment, we note that the year ago quarter was somewhat weaker than we had expected, so the year-over-year results are above average.
It is always difficult to get a good read on RBC Capital Markets. It is clear that the bank showed its 'stripes' in the domestic market in 2006, but, as importantly, the dealer continued the build-out of its global aspirations with strong performance in several of its chosen niches. We expect trading to remain strong (though not as good as the blow-out results of the second and third quarters of 2006) and the advisory business to be quite robust. We do forecast minor loan losses this quarter compared to net reversal and recoveries in all of 2006. All in, we expect modestly lower contribution from this segment this quarter. The corporate segment, which includes the TEB adjustment for tax, should be closer to breakeven this quarter, after two comparable quarters when taxes and hedging gains bolstered results. Tier 1 should remain quite stable in the 9.5-10% range with high ROE funding strong RWA growth. As we have already mentioned, a $0.04 increase in the quarterly dividend is likely.
It is also possible that the Royal will move its 'targeted' payout range higher to 45-55% to mimic BMO.
Royal will restate its segmented disclosures in the second quarter to isolate a global wealth management business line. While this will create havoc with investor models, it is hard not to be positive on the incremental disclosure.
• Scotiabank - International Strength to Offset Weakness in Domestic
As is often the case, the big bank reporting seasons end with Scotiabank reporting results- this time on Tuesday, March 6th.
We believe that the continued strength in International will offset what will be relatively weak trends in domestic Retail and Wealth. All in, this should be another solid quarter from a well diversified franchise.
In the Domestic Banking segment (both P&C Banking and Wealth Management), year-over-year comparisons are made easier by a relatively weak base (see Table 8). 2006 saw virtually no growth compared to 2005. Spreads should bottom out and loan growth (partially driven by the Maple and Travelers deals) should be good. Loan losses, which were unusually low in the fourth quarter in Commercial, are likely to moderate.
International should produce a very solid quarter. Mexico continues to benefit from good volume growth, and the acquisitions in Peru and Costa Rica will ensure strong year-over-year earnings trends. Loan losses, which are volatile, should be somewhat higher than those in the fourth quarter, and should mitigate some of the core improvements.
Scotia Capital, like TD and CIBC, appears to have had a solid quarter on the M&A and underwriting front. Trading should be down from year-ago record levels, but with good expense control and the benefi t of loan growth on the NII line, contribution is expected to be relatively stable. One other variable of focus will be loan losses, which returned to positive territory in the fourth quarter. We don’t expect much movement either way this quarter. The Corporate segment, which included the benefit of a reversal of general allowance in the fourth quarter, should be back to a more normal result.
Two very positive elements of the Scotiabank story include the depth of unrealized securities and the strength of its capital position. Specifically, we expect that quarterly realized securities gains should be $90 million, plus or minus $20 million, and that the Tier 1 will remain above 10%. With a hefty dividend increase last quarter, we do not expect any material change in the short term.
Note that the accounting change discussed earlier will result in an 'other comprehensive income' gain of over $700 million. This could impact reported book value and ROE, but we expect it to be largely ignored.
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