Scotia Capital, 22 March 2007
Event
• Earnings growth reaccelerated to 24% in the first quarter, the strongest earnings momentum in the past three years.
• The bank group recorded its best quarter in history, with return on equity of nearly 24% and return on risk-weighted assets of 224 bp.
What It Means
• Earnings growth of 24% is even more impressive considering that fiscal 2006 represented the fourth straight year of 15% plus earnings growth - the first time the banking industry has achieved this in the past half century.
• Bank earnings continue to exceed market expectations, driven by strong underlying fundamentals and strong earnings growth from all business lines.
• Earnings quality remained solid. Bank revenue growth was 10% in the first quarter, one of the highest levels in the past five years. Banks are certainly not immune to a slowdown in the economy or capital markets activity, but we believe the market is overly aggressive in discounting potential earnings weakness.
• We expect the trend of declining volatility in bank earnings to continue and we expect the market to continue to reward bank stocks for this through further expansion of the P/E multiple. We reiterate a 1-Sector Outperform rating on RY and an overweight bank recommendation.
Blockbuster Quarter - Best in History
Summary and Conclusion
• The bank group recorded its best quarter in history, with return on equity of nearly 24% and return on risk-weighted assets of 224 bp.
• Earnings growth reaccelerated to 24% in the first quarter, the strongest earnings momentum in the past three years. This growth is even more impressive considering that fiscal 2006 represented the fourth straight year of 15% plus earnings growth - the first time the banking industry has achieved this in the past half century.
• Bank earnings continue to exceed market expectations, driven by strong underlying fundamentals and strong earnings growth from all business lines. Wealth management continues to produce high positive operating leverage and earnings growth. Wholesale bank earnings remain strong, driven by high trading revenue, solid capital markets revenue, and negligible loan loss provisions. Retail banking earnings are being driven by volume growth, a stabilizing retail net interest margin, and controlled expenses.
• Bank earnings are expected to continue to be more resilient or sustainable than market expectations due to loan losses staying lower for longer than expected in addition to the strong top-line growth the banks are generating. Bank revenue growth was 10% in the first quarter, one of the highest levels in the past five years. Revenue growth was particularly high at Royal Bank (RY) and Bank of Nova Scotia (BNS), at 15% and 14%, respectively, significantly higher than the bank group. Revenue growth in the mid-teens at RY and BNS reflects a very high growth platform at these banks. This is generally inconsistent with the market’s view of the banking industry as low growth.
• Banks are certainly not immune to a slowdown in the economy or capital markets activity, but we believe the market is overly aggressive in discounting potential earnings weakness. In addition, we believe the market continues to be slow in fully recognizing the level of profitability, high capital, low earnings volatility, and revenue diversification.
• The bank group’s strong earnings and profitability are being translated into consistent and frequent dividend increases. The banks have been very active in increasing dividends in conjunction with overall earnings strength.
• Four out of the six banks increased their dividends this quarter, led by RY with a relatively large 15% bump, followed by Toronto-Dominion Bank (TD) and Canadian Imperial Bank of Commerce (CM), each at 10%, with Bank of Montreal (BMO) at 5%. BMO’s increase follows a 5% increase in the previous quarter. Bank dividends have increased fourfold since the end of 1999. BNS and RY are leading the bank group in dividend growth at 250% and 241%, respectively, since the end of 1999. Despite the growth in dividends, the payout ratio remains in the low end of the banks’ target range at 41.6% on our 2007 earnings estimates.
• Earnings quality remained solid, with moderate security gains, high trading revenue, slightly above-average capital markets revenue, weaker retail net interest margins (although stabilizing), solid retail loan growth, low loan loss provisions, and stable and growing wealth management earnings.
• Bank earnings in the first quarter were not unduly reliant on market-sensitive revenue (trading and capital markets revenue), which represented 20% of total revenue, slightly below the eight-year average of 21%. Loan loss provisions at 24 bp remained near historical lows.
• We are now forecasting bank earnings growth of 16% in 2007, which would represent five straight years of 15% plus growth. Stronger-than-expected earnings in the first quarter, higher top-line growth, continued low loan loss provisions, and retail net interest margin stability are supportive of the higher earnings outlook.
• The bank group’s outperformance of the market in 2006 represented the 12th year of outperformance in the past 13 years. Banks are outperforming the market modestly thus far in 2007.
• Bank valuations have moved from attractive to compelling based on the strength of earnings and dividend increases in the first quarter. Bank valuations on a yield basis relative to bonds, pipes and utilities, income trusts, and the S&P/TSX composite are all in the strong buy range.
• Recent bank dividend increases have boosted dividend yields to 3.3%, representing 81% of the 10-year government bond yield, which is 3.1 standard deviations above the mean. Reversion to the mean with respect to bank dividend yields relative to bonds, pipes and utilities, business income trusts, and the S&P/TSX would suggest an increase in the bank index of 55%, 45%, 23%, and 36%, respectively.
• Bank P/E multiples have drifted to 14.0x trailing earnings from a recent high of 15.1x early in 2006 due to continued strong earnings growth. Banks are trading at a relatively low 12.7x and 11.5x our 2007 and 2008 earnings estimates, respectively. Our target P/E multiple is 15.5x our 2007 earnings estimate for total expected return of 26%. Our target prices may appear aggressive in the context of a nervous equity market, but we believe they are fully supported by high profitability, earnings growth, low earnings volatility, dividend growth, and low risk profile.
• We expect the trend of declining volatility in bank earnings to continue and we expect the market to continue to reward bank stocks for this through further expansion of the P/E multiple. The level of profitability also dictates much higher valuation. We have attempted to address the potential volatility in bank earnings by stress testing bank earnings (Exhibits 8 and 9) for a recession similar to that of the early 1980s and 1990s. Based on this stress testing, we expect a moderate 8% decline in bank earnings from record levels and a trough ROE of 18%. This trough ROE is higher than the previous trough of 15% in 2002. We conclude that bank earnings volatility is relatively low and profitability is sustainable at very high levels.
• In terms of bank stock selection, we continue to focus on the banks with the strongest profitability, capital, operating platforms, and the best growth opportunities. Individual bank P/E multiples have converged to historically low levels, occurring only a half dozen times since 1970 (Exhibit 35). Thus, investors are not paying any meaningful premium for the banks with the stronger operating platforms. On a long-term basis, three bank stocks have significantly outperformed: RY, BNS, and TD.
• We reiterate 1-Sector Outperform rating on RY, as we expect its P/E multiple to expand relative to the bank group towards the 10%-15% premium range over the next several years based on superior revenue growth, high ROE, and a business platform that is more orientated towards growth. BNS and RY led the bank group in revenue growth in fiscal 2006 at 10% and 8%, and in the first quarter of 2007 at 14% and 15%, respectively. BMO and CM significantly lagged in 2006 at 3% and -1%, respectively, with BMO, TD, and National Bank (NA) lagging in the first quarter at 4%, 5%, and 6%, respectively. We believe RY is the growth bank.
• RY (1-Sector Outperform) has above-average profitability and extremely strong operating platforms in retail, wealth management, and capital markets, with a slight valuation discount. RY’s superior growth is expected to be driven by its wealth management platform, supported by growth of its U.S. & International businesses, with RBC Capital Markets expanding its platform on a product and geographic basis. RY is expected to segment its wealth management business beginning in Q2/07. Wealth management revenue reported by RY in Q1/07 was nearly $1.3 billion, a sizable business that should attract a much higher P/E multiple.
• We maintain 2-Sector Perform ratings on TD, Laurentian Bank (LB), CM, and Canadian Western Bank (CWB), with 3-Sector Underperform ratings on BMO and NA. We have no sell recommendations on an absolute return basis.
• TD (2-Sector Perform) continues to generate strong earnings growth from TDCT and Wealth Management, with greater earnings stability in wholesale banking partially offset by weak operating performance from TD Banknorth. Overall, TD Banknorth continues to create uncertainty for investors and somewhat overshadows the strong overall performance of the bank.
• LB (2-Sector Perform) continues to improve in terms of operating performance. LB earnings are expected to grow at a much higher rate than the bank group over the next few years, becoming more visible with the release of first quarter earnings. LB is the least expensive bank stock on a market to book value basis and on a P/E multiple basis on our 2008 earnings estimate. LB return on equity continues to lag, but stronger relative earnings growth in 2007 and 2008 should support strong share price performance.
• CM (2-Sector Perform) has reduced the risk in its retail loan portfolio and significantly lowered its operating expense levels. The cost cutting has produced solid earnings gains in 2006 and is expected to continue into 2007; however, revenue weakness remains a challenge. The earnings gains achieved are unlikely to be sustainable in the medium to longer term unless the bank is able to grow revenue. It is always difficult to determine when aggressive cost cutting becomes not reinvesting in the business. Revenue risk persists.
• CWB (2-Sector Perform) continues to have a high growth profile, with 20% plus loan and deposit growth. CWB concentration in the strong economies of Alberta and B.C. and continued high loan and deposit growth are expected to continue to produce industry-high earnings growth, which is reflected in the bank’s premium P/E multiple.
• We maintain our 3-Sector Underperform rating on BMO based on the absence of any meaningful P/E multiple discount, despite the fact that it has the lowest profitability of the bank group and the weakest earnings growth outlook. It appears the market is paying an embedded premium for BMO’s superior historical credit performance, anticipating a major credit crunch. We believe this premium is too high, especially given the structural changes in the bank group’s balance sheets, as leverage to credit has declined four- or fivefold since the early 1980s.
• We maintain our 3-Sector Underperform rating on NA due to its lower earnings growth outlook, concerns regarding economic prospects in Central Canada and NA’s concentration in that region, and the bank’s earnings dependency on security gains and trading revenue.
• Our 12-month bank index target is 28,700 for a total expected return of 26%. Our target is based on a forecast P/E of 15.5x our 2007 earnings estimate or 13.6x our 2008 earnings estimate.
• Our 12-month share price targets on BMO, CM, NA, RY, TD, LB, and CWB are $80, $115, $77, $75, $81, $36, and $27.50, respectively.
• Risks to our bank share price targets are overall bearish market sentiment, severe economic slowdown or recession, a major spike in long-term interest rates above 5%, or a major decline in short-term interest rates of 200 bp or more. A major spike in long-term rates negatively impacts valuation and a major decline in short-term rates would negatively impact earnings.
• We remain overweight the bank group, based on record profitability and capital levels, low financial and earnings leverage to credit, diversified revenue mix, reasonable earnings growth outlook, low earnings volatility, ability to increase dividends, and attractive valuation, including extremely high dividend yields, low P/E multiples, and low relative risk.
• Bank betas remain extremely low, with a one-year average bank beta of 0.35, compared with a three-year average bank beta of 0.37 and a five-year average bank beta of 0.74.
First Quarter Earnings Highlights
• The bank group once again exceeded expectations, with operating earnings increasing 24% year over year and 13% sequentially.
Super Growth
• CM, RY, and LB led earnings growth in the 30% plus range at 34%, 32%, and 30%, respectively.
High Growth
• CWB, BNS, and TD followed with earnings growth in the 20% plus range at 21%, 20%, and 20%, respectively.
Growth Laggards
• Significantly lagging the bank group were BMO and NA, with earnings growth of 11% and 13%, respectively.
Dividend Increases - BMO, CM, RY, TD
• Four banks announced dividend increases in the quarter, with RY increasing its dividend by 15%, CM and TD increasing their dividends by 10% each, followed by BMO with a 5% increase. RY’s increase was the largest in the past seven years. BMO’s increase occurred over back-to-back quarters, with a payout ratio of 50.4% versus the bank group at 41.6%. Overall, the bank group has now increased dividends by 205% since the end of 1999/beginning of 2000.
High Revenue Growth Led by RY and BNS
• Revenue growth for the bank group in Q1 was 10%, one of the highest growth rates in the past six years. RY and BNS were very dominant in revenue growth at 15% and 14%, respectively, considerably higher than the bank group. CM, NA, TD, and BMO followed with more moderate revenue growth of 9%, 6%, 5%, and 4%, respectively.
Retail and Wealth Management
• Domestic retail and wealth management earnings were strong, increasing 16% year over year and 11% sequentially. CM led retail earnings growth at 20.7%, primarily due to lower loan loss provisions, cost cutting, and a lower tax rate. RY earnings increased 20.2%, led by wealth management and strong insurance results. NA earnings increased 17.5%, driven by improved net interest margin and lower-than-normal run rate expenses. TD earnings increased 14.6%, driven by strong insurance results and retail loan volumes and wealth management. BNS and BMO growth rates lagged at 9.8% and 11.4%, respectively. BNS was the weakest, although the bank recorded its best growth rate in over a year. BMO continued to lose market share in residential mortgages and personal deposits.
Underlying Retail Margin Stabilizing to Improving?
• Retail net interest margin (NIM) dipped below 3% for the first time to 2.99%, representing a 4 bp decline year over year and sequentially. However, the margin appears to be stabilizing for some banks. RY, TD, and NA margin increased 1 to 2 bp, with BMO unchanged on a year-over-year basis. CM and BNS margins declined 24 bp and 20 bp year over year, respectively, with declines of 11 bp and 4 bp sequentially. The margin decline at BNS has negatively impacted its earnings growth in this segment relative to the bank group.
Wealth Management - High Revenue Growth
• Wealth management earnings were very strong in the first quarter, although only three banks (BMO, NA, and TD) currently segment these earnings, with RY beginning in Q2/07.
• Earnings growth from domestic wealth management at NA and TD were 22% and 16%, respectively, with BMO lagging at 4%. Domestic wealth management revenue growth was strong at RY at 14%, followed by TD at 12% and NA at 9%.
• Mutual fund assets for the bank group increased 14% to $243 billion, led by RY at 21% growth, followed by TD at 17%, BMO at 14%, BNS at 11%, CM at 8%, and NA at 3%. RY and TD remain the industry leaders in net long-term asset (LTA) sales including transfers, with impressive market share of 20% and 16%, respectively.
• Performance at the bank group’s International divisions varied considerably, with RY and BNS recording very high growth, TD mixed, and BMO very weak. RY U.S. & International earnings increased 45%, driven by an 18% increase in wealth management revenue. BNS earnings increased 36% despite flattish earnings from Mexico. TD International performance was mixed, with TD Banknorth earnings declining 2% and TD Ameritrade’s contribution increasing 94%. BMO results from International were weak, as U.S. P&C (Harris) earnings declined 13% due to net interest margin decline and higher expenses.
• International Banking earnings at BNS were driven by strong growth in all regions, particularly Mexico and Asia, with solid contribution from new acquisitions in Costa Rica and Peru. Revenue growth at International Banking was very high at 30%.
• RY U.S. & International represented 11% of bank earnings, with BNS International the largest contribution of any bank at 32%. TD Banknorth’s earnings contribution was $0.09 per share, representing 6.5% of total bank earnings, with Ameritrade contributing $0.07 per share or 5% of earnings for a combined contribution of 12%. BMO’s U.S. P&C (Harris) contributed 5% to bank earnings.
Wholesale Banking Earnings Increase 12%, Strong at CM, RY, BNS; Weak at BMO, NA, TD
• Wholesale earnings for the bank group increased 12% year over year, led by CM with earnings growth of 63%, followed by RY at 34% and BNS at 14%. CM recorded significantly higher merchant banking and capital markets fees including M&A. RY recorded strong trading revenue and capital markets revenue growth. BNS offset a 25% decline in trading revenue, with higher spread income driven by asset growth as well as higher loan loss recoveries.
• NA, BMO, and TD all recorded slight earnings declines in wholesale banking of 4%, 2%, and 1%, respectively. BMO and TD earnings were both negatively impacted by lower fee income and trading revenue. NA earnings were relatively weak due to lower security gains and higher operating expenses.
• NA continues to have the highest earnings reliance on wholesale banking at 36% of earnings, followed by BMO at 32%, BNS 30%, RY 28%, CM 27%, and TD at 20%.
Trading Revenue Strength Indicator : 125%; YOY Change 2%
• The bank group recorded strong first quarter trading revenue, with a strength indicator of 125% (compared with the eight-quarter average). However, trading revenue actually increased a modest 2% to $1,775 million. There is clear seasonality in Canadian bank trading revenue, particularly in the first quarter. RY recorded the strongest trading revenue as it continues to build out its platform, with BNS reporting the weakest trading revenue of the group.
• In terms of trading volatility, BMO continues to have the highest trading volatility, with CM declining to the lowest of the bank group. BMO’s high volatility is followed by TD, RY, NA, BNS, and CM.
Capital Markets Revenue Strength Indicator : 105%
• Capital markets revenue was $2,222 million, a 9% increase year over year. The capital markets revenue strength indicator was at 105%, with BNS and RY above average at 118% and 110%, respectively, with TD and NA the weakest at 90% and 102%, respectively.
Market-Sensitive Revenue Remains Below Eight-Year Average; Outliers - NA on High End, BNS on Low End
• Market-sensitive revenue (which includes trading revenue and capital markets revenue) for the bank group represented 20% of total revenue, below the eight-year average of 21%. NA led the group with market-sensitive revenue representing 27% of total revenue, with BMO and RY at 22% each, CM and TD at 21%, and BNS trailing at 16%. The outliers are NA at 27% and BNS at 16%.
Loan Loss Provisions Stable at 24 bp
• Specific loan loss provisions (LLPs) increased 21% year over year to $611 million or 24 bp. Bank LLPs have been incredibly stable, running at approximately $500 million to $600 million per quarter for the past three years. LLPs are expected to remain lower for longer than market expectations.
• In terms of individual banks, BNS and BMO recorded extremely low LLPs, at 11 bp and 13 bp, respectively, aided by continued LLP recoveries.
• We have reduced our 2007 LLP forecast by $90 million or 3% to $2,550 million or 26 bp of loans due to the level of recoveries in the first quarter and continued strong credit quality. Our 2008 LLP estimate declined $100 million to $3,025 million or 30 bp of loans.
Impaired Loan Formations Increase Modestly
• Gross impaired loan formations increased modestly to $1,435 million versus $1,375 million in the previous quarter and $1,329 million a year earlier. Gross impaired loan formations are at extremely low levels, at 14 bp of the bank group’s loan portfolio, for an annualized rate of 58 bp.
• Net impaired loan formations increased to $961 million versus $896 million in the previous quarter and $630 million a year earlier.
Risk-Weighted Assets Growth Accelerates
• Bank risk-weighted asset (RWA) growth has been accelerating over the past three years from the lows of 2002 and 2003, which saw actual declines in RWA levels. Bank RWA growth in Q1/07 was 14%, the highest level since 1997. Banks have increased their trading operations, with market at risk being a growth driver in overall bank RWA levels. Market at risk is now 5% of total RWA and has been running in the 4%-5% range since mid-2003. The leaders in RWA growth have been BNS, RY, and BMO.
Record Profitability : RRWA : ROE
• The bank group reported record profitability, with return on risk-weighted assets (RRWA) of 224 bp and return on equity of 24%. This represents the highest RRWA and ROE ever recorded by the bank group. The divergence in profitability among the various banks is relatively wide contrary to their P/E multiples, which are narrow by historical standards.
• TD holds the lead in terms of profitability based on this measure, with RRWA of 2.73%, assisted by its business mix, followed by RY at 2.55%, CM at 2.46%, BNS at 2.00%, and NA at 1.94%, with BMO trailing badly at 1.59%. We believe TD’s and RY’s retail and wealth management platforms have a competitive advantage, which is reflected in their higher profitability. TD’s and RY’s RRWA are 114 bp and 96 bp higher than BMO’s, respectively.
• Return on equity for the bank group in the first quarter was a record at 23.6% on extremely high capital levels. CM, RY, and BNS led the bank group in ROE at 28.1%, 27.5%, and 23.1%, respectively. BMO is the laggard at 18.3%, which is 9.8% lower than CM and 9.2% lower than RY. This spread is enormous and is certainly not reflected in relative P/E multiples.
;
Event
• Earnings growth reaccelerated to 24% in the first quarter, the strongest earnings momentum in the past three years.
• The bank group recorded its best quarter in history, with return on equity of nearly 24% and return on risk-weighted assets of 224 bp.
What It Means
• Earnings growth of 24% is even more impressive considering that fiscal 2006 represented the fourth straight year of 15% plus earnings growth - the first time the banking industry has achieved this in the past half century.
• Bank earnings continue to exceed market expectations, driven by strong underlying fundamentals and strong earnings growth from all business lines.
• Earnings quality remained solid. Bank revenue growth was 10% in the first quarter, one of the highest levels in the past five years. Banks are certainly not immune to a slowdown in the economy or capital markets activity, but we believe the market is overly aggressive in discounting potential earnings weakness.
• We expect the trend of declining volatility in bank earnings to continue and we expect the market to continue to reward bank stocks for this through further expansion of the P/E multiple. We reiterate a 1-Sector Outperform rating on RY and an overweight bank recommendation.
Blockbuster Quarter - Best in History
Summary and Conclusion
• The bank group recorded its best quarter in history, with return on equity of nearly 24% and return on risk-weighted assets of 224 bp.
• Earnings growth reaccelerated to 24% in the first quarter, the strongest earnings momentum in the past three years. This growth is even more impressive considering that fiscal 2006 represented the fourth straight year of 15% plus earnings growth - the first time the banking industry has achieved this in the past half century.
• Bank earnings continue to exceed market expectations, driven by strong underlying fundamentals and strong earnings growth from all business lines. Wealth management continues to produce high positive operating leverage and earnings growth. Wholesale bank earnings remain strong, driven by high trading revenue, solid capital markets revenue, and negligible loan loss provisions. Retail banking earnings are being driven by volume growth, a stabilizing retail net interest margin, and controlled expenses.
• Bank earnings are expected to continue to be more resilient or sustainable than market expectations due to loan losses staying lower for longer than expected in addition to the strong top-line growth the banks are generating. Bank revenue growth was 10% in the first quarter, one of the highest levels in the past five years. Revenue growth was particularly high at Royal Bank (RY) and Bank of Nova Scotia (BNS), at 15% and 14%, respectively, significantly higher than the bank group. Revenue growth in the mid-teens at RY and BNS reflects a very high growth platform at these banks. This is generally inconsistent with the market’s view of the banking industry as low growth.
• Banks are certainly not immune to a slowdown in the economy or capital markets activity, but we believe the market is overly aggressive in discounting potential earnings weakness. In addition, we believe the market continues to be slow in fully recognizing the level of profitability, high capital, low earnings volatility, and revenue diversification.
• The bank group’s strong earnings and profitability are being translated into consistent and frequent dividend increases. The banks have been very active in increasing dividends in conjunction with overall earnings strength.
• Four out of the six banks increased their dividends this quarter, led by RY with a relatively large 15% bump, followed by Toronto-Dominion Bank (TD) and Canadian Imperial Bank of Commerce (CM), each at 10%, with Bank of Montreal (BMO) at 5%. BMO’s increase follows a 5% increase in the previous quarter. Bank dividends have increased fourfold since the end of 1999. BNS and RY are leading the bank group in dividend growth at 250% and 241%, respectively, since the end of 1999. Despite the growth in dividends, the payout ratio remains in the low end of the banks’ target range at 41.6% on our 2007 earnings estimates.
• Earnings quality remained solid, with moderate security gains, high trading revenue, slightly above-average capital markets revenue, weaker retail net interest margins (although stabilizing), solid retail loan growth, low loan loss provisions, and stable and growing wealth management earnings.
• Bank earnings in the first quarter were not unduly reliant on market-sensitive revenue (trading and capital markets revenue), which represented 20% of total revenue, slightly below the eight-year average of 21%. Loan loss provisions at 24 bp remained near historical lows.
• We are now forecasting bank earnings growth of 16% in 2007, which would represent five straight years of 15% plus growth. Stronger-than-expected earnings in the first quarter, higher top-line growth, continued low loan loss provisions, and retail net interest margin stability are supportive of the higher earnings outlook.
• The bank group’s outperformance of the market in 2006 represented the 12th year of outperformance in the past 13 years. Banks are outperforming the market modestly thus far in 2007.
• Bank valuations have moved from attractive to compelling based on the strength of earnings and dividend increases in the first quarter. Bank valuations on a yield basis relative to bonds, pipes and utilities, income trusts, and the S&P/TSX composite are all in the strong buy range.
• Recent bank dividend increases have boosted dividend yields to 3.3%, representing 81% of the 10-year government bond yield, which is 3.1 standard deviations above the mean. Reversion to the mean with respect to bank dividend yields relative to bonds, pipes and utilities, business income trusts, and the S&P/TSX would suggest an increase in the bank index of 55%, 45%, 23%, and 36%, respectively.
• Bank P/E multiples have drifted to 14.0x trailing earnings from a recent high of 15.1x early in 2006 due to continued strong earnings growth. Banks are trading at a relatively low 12.7x and 11.5x our 2007 and 2008 earnings estimates, respectively. Our target P/E multiple is 15.5x our 2007 earnings estimate for total expected return of 26%. Our target prices may appear aggressive in the context of a nervous equity market, but we believe they are fully supported by high profitability, earnings growth, low earnings volatility, dividend growth, and low risk profile.
• We expect the trend of declining volatility in bank earnings to continue and we expect the market to continue to reward bank stocks for this through further expansion of the P/E multiple. The level of profitability also dictates much higher valuation. We have attempted to address the potential volatility in bank earnings by stress testing bank earnings (Exhibits 8 and 9) for a recession similar to that of the early 1980s and 1990s. Based on this stress testing, we expect a moderate 8% decline in bank earnings from record levels and a trough ROE of 18%. This trough ROE is higher than the previous trough of 15% in 2002. We conclude that bank earnings volatility is relatively low and profitability is sustainable at very high levels.
• In terms of bank stock selection, we continue to focus on the banks with the strongest profitability, capital, operating platforms, and the best growth opportunities. Individual bank P/E multiples have converged to historically low levels, occurring only a half dozen times since 1970 (Exhibit 35). Thus, investors are not paying any meaningful premium for the banks with the stronger operating platforms. On a long-term basis, three bank stocks have significantly outperformed: RY, BNS, and TD.
• We reiterate 1-Sector Outperform rating on RY, as we expect its P/E multiple to expand relative to the bank group towards the 10%-15% premium range over the next several years based on superior revenue growth, high ROE, and a business platform that is more orientated towards growth. BNS and RY led the bank group in revenue growth in fiscal 2006 at 10% and 8%, and in the first quarter of 2007 at 14% and 15%, respectively. BMO and CM significantly lagged in 2006 at 3% and -1%, respectively, with BMO, TD, and National Bank (NA) lagging in the first quarter at 4%, 5%, and 6%, respectively. We believe RY is the growth bank.
• RY (1-Sector Outperform) has above-average profitability and extremely strong operating platforms in retail, wealth management, and capital markets, with a slight valuation discount. RY’s superior growth is expected to be driven by its wealth management platform, supported by growth of its U.S. & International businesses, with RBC Capital Markets expanding its platform on a product and geographic basis. RY is expected to segment its wealth management business beginning in Q2/07. Wealth management revenue reported by RY in Q1/07 was nearly $1.3 billion, a sizable business that should attract a much higher P/E multiple.
• We maintain 2-Sector Perform ratings on TD, Laurentian Bank (LB), CM, and Canadian Western Bank (CWB), with 3-Sector Underperform ratings on BMO and NA. We have no sell recommendations on an absolute return basis.
• TD (2-Sector Perform) continues to generate strong earnings growth from TDCT and Wealth Management, with greater earnings stability in wholesale banking partially offset by weak operating performance from TD Banknorth. Overall, TD Banknorth continues to create uncertainty for investors and somewhat overshadows the strong overall performance of the bank.
• LB (2-Sector Perform) continues to improve in terms of operating performance. LB earnings are expected to grow at a much higher rate than the bank group over the next few years, becoming more visible with the release of first quarter earnings. LB is the least expensive bank stock on a market to book value basis and on a P/E multiple basis on our 2008 earnings estimate. LB return on equity continues to lag, but stronger relative earnings growth in 2007 and 2008 should support strong share price performance.
• CM (2-Sector Perform) has reduced the risk in its retail loan portfolio and significantly lowered its operating expense levels. The cost cutting has produced solid earnings gains in 2006 and is expected to continue into 2007; however, revenue weakness remains a challenge. The earnings gains achieved are unlikely to be sustainable in the medium to longer term unless the bank is able to grow revenue. It is always difficult to determine when aggressive cost cutting becomes not reinvesting in the business. Revenue risk persists.
• CWB (2-Sector Perform) continues to have a high growth profile, with 20% plus loan and deposit growth. CWB concentration in the strong economies of Alberta and B.C. and continued high loan and deposit growth are expected to continue to produce industry-high earnings growth, which is reflected in the bank’s premium P/E multiple.
• We maintain our 3-Sector Underperform rating on BMO based on the absence of any meaningful P/E multiple discount, despite the fact that it has the lowest profitability of the bank group and the weakest earnings growth outlook. It appears the market is paying an embedded premium for BMO’s superior historical credit performance, anticipating a major credit crunch. We believe this premium is too high, especially given the structural changes in the bank group’s balance sheets, as leverage to credit has declined four- or fivefold since the early 1980s.
• We maintain our 3-Sector Underperform rating on NA due to its lower earnings growth outlook, concerns regarding economic prospects in Central Canada and NA’s concentration in that region, and the bank’s earnings dependency on security gains and trading revenue.
• Our 12-month bank index target is 28,700 for a total expected return of 26%. Our target is based on a forecast P/E of 15.5x our 2007 earnings estimate or 13.6x our 2008 earnings estimate.
• Our 12-month share price targets on BMO, CM, NA, RY, TD, LB, and CWB are $80, $115, $77, $75, $81, $36, and $27.50, respectively.
• Risks to our bank share price targets are overall bearish market sentiment, severe economic slowdown or recession, a major spike in long-term interest rates above 5%, or a major decline in short-term interest rates of 200 bp or more. A major spike in long-term rates negatively impacts valuation and a major decline in short-term rates would negatively impact earnings.
• We remain overweight the bank group, based on record profitability and capital levels, low financial and earnings leverage to credit, diversified revenue mix, reasonable earnings growth outlook, low earnings volatility, ability to increase dividends, and attractive valuation, including extremely high dividend yields, low P/E multiples, and low relative risk.
• Bank betas remain extremely low, with a one-year average bank beta of 0.35, compared with a three-year average bank beta of 0.37 and a five-year average bank beta of 0.74.
First Quarter Earnings Highlights
• The bank group once again exceeded expectations, with operating earnings increasing 24% year over year and 13% sequentially.
Super Growth
• CM, RY, and LB led earnings growth in the 30% plus range at 34%, 32%, and 30%, respectively.
High Growth
• CWB, BNS, and TD followed with earnings growth in the 20% plus range at 21%, 20%, and 20%, respectively.
Growth Laggards
• Significantly lagging the bank group were BMO and NA, with earnings growth of 11% and 13%, respectively.
Dividend Increases - BMO, CM, RY, TD
• Four banks announced dividend increases in the quarter, with RY increasing its dividend by 15%, CM and TD increasing their dividends by 10% each, followed by BMO with a 5% increase. RY’s increase was the largest in the past seven years. BMO’s increase occurred over back-to-back quarters, with a payout ratio of 50.4% versus the bank group at 41.6%. Overall, the bank group has now increased dividends by 205% since the end of 1999/beginning of 2000.
High Revenue Growth Led by RY and BNS
• Revenue growth for the bank group in Q1 was 10%, one of the highest growth rates in the past six years. RY and BNS were very dominant in revenue growth at 15% and 14%, respectively, considerably higher than the bank group. CM, NA, TD, and BMO followed with more moderate revenue growth of 9%, 6%, 5%, and 4%, respectively.
Retail and Wealth Management
• Domestic retail and wealth management earnings were strong, increasing 16% year over year and 11% sequentially. CM led retail earnings growth at 20.7%, primarily due to lower loan loss provisions, cost cutting, and a lower tax rate. RY earnings increased 20.2%, led by wealth management and strong insurance results. NA earnings increased 17.5%, driven by improved net interest margin and lower-than-normal run rate expenses. TD earnings increased 14.6%, driven by strong insurance results and retail loan volumes and wealth management. BNS and BMO growth rates lagged at 9.8% and 11.4%, respectively. BNS was the weakest, although the bank recorded its best growth rate in over a year. BMO continued to lose market share in residential mortgages and personal deposits.
Underlying Retail Margin Stabilizing to Improving?
• Retail net interest margin (NIM) dipped below 3% for the first time to 2.99%, representing a 4 bp decline year over year and sequentially. However, the margin appears to be stabilizing for some banks. RY, TD, and NA margin increased 1 to 2 bp, with BMO unchanged on a year-over-year basis. CM and BNS margins declined 24 bp and 20 bp year over year, respectively, with declines of 11 bp and 4 bp sequentially. The margin decline at BNS has negatively impacted its earnings growth in this segment relative to the bank group.
Wealth Management - High Revenue Growth
• Wealth management earnings were very strong in the first quarter, although only three banks (BMO, NA, and TD) currently segment these earnings, with RY beginning in Q2/07.
• Earnings growth from domestic wealth management at NA and TD were 22% and 16%, respectively, with BMO lagging at 4%. Domestic wealth management revenue growth was strong at RY at 14%, followed by TD at 12% and NA at 9%.
• Mutual fund assets for the bank group increased 14% to $243 billion, led by RY at 21% growth, followed by TD at 17%, BMO at 14%, BNS at 11%, CM at 8%, and NA at 3%. RY and TD remain the industry leaders in net long-term asset (LTA) sales including transfers, with impressive market share of 20% and 16%, respectively.
• Performance at the bank group’s International divisions varied considerably, with RY and BNS recording very high growth, TD mixed, and BMO very weak. RY U.S. & International earnings increased 45%, driven by an 18% increase in wealth management revenue. BNS earnings increased 36% despite flattish earnings from Mexico. TD International performance was mixed, with TD Banknorth earnings declining 2% and TD Ameritrade’s contribution increasing 94%. BMO results from International were weak, as U.S. P&C (Harris) earnings declined 13% due to net interest margin decline and higher expenses.
• International Banking earnings at BNS were driven by strong growth in all regions, particularly Mexico and Asia, with solid contribution from new acquisitions in Costa Rica and Peru. Revenue growth at International Banking was very high at 30%.
• RY U.S. & International represented 11% of bank earnings, with BNS International the largest contribution of any bank at 32%. TD Banknorth’s earnings contribution was $0.09 per share, representing 6.5% of total bank earnings, with Ameritrade contributing $0.07 per share or 5% of earnings for a combined contribution of 12%. BMO’s U.S. P&C (Harris) contributed 5% to bank earnings.
Wholesale Banking Earnings Increase 12%, Strong at CM, RY, BNS; Weak at BMO, NA, TD
• Wholesale earnings for the bank group increased 12% year over year, led by CM with earnings growth of 63%, followed by RY at 34% and BNS at 14%. CM recorded significantly higher merchant banking and capital markets fees including M&A. RY recorded strong trading revenue and capital markets revenue growth. BNS offset a 25% decline in trading revenue, with higher spread income driven by asset growth as well as higher loan loss recoveries.
• NA, BMO, and TD all recorded slight earnings declines in wholesale banking of 4%, 2%, and 1%, respectively. BMO and TD earnings were both negatively impacted by lower fee income and trading revenue. NA earnings were relatively weak due to lower security gains and higher operating expenses.
• NA continues to have the highest earnings reliance on wholesale banking at 36% of earnings, followed by BMO at 32%, BNS 30%, RY 28%, CM 27%, and TD at 20%.
Trading Revenue Strength Indicator : 125%; YOY Change 2%
• The bank group recorded strong first quarter trading revenue, with a strength indicator of 125% (compared with the eight-quarter average). However, trading revenue actually increased a modest 2% to $1,775 million. There is clear seasonality in Canadian bank trading revenue, particularly in the first quarter. RY recorded the strongest trading revenue as it continues to build out its platform, with BNS reporting the weakest trading revenue of the group.
• In terms of trading volatility, BMO continues to have the highest trading volatility, with CM declining to the lowest of the bank group. BMO’s high volatility is followed by TD, RY, NA, BNS, and CM.
Capital Markets Revenue Strength Indicator : 105%
• Capital markets revenue was $2,222 million, a 9% increase year over year. The capital markets revenue strength indicator was at 105%, with BNS and RY above average at 118% and 110%, respectively, with TD and NA the weakest at 90% and 102%, respectively.
Market-Sensitive Revenue Remains Below Eight-Year Average; Outliers - NA on High End, BNS on Low End
• Market-sensitive revenue (which includes trading revenue and capital markets revenue) for the bank group represented 20% of total revenue, below the eight-year average of 21%. NA led the group with market-sensitive revenue representing 27% of total revenue, with BMO and RY at 22% each, CM and TD at 21%, and BNS trailing at 16%. The outliers are NA at 27% and BNS at 16%.
Loan Loss Provisions Stable at 24 bp
• Specific loan loss provisions (LLPs) increased 21% year over year to $611 million or 24 bp. Bank LLPs have been incredibly stable, running at approximately $500 million to $600 million per quarter for the past three years. LLPs are expected to remain lower for longer than market expectations.
• In terms of individual banks, BNS and BMO recorded extremely low LLPs, at 11 bp and 13 bp, respectively, aided by continued LLP recoveries.
• We have reduced our 2007 LLP forecast by $90 million or 3% to $2,550 million or 26 bp of loans due to the level of recoveries in the first quarter and continued strong credit quality. Our 2008 LLP estimate declined $100 million to $3,025 million or 30 bp of loans.
Impaired Loan Formations Increase Modestly
• Gross impaired loan formations increased modestly to $1,435 million versus $1,375 million in the previous quarter and $1,329 million a year earlier. Gross impaired loan formations are at extremely low levels, at 14 bp of the bank group’s loan portfolio, for an annualized rate of 58 bp.
• Net impaired loan formations increased to $961 million versus $896 million in the previous quarter and $630 million a year earlier.
Risk-Weighted Assets Growth Accelerates
• Bank risk-weighted asset (RWA) growth has been accelerating over the past three years from the lows of 2002 and 2003, which saw actual declines in RWA levels. Bank RWA growth in Q1/07 was 14%, the highest level since 1997. Banks have increased their trading operations, with market at risk being a growth driver in overall bank RWA levels. Market at risk is now 5% of total RWA and has been running in the 4%-5% range since mid-2003. The leaders in RWA growth have been BNS, RY, and BMO.
Record Profitability : RRWA : ROE
• The bank group reported record profitability, with return on risk-weighted assets (RRWA) of 224 bp and return on equity of 24%. This represents the highest RRWA and ROE ever recorded by the bank group. The divergence in profitability among the various banks is relatively wide contrary to their P/E multiples, which are narrow by historical standards.
• TD holds the lead in terms of profitability based on this measure, with RRWA of 2.73%, assisted by its business mix, followed by RY at 2.55%, CM at 2.46%, BNS at 2.00%, and NA at 1.94%, with BMO trailing badly at 1.59%. We believe TD’s and RY’s retail and wealth management platforms have a competitive advantage, which is reflected in their higher profitability. TD’s and RY’s RRWA are 114 bp and 96 bp higher than BMO’s, respectively.
• Return on equity for the bank group in the first quarter was a record at 23.6% on extremely high capital levels. CM, RY, and BNS led the bank group in ROE at 28.1%, 27.5%, and 23.1%, respectively. BMO is the laggard at 18.3%, which is 9.8% lower than CM and 9.2% lower than RY. This spread is enormous and is certainly not reflected in relative P/E multiples.
