The Globe and Mail, Tara Perkins, 6 June 2007
Banks and insurers could take a bit of a bruising in the coming quarters from the rapid ascension of the Canadian dollar.
"The recent surge in the [Canadian dollar] has been acute and will put some nearer-term earning pressure on the bank group," Scotia Capital Inc. analyst Kevin Choquette wrote in a note to clients yesterday.
The loonie has already risen 8 per cent since the end of the banks' second quarter, which was April 30, he noted.
If it remains at its current level, he estimates that Canadian banks' profits will take a 2.2-per-cent hit in the third quarter. The impact will vary bank by bank, with Bank of Nova Scotia feeling the most pain because of its large international operations.
Mr. Choquette trimmed his estimates for the banks yesterday, and downgraded Scotiabank to "sector perform" from "sector outperform."
His estimates assume that the banks are not hedging against the currency risk.
Toronto-Dominion Bank said yesterday that it does not actively hedge its exposure "because the potential impact to TD is so small."
TD's exposure to fluctuations in the exchange rate is estimated at about 1 cent of annual share earnings for each 1-cent change in the exchange rate, meaning that if the Canadian dollar appreciates from $1.15 to $1.14 per U.S. dollar, about 1 cent will be cut from share earnings, spokesman Nick Petter said in an e-mail.
Royal Bank of Canada said it does not hedge against its own exposure, while Bank of Montreal said it hedges its U.S. earnings one quarter forward.
On a conference call with analysts last month, Scotiabank chief financial officer Luc Vanneste said "obviously, a rise in the Canadian dollar for a bank that earns as much as we do, non-Canadian currency, is a head wind."
He added that "we hedge our foreign currency earnings to a degree ... but it's certainly not enough to offset the full effect."
At Genuity Capital Markets, analyst Mario Mendonca is not changing his bank earnings estimates, saying any reduction by a few pennies could be overshadowed by larger items such as trading revenue.
"Among the large-capitalization banks, we have found that only [Scotiabank's] earnings in the international segment can swing on significant changes in the value of the Canadian dollar," he wrote in a note to clients.
Mr. Mendonca did change his exchange rate model for insurers, to $1.06 (Canadian) for each U.S. dollar from $1.15.
"Over a full year, an 8-per-cent reduction in our currency input reduces our [Sun Life Financial] estimate by 2 to 3 per cent, approximately half the effect for Manulife," he wrote.
He estimates that about 30 to 35 per cent of Sun Life's earnings are denominated in U.S. dollars, compared with 60 to 65 per cent of Manulife's.
"We have found, however, that the Canadian insurers' earnings generally do not adjust [up or down] for the full effect implied by changes in currency," he wrote.
Banks and insurers could take a bit of a bruising in the coming quarters from the rapid ascension of the Canadian dollar.
"The recent surge in the [Canadian dollar] has been acute and will put some nearer-term earning pressure on the bank group," Scotia Capital Inc. analyst Kevin Choquette wrote in a note to clients yesterday.
The loonie has already risen 8 per cent since the end of the banks' second quarter, which was April 30, he noted.
If it remains at its current level, he estimates that Canadian banks' profits will take a 2.2-per-cent hit in the third quarter. The impact will vary bank by bank, with Bank of Nova Scotia feeling the most pain because of its large international operations.
Mr. Choquette trimmed his estimates for the banks yesterday, and downgraded Scotiabank to "sector perform" from "sector outperform."
His estimates assume that the banks are not hedging against the currency risk.
Toronto-Dominion Bank said yesterday that it does not actively hedge its exposure "because the potential impact to TD is so small."
TD's exposure to fluctuations in the exchange rate is estimated at about 1 cent of annual share earnings for each 1-cent change in the exchange rate, meaning that if the Canadian dollar appreciates from $1.15 to $1.14 per U.S. dollar, about 1 cent will be cut from share earnings, spokesman Nick Petter said in an e-mail.
Royal Bank of Canada said it does not hedge against its own exposure, while Bank of Montreal said it hedges its U.S. earnings one quarter forward.
On a conference call with analysts last month, Scotiabank chief financial officer Luc Vanneste said "obviously, a rise in the Canadian dollar for a bank that earns as much as we do, non-Canadian currency, is a head wind."
He added that "we hedge our foreign currency earnings to a degree ... but it's certainly not enough to offset the full effect."
At Genuity Capital Markets, analyst Mario Mendonca is not changing his bank earnings estimates, saying any reduction by a few pennies could be overshadowed by larger items such as trading revenue.
"Among the large-capitalization banks, we have found that only [Scotiabank's] earnings in the international segment can swing on significant changes in the value of the Canadian dollar," he wrote in a note to clients.
Mr. Mendonca did change his exchange rate model for insurers, to $1.06 (Canadian) for each U.S. dollar from $1.15.
"Over a full year, an 8-per-cent reduction in our currency input reduces our [Sun Life Financial] estimate by 2 to 3 per cent, approximately half the effect for Manulife," he wrote.
He estimates that about 30 to 35 per cent of Sun Life's earnings are denominated in U.S. dollars, compared with 60 to 65 per cent of Manulife's.
"We have found, however, that the Canadian insurers' earnings generally do not adjust [up or down] for the full effect implied by changes in currency," he wrote.
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Scotia Capital, 5 June 2007
C$ Appreciates 8% from Fiscal Q2/07 End
• The rapidly appreciating Canadian dollar has recently caught the market by surprise after languishing in the $0.85 to $0.90 range over the past six quarters. The C$ has appreciated 8% thus far in Q3/07 against the USD (average exchange rate) from the banks second fiscal quarter ending April 30th.
• The magnitude of the spike in the C$ this quarter compares withyearly appreciations (Exhibit 10) in 2002, 2003 and 2004. This rapid rise in the Canadian dollar is expected to negatively impact bank third quarter earnings and put modest pressure on earnings growth rates in 2008.
• Scotia Capital Economics has recently increased its C$ forecast against the US $ to $0.96 by the end of 2008 up from the previous forecast of $0.92.
Bank Earnings Negatively Impacted by C$ Appreciation
• In estimating bank earnings sensitivity to the level of the Canadian dollar we assume no hedging activity has been undertaken to mitigate the earnings impact. We estimate that Canadian bank's earnings will be negatively impacted by 2.2% in Q3/07 assuming no hedging and that the C$ stays at its current level. The individual banks impact varies with BNS being impacted the most and NA the least as highlighted in Exhibit 4.
• If the C$ was to remain at the current level of $0.945 against the US$ bank earnings in 2007 we estimate would be negatively impacted by 1.2% with our 2008 earnings estimate negatively impacted by 2.3% as per Exhibit 2.
• The appreciation in the C$ from 2003 to the end of fiscal 2006 has reduced the various banks book values as highlighted in Exhibit x. The bank group has earned through the major C$ appreciation from $0.60 to $0.90 which represented a 50% increase. The recent surge in the C$ has been acute and will put some nearer term earning pressure on the bank group. The appreciation of the C$ to Par from the $0.90 level would represent a 11% increase, not insignificant but manageable. We expect the bank group to earn through the most recent spike in the C$ in the medium term. However an additional concern is the potential impact to the Canadian economy of a higher C$ particularly the manufacturing base in Ontario and Quebec.
Trimming Bank Earnings Estimates
• As a result of the potential near term negative earnings impact we are trimming modestly our 2007 and 2008 earnings estimates as highlighted in Exhibit 1. Our 2007 earnings estimates are being reduced by $0.05 per share per bank except for NA with no change in earnings. We are reducing our 2008 earnings estimates for the banks in the range of $0.05 to $0.15 per share.
• We are also fine tuning some of our share price targets. We are increasing our 12 month share price target on TD to $90 per share form $85, LB to $39 from $36 and CWB from $27.50 to $30. We are reducing modestly our 12-month share price target on NA to $75 from $77 per share.
BNS Downgrading to 2-Sector Perform
• We are also downgrading BNS to a 2-Sector Perform from a 1-Sector Outperform based on potential slowdown in relative earnings growth in the near term and the balancing of our bank recommendations in light of our May 24, 2007 upgrade on TD Bank to a 1-Sector Outperform.
• In terms of BNS's relative earnings growth in the near term, we are concerned about the higher negative earnings impact from the appreciating C$, the higher potential negative impact from a possible increase in short term interest rates based on the banks funding of its retail loan portfolio (low percentage of demand and notice) and the slower than expected reacceleration of earnings growth from Mexico.
• Exhibit 15 highlights BNS's funding of its retail loan portfolio with only 28% coming from demand and notice the least expensive funding versus TD Bank at a bank group high of 69%. Thus, if we get another round of short term interest rate hikes, BNS's retail margin may be under greater pressure in the near term as the bank is more dependent on short term wholesale funding for its retail book.
Maintain Overweight Recommendation on Banks
• We maintain an overweight recommendation in the bank group based on attractive valuations and strong fundamentals. Banks are trading at low a P/E multiple of 12.0x on our slightly revised 2008 earnings estimate. The market in our view is heavily discounting bank earnings levels and the multiple does not reflect the level of profitability, earnings resilience or growth.
• Maintain 1-Sector Outperforms on TD and RY with 2-Sector Performs on BNS and CM and 3-Sector Underperforms on BMO and NA. CWB and LB remain both 2-Sector Performs with CWB representing growth and LB representing value.
C$ Appreciates 8% from Fiscal Q2/07 End
• The rapidly appreciating Canadian dollar has recently caught the market by surprise after languishing in the $0.85 to $0.90 range over the past six quarters. The C$ has appreciated 8% thus far in Q3/07 against the USD (average exchange rate) from the banks second fiscal quarter ending April 30th.
• The magnitude of the spike in the C$ this quarter compares withyearly appreciations (Exhibit 10) in 2002, 2003 and 2004. This rapid rise in the Canadian dollar is expected to negatively impact bank third quarter earnings and put modest pressure on earnings growth rates in 2008.
• Scotia Capital Economics has recently increased its C$ forecast against the US $ to $0.96 by the end of 2008 up from the previous forecast of $0.92.
Bank Earnings Negatively Impacted by C$ Appreciation
• In estimating bank earnings sensitivity to the level of the Canadian dollar we assume no hedging activity has been undertaken to mitigate the earnings impact. We estimate that Canadian bank's earnings will be negatively impacted by 2.2% in Q3/07 assuming no hedging and that the C$ stays at its current level. The individual banks impact varies with BNS being impacted the most and NA the least as highlighted in Exhibit 4.
• If the C$ was to remain at the current level of $0.945 against the US$ bank earnings in 2007 we estimate would be negatively impacted by 1.2% with our 2008 earnings estimate negatively impacted by 2.3% as per Exhibit 2.
• The appreciation in the C$ from 2003 to the end of fiscal 2006 has reduced the various banks book values as highlighted in Exhibit x. The bank group has earned through the major C$ appreciation from $0.60 to $0.90 which represented a 50% increase. The recent surge in the C$ has been acute and will put some nearer term earning pressure on the bank group. The appreciation of the C$ to Par from the $0.90 level would represent a 11% increase, not insignificant but manageable. We expect the bank group to earn through the most recent spike in the C$ in the medium term. However an additional concern is the potential impact to the Canadian economy of a higher C$ particularly the manufacturing base in Ontario and Quebec.
Trimming Bank Earnings Estimates
• As a result of the potential near term negative earnings impact we are trimming modestly our 2007 and 2008 earnings estimates as highlighted in Exhibit 1. Our 2007 earnings estimates are being reduced by $0.05 per share per bank except for NA with no change in earnings. We are reducing our 2008 earnings estimates for the banks in the range of $0.05 to $0.15 per share.
• We are also fine tuning some of our share price targets. We are increasing our 12 month share price target on TD to $90 per share form $85, LB to $39 from $36 and CWB from $27.50 to $30. We are reducing modestly our 12-month share price target on NA to $75 from $77 per share.
BNS Downgrading to 2-Sector Perform
• We are also downgrading BNS to a 2-Sector Perform from a 1-Sector Outperform based on potential slowdown in relative earnings growth in the near term and the balancing of our bank recommendations in light of our May 24, 2007 upgrade on TD Bank to a 1-Sector Outperform.
• In terms of BNS's relative earnings growth in the near term, we are concerned about the higher negative earnings impact from the appreciating C$, the higher potential negative impact from a possible increase in short term interest rates based on the banks funding of its retail loan portfolio (low percentage of demand and notice) and the slower than expected reacceleration of earnings growth from Mexico.
• Exhibit 15 highlights BNS's funding of its retail loan portfolio with only 28% coming from demand and notice the least expensive funding versus TD Bank at a bank group high of 69%. Thus, if we get another round of short term interest rate hikes, BNS's retail margin may be under greater pressure in the near term as the bank is more dependent on short term wholesale funding for its retail book.
Maintain Overweight Recommendation on Banks
• We maintain an overweight recommendation in the bank group based on attractive valuations and strong fundamentals. Banks are trading at low a P/E multiple of 12.0x on our slightly revised 2008 earnings estimate. The market in our view is heavily discounting bank earnings levels and the multiple does not reflect the level of profitability, earnings resilience or growth.
• Maintain 1-Sector Outperforms on TD and RY with 2-Sector Performs on BNS and CM and 3-Sector Underperforms on BMO and NA. CWB and LB remain both 2-Sector Performs with CWB representing growth and LB representing value.
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Financial Post, Duncan Mavin, 5 June 2007
These must be tough times to be a bailiff if the strength of banking loan books is anything to go by.
Despite a 35% year over year increase in provision for loan losses at the big banks in the second quarter of 2007, loan defaults remain at historically low levels.
“It’s still tame,” said UBS Investment Research analyst Jason Bilodeau. “It’s still fair to say the credit environment remains benign and conditions are pretty favourable.”
Across the big banks, the total provision for bad debts has been between $600-million and $700-million for the past three quarters — as recently as 2003, the banks were recording provisions almost twice as large.
In fact, the rise in loan loss provisions in the most recent quarter has less to do with new loans going bad than it is caused by the drying up of recoveries of loans written off by the banks in prior periods, he said. “It’s really that benefit that is going away that is starting to show up,” Mr. Bilodeau explained.
Most analysts still expect a gradual increase in loan losses. “You’re coming from such an incredibly benign credit environment, you’ve almost got nowhere to go but to get worse,” Mr. Bilodeau said.
Continued growth in loan portfolios and an increase in impaired loans should result in the absolute level of provisions rising in 2008, said Dundee Securities analyst John Aiken.
The forecast change in provision levels will have the least impact on Royal Bank of Canada and Toronto-Dominion Bank, which both benefit from having a broad range of earnings sources, Mr. Aiken said.
“TD’s ownership of TD Waterhouse and interest in TD Ameritrade provide significant diversification away from its lending operations, while Royal has one of the lowest reliance on net interest income sourced earnings of the group,” he said.
These must be tough times to be a bailiff if the strength of banking loan books is anything to go by.
Despite a 35% year over year increase in provision for loan losses at the big banks in the second quarter of 2007, loan defaults remain at historically low levels.
“It’s still tame,” said UBS Investment Research analyst Jason Bilodeau. “It’s still fair to say the credit environment remains benign and conditions are pretty favourable.”
Across the big banks, the total provision for bad debts has been between $600-million and $700-million for the past three quarters — as recently as 2003, the banks were recording provisions almost twice as large.
In fact, the rise in loan loss provisions in the most recent quarter has less to do with new loans going bad than it is caused by the drying up of recoveries of loans written off by the banks in prior periods, he said. “It’s really that benefit that is going away that is starting to show up,” Mr. Bilodeau explained.
Most analysts still expect a gradual increase in loan losses. “You’re coming from such an incredibly benign credit environment, you’ve almost got nowhere to go but to get worse,” Mr. Bilodeau said.
Continued growth in loan portfolios and an increase in impaired loans should result in the absolute level of provisions rising in 2008, said Dundee Securities analyst John Aiken.
The forecast change in provision levels will have the least impact on Royal Bank of Canada and Toronto-Dominion Bank, which both benefit from having a broad range of earnings sources, Mr. Aiken said.
“TD’s ownership of TD Waterhouse and interest in TD Ameritrade provide significant diversification away from its lending operations, while Royal has one of the lowest reliance on net interest income sourced earnings of the group,” he said.
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RBC Capital Markets, 4 June 2007
All banks reported Q2/07 EPS that were higher than our expectations (and consensus), with the exception of Royal Bank. TD was most ahead of expectations, and it and BNS posted the highest quality earnings against our expectations.
The industry continued to benefit from solid growth in retail revenues and net income, as well as active capital markets and low loan losses. We believe that retail banking divisions will continue to grow rapidly, but are concerned that the current strength in capital markets revenues may not be sustainable and credit quality is showing signs of having peaked.
We continue to believe that there is limited upside to current valuation multiples. We expect profitability to remain high by long-term standards but earnings growth is likely to slow compared to recent years. Credit losses are likely to come off their lows, equity markets are unlikely to maintain their torrid pace of the last four years and capital markets activity is benefiting from high levels of liquidity. Also, interest rates are likely to increase, which presents a risk to bank valuations.
We are increasing our investment rating on Royal Bank from Sector Perform to Outperform. The bank's shares have underperformed its peers since May 1, 2007, partly because it was the only bank not to surpass Q2/07 EPS expectations. However, some of the items that caused the miss were one-timish in nature, particularly disability claims in the insurance businesses, trading revenues related to U.S. sub-prime securities and integration costs in U.S. retail banking. These businesses are also "lower multiple businesses" in our view. Wealth management and retail banking continued to perform well.
We are lowering our investment rating on CIBC from Top Pick to Outperform. We now forecast similar total returns (appreciation in stock prices plus dividends) of 13-14% in the next 12 months for CIBC, TD and Royal Bank following the appreciation in CIBC's stock since May 1, 2007 and our recent increase in our 12-month target price for TD Bank. We believe that CIBC's slight P/E discount makes the stock attractive, in spite of a lower revenue growth profile, given improving retail revenue growth (and tight expense controls), the prospects for a 17% increase in the dividend in Q3/07, and less exposure to wholesale income and potentially rising business loan losses.
Royal Bank - Upgrading to Outperform from Sector Perform
We are increasing our investment rating on Royal Bank from Sector Perform to Outperform.
• Attractive Relative Value - RBC shares have underperformed the financials group since May 1 2007, most notably against CIBC, TD Bank, National Bank, Industrial Alliance and Northbridge. The bank’s shares have even underperformed those of Bank of Montreal, which has had well-publicized issues related to its commodity trading businesses.
• Strength in the highest multiple businesses – Q2/07 earnings highlighted strength in wealth management and retail banking. Wealth management income was up 22% against Q2/06 on revenue growth of 13%. The domestic retail bank (ex insurance) had a very impressive quarter in our view, with revenues rising 11%, market share increases in lending products, and a 23% increase in income.
• Q2/07 earnings were below the high expectations we and the street had for the bank. However, some of the items that caused the miss were one-timish in nature, particularly disability claims in the insurance businesses, trading revenues related to U.S. subprime securities and integration costs in U.S. retail banking. These businesses are also “lower multiple businesses” in our view.
• We believe that the bank’s premium valuation is sustainable (0.6x on 2007E P/E and 0.3x on 2008E) on the basis that the bank will grow earnings at a more rapid rate than its peers in 2007 and 2008 (19% and 11% versus an industry median of 17% and 7%), driven by:
o Dominant, and rapidly growing retail banking and wealth management franchises, the two highest multiple businesses Canadian banks participate in.
o A more diversified capital markets business, which should lead to lower volatility in revenue and earnings than other Canadian banks’ investment dealers.
o A superior outlook for near-term revenue growth, driven by a 16% increase in risk weighted assets in the last 12 months, a result of organic growth and acquisitions.
• The two biggest risks to our Outperform recommendation relate to credit quality and capital markets.
o A very rapid deterioration in credit quality would hurt Royal Bank more than TD Bank and CIBC, as well as the insurers, in our view. Although we are expecting credit losses to rise, we are not calling for significant deterioration in credit quality in the near term and believe that the bank can maintain above-average bottom line growth if credit losses rise gradually, as we predict.
o A worldwide decline in equity markets and capital markets activity would likely hurt the bank more than most of its peers given the size of its wealth management and capital markets businesses. A mild decline would be offset by increased investments in those businesses, in our view, while isolated declines would be mitigated by greater geographic diversification than other Canadian peers.
CIBC - Downgrading to Outperform from Top Pick
We are lowering our investment rating on CIBC from Top Pick to Outperform.
We now forecast similar total returns (appreciation in stock price plus dividends) of 13-14% in the next 12 months for CIBC, TD and Royal Bank following the appreciation in CIBC’s stock since May 1, 2007 and our recent increase in our 12-month target price for TD Bank.
CIBC trades at 12.5x our estimated 2007E earnings versus a peer average of 13.0 times. We believe that the relative multiple makes CIBC’s stock attractive, in spite of a lower revenue growth profile, hence our Outperform rating. The following points summarize our investment thesis on CIBC shares.
• Potential for Upward Earnings Revisions - We expect the consolidation of FirstCaribbean’s results and improving retail revenue growth, combined with flat expenses in Canada, will drive earnings growth that exceeds expectations in H2/07. We also believe that Q2/07 retail loan losses could prove to have been abnormally high in the near term.
• 17% increase in the dividend expected in Q3/07 - The current dividend rate of $3.08 implies a payout ratio of 38% based on our 2007E EPS, well below the bank's official target range of 40%-50%.
• The bank’s multiple should benefit from having the second-lowest exposure to wholesale income. The retail mix should also increase given the acquisition of FirstCaribbean, improving revenue growth in retail businesses and a likely reduction in merchant banking gains.
• Less exposed to potentially rising business loan losses, the area that most concerns us from a credit quality standpoint. Business loan losses for the Canadian banks are currently non-existent, compared to a 17-year average of 80 basis points. CIBC's loan book has the least exposure to business and government loans and the bank holds $10.4 billion in credit default swaps – a large amount relative to its $34.0 billion business and government loan book.
Valuation - Thesis Unchanged Post Q2/07 Results
Valuation Multiples Do Not Have Much Upside
Canadian bank valuations are justifiably well above very long term averages, although it is difficult to argue for more upside at this stage in the credit and capital markets cycles.
In the near term, valuations should benefit from very active capital markets, low credit losses, strong growth in retail lending and the rash of takeout activity of Canadian companies, which is likely to lead to reinvestment in Canadian financial services stocks.
Furthermore, over the last 15 years banks have improved their ROEs and capitalization ratios, lowered their exposure to credit risk and grown higher-multiple businesses such as wealth management and retail banking, while risk-free rates have declined.
We believe that further multiple expansion is unlikely, however, as ROE cyclicality has been lowered, not eliminated, and it is hard to picture a better environment for banks.
• Volatility will still arise in poor credit and capital markets environments. Repeating the strong earnings growth of recent years is likely to be difficult, given the phenomenal credit performance of the last 5 years, strong equity market appreciation, and very active debt and M&A markets.
• A rise in Canadian bond yields would likely negatively impact bank valuations, particularly if the 10-year yield were to extend above 5%. Bank valuations have historically been highly negatively correlated with long-term interest rates.
• The bank sector’s relative forward P/E is at 80% of the market multiple, well above the 64% long-term average, limiting potential upside. We are not alarmed by potential downside either, though. Part of this increased relative valuation is driven by cyclically high profitability of the key basic materials and energy sectors (which as usual is accompanied by lower than average P/Es) and part would be driven by justified increases in bank valuations. Basic materials and energy make up 44% of the S&P/TSX Composite Index, versus 17% for banks.
• Retail and institutional appetite for foreign securities has risen following changes to pension regulation and years of outperformance by Canadian equity markets and the Canadian dollar. Increased interest in foreign securities is a negative, in our view, as bank stocks have always been popular with both Canadian institutional and retail investors, given their earnings and dividend growth track records.
Prefer Lifecos Over Banks
We continue to believe that there are fewer risks to owning the shares of life insurance companies at current valuations, although two key macro indicators are currently more favourable to the banks’ shares in our view, while the other two are only beginning to show signs of trending in a direction that would favour life insurers versus banks.
• Capital markets activity remains high, fueled by high liquidity, low risk premiums and the increasingly easier access to bank lending. Mergers and acquisitions, debt and equity underwriting, trading businesses and proprietary investing have all benefited. While this level of activity appears unsustainable, the longer it lasts, the better off banks are versus life insurers.
• The rapid increase in the Canadian dollar, up 11% since February 7, 2007, is more negative for the life insurers, who generate more earnings from outside of Canada than the banks (Industrial Alliance excepted) and do not have trading operations that benefit from the rapidly rising dollar.
• Long-term interest rates remain low by long-term standards but 10-year Government bond yields have risen by 53 basis points in Canada and 39 basis points in the U.S. since March 7, 2007. Rising long-term rates are positive for the life insurers, which have liabilities that are of longer duration than assets. Conversely, rising rates are negative for bank’s P/E ratios given their high dividend yields and the potential impact on their earnings because of the negative impact on loan growth and credit quality. RBC Economics expects 10-year Government of Canada bond yields to continue rising with a target of 5.4% by the end of 2008.
o The outlook for short-term rates in Canada has also changed, with the Bank of Canada now expected to raise rates earlier than had previously been the case. Rising Bank of Canada rates have historically been negative for bank stocks more often than not.
• Exposure to deteriorating credit quality is higher at the banks than the life insurers. Credit losses remain low by long-term standards but signs of deterioration in the near term are appearing. Net impaired loan losses are higher, provisions for credit losses have risen, as have formations, and coverage ratios have weakened since the H2/06 peak. Reduced recoveries in business loan portfolios and growth in credit card lending are the main drivers of the increased losses.
Bank Q2/07 Results Ahead of Expectations
All banks reported Q2/07 EPS that were higher than our expectations (and consensus), with the exception of Royal Bank. TD was most ahead of expectations. The sources of the variance varied by bank.
• TD exceeded our expectations in the highest quality businesses (retail banking and wealth management) while Scotiabank also delivered better-than expected results in its retail division. TD’s results were by far the least dependant on wholesale income, in spite of that division’s net income coming in well ahead of our estimate.
• Bank of Montreal, CIBC and National Bank beat estimates on the bottom line, but the main drivers were wholesale businesses (and a low tax rate in the retail division at CIBC) and as such their stocks did not react as well following the release of their results. National Bank and Bank of Montreal generated the highest proportion of core earnings from wholesale businesses.
• Royal Bank’s earnings were below the high expectations we and the street had for the bank. However, some of the items that caused the miss were one-timish in nature, particularly disability claims in the insurance businesses, trading revenues related to U.S. sub-prime securities and integration costs in US retail banking. These businesses are also “lower multiple businesses” in our view.
Retail Banking Shows Few Signs of Slowing Down
Q2/07 results highlighted well-established positive retail trends, which show no signs of abating:
o Loan growth remained strong in the quarter. Residential mortgages rose 9.1% and other consumer loans were up 8.7% in the 12 months ending April 30/07. The conditions that have driven the rapid loan growth remain in place – employment growth, rising incomes, low interest rates and a solid housing market. There is likely to be deterioration in some of those factors but the environment for retail loan growth remains very good, both in absolute terms and relative to the U.S. TD Bank, Royal Bank and Scotiabank have increased their market share in the last year, while CIBC and Bank of Montreal have lost some.
o Revenue growth did not necessarily follow market share trends, which is best exemplified by looking at Bank of Montreal and Scotiabank’s results. Domestic market share grew 18 basis points in the last year at Scotiabank and dropped 101 basis points at Bank of Montreal, partly driven by the bank’s withdrawal from third party mortgage channels. Revenue growth at the two banks was similar, however, which is indicative of the spread erosion that has occurred in the mortgage space in our view.
o Canada’s two largest retail banks, Royal Bank and TD Canada Trust, would have continued to grow core revenue and earnings more rapidly than the other Big 5 banks if it were not for the higher than usual disability claims at Royal Bank. These two banks benefit from heftier physical presences, larger sales forces and larger customer bases to which they sell additional products and services, as well as greater exposure to insurance. The others continue to be challenged to profitably grow their market share.
o Revenue growth of 11-13% at those two banks was higher than the group average.
o Net interest income margins improved versus Q2/06, compared to declines at 3 of the 4 other banks.
o Net income growth was at the high end of the group despite the disability insurance claims at Royal Bank. Both banks increased their market share of lending products, indicating that they are not sacrificing profitability for share - something the smaller players have struggled to accomplish.
o Retail net interest income margins were down 5 basis points in the last 12 months, in line with the year-over-year decline in
Q1/07. We expect continued pressure on retail margins based on (1) continued increases in money market funds and high-yield transaction accounts at the expense of checking accounts; (2) loan portfolios are increasingly secured; (3) in a rising rate environment, consumers may decide to lock in their mortgages at five-year rates, which would negatively impact most banks' margins, and they may be more incentivized to move savings from transaction accounts into term deposits; and (4) increased demand for mutual funds or other types of equity market-driven savings is a negative for deposit growth.
Capital Market Environment Remains Active
Capital markets businesses again delivered strong revenue growth, maintaining a trend that we believe is at risk of eventually turning.
o Revenue growth in wholesale businesses for the industry was 12% versus Q2/06, driven by mergers and acquisitions, debt and equity underwriting activity and trading revenues that remained high. National Bank led the group with 31% revenue growth while Royal Bank trailed with flat revenues on tough fixed income trading comparisons (and brought down the group by virtue of being the biggest in this area). Worldwide M&A, equity markets and credit markets are all very active, driven by massive liquidity, with no obvious near-term catalysts for change. Unexpected increases in interest rates by central banks or increases in long bond yields (which would impact borrowing rates for private equity buyers) are risks to the current environment in our view.
o Wealth management businesses continued to benefit from the upward path the S&P/TSX Composite Index has been for almost five years. The index is up 9.4% so far this year, following four years of excellent returns (24.3% in 2003, 12.5% in 2004, 21.9% in 2005 and 14.5% in 2006). A return to more normal appreciation in equity markets would negatively impact the revenue growth of the Canadian banks’ wealth management operations, which was 10% in the last quarter (Royal Bank and TD Bank led the way with 13-14% revenue growth while CIBC, Bank of Montreal and National Bank had growth rates in the 4-6% range).
Canadian Dollar Has Resumed Its Rising Path
The Canadian dollar has resumed its upward trajectory against the US dollar, rising 11% since February 7, 2007. Canadian banks’ trading businesses should benefit from more active currency trading, driven by both hedgers and speculators but the net impact to net income is likely to be negative given the scale of their operations outside of Canada. Scotiabank is clearly more impacted by a rising Canadian dollar, with about 45% of its net income coming from outside of Canada, while the impact on National Bank would be marginal. The Big 3 Canadian lifecos would all be more impacted than the banks by a rising Canadian dollar as they all generate more than 50% of their earnings from outside of Canada, with Manulife highest at 75%. (Exhibit 15)
Increase in Risk Weighted Assets Driving Revenue Growth and Higher Risk
The increase in Canadian banks’ risk weighted assets has recently been very rapid (12% in the last 12 months), driven by acquisitions, strong corporate loan growth (business and government loans on the banks’ balance sheets are up 18% in the last 12 months) and rising market risk. Disaggregating where the increase in risk is coming from and looking at return on risk weighted assets helps understand the reward aspect of the equation:
o Increases in risk weighted assets driven by acquisitions normally come with a net income base, and do not necessarily suggest that banks are taking on incremental risk without being rewarded for that added risk.
o Increases in market risk weighted assets tend to lead to rapid revenue realization as they often relate to trading businesses. Trading businesses are high ROE businesses but the market does not reward investment banks with high valuation multiples given the volatility and unpredictability of revenues.
o Increases coming from rapidly growing corporate loan books are fueling revenue growth but are also leading to an implied increase in credit risk, which is not currently reflected in income statements given (1) a very benign credit environment; (2) recoveries of loans previously classified as impaired; and (3) normal seasoning.
Core returns on risk weighted assets have not been negatively impacted by the rapid rise in risk weighted assets, suggesting that the banks are getting rewarded (so far) for the risks they are taking. However, the nature of certain activities (business loans in particular) would lead to revenues today with 'costs' coming later (in the form of loan losses).
Credit No Longer Improving (But Losses Are Still Low)
Credit losses remain low by long-term standards but signs of deterioration in the near term are appearing.
o Industry specific provisions for credit losses were up 34% versus Q2/06, with larger increases at TD Bank and Royal Bank. Scotiabank was at the other end with a 43% decline in specific provisions.
o Rising provisions related to growth in credit card portfolios were a common theme as growth in those portfolios has been strong. Lower recoveries in business loans were also cited as a cause of rising provisions.
o Specific and total coverage ratios, as well as impaired loans to equity continued to show early signs of deterioration, a trend that started in Q3/06.
o Impaired loan formations, although lower than in the last two quarters, remained higher than the experience of most of 2005 and 2006.
Business loans are witnessing loan losses most below long-term averages and are most at risk of normalizing. Canadian corporate profit growth is slowing, debt has grown rapidly (and underwriting standards have loosened, particularly in the U.S.) and interest rates have risen (albeit modestly) – we expect credit quality to deteriorate as a result. However, a strong case can be made that deterioration should be modest by long-term standards given low leverage ratios and interest rates. While the biggest potential swing in loss rates resides in the corporate portfolio, in our view, increases in loan losses are likely to initially arise in commercial lending, as the increasing Canadian dollar is likely to negatively impact central Canada’s manufacturers and credit card losses are likely to rise on fairly rapid portfolio growth and the knock-on impact of manufacturing job losses, if they occur.
Relative to long-term average loss rates, Q2/07 specific provisions for credit losses were lowest at Scotiabank (18%) and National Bank (27%), largely reflective of greater exposure to business loans. We therefore believe that those two banks are more exposed to deteriorating credit quality.
Risk From Current Tax Proposals Manageable; But Risk Remains
Banks’ tax rates have generally been in line with guidance so far in 2007. We expect tax rates to remain within banks’ targeted ranges in 2008, which would imply flat to slightly higher tax rates, in contrast with the declines experienced from 2004 to 2006.
The proposed elimination of double-dipping structures1 is negative for banks, but is likely to ultimately cause more headaches than have a material impact on tax rates.
o The five-year grace period on both existing and new double-dipping structures gives financial services companies time to examine other alternatives to reduce their tax rates.
o The exemption of withholding taxes on interest between Canada and the US will make tax structures that were previously unappealing more attractive.
o The implementation of the Government’s proposal may not come through as it does not seem to generate any revenue to Canadian tax authorities – it would more likely lead to lower deductions outside of Canada. The establishment of a panel to review Canada’s system of international taxation may or may not lead to changes in the proposal.
It is important to understand that double-dipping structures are an important source of tax management, but far from being the only one. We believe that tax strategies around insurance and trading revenues are two key contributors to the lower tax rates, as well as established presences in the Caribbean and Asia.
Banks’ tax rates could still be at risk of increasing. We believe that the federal Government’s comments at the time it released its budget in March 2007 indicate a desire to make it harder for corporations to lower their tax rates by taking advantage of lower tax jurisdictions. We believe that the use of (legal) tax structures to book income outside of Canada when most of the physical and intellectual infrastructures as well as clients are in North America are most at risk of being targeted by the Government. We do not believe that financial services companies with large operations and client bases in lower tax jurisdictions are at risk.
Banks’ tax rates fell by an average of 6 percentage points to 21% from 2004 to 2006, which has led to a cumulative earnings lift of 8%. We believe that the decline in tax rates of the last few years may end as banks are likely to become more cautious in using tax structures to lower their tax rates, in order to avoid drawing attention to themselves. The tax line that is at risk is “income from foreign operations subject to different tax rates.” To blindly say, however, that that entire line would disappear would be misguided, as part of that deduction comes from operations in foreign jurisdictions – not just the use of foreign tax structures. For sensitivity purposes, if half that deduction were lost, bank earnings would drop by an average of 5%.
Investment Thesis
BMO: We maintain our Underperform rating. BMO trades at 12.8x 2007E EPS, compared to an industry median of 13.0x. We feel that a discount is justified given retail banking challenges in both Canada and the U.S., less room for dividend increases and less earnings coming from retail businesses.
BNS: We maintain our Sector Perform rating. Scotiabank's stock trades at 13.3x 2007E earnings, slightly above the Canadian peer average of 12.9x. Scotiabank holds the most excess capital of the Canadian group and has, in our mind, above-average medium-and long-term growth prospects compared to its peers due to its presence in Latin America and the Caribbean. However, domestic retail revenue and net income growth lags the leading banks', the bank is more exposed to normalizing business loan losses and Mexican operations are likely to be taxed at a higher rate and see higher loan losses in 2007 than in 2006. Our 12-month price target of $57 implies a forward P/E multiple of 13.1x, compared to the current multiple of 13.3x.
CM: We rate CIBC’s shares Outperform. CIBC trades at 12.5x our estimated 2007 earnings versus a peer average of 12.9x. We believe that the relative multiple makes CIBC’s stock attractive, in spite of a lower revenue growth profile, hence our Outperform rating. We believe that revenue growth will continue to lag the industry in the near term but that earnings could still come in ahead of consensus estimates in H2/07. We expect the consolidation of FirstCaribbean’s results and improving retail revenue growth, combined with flat expenses in Canada, will drive earnings growth that exceeds expectations. We also believe that Q2/07 retail loan losses could prove to have been abnormally high in the near term. We are looking for a 17% increase in the dividend in Q3/07 as the current dividend rate of $3.08 implies a payout ratio of 38% based on our 2007E EPS, well below the bank's official target range of 40%-50%. The bank’s multiple should benefit from having the second-lowest exposure to lower-multiple wholesale income. The retail mix should also improve given the acquisition of FirstCaribbean, improving revenue growth in retail businesses and a likely reduction in merchant banking gains. The bank is less exposed to potentially rising business loan losses, the area that most concerns us from a credit quality standpoint.
NA: We maintain our Underperform rating. National Bank trades at a 0.9x 2008E P/E discount to the group, in line with its average of the last five years, and we do not believe the discount will narrow in the coming year as EPS growth should lag the group. National Bank's current provisioning rate is more at risk of rising than other banks' in our view, retail loan growth has slowed in Quebec due to increased competition, and the company's successful partnership programs with wealth management firms are not yet large enough to offset slower growth in the bank's base market. Securities gains were also abnormally high in 2006. The proportion of earnings coming from wholesale businesses is also higher than for peers, supporting a lower multiple. Our 12-month price target of $65 implies a forward P/E multiple of 11.2x, compared to the current multiple of 11.5x.
RY: We are upgrading our rating from Sector Perform to Outperform. We believe that the bank’s premium valuation is sustainable (0.6x on 2007E P/E and 0.3x on 2008E) and that the bank will grow earnings at a more rapid rate than its peers in 2007 and 2008 (19% and 11% versus an industry median of 17% and 7%), based on: 1) Dominant, and rapidly growing retail banking and wealth management franchises, the two highest multiple businesses Canadian banks participate in; 2) A more diversified capital markets business, which should lead to lower volatility in revenue and earnings than other Canadian banks’ investment dealers; 3) A superior outlook for near-term revenue growth, driven by a 16% increase in risk weighted assets in the last 12 months, a result of organic growth and acquisitions.
TD: We rate TD Bank shares Outperform. TD Bank’s shares currently trade at 13.5x 2007E earnings compared to the Canadian peer average of 12.9x. Domestic retail growth and higher earnings from the U.S. (driven by cost synergies at TD Ameritrade, and by higher ownership of TD Banknorth) should buoy earnings growth for TD. We believe that TD can grow 2007 and 2008 earnings per share by 19% and 11%, respectively, ahead of median expected growth of 16% in 2007 and 8% in 2008 for the bank's five Canadian peers. We also believe that there is less downside risk to our forecast for TD than for the industry.
Valuation
BMO: Our 12-month price target of $71 is a combination of our sum of the parts and price to book methodologies. It implies a multiple of 12.0x 2008E cash EPS, compared to the a 5-year average forward multiple of 12.5x.Our P/B target of 2.2x book value in 12 months is at the low end of the banking sector given a lower ROE. Our sum of the parts target of 11.3x 2008E earnings is below our target industry average for banks, reflecting higher exposure to low-multiple wholesale businesses and retail banking execution challenges.
BNS: Our 12-month price target of $57 is a combination of our sum of the parts and price to book methodologies. It implies a multiple of 13.1x 2008E cash EPS, compared to the current 13.3x multiple on 2007E earnings and a 5-year average forward multiple of 12.3x. Our P/B target of 2.6x in 12 months is slightly higher than our target average for the banks given a higher ROE and strong capitalization. Our sum of the parts target of 12.7x 2008E earnings is slightly higher than our target average for the banks, as strong performance in the rapidly growing international division is offset by slower growth in domestic retail banking relative to other banks in recent years and lower exposure to wealth management
CM: Our 12-month price target of $114 is a combination of our sum of the parts and price to book methodologies. It implies a multiple of 13.0x 2008E cash EPS, compared to the current 12.5x multiple on 2007E earnings and a 5-year average forward multiple of 11.9x. Our target multiple is high versus the historical multiple because we believe there is upside to earnings estimates. Our relatively high price to book target multiple of 3.0x reflects the bank's industry-leading ROE and low credit risk. Our sum of the parts target P/E of 12.3x is in line with our target average for the banks, as lower exposure to low-multiple wholesale businesses is offset by slower than average revenue growth.
NA: Our 12-month price target of $65 is a combination of our sum of the parts and price to book methodologies. It implies a multiple of 11.2x 2008E cash EPS, compared to the current 11.5x multiple on 2007E earnings and a 5-year average forward multiple of 11.3x. Our P/B target of 2.1x in 12 months is at the low end of our target for banks given a lower ROE and a higher risk premium, based on more exposure to deteriorating credit quality. Our sum of the parts target of 11.3x 2008E earnings is below our target industry average, reflecting higher exposure to low-multiple wholesale businesses and slow revenue growth in retail banking.
RY: Our 12-month price target of $64 is a combination of our sum of the parts and price to book methodologies. It implies a multiple of 13.6x 2008E cash EPS (highest of the six banks we cover), compared to the 5-year average forward multiple of 12.7x. Our relatively high price to book target multiple of 3.2x reflects the bank’s industry leading ROE and strong capitalization. Our sum of the parts target of 13.8x 2008E earnings is higher than our target industry average for the banks, reflecting a leading domestic retail franchise and more diversified wholesale banking revenues.
TD: Our 12-month price target of $82 is a combination of our sum of the parts and price to book methodologies. It implies a multiple of 13.4x 2008E cash EPS, compared to the current 13.5x multiple on 2007E earnings and a 5-year average forward multiple of 12.1x. Our P/B target of 2.4x in 12 months is at the low end of the bank sector given a lower ROE. Our sum of the parts target of 13.7x 2008E earnings is higher than our target industry average, reflecting a superior domestic retail franchise and lower exposure to low multiple wholesale businesses.
Price Impediments
BMO: Risks to our price target include the health of the overall economy, sustained deterioration in the capital markets environment, the potential for non-accretive acquisitions and/or related execution risk, declining domestic market share and a rising Canadian dollar. Risks to our cautious view relative to peers include better than expected operating leverage, a turnaround in retail earnings and changing sentiment toward bank mergers.
BNS: Risks to our price target include the health of the overall economy, sustained deterioration in the capital markets environment, the potential for non-accretive acquisitions and/or related execution risk, deterioration in the Latin American political and economic climate a rising Canadian dollar and rising business loan losses.
CM: Risks to our price target include the health of the overall economy, sustained deterioration in the capital markets environment, loss of domestic market share, a decline in underwriting activity (particularly income trusts) and weakening retail credit quality.
NA: Risks to our price target include the health of the overall economy, sustained deterioration in the capital markets environment, the health of the Quebec economy, an unexpected acquisition, rising business loan losses and a change in the competitive or political environment in Quebec.
RY: The biggest risks to our recommendation change and to our price target relate to credit quality and capital markets. Although we are expecting credit losses to rise, we are not calling for significant deterioration in credit quality in the near term and believe that the bank can maintain above-average bottom line growth if credit losses rise gradually. A worldwide decline in equity markets and capital markets activity would likely hurt the bank more than most peers given the size of its wealth management and capital markets businesses. Additional risks include the potential for non-accretive acquisitions and/or related execution risk and a worse than expected impact from Enron-related litigation (although it appears that risk has declined, given a court ruling in another Enron trial).
TD: Risks to our price target include the health of the overall economy, sustained deterioration in the capital markets environment, an unexpected acquisition, pricing pressure in the discount brokerage industry, integration risk with both TD Ameritrade and TD Banknorth, a rising Canadian dollar and a worse than expected impact from Enron-related litigation (although it appears that risk has declined, given a court ruling in another Enron trial).
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All banks reported Q2/07 EPS that were higher than our expectations (and consensus), with the exception of Royal Bank. TD was most ahead of expectations, and it and BNS posted the highest quality earnings against our expectations.
The industry continued to benefit from solid growth in retail revenues and net income, as well as active capital markets and low loan losses. We believe that retail banking divisions will continue to grow rapidly, but are concerned that the current strength in capital markets revenues may not be sustainable and credit quality is showing signs of having peaked.
We continue to believe that there is limited upside to current valuation multiples. We expect profitability to remain high by long-term standards but earnings growth is likely to slow compared to recent years. Credit losses are likely to come off their lows, equity markets are unlikely to maintain their torrid pace of the last four years and capital markets activity is benefiting from high levels of liquidity. Also, interest rates are likely to increase, which presents a risk to bank valuations.
We are increasing our investment rating on Royal Bank from Sector Perform to Outperform. The bank's shares have underperformed its peers since May 1, 2007, partly because it was the only bank not to surpass Q2/07 EPS expectations. However, some of the items that caused the miss were one-timish in nature, particularly disability claims in the insurance businesses, trading revenues related to U.S. sub-prime securities and integration costs in U.S. retail banking. These businesses are also "lower multiple businesses" in our view. Wealth management and retail banking continued to perform well.
We are lowering our investment rating on CIBC from Top Pick to Outperform. We now forecast similar total returns (appreciation in stock prices plus dividends) of 13-14% in the next 12 months for CIBC, TD and Royal Bank following the appreciation in CIBC's stock since May 1, 2007 and our recent increase in our 12-month target price for TD Bank. We believe that CIBC's slight P/E discount makes the stock attractive, in spite of a lower revenue growth profile, given improving retail revenue growth (and tight expense controls), the prospects for a 17% increase in the dividend in Q3/07, and less exposure to wholesale income and potentially rising business loan losses.
Royal Bank - Upgrading to Outperform from Sector Perform
We are increasing our investment rating on Royal Bank from Sector Perform to Outperform.
• Attractive Relative Value - RBC shares have underperformed the financials group since May 1 2007, most notably against CIBC, TD Bank, National Bank, Industrial Alliance and Northbridge. The bank’s shares have even underperformed those of Bank of Montreal, which has had well-publicized issues related to its commodity trading businesses.
• Strength in the highest multiple businesses – Q2/07 earnings highlighted strength in wealth management and retail banking. Wealth management income was up 22% against Q2/06 on revenue growth of 13%. The domestic retail bank (ex insurance) had a very impressive quarter in our view, with revenues rising 11%, market share increases in lending products, and a 23% increase in income.
• Q2/07 earnings were below the high expectations we and the street had for the bank. However, some of the items that caused the miss were one-timish in nature, particularly disability claims in the insurance businesses, trading revenues related to U.S. subprime securities and integration costs in U.S. retail banking. These businesses are also “lower multiple businesses” in our view.
• We believe that the bank’s premium valuation is sustainable (0.6x on 2007E P/E and 0.3x on 2008E) on the basis that the bank will grow earnings at a more rapid rate than its peers in 2007 and 2008 (19% and 11% versus an industry median of 17% and 7%), driven by:
o Dominant, and rapidly growing retail banking and wealth management franchises, the two highest multiple businesses Canadian banks participate in.
o A more diversified capital markets business, which should lead to lower volatility in revenue and earnings than other Canadian banks’ investment dealers.
o A superior outlook for near-term revenue growth, driven by a 16% increase in risk weighted assets in the last 12 months, a result of organic growth and acquisitions.
• The two biggest risks to our Outperform recommendation relate to credit quality and capital markets.
o A very rapid deterioration in credit quality would hurt Royal Bank more than TD Bank and CIBC, as well as the insurers, in our view. Although we are expecting credit losses to rise, we are not calling for significant deterioration in credit quality in the near term and believe that the bank can maintain above-average bottom line growth if credit losses rise gradually, as we predict.
o A worldwide decline in equity markets and capital markets activity would likely hurt the bank more than most of its peers given the size of its wealth management and capital markets businesses. A mild decline would be offset by increased investments in those businesses, in our view, while isolated declines would be mitigated by greater geographic diversification than other Canadian peers.
CIBC - Downgrading to Outperform from Top Pick
We are lowering our investment rating on CIBC from Top Pick to Outperform.
We now forecast similar total returns (appreciation in stock price plus dividends) of 13-14% in the next 12 months for CIBC, TD and Royal Bank following the appreciation in CIBC’s stock since May 1, 2007 and our recent increase in our 12-month target price for TD Bank.
CIBC trades at 12.5x our estimated 2007E earnings versus a peer average of 13.0 times. We believe that the relative multiple makes CIBC’s stock attractive, in spite of a lower revenue growth profile, hence our Outperform rating. The following points summarize our investment thesis on CIBC shares.
• Potential for Upward Earnings Revisions - We expect the consolidation of FirstCaribbean’s results and improving retail revenue growth, combined with flat expenses in Canada, will drive earnings growth that exceeds expectations in H2/07. We also believe that Q2/07 retail loan losses could prove to have been abnormally high in the near term.
• 17% increase in the dividend expected in Q3/07 - The current dividend rate of $3.08 implies a payout ratio of 38% based on our 2007E EPS, well below the bank's official target range of 40%-50%.
• The bank’s multiple should benefit from having the second-lowest exposure to wholesale income. The retail mix should also increase given the acquisition of FirstCaribbean, improving revenue growth in retail businesses and a likely reduction in merchant banking gains.
• Less exposed to potentially rising business loan losses, the area that most concerns us from a credit quality standpoint. Business loan losses for the Canadian banks are currently non-existent, compared to a 17-year average of 80 basis points. CIBC's loan book has the least exposure to business and government loans and the bank holds $10.4 billion in credit default swaps – a large amount relative to its $34.0 billion business and government loan book.
Valuation - Thesis Unchanged Post Q2/07 Results
Valuation Multiples Do Not Have Much Upside
Canadian bank valuations are justifiably well above very long term averages, although it is difficult to argue for more upside at this stage in the credit and capital markets cycles.
In the near term, valuations should benefit from very active capital markets, low credit losses, strong growth in retail lending and the rash of takeout activity of Canadian companies, which is likely to lead to reinvestment in Canadian financial services stocks.
Furthermore, over the last 15 years banks have improved their ROEs and capitalization ratios, lowered their exposure to credit risk and grown higher-multiple businesses such as wealth management and retail banking, while risk-free rates have declined.
We believe that further multiple expansion is unlikely, however, as ROE cyclicality has been lowered, not eliminated, and it is hard to picture a better environment for banks.
• Volatility will still arise in poor credit and capital markets environments. Repeating the strong earnings growth of recent years is likely to be difficult, given the phenomenal credit performance of the last 5 years, strong equity market appreciation, and very active debt and M&A markets.
• A rise in Canadian bond yields would likely negatively impact bank valuations, particularly if the 10-year yield were to extend above 5%. Bank valuations have historically been highly negatively correlated with long-term interest rates.
• The bank sector’s relative forward P/E is at 80% of the market multiple, well above the 64% long-term average, limiting potential upside. We are not alarmed by potential downside either, though. Part of this increased relative valuation is driven by cyclically high profitability of the key basic materials and energy sectors (which as usual is accompanied by lower than average P/Es) and part would be driven by justified increases in bank valuations. Basic materials and energy make up 44% of the S&P/TSX Composite Index, versus 17% for banks.
• Retail and institutional appetite for foreign securities has risen following changes to pension regulation and years of outperformance by Canadian equity markets and the Canadian dollar. Increased interest in foreign securities is a negative, in our view, as bank stocks have always been popular with both Canadian institutional and retail investors, given their earnings and dividend growth track records.
Prefer Lifecos Over Banks
We continue to believe that there are fewer risks to owning the shares of life insurance companies at current valuations, although two key macro indicators are currently more favourable to the banks’ shares in our view, while the other two are only beginning to show signs of trending in a direction that would favour life insurers versus banks.
• Capital markets activity remains high, fueled by high liquidity, low risk premiums and the increasingly easier access to bank lending. Mergers and acquisitions, debt and equity underwriting, trading businesses and proprietary investing have all benefited. While this level of activity appears unsustainable, the longer it lasts, the better off banks are versus life insurers.
• The rapid increase in the Canadian dollar, up 11% since February 7, 2007, is more negative for the life insurers, who generate more earnings from outside of Canada than the banks (Industrial Alliance excepted) and do not have trading operations that benefit from the rapidly rising dollar.
• Long-term interest rates remain low by long-term standards but 10-year Government bond yields have risen by 53 basis points in Canada and 39 basis points in the U.S. since March 7, 2007. Rising long-term rates are positive for the life insurers, which have liabilities that are of longer duration than assets. Conversely, rising rates are negative for bank’s P/E ratios given their high dividend yields and the potential impact on their earnings because of the negative impact on loan growth and credit quality. RBC Economics expects 10-year Government of Canada bond yields to continue rising with a target of 5.4% by the end of 2008.
o The outlook for short-term rates in Canada has also changed, with the Bank of Canada now expected to raise rates earlier than had previously been the case. Rising Bank of Canada rates have historically been negative for bank stocks more often than not.
• Exposure to deteriorating credit quality is higher at the banks than the life insurers. Credit losses remain low by long-term standards but signs of deterioration in the near term are appearing. Net impaired loan losses are higher, provisions for credit losses have risen, as have formations, and coverage ratios have weakened since the H2/06 peak. Reduced recoveries in business loan portfolios and growth in credit card lending are the main drivers of the increased losses.
Bank Q2/07 Results Ahead of Expectations
All banks reported Q2/07 EPS that were higher than our expectations (and consensus), with the exception of Royal Bank. TD was most ahead of expectations. The sources of the variance varied by bank.
• TD exceeded our expectations in the highest quality businesses (retail banking and wealth management) while Scotiabank also delivered better-than expected results in its retail division. TD’s results were by far the least dependant on wholesale income, in spite of that division’s net income coming in well ahead of our estimate.
• Bank of Montreal, CIBC and National Bank beat estimates on the bottom line, but the main drivers were wholesale businesses (and a low tax rate in the retail division at CIBC) and as such their stocks did not react as well following the release of their results. National Bank and Bank of Montreal generated the highest proportion of core earnings from wholesale businesses.
• Royal Bank’s earnings were below the high expectations we and the street had for the bank. However, some of the items that caused the miss were one-timish in nature, particularly disability claims in the insurance businesses, trading revenues related to U.S. sub-prime securities and integration costs in US retail banking. These businesses are also “lower multiple businesses” in our view.
Retail Banking Shows Few Signs of Slowing Down
Q2/07 results highlighted well-established positive retail trends, which show no signs of abating:
o Loan growth remained strong in the quarter. Residential mortgages rose 9.1% and other consumer loans were up 8.7% in the 12 months ending April 30/07. The conditions that have driven the rapid loan growth remain in place – employment growth, rising incomes, low interest rates and a solid housing market. There is likely to be deterioration in some of those factors but the environment for retail loan growth remains very good, both in absolute terms and relative to the U.S. TD Bank, Royal Bank and Scotiabank have increased their market share in the last year, while CIBC and Bank of Montreal have lost some.
o Revenue growth did not necessarily follow market share trends, which is best exemplified by looking at Bank of Montreal and Scotiabank’s results. Domestic market share grew 18 basis points in the last year at Scotiabank and dropped 101 basis points at Bank of Montreal, partly driven by the bank’s withdrawal from third party mortgage channels. Revenue growth at the two banks was similar, however, which is indicative of the spread erosion that has occurred in the mortgage space in our view.
o Canada’s two largest retail banks, Royal Bank and TD Canada Trust, would have continued to grow core revenue and earnings more rapidly than the other Big 5 banks if it were not for the higher than usual disability claims at Royal Bank. These two banks benefit from heftier physical presences, larger sales forces and larger customer bases to which they sell additional products and services, as well as greater exposure to insurance. The others continue to be challenged to profitably grow their market share.
o Revenue growth of 11-13% at those two banks was higher than the group average.
o Net interest income margins improved versus Q2/06, compared to declines at 3 of the 4 other banks.
o Net income growth was at the high end of the group despite the disability insurance claims at Royal Bank. Both banks increased their market share of lending products, indicating that they are not sacrificing profitability for share - something the smaller players have struggled to accomplish.
o Retail net interest income margins were down 5 basis points in the last 12 months, in line with the year-over-year decline in
Q1/07. We expect continued pressure on retail margins based on (1) continued increases in money market funds and high-yield transaction accounts at the expense of checking accounts; (2) loan portfolios are increasingly secured; (3) in a rising rate environment, consumers may decide to lock in their mortgages at five-year rates, which would negatively impact most banks' margins, and they may be more incentivized to move savings from transaction accounts into term deposits; and (4) increased demand for mutual funds or other types of equity market-driven savings is a negative for deposit growth.
Capital Market Environment Remains Active
Capital markets businesses again delivered strong revenue growth, maintaining a trend that we believe is at risk of eventually turning.
o Revenue growth in wholesale businesses for the industry was 12% versus Q2/06, driven by mergers and acquisitions, debt and equity underwriting activity and trading revenues that remained high. National Bank led the group with 31% revenue growth while Royal Bank trailed with flat revenues on tough fixed income trading comparisons (and brought down the group by virtue of being the biggest in this area). Worldwide M&A, equity markets and credit markets are all very active, driven by massive liquidity, with no obvious near-term catalysts for change. Unexpected increases in interest rates by central banks or increases in long bond yields (which would impact borrowing rates for private equity buyers) are risks to the current environment in our view.
o Wealth management businesses continued to benefit from the upward path the S&P/TSX Composite Index has been for almost five years. The index is up 9.4% so far this year, following four years of excellent returns (24.3% in 2003, 12.5% in 2004, 21.9% in 2005 and 14.5% in 2006). A return to more normal appreciation in equity markets would negatively impact the revenue growth of the Canadian banks’ wealth management operations, which was 10% in the last quarter (Royal Bank and TD Bank led the way with 13-14% revenue growth while CIBC, Bank of Montreal and National Bank had growth rates in the 4-6% range).
Canadian Dollar Has Resumed Its Rising Path
The Canadian dollar has resumed its upward trajectory against the US dollar, rising 11% since February 7, 2007. Canadian banks’ trading businesses should benefit from more active currency trading, driven by both hedgers and speculators but the net impact to net income is likely to be negative given the scale of their operations outside of Canada. Scotiabank is clearly more impacted by a rising Canadian dollar, with about 45% of its net income coming from outside of Canada, while the impact on National Bank would be marginal. The Big 3 Canadian lifecos would all be more impacted than the banks by a rising Canadian dollar as they all generate more than 50% of their earnings from outside of Canada, with Manulife highest at 75%. (Exhibit 15)
Increase in Risk Weighted Assets Driving Revenue Growth and Higher Risk
The increase in Canadian banks’ risk weighted assets has recently been very rapid (12% in the last 12 months), driven by acquisitions, strong corporate loan growth (business and government loans on the banks’ balance sheets are up 18% in the last 12 months) and rising market risk. Disaggregating where the increase in risk is coming from and looking at return on risk weighted assets helps understand the reward aspect of the equation:
o Increases in risk weighted assets driven by acquisitions normally come with a net income base, and do not necessarily suggest that banks are taking on incremental risk without being rewarded for that added risk.
o Increases in market risk weighted assets tend to lead to rapid revenue realization as they often relate to trading businesses. Trading businesses are high ROE businesses but the market does not reward investment banks with high valuation multiples given the volatility and unpredictability of revenues.
o Increases coming from rapidly growing corporate loan books are fueling revenue growth but are also leading to an implied increase in credit risk, which is not currently reflected in income statements given (1) a very benign credit environment; (2) recoveries of loans previously classified as impaired; and (3) normal seasoning.
Core returns on risk weighted assets have not been negatively impacted by the rapid rise in risk weighted assets, suggesting that the banks are getting rewarded (so far) for the risks they are taking. However, the nature of certain activities (business loans in particular) would lead to revenues today with 'costs' coming later (in the form of loan losses).
Credit No Longer Improving (But Losses Are Still Low)
Credit losses remain low by long-term standards but signs of deterioration in the near term are appearing.
o Industry specific provisions for credit losses were up 34% versus Q2/06, with larger increases at TD Bank and Royal Bank. Scotiabank was at the other end with a 43% decline in specific provisions.
o Rising provisions related to growth in credit card portfolios were a common theme as growth in those portfolios has been strong. Lower recoveries in business loans were also cited as a cause of rising provisions.
o Specific and total coverage ratios, as well as impaired loans to equity continued to show early signs of deterioration, a trend that started in Q3/06.
o Impaired loan formations, although lower than in the last two quarters, remained higher than the experience of most of 2005 and 2006.
Business loans are witnessing loan losses most below long-term averages and are most at risk of normalizing. Canadian corporate profit growth is slowing, debt has grown rapidly (and underwriting standards have loosened, particularly in the U.S.) and interest rates have risen (albeit modestly) – we expect credit quality to deteriorate as a result. However, a strong case can be made that deterioration should be modest by long-term standards given low leverage ratios and interest rates. While the biggest potential swing in loss rates resides in the corporate portfolio, in our view, increases in loan losses are likely to initially arise in commercial lending, as the increasing Canadian dollar is likely to negatively impact central Canada’s manufacturers and credit card losses are likely to rise on fairly rapid portfolio growth and the knock-on impact of manufacturing job losses, if they occur.
Relative to long-term average loss rates, Q2/07 specific provisions for credit losses were lowest at Scotiabank (18%) and National Bank (27%), largely reflective of greater exposure to business loans. We therefore believe that those two banks are more exposed to deteriorating credit quality.
Risk From Current Tax Proposals Manageable; But Risk Remains
Banks’ tax rates have generally been in line with guidance so far in 2007. We expect tax rates to remain within banks’ targeted ranges in 2008, which would imply flat to slightly higher tax rates, in contrast with the declines experienced from 2004 to 2006.
The proposed elimination of double-dipping structures1 is negative for banks, but is likely to ultimately cause more headaches than have a material impact on tax rates.
o The five-year grace period on both existing and new double-dipping structures gives financial services companies time to examine other alternatives to reduce their tax rates.
o The exemption of withholding taxes on interest between Canada and the US will make tax structures that were previously unappealing more attractive.
o The implementation of the Government’s proposal may not come through as it does not seem to generate any revenue to Canadian tax authorities – it would more likely lead to lower deductions outside of Canada. The establishment of a panel to review Canada’s system of international taxation may or may not lead to changes in the proposal.
It is important to understand that double-dipping structures are an important source of tax management, but far from being the only one. We believe that tax strategies around insurance and trading revenues are two key contributors to the lower tax rates, as well as established presences in the Caribbean and Asia.
Banks’ tax rates could still be at risk of increasing. We believe that the federal Government’s comments at the time it released its budget in March 2007 indicate a desire to make it harder for corporations to lower their tax rates by taking advantage of lower tax jurisdictions. We believe that the use of (legal) tax structures to book income outside of Canada when most of the physical and intellectual infrastructures as well as clients are in North America are most at risk of being targeted by the Government. We do not believe that financial services companies with large operations and client bases in lower tax jurisdictions are at risk.
Banks’ tax rates fell by an average of 6 percentage points to 21% from 2004 to 2006, which has led to a cumulative earnings lift of 8%. We believe that the decline in tax rates of the last few years may end as banks are likely to become more cautious in using tax structures to lower their tax rates, in order to avoid drawing attention to themselves. The tax line that is at risk is “income from foreign operations subject to different tax rates.” To blindly say, however, that that entire line would disappear would be misguided, as part of that deduction comes from operations in foreign jurisdictions – not just the use of foreign tax structures. For sensitivity purposes, if half that deduction were lost, bank earnings would drop by an average of 5%.
Investment Thesis
BMO: We maintain our Underperform rating. BMO trades at 12.8x 2007E EPS, compared to an industry median of 13.0x. We feel that a discount is justified given retail banking challenges in both Canada and the U.S., less room for dividend increases and less earnings coming from retail businesses.
BNS: We maintain our Sector Perform rating. Scotiabank's stock trades at 13.3x 2007E earnings, slightly above the Canadian peer average of 12.9x. Scotiabank holds the most excess capital of the Canadian group and has, in our mind, above-average medium-and long-term growth prospects compared to its peers due to its presence in Latin America and the Caribbean. However, domestic retail revenue and net income growth lags the leading banks', the bank is more exposed to normalizing business loan losses and Mexican operations are likely to be taxed at a higher rate and see higher loan losses in 2007 than in 2006. Our 12-month price target of $57 implies a forward P/E multiple of 13.1x, compared to the current multiple of 13.3x.
CM: We rate CIBC’s shares Outperform. CIBC trades at 12.5x our estimated 2007 earnings versus a peer average of 12.9x. We believe that the relative multiple makes CIBC’s stock attractive, in spite of a lower revenue growth profile, hence our Outperform rating. We believe that revenue growth will continue to lag the industry in the near term but that earnings could still come in ahead of consensus estimates in H2/07. We expect the consolidation of FirstCaribbean’s results and improving retail revenue growth, combined with flat expenses in Canada, will drive earnings growth that exceeds expectations. We also believe that Q2/07 retail loan losses could prove to have been abnormally high in the near term. We are looking for a 17% increase in the dividend in Q3/07 as the current dividend rate of $3.08 implies a payout ratio of 38% based on our 2007E EPS, well below the bank's official target range of 40%-50%. The bank’s multiple should benefit from having the second-lowest exposure to lower-multiple wholesale income. The retail mix should also improve given the acquisition of FirstCaribbean, improving revenue growth in retail businesses and a likely reduction in merchant banking gains. The bank is less exposed to potentially rising business loan losses, the area that most concerns us from a credit quality standpoint.
NA: We maintain our Underperform rating. National Bank trades at a 0.9x 2008E P/E discount to the group, in line with its average of the last five years, and we do not believe the discount will narrow in the coming year as EPS growth should lag the group. National Bank's current provisioning rate is more at risk of rising than other banks' in our view, retail loan growth has slowed in Quebec due to increased competition, and the company's successful partnership programs with wealth management firms are not yet large enough to offset slower growth in the bank's base market. Securities gains were also abnormally high in 2006. The proportion of earnings coming from wholesale businesses is also higher than for peers, supporting a lower multiple. Our 12-month price target of $65 implies a forward P/E multiple of 11.2x, compared to the current multiple of 11.5x.
RY: We are upgrading our rating from Sector Perform to Outperform. We believe that the bank’s premium valuation is sustainable (0.6x on 2007E P/E and 0.3x on 2008E) and that the bank will grow earnings at a more rapid rate than its peers in 2007 and 2008 (19% and 11% versus an industry median of 17% and 7%), based on: 1) Dominant, and rapidly growing retail banking and wealth management franchises, the two highest multiple businesses Canadian banks participate in; 2) A more diversified capital markets business, which should lead to lower volatility in revenue and earnings than other Canadian banks’ investment dealers; 3) A superior outlook for near-term revenue growth, driven by a 16% increase in risk weighted assets in the last 12 months, a result of organic growth and acquisitions.
TD: We rate TD Bank shares Outperform. TD Bank’s shares currently trade at 13.5x 2007E earnings compared to the Canadian peer average of 12.9x. Domestic retail growth and higher earnings from the U.S. (driven by cost synergies at TD Ameritrade, and by higher ownership of TD Banknorth) should buoy earnings growth for TD. We believe that TD can grow 2007 and 2008 earnings per share by 19% and 11%, respectively, ahead of median expected growth of 16% in 2007 and 8% in 2008 for the bank's five Canadian peers. We also believe that there is less downside risk to our forecast for TD than for the industry.
Valuation
BMO: Our 12-month price target of $71 is a combination of our sum of the parts and price to book methodologies. It implies a multiple of 12.0x 2008E cash EPS, compared to the a 5-year average forward multiple of 12.5x.Our P/B target of 2.2x book value in 12 months is at the low end of the banking sector given a lower ROE. Our sum of the parts target of 11.3x 2008E earnings is below our target industry average for banks, reflecting higher exposure to low-multiple wholesale businesses and retail banking execution challenges.
BNS: Our 12-month price target of $57 is a combination of our sum of the parts and price to book methodologies. It implies a multiple of 13.1x 2008E cash EPS, compared to the current 13.3x multiple on 2007E earnings and a 5-year average forward multiple of 12.3x. Our P/B target of 2.6x in 12 months is slightly higher than our target average for the banks given a higher ROE and strong capitalization. Our sum of the parts target of 12.7x 2008E earnings is slightly higher than our target average for the banks, as strong performance in the rapidly growing international division is offset by slower growth in domestic retail banking relative to other banks in recent years and lower exposure to wealth management
CM: Our 12-month price target of $114 is a combination of our sum of the parts and price to book methodologies. It implies a multiple of 13.0x 2008E cash EPS, compared to the current 12.5x multiple on 2007E earnings and a 5-year average forward multiple of 11.9x. Our target multiple is high versus the historical multiple because we believe there is upside to earnings estimates. Our relatively high price to book target multiple of 3.0x reflects the bank's industry-leading ROE and low credit risk. Our sum of the parts target P/E of 12.3x is in line with our target average for the banks, as lower exposure to low-multiple wholesale businesses is offset by slower than average revenue growth.
NA: Our 12-month price target of $65 is a combination of our sum of the parts and price to book methodologies. It implies a multiple of 11.2x 2008E cash EPS, compared to the current 11.5x multiple on 2007E earnings and a 5-year average forward multiple of 11.3x. Our P/B target of 2.1x in 12 months is at the low end of our target for banks given a lower ROE and a higher risk premium, based on more exposure to deteriorating credit quality. Our sum of the parts target of 11.3x 2008E earnings is below our target industry average, reflecting higher exposure to low-multiple wholesale businesses and slow revenue growth in retail banking.
RY: Our 12-month price target of $64 is a combination of our sum of the parts and price to book methodologies. It implies a multiple of 13.6x 2008E cash EPS (highest of the six banks we cover), compared to the 5-year average forward multiple of 12.7x. Our relatively high price to book target multiple of 3.2x reflects the bank’s industry leading ROE and strong capitalization. Our sum of the parts target of 13.8x 2008E earnings is higher than our target industry average for the banks, reflecting a leading domestic retail franchise and more diversified wholesale banking revenues.
TD: Our 12-month price target of $82 is a combination of our sum of the parts and price to book methodologies. It implies a multiple of 13.4x 2008E cash EPS, compared to the current 13.5x multiple on 2007E earnings and a 5-year average forward multiple of 12.1x. Our P/B target of 2.4x in 12 months is at the low end of the bank sector given a lower ROE. Our sum of the parts target of 13.7x 2008E earnings is higher than our target industry average, reflecting a superior domestic retail franchise and lower exposure to low multiple wholesale businesses.
Price Impediments
BMO: Risks to our price target include the health of the overall economy, sustained deterioration in the capital markets environment, the potential for non-accretive acquisitions and/or related execution risk, declining domestic market share and a rising Canadian dollar. Risks to our cautious view relative to peers include better than expected operating leverage, a turnaround in retail earnings and changing sentiment toward bank mergers.
BNS: Risks to our price target include the health of the overall economy, sustained deterioration in the capital markets environment, the potential for non-accretive acquisitions and/or related execution risk, deterioration in the Latin American political and economic climate a rising Canadian dollar and rising business loan losses.
CM: Risks to our price target include the health of the overall economy, sustained deterioration in the capital markets environment, loss of domestic market share, a decline in underwriting activity (particularly income trusts) and weakening retail credit quality.
NA: Risks to our price target include the health of the overall economy, sustained deterioration in the capital markets environment, the health of the Quebec economy, an unexpected acquisition, rising business loan losses and a change in the competitive or political environment in Quebec.
RY: The biggest risks to our recommendation change and to our price target relate to credit quality and capital markets. Although we are expecting credit losses to rise, we are not calling for significant deterioration in credit quality in the near term and believe that the bank can maintain above-average bottom line growth if credit losses rise gradually. A worldwide decline in equity markets and capital markets activity would likely hurt the bank more than most peers given the size of its wealth management and capital markets businesses. Additional risks include the potential for non-accretive acquisitions and/or related execution risk and a worse than expected impact from Enron-related litigation (although it appears that risk has declined, given a court ruling in another Enron trial).
TD: Risks to our price target include the health of the overall economy, sustained deterioration in the capital markets environment, an unexpected acquisition, pricing pressure in the discount brokerage industry, integration risk with both TD Ameritrade and TD Banknorth, a rising Canadian dollar and a worse than expected impact from Enron-related litigation (although it appears that risk has declined, given a court ruling in another Enron trial).
