Scotia Capital, 30 November 2007
Q4/07 Earnings - Low Quality - Dividend Increase
• National Bank of Canada (NA) reported a modest 2% increase in fourth quarter cash operating earnings (excluding ABCP related write-downs and other charges) to $1.34 per share driven by strong trading revenue (highest in four years and second highest in history) and security gain of $0.13 per share offset partially by weak retail earnings growth.
• Fiscal 2007 operating earnings increased 12% to $5.65 (excluding ABCP write-downs) from $5.05 per share in fiscal 2006.
• Return on equity for the quarter was 18.4% versus 19.7% a year earlier. Return on riskweighted assets was 1.66%, down from 1.78% a year earlier.
• Reported earnings were a loss of $1.14 per share including $2.48 per share in charges. Charges included a $2.41 per share write-down related to ABCP, a $0.03 per share restructuring charge of Altamira's activities, and $0.04 per share charge for the impairment in value of an intangible asset.
• Earnings were driven by Wealth Management and Financial Markets growth of 27% and 19%, respectively with retail earnings growth weak at 5%. Revenue growth was negligible due mainly to lower net interest margin.
Dividend Increased 3%
• In a very positive development NA kept the Canadian Bank group's four to five year track record of dividend increases every second quarter intact. NA increased its dividend a modest 3.3% to $2.48 per share from $2.40 per share.
Personal & Commercial Banking Earnings Weak
• P&C Banking earnings growth was weak increasing a modest 5% to $111 million excluding a gain on securities from insurance activities in the prior year. Including the gain, earnings declined 4%.
• Revenue growth in retail was very weak at 1% due to a 20 bp decline in net interest margin which offset 7% loan growth. Retail expense growth was controlled at 2% although outpacing revenue growth.
• NA experienced growth in personal loans and deposits of 9% and 3%, respectively.
Commercial deposits increased 9% with commercial loans increasing 2%.
• Fiscal 2007 P&C Banking earnings increased 7% (excluding securities gain) to $466 million from $447 million a year earlier. Including the gain, earnings increased a modest 4%.
Retail NIM declines 20 basis points
• Retail net interest margin (NIM) was 2.71% in Q4, down 20 basis points (bp) from a year earlier and 7 bp sequentially. The increase in BA's spreads cost the bank approximately $25 million or $0.10 per share this quarter. Excluding this market impact on net interest margin, retail earnings growth would have been 10%.
Wealth Management - Earnings Growth 27%
• Wealth Management earnings increased 27% to $38 million, attributable to growth in mutual fund and private investment management (PIM) revenue. Mutual fund revenue increased 16% to $39 million.
• Wealth Management revenue growth was 2.8%, with expenses declining 2.5% for positive operating leverage of 5.3%.
• Mutual Fund assets increased a modest 4% to $11.8 billion from $11.3 billion a year earlier.
• Wealth Management earnings increased 16% in fiscal 2007 to $164 million from $141 million in fiscal 2006.
Financial Markets Earnings increase 19%
• Financial Markets Q4 earnings increased 19% to $93 million (excluding ABCP write-down), driven by 15% increase in revenue with expenses increasing 7% for strong operating leverage of 8%. Including the ABCP write-down, Financial Markets earnings declined 3%.
• In fiscal 2007, Financial Markets earnings increased 20% to $371 million from $308 million a year earlier.
Trading Revenue Highest Since Q4/03
•Trading revenue was strong at $121 million versus $90 million in the previous quarter and $118 million a year earlier, the highest level since Q4/03 and the second highest in history. Equities trading revenue was solid at $62 million versus $56 million in the previous quarter and $53 million a year earlier. Trading revenue represented 11.5% of total revenue.
•Trading revenue in fiscal 2007 increased 20% to $438 million versus $364 million in fiscal 2006.
Capital Markets Revenue
• Capital Markets revenue declined to $136 million from $165 million in the previous quarter and $168 million a year earlier due to lower M&A activity and the sale of the U.S. advisory practice.
• In fiscal 2007, Capital Markets revenue increased 3% to $647 million from $629 million a year earlier.
Security Gains Represent 10% Earnings
• Security gains remain relatively high at $33 million or $0.13 per share (excluding ABCP write-down) in the quarter, representing 10% of earnings versus $43 million or $0.18 per share, representing 12% of earnings in the previous quarter. Security gains a year earlier were $50 million or $0.20 per share representing 15% of earnings.
Unrealized Security Surplus $148 Million
• Total unrealized security surplus was $148 million versus $206 million in the previous quarter and $126 million a year earlier. Equity securities surplus increasedyear over year to $161 million versus $252 million in the previous quarter and $129 million a year earlier.
Operating Leverage Low
• Operating leverage in Q4 was low at 0.4%, with revenue declining 0.1% and non-interest expenses declining 0.5%.
Loan Loss Provisions Increase Modestly
• Specific loan loss provisions (LLPs) increased 28% on a very low base to $29 million or 0.22% of loans, versus $22 million or 0.17% of loans in the previous quarter and $23 million or 0.18% of loans a year earlier.
• LLPs for fiscal 2007 were $103 million or 0.20% of loans versus $77 million or 0.15% of loans in fiscal 2006.
• We are increasing our 2008 LLP estimate to $130 million or 0.24% of loans from $120 million or 0.22% of loans. We are introducing our 2009 LLP estimate at $150 million or 0.27% of loans.
• Gross impaired loans (GILs) were $249 million in the quarter (mostly in commercial loans) versus $236 million in the previous quarter. Net impaired loans (NILs) were negative $179 million versus $198 million in the previous quarter.
• Impaired loan formations in the quarter were $45 million versus $18 million in the previous quarter and $40 million a year earlier.
Tier 1 - 9.0%
• Tier 1 ratio declined slightly to 9.0% from 9.4% in the previous quarter and from 9.9% a year earlier primarily due to the write-down in ABCP. Risk-weighted assets increased 4.3% to $49.3 billion, with market at risk assets increasing 24% to $3.6 billion.
• Book value declined 1% YOY to $26.85 per share.
Exposure to High Risk Assets
• NA has $588 million of bank sponsored ABCP with liquidity support on balance sheet although the backstop liquidity facilities are not significant. This ABCP has no exposure to U.S. sub-prime mortgages and is not levered. The bank also has $1.7 billion in non-bank ABCP on balance sheet purchased from its mutual funds and retail clients in August 2007. Approximately 10% or $170 million of these holdings have exposure to U.S. sub-prime mortgages. Other than the ABCP holdings the bank does not have any additional level three assets.
• Hedge fund trading and lending exposure is fully collateralized and there are no credit issues with counterparties. The bank has no exposure to Structured Investment Vehicles (SIVs) and no LBO exposure.
Share Buyback Activity
• In fiscal 2007, NA repurchased five million shares at an average price of $62.94 per share. The bank repurchased 264,000 shares in the quarter prior to the ABCP debaucle.
Recommendation
• Our 2008 earnings estimate is unchanged at $6.10 per share. We are introducing our 2009 earnings estimate at $6.60 per share.
• Our 12-month share price target on NA shares is unchanged at $75, representing 12.3x our 2008 earnings estimate and 11.4x our 2009 earnings estimate.
• NA is rated a 2-Sector Perform as P/E multiple discount reflects lower profitability and capital ratios, higher earnings reliance on wholesale, particularly trading and security gains, and low retail banking geographic diversification (concentration in Quebec).
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Q4/07 Earnings - Low Quality - Dividend Increase
• National Bank of Canada (NA) reported a modest 2% increase in fourth quarter cash operating earnings (excluding ABCP related write-downs and other charges) to $1.34 per share driven by strong trading revenue (highest in four years and second highest in history) and security gain of $0.13 per share offset partially by weak retail earnings growth.
• Fiscal 2007 operating earnings increased 12% to $5.65 (excluding ABCP write-downs) from $5.05 per share in fiscal 2006.
• Return on equity for the quarter was 18.4% versus 19.7% a year earlier. Return on riskweighted assets was 1.66%, down from 1.78% a year earlier.
• Reported earnings were a loss of $1.14 per share including $2.48 per share in charges. Charges included a $2.41 per share write-down related to ABCP, a $0.03 per share restructuring charge of Altamira's activities, and $0.04 per share charge for the impairment in value of an intangible asset.
• Earnings were driven by Wealth Management and Financial Markets growth of 27% and 19%, respectively with retail earnings growth weak at 5%. Revenue growth was negligible due mainly to lower net interest margin.
Dividend Increased 3%
• In a very positive development NA kept the Canadian Bank group's four to five year track record of dividend increases every second quarter intact. NA increased its dividend a modest 3.3% to $2.48 per share from $2.40 per share.
Personal & Commercial Banking Earnings Weak
• P&C Banking earnings growth was weak increasing a modest 5% to $111 million excluding a gain on securities from insurance activities in the prior year. Including the gain, earnings declined 4%.
• Revenue growth in retail was very weak at 1% due to a 20 bp decline in net interest margin which offset 7% loan growth. Retail expense growth was controlled at 2% although outpacing revenue growth.
• NA experienced growth in personal loans and deposits of 9% and 3%, respectively.
Commercial deposits increased 9% with commercial loans increasing 2%.
• Fiscal 2007 P&C Banking earnings increased 7% (excluding securities gain) to $466 million from $447 million a year earlier. Including the gain, earnings increased a modest 4%.
Retail NIM declines 20 basis points
• Retail net interest margin (NIM) was 2.71% in Q4, down 20 basis points (bp) from a year earlier and 7 bp sequentially. The increase in BA's spreads cost the bank approximately $25 million or $0.10 per share this quarter. Excluding this market impact on net interest margin, retail earnings growth would have been 10%.
Wealth Management - Earnings Growth 27%
• Wealth Management earnings increased 27% to $38 million, attributable to growth in mutual fund and private investment management (PIM) revenue. Mutual fund revenue increased 16% to $39 million.
• Wealth Management revenue growth was 2.8%, with expenses declining 2.5% for positive operating leverage of 5.3%.
• Mutual Fund assets increased a modest 4% to $11.8 billion from $11.3 billion a year earlier.
• Wealth Management earnings increased 16% in fiscal 2007 to $164 million from $141 million in fiscal 2006.
Financial Markets Earnings increase 19%
• Financial Markets Q4 earnings increased 19% to $93 million (excluding ABCP write-down), driven by 15% increase in revenue with expenses increasing 7% for strong operating leverage of 8%. Including the ABCP write-down, Financial Markets earnings declined 3%.
• In fiscal 2007, Financial Markets earnings increased 20% to $371 million from $308 million a year earlier.
Trading Revenue Highest Since Q4/03
•Trading revenue was strong at $121 million versus $90 million in the previous quarter and $118 million a year earlier, the highest level since Q4/03 and the second highest in history. Equities trading revenue was solid at $62 million versus $56 million in the previous quarter and $53 million a year earlier. Trading revenue represented 11.5% of total revenue.
•Trading revenue in fiscal 2007 increased 20% to $438 million versus $364 million in fiscal 2006.
Capital Markets Revenue
• Capital Markets revenue declined to $136 million from $165 million in the previous quarter and $168 million a year earlier due to lower M&A activity and the sale of the U.S. advisory practice.
• In fiscal 2007, Capital Markets revenue increased 3% to $647 million from $629 million a year earlier.
Security Gains Represent 10% Earnings
• Security gains remain relatively high at $33 million or $0.13 per share (excluding ABCP write-down) in the quarter, representing 10% of earnings versus $43 million or $0.18 per share, representing 12% of earnings in the previous quarter. Security gains a year earlier were $50 million or $0.20 per share representing 15% of earnings.
Unrealized Security Surplus $148 Million
• Total unrealized security surplus was $148 million versus $206 million in the previous quarter and $126 million a year earlier. Equity securities surplus increasedyear over year to $161 million versus $252 million in the previous quarter and $129 million a year earlier.
Operating Leverage Low
• Operating leverage in Q4 was low at 0.4%, with revenue declining 0.1% and non-interest expenses declining 0.5%.
Loan Loss Provisions Increase Modestly
• Specific loan loss provisions (LLPs) increased 28% on a very low base to $29 million or 0.22% of loans, versus $22 million or 0.17% of loans in the previous quarter and $23 million or 0.18% of loans a year earlier.
• LLPs for fiscal 2007 were $103 million or 0.20% of loans versus $77 million or 0.15% of loans in fiscal 2006.
• We are increasing our 2008 LLP estimate to $130 million or 0.24% of loans from $120 million or 0.22% of loans. We are introducing our 2009 LLP estimate at $150 million or 0.27% of loans.
• Gross impaired loans (GILs) were $249 million in the quarter (mostly in commercial loans) versus $236 million in the previous quarter. Net impaired loans (NILs) were negative $179 million versus $198 million in the previous quarter.
• Impaired loan formations in the quarter were $45 million versus $18 million in the previous quarter and $40 million a year earlier.
Tier 1 - 9.0%
• Tier 1 ratio declined slightly to 9.0% from 9.4% in the previous quarter and from 9.9% a year earlier primarily due to the write-down in ABCP. Risk-weighted assets increased 4.3% to $49.3 billion, with market at risk assets increasing 24% to $3.6 billion.
• Book value declined 1% YOY to $26.85 per share.
Exposure to High Risk Assets
• NA has $588 million of bank sponsored ABCP with liquidity support on balance sheet although the backstop liquidity facilities are not significant. This ABCP has no exposure to U.S. sub-prime mortgages and is not levered. The bank also has $1.7 billion in non-bank ABCP on balance sheet purchased from its mutual funds and retail clients in August 2007. Approximately 10% or $170 million of these holdings have exposure to U.S. sub-prime mortgages. Other than the ABCP holdings the bank does not have any additional level three assets.
• Hedge fund trading and lending exposure is fully collateralized and there are no credit issues with counterparties. The bank has no exposure to Structured Investment Vehicles (SIVs) and no LBO exposure.
Share Buyback Activity
• In fiscal 2007, NA repurchased five million shares at an average price of $62.94 per share. The bank repurchased 264,000 shares in the quarter prior to the ABCP debaucle.
Recommendation
• Our 2008 earnings estimate is unchanged at $6.10 per share. We are introducing our 2009 earnings estimate at $6.60 per share.
• Our 12-month share price target on NA shares is unchanged at $75, representing 12.3x our 2008 earnings estimate and 11.4x our 2009 earnings estimate.
• NA is rated a 2-Sector Perform as P/E multiple discount reflects lower profitability and capital ratios, higher earnings reliance on wholesale, particularly trading and security gains, and low retail banking geographic diversification (concentration in Quebec).
