Citigroup Global Markets, 19 March 2008
• We are Maintaining Hold Rating but Elevating the Risk Rating — The Canadian bank stock prices have been adversely impacted along with other financial institutions on concerns of credit and liquidity. Considering the size of the banks, the significant reduction in valuations, the likely resolution to some of the credit concerns by the 2H08, we maintain the ratings, adjusting price and risk.
• Anticipate Higher Impaired Assets/Loans at BMO — Due to the bank’s credit related exposures we are reducing the target price to C$43 from C$54 and also changing the risk rating to High from Medium. To adjust for our increased provisions and lower Q108 results, we are reducing FY08E another -8%, bringing our estimated C$3.71 nearly 30% below consensus.
• Increased Funding Costs and Insurance Expenses at CWB — Our revised target price of C$23, down from C$36, reflects our lower FY08E of C$1.74 from C$1.87. The -7% decline in estimated earnings reflects higher funding costs, increased impaired loans and anticipated higher insurance related expenses. Our earnings estimate is fairly in line with consensus.
• Mono-line and Trading Related Credit Derivative Risk at RY — We are reducing the target price to C$47 from C$58, and elevating the bank’s risk rating to High. Both changes reflect the bank’s sizable securities holdings and derivatives trading related exposure to the U.S. We also reduced our FY08E -3% to reflect our views of higher PCL’s. Our revised FY08E of C$4.30/share is 1% below consensus.
Opinion - Summary
The current credit turmoil has increased the volatility and Risk associated with many financial institutions. As such, we are revising our risk rating on two of Canada’s large banks, Royal and Bank of Montreal. Both banks have a significant asset base with many potential points of exposure. Neither bank has recorded significant write-downs to reflect the potential exposures. Our view is the market has priced in C$14B for BMO and C$11B for RY. We are revising the risk rating on both to High.
Another aspect of the credit crisis is higher funding costs. Canadian Western relies on deposit brokers and the wholesale markets. As such, we are reducing our earnings estimate and price target on CWB to reflect the higher costs.
Bank of Montreal - Anticipate Higher Impaired Assets/Loans
Deteriorating Credit Trends to Impact BMO Assets — First quarter provisions were up over 300% driven by new impaired loan formations. We expect increased PCL ratio to cover impairments in current portfolio and any assets brought onto the balance sheet as a result of the SIV and Canadian ABCP restructuring efforts.
Expect Increased Funding Costs —We incorporated a 2 percentage point increase to the cost of equity to reflect the higher funding costs. Over 80% of the bank’s funding base is rate sensitive. Only 34% of the liabilities are comprised of individual deposits.
Anticipate Capital Markets Slow down and Higher Expenses — The pipeline for capital markets has been disrupted by the credit issues, we estimate 5% reductions to revenues. We estimate significant increases to non-interest expenses as the bank capitalizes on acquisition related disruption in the Midwestern U.S. to build out franchise teams.
Monoline, SIV, and Canadian ABCP Exposures — The bank disclosed C$3.8B direct notional derivative exposure, C$3.6B indirect notional derivative amounts, over C$10B in SIV related exposure, C$23.4B in ABCP liquidity, US$10.2B liquidity with exposure to U.S. sub-prime, and C$2B in Canadian ABCP. Market priced in estimated C$14B write down, bank announced less than C$1B.
Overall, Anticipate Continued Volatility — As such we are increasing the risk rating on the name to High from Medium. We are not recommending a Sell given valuation and likely resolution to outstanding credit concerns by 2H08.
Royal Bank of Canada - Mono-line and Trading Related Credit Derivative Risk
Risk Associated with Potential Additional Write-downs — To date the bank has announced less than C$1B in write downs resulting from disruption in the credit markets. Based on our estimates, the bank has disclosed at least $8B of exposure, which translates to approximately C$6.28/share loss to either earnings or book value depending on how it is accounted for.
Types of Exposures include: — US$4.938B CDO hedged with monoline insurers, US$9.126B credit protection by monocline insurers of which US$5.234B is subprime related, US$4.361B in U.S. ABCP that contains US$600mm non-agency, US$765mm in U.S, CMBS on the trading book, and a C$15.2B increased notional value of traded credit derivatives due to wider credit spreads.
Increased Our Provision for Credit Loss Estimate — PCL’s jumped 81% in the first quarter reflecting higher impaired loans in their U.S. residential builder finance business. The U.S. housing market remains weak therefore we expect continued loan losses.
Assets to Capital Leverage is High — As of YE07 the bank’s asset to capital multiple was 20x, the highest of the 8 large banks. The regulated maximum is 20x, and can be as large as 23x with OSFI approval. This indicates the bank will need to sell assets or raise capital to be within guidelines. Given reduced value of certain assets, either action will likely be an offset to earnings.
Maintain Hold Rating, with Increased Risk Rating — Based on the sell off in the stock since 2H07 estimate market has priced in approximately C$11B in write downs, furthermore given the bank’s size we expect long term resolution to the current credit related issues, as such we are not assigning a Sell rating. However, we do anticipate near term volatility, hence our revised High Risk rating.
Bank of Montreal
Company description
BMO Financial Group, with more than C$360B in assets and more than 34,000 employees, is a highly diversified financial services organization. The bank provides a broad range of retail banking, wealth management, and investment banking products and solutions in both the U.S. and Canada. In Canada, the brands are BMO Bank of Montreal, and BMO Nesbitt Burns. In the U.S. the brand is Harris Bank. In both countries the corporate and investment bank’s brand is BMO Capital Markets.
Investment strategy
We rate Bank of Montreal a Hold, High Risk Rating. The rating reflects our view that in the near term there is limited upside to the stock given the bank's exposure to structured products in Canada and the U.S. The bank had a higher risk profile than anticipated and has not been effectively managing the risk and related exposures.
The bank operates in two highly competitive arenas: Canada and Midwestern United States. The Canadian market suffers from slow population growth combined with 5 large banks all fighting to gain the few customers. The U.S. market where the bank operates (Midwest) has a similar set up, a few large banks fighting to acquire the same set of customers plus many small community banks also vying for the same customer base. Our rating reflects our view the bank could focus on the core retail operations, specifically in Canada to help provide a solid base to help stabilize the more volatile businesses.
Traditionally, the bank’s strength was credit risk management and we believe this will be needed as the overall credit environment continues to sour. We'd become more positive on the name once additional controls and checks have been successfully implemented. Furthermore, the bank's recent commodities and credit related exposures have adversely impacted the stock's valuation, making it inexpensive relative to the group. As such, we do not think a Sell Rating is warranted given valuation and the earnings potential of the retail franchises. The management team has taken steps to limit specific exposures and enhanced the risk teams.
Valuation
Our revised 12-month target price of C$43 is derived using the same methodology as the prior target, utilizing an updated set of assumptions to reflect current market conditions. The revised assumptions are a group forward P/E multiple of 10.0x, which represents a 10% premium to the U.S. bank group but a 9-17% discount to the historical group average for the Canadian banks. We feel the current credit trends, deteriorating earnings estimates, and volume of risky assets warrant the discount. The 2009 EPS estimate of C$5.05 yields a C$50.50 target based on the forward P/E. The ERM generated C$35.65, based on a cost of equity of 12% (reflecting the current credit crunch) and a 2% long term growth rate (reflects economic slow down). The rounded average of both is C$43.
Our prior 12-month target price of C$56 was derived using the same methodology. The assumptions were 2009 EPS estimate of C$5.05, yielded a C$58.03 target based on the 11.5x group forward P/E. The ERM generated C$53.72, based on a cost of equity of 10% and a 2% long term growth rate. The rounded average of both was C$56.
Risks
We assign a High Risk rating because we think operating in highly competitive markets in two countries, the recent acquisitions, and the significant exposure to the credit crisis warrants a high risk rating. In our view, the bank might become aggressive with the acquisitions plans and over pay for a U.S. operation that does not add considerable earnings growth to the bank. Should that happen the bank’s capital ratios and earnings momentum would likely deteriorate and both the earnings and stock may not achieve our estimates. Our earnings estimates assume a rebound in fee businesses by 2009. If the pipeline remains dry there would be an adverse impact to earnings and our estimates would be overstated. This would likely lead to the stock not attaining our earnings estimates and price targets.
The bank attempts to hedge the associated risks of being exposed to credit, interest rates, currency, and market dynamics, on behalf of its clients but if it is not able to unload the risk into the market the bank holds it. We believe there is risk associated with these exposures and to hedge funds, SIV’s, and various counterparties. All of these could lead to performance results that would hinder the bank from attaining our estimates. There is potential litigation risk due to commodity trading losses and clients of the various structured paper products.
Conversely, the risk to the upside is the bank’s strategy in the U.S. and Canada may yield exceptional earnings growth that would drive the stock price well above our target.
Royal Bank of Canada
Company description
Royal Bank of Canada is the largest bank in Canada based on assets and market capitalization. Royal provides personal and commercial banking, wealth management services, insurance, corporate and investment banking, and transaction processing services. The bank’s primary operations are in Canada and the United States with exposure to the Caribbean, Europe, South America, Asia-Pacific, Australia, and the Middle East. Within Canada the bank has an exceptionally strong market position in most businesses. The bank has over C$600B in assets and approximately C$230B in loans.
Investment strategy
We rate Royal Bank of Canada Hold, High Risk (2H) and have a 12 month target price of C$47. In our view, as the largest of the Canadian banks, Royal likely has significant exposure to the deteriorating credit markets. Given the bank’s size, C$632B in assets, and diversified lines of business we think long term the bank will be able to withstand the current credit crunch. However, aside from the sector recovery we do not foresee any catalyst specific to Royal, to drive near term share price appreciation. The Canadian market is intensely competitive yielding minimal top line growth that falls to the bottom line. The bank has international exposure, particularly in the U.S. through its subsidiary Centura. The main driver for the U.S. business will be the recent acquisitions. The bank's capital markets businesses in both Canada and the U.S. will likely add to the growth engine for the bank after the financial sector recovery.
Valuation
We derive our revised C$47 twelve-month target price by taking the equal weighted average of our excess returns model (ERM), and valuation based on the forward P/E multiple. We use the group forward P/E multiple of 10x our 2009 earnings estimate ofC$4.60/share, yielding C$46. The group P/E multiple 10x, reflects a discount to the historical group average that ranged from 11-12.5x. The discount reflects the current credit crisis and takes in to consideration where the comparable U.S. banks are expected to trade. The ERM derives C$48.58, both averaged is C$47.29 which we round to C$47.
We derived our prior C$58 twelve-month target price using the same method with a different set of assumptions. We used the forward P/E multiple of 12.5x our 2008 earnings estimate of C$4.45/share. The P/E multiple 12.5x, reflected a premium to the group average of 11.5x. The premium was driven by Royal's share of market, stability, and historical trends reflect Royal consistently trades at a premium to the group.
Additionally our estimated 3 year CAGR for Royal Bank of exceeds the group average. We believe this valuation method is appropriate given it employs a fundamental method and a market based multiple. The ERM derived $59.61 the P/E derived $55.51 for an equal weighted average target price of C$57.56, which we rounded to C$58.
Risks
We rate Royal High Risk because of the risks associated with being the largest financial institution in such a tight market given the current credit, and market related crisis. The bank has C$150B in trading securities, C$76B in reverse repurchases, and C$72B in wholesale loans on the balance sheet. The market for those types of assets has frozen in the U.S. and in Canada making it difficult to reduce balance sheet exposure to them. As such, we think the bank is at risk for credit crunch related write downs. The bank has announced less than C$1B in related write downs but has disclosed over C$5B in mono-line, CDO, and 3rd party exposure. The downside risk to the stock is that we think the potential write downs may reduce earnings preventing the stock from reaching our target price.
Additionally, excessive integration costs are a risk and could result in earnings below our estimates, which would likely have an adverse impact the stock price not meeting our established target. Royal may also be exposed to litigation risks from any follow on Enron related charges. This could pressure earnings and likely the stock price. Furthermore the projected rebound in capital markets related businesses, stable trading revenues, and alleviation of margin compression may not materialize, if these items do not develop the bank may not reach our earnings estimate which could adversely impact the stock.
The upside risk to our rating and price target is that alternatively, their may be a rebound in capital markets businesses that could exceed our expectations contributing favorably to earnings and the likelihood that the share price exceeds our target.
;
• We are Maintaining Hold Rating but Elevating the Risk Rating — The Canadian bank stock prices have been adversely impacted along with other financial institutions on concerns of credit and liquidity. Considering the size of the banks, the significant reduction in valuations, the likely resolution to some of the credit concerns by the 2H08, we maintain the ratings, adjusting price and risk.
• Anticipate Higher Impaired Assets/Loans at BMO — Due to the bank’s credit related exposures we are reducing the target price to C$43 from C$54 and also changing the risk rating to High from Medium. To adjust for our increased provisions and lower Q108 results, we are reducing FY08E another -8%, bringing our estimated C$3.71 nearly 30% below consensus.
• Increased Funding Costs and Insurance Expenses at CWB — Our revised target price of C$23, down from C$36, reflects our lower FY08E of C$1.74 from C$1.87. The -7% decline in estimated earnings reflects higher funding costs, increased impaired loans and anticipated higher insurance related expenses. Our earnings estimate is fairly in line with consensus.
• Mono-line and Trading Related Credit Derivative Risk at RY — We are reducing the target price to C$47 from C$58, and elevating the bank’s risk rating to High. Both changes reflect the bank’s sizable securities holdings and derivatives trading related exposure to the U.S. We also reduced our FY08E -3% to reflect our views of higher PCL’s. Our revised FY08E of C$4.30/share is 1% below consensus.
Opinion - Summary
The current credit turmoil has increased the volatility and Risk associated with many financial institutions. As such, we are revising our risk rating on two of Canada’s large banks, Royal and Bank of Montreal. Both banks have a significant asset base with many potential points of exposure. Neither bank has recorded significant write-downs to reflect the potential exposures. Our view is the market has priced in C$14B for BMO and C$11B for RY. We are revising the risk rating on both to High.
Another aspect of the credit crisis is higher funding costs. Canadian Western relies on deposit brokers and the wholesale markets. As such, we are reducing our earnings estimate and price target on CWB to reflect the higher costs.
Bank of Montreal - Anticipate Higher Impaired Assets/Loans
Deteriorating Credit Trends to Impact BMO Assets — First quarter provisions were up over 300% driven by new impaired loan formations. We expect increased PCL ratio to cover impairments in current portfolio and any assets brought onto the balance sheet as a result of the SIV and Canadian ABCP restructuring efforts.
Expect Increased Funding Costs —We incorporated a 2 percentage point increase to the cost of equity to reflect the higher funding costs. Over 80% of the bank’s funding base is rate sensitive. Only 34% of the liabilities are comprised of individual deposits.
Anticipate Capital Markets Slow down and Higher Expenses — The pipeline for capital markets has been disrupted by the credit issues, we estimate 5% reductions to revenues. We estimate significant increases to non-interest expenses as the bank capitalizes on acquisition related disruption in the Midwestern U.S. to build out franchise teams.
Monoline, SIV, and Canadian ABCP Exposures — The bank disclosed C$3.8B direct notional derivative exposure, C$3.6B indirect notional derivative amounts, over C$10B in SIV related exposure, C$23.4B in ABCP liquidity, US$10.2B liquidity with exposure to U.S. sub-prime, and C$2B in Canadian ABCP. Market priced in estimated C$14B write down, bank announced less than C$1B.
Overall, Anticipate Continued Volatility — As such we are increasing the risk rating on the name to High from Medium. We are not recommending a Sell given valuation and likely resolution to outstanding credit concerns by 2H08.
Royal Bank of Canada - Mono-line and Trading Related Credit Derivative Risk
Risk Associated with Potential Additional Write-downs — To date the bank has announced less than C$1B in write downs resulting from disruption in the credit markets. Based on our estimates, the bank has disclosed at least $8B of exposure, which translates to approximately C$6.28/share loss to either earnings or book value depending on how it is accounted for.
Types of Exposures include: — US$4.938B CDO hedged with monoline insurers, US$9.126B credit protection by monocline insurers of which US$5.234B is subprime related, US$4.361B in U.S. ABCP that contains US$600mm non-agency, US$765mm in U.S, CMBS on the trading book, and a C$15.2B increased notional value of traded credit derivatives due to wider credit spreads.
Increased Our Provision for Credit Loss Estimate — PCL’s jumped 81% in the first quarter reflecting higher impaired loans in their U.S. residential builder finance business. The U.S. housing market remains weak therefore we expect continued loan losses.
Assets to Capital Leverage is High — As of YE07 the bank’s asset to capital multiple was 20x, the highest of the 8 large banks. The regulated maximum is 20x, and can be as large as 23x with OSFI approval. This indicates the bank will need to sell assets or raise capital to be within guidelines. Given reduced value of certain assets, either action will likely be an offset to earnings.
Maintain Hold Rating, with Increased Risk Rating — Based on the sell off in the stock since 2H07 estimate market has priced in approximately C$11B in write downs, furthermore given the bank’s size we expect long term resolution to the current credit related issues, as such we are not assigning a Sell rating. However, we do anticipate near term volatility, hence our revised High Risk rating.
Bank of Montreal
Company description
BMO Financial Group, with more than C$360B in assets and more than 34,000 employees, is a highly diversified financial services organization. The bank provides a broad range of retail banking, wealth management, and investment banking products and solutions in both the U.S. and Canada. In Canada, the brands are BMO Bank of Montreal, and BMO Nesbitt Burns. In the U.S. the brand is Harris Bank. In both countries the corporate and investment bank’s brand is BMO Capital Markets.
Investment strategy
We rate Bank of Montreal a Hold, High Risk Rating. The rating reflects our view that in the near term there is limited upside to the stock given the bank's exposure to structured products in Canada and the U.S. The bank had a higher risk profile than anticipated and has not been effectively managing the risk and related exposures.
The bank operates in two highly competitive arenas: Canada and Midwestern United States. The Canadian market suffers from slow population growth combined with 5 large banks all fighting to gain the few customers. The U.S. market where the bank operates (Midwest) has a similar set up, a few large banks fighting to acquire the same set of customers plus many small community banks also vying for the same customer base. Our rating reflects our view the bank could focus on the core retail operations, specifically in Canada to help provide a solid base to help stabilize the more volatile businesses.
Traditionally, the bank’s strength was credit risk management and we believe this will be needed as the overall credit environment continues to sour. We'd become more positive on the name once additional controls and checks have been successfully implemented. Furthermore, the bank's recent commodities and credit related exposures have adversely impacted the stock's valuation, making it inexpensive relative to the group. As such, we do not think a Sell Rating is warranted given valuation and the earnings potential of the retail franchises. The management team has taken steps to limit specific exposures and enhanced the risk teams.
Valuation
Our revised 12-month target price of C$43 is derived using the same methodology as the prior target, utilizing an updated set of assumptions to reflect current market conditions. The revised assumptions are a group forward P/E multiple of 10.0x, which represents a 10% premium to the U.S. bank group but a 9-17% discount to the historical group average for the Canadian banks. We feel the current credit trends, deteriorating earnings estimates, and volume of risky assets warrant the discount. The 2009 EPS estimate of C$5.05 yields a C$50.50 target based on the forward P/E. The ERM generated C$35.65, based on a cost of equity of 12% (reflecting the current credit crunch) and a 2% long term growth rate (reflects economic slow down). The rounded average of both is C$43.
Our prior 12-month target price of C$56 was derived using the same methodology. The assumptions were 2009 EPS estimate of C$5.05, yielded a C$58.03 target based on the 11.5x group forward P/E. The ERM generated C$53.72, based on a cost of equity of 10% and a 2% long term growth rate. The rounded average of both was C$56.
Risks
We assign a High Risk rating because we think operating in highly competitive markets in two countries, the recent acquisitions, and the significant exposure to the credit crisis warrants a high risk rating. In our view, the bank might become aggressive with the acquisitions plans and over pay for a U.S. operation that does not add considerable earnings growth to the bank. Should that happen the bank’s capital ratios and earnings momentum would likely deteriorate and both the earnings and stock may not achieve our estimates. Our earnings estimates assume a rebound in fee businesses by 2009. If the pipeline remains dry there would be an adverse impact to earnings and our estimates would be overstated. This would likely lead to the stock not attaining our earnings estimates and price targets.
The bank attempts to hedge the associated risks of being exposed to credit, interest rates, currency, and market dynamics, on behalf of its clients but if it is not able to unload the risk into the market the bank holds it. We believe there is risk associated with these exposures and to hedge funds, SIV’s, and various counterparties. All of these could lead to performance results that would hinder the bank from attaining our estimates. There is potential litigation risk due to commodity trading losses and clients of the various structured paper products.
Conversely, the risk to the upside is the bank’s strategy in the U.S. and Canada may yield exceptional earnings growth that would drive the stock price well above our target.
Royal Bank of Canada
Company description
Royal Bank of Canada is the largest bank in Canada based on assets and market capitalization. Royal provides personal and commercial banking, wealth management services, insurance, corporate and investment banking, and transaction processing services. The bank’s primary operations are in Canada and the United States with exposure to the Caribbean, Europe, South America, Asia-Pacific, Australia, and the Middle East. Within Canada the bank has an exceptionally strong market position in most businesses. The bank has over C$600B in assets and approximately C$230B in loans.
Investment strategy
We rate Royal Bank of Canada Hold, High Risk (2H) and have a 12 month target price of C$47. In our view, as the largest of the Canadian banks, Royal likely has significant exposure to the deteriorating credit markets. Given the bank’s size, C$632B in assets, and diversified lines of business we think long term the bank will be able to withstand the current credit crunch. However, aside from the sector recovery we do not foresee any catalyst specific to Royal, to drive near term share price appreciation. The Canadian market is intensely competitive yielding minimal top line growth that falls to the bottom line. The bank has international exposure, particularly in the U.S. through its subsidiary Centura. The main driver for the U.S. business will be the recent acquisitions. The bank's capital markets businesses in both Canada and the U.S. will likely add to the growth engine for the bank after the financial sector recovery.
Valuation
We derive our revised C$47 twelve-month target price by taking the equal weighted average of our excess returns model (ERM), and valuation based on the forward P/E multiple. We use the group forward P/E multiple of 10x our 2009 earnings estimate ofC$4.60/share, yielding C$46. The group P/E multiple 10x, reflects a discount to the historical group average that ranged from 11-12.5x. The discount reflects the current credit crisis and takes in to consideration where the comparable U.S. banks are expected to trade. The ERM derives C$48.58, both averaged is C$47.29 which we round to C$47.
We derived our prior C$58 twelve-month target price using the same method with a different set of assumptions. We used the forward P/E multiple of 12.5x our 2008 earnings estimate of C$4.45/share. The P/E multiple 12.5x, reflected a premium to the group average of 11.5x. The premium was driven by Royal's share of market, stability, and historical trends reflect Royal consistently trades at a premium to the group.
Additionally our estimated 3 year CAGR for Royal Bank of exceeds the group average. We believe this valuation method is appropriate given it employs a fundamental method and a market based multiple. The ERM derived $59.61 the P/E derived $55.51 for an equal weighted average target price of C$57.56, which we rounded to C$58.
Risks
We rate Royal High Risk because of the risks associated with being the largest financial institution in such a tight market given the current credit, and market related crisis. The bank has C$150B in trading securities, C$76B in reverse repurchases, and C$72B in wholesale loans on the balance sheet. The market for those types of assets has frozen in the U.S. and in Canada making it difficult to reduce balance sheet exposure to them. As such, we think the bank is at risk for credit crunch related write downs. The bank has announced less than C$1B in related write downs but has disclosed over C$5B in mono-line, CDO, and 3rd party exposure. The downside risk to the stock is that we think the potential write downs may reduce earnings preventing the stock from reaching our target price.
Additionally, excessive integration costs are a risk and could result in earnings below our estimates, which would likely have an adverse impact the stock price not meeting our established target. Royal may also be exposed to litigation risks from any follow on Enron related charges. This could pressure earnings and likely the stock price. Furthermore the projected rebound in capital markets related businesses, stable trading revenues, and alleviation of margin compression may not materialize, if these items do not develop the bank may not reach our earnings estimate which could adversely impact the stock.
The upside risk to our rating and price target is that alternatively, their may be a rebound in capital markets businesses that could exceed our expectations contributing favorably to earnings and the likelihood that the share price exceeds our target.
