30 April 2008

Scotia Capital on RBC's Investor Day

Scotia Capital, 30 April 2008

RY Investor Day - Widening the Gap over the Competition

• RY held an Investor Day yesterday Tuesday, April 29. The theme was "Widening the Gap over the Competition".

• RY highlighted its brand and financial strength and its plans to capitalize on the market disruption. Presentations were viewed very positively.

• RY's financial strength is its high quality balance sheet, solid liquidity and funding positions and modest term funding needs in the near term.

• RY's financial strengths are expected to enable RY to fund at better spreads than competitors, continue to reinvest and focus on profitable revenue growth in order to:
o Attract clients and advisors.
o Increase market share in key products and services.

Retail and Wealth Management Strength Expected to Continue

• The presentations were focused on the bank's two very powerful operating platforms Canadian Banking (#1 or #2) which represents 50% of total bank revenue and Wealth Management the clear (#1) in the industry.

• RY has already enjoyed significant positive momentum in the past three years in Canadian Banking and Wealth Management with revenue market share gains of 220 bp and 170 bp, respectively.

• RY has made solid market share gains in all its major Canadian banking products over the past three years except core deposits. RY has been losing market share in the very important core deposits for the past four years. However with the introduction of multi product rebates and an online HISA (High Interest Savings Account) the bank has managed to gain 47 bp in market share in core deposits in the past year. The bank has acquired over 500,000 HISA accounts with $7 billion in balances (50% new money).

• The turn around in core deposits is expected to support future revenue market share gains for Canadian Banking.

• In wealth management RY has a truly dominant position. In Canada, RY continues to lead the mutual fund industry in sales and has grown market share to 12.5%. RY advisor channel is strong with the highest revenue and AUA per advisor.

U.S. & International Expansion Adds Scale

• In the U.S., RY continues to add scale and improve operating performance. RY acquired JB Hanauer in Q3/07 with Ferris, Baker Watts pending. The Financial Consultants (FCs) or IAs are expected to be at 2,000 with recent acquisitions up from 1,646 in 2005. RY is now the 7th largest brokerage firm in the U.S. by number of FCs. Revenue per FC has increased to $582 in Q1/08 from $471 in 2005.

• The bank is also continuing to expand its International Wealth platform. The bank has increased presence in select markets, opening offices in Mexico City, Santiago, Beijing and Mumbai. U.K. represents 40% of client base.

RY Reiterates High Risk Exposure Very Manageable

• Prior to the presentations RY briefly repeated its press release from a day earlier in regards to a Citigroup research report. "We believe the analysis contained significant errors of fact and significantly overstates both the risks and the amount of any potential writedown RBC might incur." "Our exposures are within our risk appetite and are very manageable."

• Operative words may be very manageable. However despite RY's response the share price is expected to lag until the matter is fully clarified with the release of earnings on May 29, 2008.

• We expect the potential writedowns or mark-to-market on the securities portfolio to be modest in the $200 million to $400 million range or $0.10 to $0.20 per share.


• Our 2008 and 2009 earnings estimates are unchanged at $4.50 per share and $5.00 per share, respectively. Our share price target is unchanged at $75 per share representing 16.7x our 2008 earnings estimate.

• We maintain our 1-Sector Outperform based on the low relative P/E multiple to the group, high profitability, superior retail and wealth management platforms, and revenue growth prospects based on relatively heavy reinvestment.

27 April 2008

Citigroup Downgrades RBC

Citigroup Global Markets, 27 April 2008

• Downgrading to 3H from 2H, and Lowering Target Price to C$40 — The downgrade is driven by our conservative estimate of a C$5B potential credit related write down and a C$2B increase to the provision for credit losses. Our estimates are based on our assessment of the bank’s exposures and the actions employed by similar U.S. banks during Q108 results reporting.

• Reduced our Already below Consensus FY08E to C$2.91 — We reduced our prior FY08E of C$4.30 by C$0.06 to reflect the anticipated write-downs, and by C$1.33 to reflect the increased provision for credit losses. The reduced target price reflects the hit to book value driven by recording fair value to OCI.

• Other Comprehensive Income (OCI) vs. Net Income — Managerial discretion is used to determine the asset classifications. Fair value adjustments to securities classified as available for sale are recognized in OCI, held for trading and to maturity are recognized in net income. Under Basel II, changes to OCI impact book valuations and Tier 1 regulatory capital.

• Increased Credit Coverage Ratio to 200% — As of the end of Q108A, the coverage ratio was 96%. Based on our estimate of the FY08E impaired loans ratio increasing to 0.8% from FY07A of 0.45%, the allowance needs to be increased by approximately C$2B to generate a 200% coverage ratio.

• Risk to Our View — Given Royal’s weight in the benchmark, investors may continue to hold the stock even after the disclosures. Additionally, asset values may change prior to disclosure.

25 April 2008

Banks Build Up Their Insurance Business

The Globe and Mail, tara Perkins, 26 April 2008

Customers who pull up in front of the new Royal Bank of Canada branch in Oakville, Ont., might not notice anything unusual. Through the front doors there's a set of ABMs. Turn left and there's an insurance office, turn right and there's a bank branch. Windows and transparent doors divide them.

What's unusual here, even revolutionary, is that those two glass walls separating that bank branch from the coveted world of insurance sales represent one of the biggest growth opportunities that's left for the big banks in this country.

Canada's Bank Act outlaws the promotion of most types of insurance in bank branches, a law that's unique in the developed world. The insurance ban is among the few remaining restrictions banks continue to face in financial services, which is increasingly moving towards one-stop shopping.

If a customer walks into the banking side of the RBC location in Oakville and asks an employee if they know where they can buy some car insurance, the employee's likely to squirm. Responding with "we sell insurance," or "next door," or even just pointing to the insurance office, could be breaking the law. They're instructed to hand over a generic brochure about insurance that does not promote RBC.

Within the next five years, the industry is hoping to demolish the laws that ban banks from selling most insurance products — including life, health, home and auto insurance — in a branch.

In the meantime, banks are diving deeper into insurance. For now, that involves devising clever new ways to get around the rules, and the ingenuity is bridging the divide between banks and insurers, threatening to make Ottawa's rules increasingly irrelevant. Some bankers see the sale of insurance within branches as an initial step toward the eventual amalgamation of the two sectors — something that would radically change how Canadians consume their financial products.

"We're on the thin edge of the wedge here," says Neil Skelding, chief executive officer of RBC Insurance. "It is a terrific potential growth business for the banks."

It's not surprising the insurance charge is being led by the country's biggest bank, RBC, which is increasingly struggling to find growth in this mature banking market. The company has signalled its plan to carve out insurance as a new reporting division; starting in the third quarter, profits from insurance operations will be separated out from the banking figures, making it easier for the market to track just how profitable insurance is becoming for the company.

It's the early stages, but Royal Bank's total insurance operations earned $442-million last year, 46 per cent more than the previous year, making up about 8 per cent of the company's profit. The insurance side has grown faster than the bank as a whole over the past few years, notes Jim Westlake, the new head of international banking and insurance. It's telling that Mr. Westlake, who spent 19 years at Metropolitan Life Insurance Co. and nine years running Royal Bank's insurance strategy, has jumped up the company's senior ranks.

Over at Toronto-Dominion, another bank at the forefront in this area, insurance revenue surpassed the $1-billion milestone last year, contributing just under 10 per cent of total Canadian revenue.

The federal Bank Act attempts to erect a wall between banks and insurers. A bank can own an insurance subsidiary and an insurance company can own a banking subsidiary, but banks can't use their extensive branch networks to sell, or even market, most kinds of insurance.

Royal Bank is doing all it can to make use of its physical locations — as opposed to the phone or Internet, where there are fewer prohibitions — by building insurance offices right next door to some branches. As Mr. Skelding put it, they are "a piece of drywall away from being part of the branch."

Or, in the newest model, two pieces of glass.

RBC has 25 so-called "adjacent" locations, one-quarter of the way to its goal of 100.

The model is proving very successful, and will likely spur duplicates, Mr. Skelding suggested. "I think you will see more retail insurance businesses located near bank branches." Some credit unions in Saskatchewan are trying out the model, testing the limits of that province's regulations. (Credit unions are provincially regulated. Those in Ontario recently lost a battle to obtain more leeway in the insurance arena, while Quebec's have more power.). "Credit unions have been relatively aggressive at building insurance businesses for the simple reason that they know their clients have this need," Mr. Skelding said.

Under the current legislation, if you walk into an RBC Insurance office, they can bombard you with all of the promotional material about banking products that they want. "One of the unique things we found about the retail insurance offices is that 50 per cent of the clients that walk in the door are not RBC clients," Mr. Skelding said. "And we refer them every day to the bank for mortgages, lines of credit and other things."

During a presentation to analysts this month, executives at Bank of Montreal suggested the growth of banks' insurance businesses could play out in a similar way to that of their asset-management businesses.

"This is the same thing that happened with the managed asset business way back when, when we first came out," said Dean Manjuris, vice-chairman of BMO Nesbitt Burns' private client division. "It's only in the last six or seven years that the managed asset business in Canada has really grown, and it looks like insurance is taking on that same kind of track."

Mr. Skelding concurs. Banks made the first big push into asset management about a decade ago, initially focusing on small investors, an "underserved market," he said. Existing financial planners didn't have much interest in people who just put $10 or $20 a month into an RRSP, he said. Banks did. "We had the distribution infrastructure to make that successful, and we could do it in an economic way."

Banks went on to reinvent the business, for instance by coming out with products like no-load funds (mutual funds that don't have a sales charge), and the industry at large grew as a result, he said. "I think if you look at insurance it's going to be a very similar evolution."

At the moment, banks have to squeeze their insurance businesses out through a maze of regulations with a brick wall at the end.

The rules are fairly complex, and have faced few judicial tests. For example, if a customer asks an RBC branch employee "do they sell insurance at that office next door?," then they are allowed to reply that they do, Mr. Skelding said. But "only if you trigger that question."

There are some limited types of insurance banks that are allowed to sell in their branches, mainly those with ties to their lending businesses, such as creditors' insurance, which pays off loans if a customer dies or loses their job. But banking and insurance are naturally more interwoven than the relationship between lending and creditors' insurance, Mr. Skelding said. "Virtually any financial transaction requires some form of insurance, or peace of mind, that goes with it. If you get a mortgage, you're going to need home insurance to close the sale. If you buy a car, you're going to need car insurance. If you retire and you want to buy an annuity, that's an insurance product."

Customers aren't thinking about the Bank Act or the division of financial pillars, they're thinking about the product they need, he said.

Banks often put years into building an investment relationship with a customer. But when it comes time to convert those investments into an income stream to live off of in retirement, the relationship can dissolve.

"When they go to annuitize, we can't actually sell that in the branch," Mr. Skelding said. "To a client, it seems strange. If I've spent 30 years working with RBC on building my investment portfolio and I want to turn it into an annuity, I can't do that, I have to leave RBC 'the bank' and go to an insurance company for that."

It's an unnatural break in the customer relationship imposed by the legislation, Mr. Skelding said. And the "break, this unnatural fissure in the relationship, is going to happen even more as the retired population grows."

Michael Goldberg, an analyst with Desjardins Securities, said "the banks have been heavily involved in wealth products that are associated with the accumulation phase of pension, or retirement, build-up. And insurance companies are going beyond that, to the payout phase of the build-up," ranging from annuities to the guaranteed minimum withdrawal benefit products insurers are now offering. "Because of the way the demographics are going right now, it looks like a lot more product sales are going to be aimed at the payout phase that's beyond the accumulation phase," he said. "Only insurance companies sell those products."

So part of the reason banks don't want to wait for Ottawa to change the rules stems from demographics. As baby boomers move from building up their retirement savings to drawing on those savings, they will turn to insurers for annuities, products that make regular payments to retirees.

Alain Thibault, executive vice-president of insurance at Toronto-Dominion Bank, said "it's not like we're going to be absent from this, because a lot of the business is conducted outside the branches, but obviously it would be more convenient if it was also available in the branches."

(The prohibitions on banks mean they cannot share customer data, even phone numbers or addresses, with their insurance businesses. If an RBC banking customer walks into the insurance office, they'll have to start from scratch.) George Lewis, the executive who runs Royal Bank's wealth management business, said "there is probably a need to look at innovation around products and services that do explicitly provide clients the ability to give us an amount of money to invest when they're 65 or 70, and receive back a lifetime of income or cash flow." It's an area "that we are looking very closely at this year, in terms of coming out with probably a range of products and services to address that."

In Canada's mature banking market, the big five can temporarily steal market share from one another by, for instance, undercutting prices on mortgages or other products. But real long-term growth is harder to come by. Insurance is one avenue.

"We want to understand what role we can fill for Canadians, and what is our right place. And we don't want to be everything to everybody," said Mr. Thibault. "But we believe that insurance can be a real extension of banking services."

While it might seem like the banks are battling Ottawa, their real opponent is the insurance industry.

Dan Danyluk, the chief executive officer of the powerful Insurance Brokers Association of Canada, an organization with much clout among politicians, thinks that even the adjacent branch strategy — which began in 2005, and really ramped up late last year — flouts the intent of the law, if not the letter.

"They never did this before, they wouldn't dare do this before," he said. "But I think what's happening is that they've just decided that they are, after all, the Canadian banks and they're going to do what they want to do."

When Royal Bank began building the adjacent branches, "from the brokers' point of view, we assumed that this was just a little bit of theatrics and we would see these things closed down," he said.

A spokesperson for the country's banking regulator, the Office of the Superintendent of Financial Institutions, said the Bank Act states that banks cannot carry out business in premises adjacent to the office of an insurance company, agent or broker unless there is a clear indication that the two offices are separate. "As long as they are separate, it's legal," he said.

Mr. Danyluk doesn't buy it, and he believes he's got Parliament on his side.

"Our position is that credit-granting institutions, all of them, ought not to be selling insurance at the point of granting credit," he said. The worry is that, as they offer a loan, they'll find a way to make it a quid pro quo that the customer also buys insurance from them — so-called "tied selling." Customers might feel pressure to buy home insurance to get a mortgage, or auto insurance to get car financing, he suggested. "Outside of the shower, can you remember feeling more naked than when you go for credit?"

Banks, which have so much information about their customers' wealth and credit scores, could add to that database information about their health or tendency to get in car accidents, the insurance industry points out.

"Over the last number of years, they've been allowed to sell mortgages, there was a time when they couldn't," Mr. Danyluk added. "They've been allowed to take over the trust industry, there was a time when they couldn't. They've been allowed to own stock brokerages, there was a time when they couldn't.

"I find it appalling quite frankly that they would break the law. And their interpretation of the law, by the way, was the same as mine until the discussions about the last Bank Act (review) when RBC came out and decided, I guess, that they're above the law."

Every five years, Ottawa dusts off the Bank Act and considers if it needs changing. In the lead-up to the latest review, in 2006, banks pushed the issue full throttle. At Royal Bank's annual meeting, chief executive Gordon Nixon said "government should support and defend its key industries through good policies, rather than what sometimes makes for good politics."

Finance Minister Jim Flaherty didn't budge, sticking to the Conservatives' earlier campaign pledge not to allow banks to market insurance in branches.

"The Bank Act passed with no changes to the prohibition against marketing, the only thing that changed was the behaviour of banks," Mr. Danyluk said. "We've erected a two-foot picket fence around a 30-foot giant, and that giant is just not used to anybody telling them they can't do anything they want to do, so they kick through the pickets."
It's legal for banks to be in insurance, he notes, adding "there isn't an insurance broker, an insurance professional in the country that has a problem with that. Our problem is, we just think that at the point of granting credit, which is a bank branch, they shouldn't be offering insurance products because quite frankly consumers are vulnerable."

It's not only the brokers who resist the banks' efforts.

If banks sold all types of insurance in their branches, they would make some of the insurance products themselves, but they could also sell those of the country's big insurers. Given that, you might not suspect strong opposition from the insurers to changing the rules. But that's not the case.

From mortgages to the trust business, banks have come to dominate every sector they've been given the power to enter, notes an executive at one of Canada's largest insurers. Right now banks can have insurance subsidiaries and insurance companies can have banking subsidiaries and the playing field is relatively even, he argued. Combine all of the banks' businesses with their ability to tap into the extensive customer databases they've developed from their lending operations, and "that's a huge advantage," he said.

Manulife Financial Corp chief executive officer Dominic D'Alessandro has noted that banks are already allowed to solicit business exactly the same way insurers do, including direct mail, referrals, and brokers. He's on record saying he's against banks being allowed to distribute or market insurance in branches.

But, he also notes that products offered by banks and insurers are increasingly substitutes for one another and it's no longer useful to think of the sectors as being inherently different. Selling insurance in branches is one thing, but the more fundamental issue that should be dealt with first is the structure of the financial services sector in Canada, Mr. D'Alessandro thinks. And he also believes that banks and insurers should be allowed to merge, and "it is no longer useful to think of the banking and insurance sectors as being inherently different from one another."

While the banks have been setting up tents in the insurers' backyards, Manulife's reciprocating.

Mr. Skelding said that "companies like Manulife are using their adviser channels to do banking. They're saying, 'okay, if you're buying an annuity, you must have an investment portfolio, [and] do you need a mortgage? Do you want a line of credit? And so on."

"You can do it one way, and not the other way."

Many Canadians will have spotted the ads for "Manulife One," which bills itself as the first flexible mortgage account, combining a customer's mortgage with their chequing and savings account so that any income immediately starts paying off their debt.

Manulife Bank is still a relatively puny portion of its parent company, but it's bulking up quickly and executives think it could eventually account for 10 per cent of the insurer's Canadian earnings. They like to joke that it could be Canada's biggest bank if it keeps up its recent growth rate of about 50 per cent per year (something that's clearly not sustainable). The bank's assets surpassed the $10-billion mark for the first time last year, up 26 per cent from 2006, thanks to its loan and mortgage products.

Manulife Bank is a way for the insurance giant to provide bank-type products without having to use another bank, "so they can do things that are a little bit creative with that," Mr. Goldberg said.

The line between banks and insurers is blurring, Mr. Goldberg added.

So will Ottawa step in, like a referee pulling two fighters apart? Or will it change the Bank Act to reflect reality?

Last time the Act was under review, in 2006, the banks watered down their requests, knowing mergers were a non-starter with the Conservatives.

But they did raise the issue of selling insurance in branches. When it became clear that Mr. Flaherty wasn't going to allow that, they asked to be allowed to promote insurance from their branches.

Ottawa instead maintained the status quo — to the delight of the insurance industry and its army of 30,000 brokers.

That may be more difficult next time around. Since the last review, Mr. Flaherty has asked a panel to review the country's competition laws, rekindling the debate over bank and insurance mergers. And the banks are doing all they can to demonstrate that the laws prohibiting the sale of insurance in branches are outdated.

Anyone doubting their plans need only look at new RBC branches like the one in Oakville. The bank is building them in such a way that, should opportunity knock, they can enter another new age for financial services in Canada by just tearing down a strip of drywall.

22 April 2008

Preview of Life Insurance Cos Q1 2008 Earnings

BMO Capital Markets, 22 April 2008

In light of the continued volatility in the marketplace over the last quarter and the global credit deterioration, the Canadian lifecos should report modest earnings growth in Q1/08. Q4/07 results did highlight the strength of these franchises: specifically, no exposure to short-term liquidity challenges faced by the global banking system due to the long-term nature of their funding sources and little credit exposure to troubled sectors in the North American economy such as U.S. subprime mortgages and leveraged CDOs.

The conventional wisdom on the Canadian life insurers is that the conservatism embedded in the accounting model should provide relative stability in earnings emergence over time. However, recent share price performance has not supported this conventional wisdom. Over the last year, the Canadian life and health index outperformed the Canadian bank index and the S&P 500, but underperformed the S&P/TSX Composite (Table 1). During the first quarter of 2008, the Canadian Life & Health index underperformed both the S&P/TSX composite and the Canadian bank index. Year to date, the lifecos have underperformed. Therecent underperformance may refl ect concerns on future credit deterioration among the Canadian lifecos and concerns on future acquisitions given increased acquisition opportunities in the U.S. While we cannot gauge the impact of acquisitions until a deal is announced, we believe that the Canadian lifecos, in general, have a good track record of acquisitions. With respect to asset quality, we believe that the Canadian lifecos should distinguish themselves relative to their peers in terms of asset quality.

For the industry, we are projecting an average of 4% EPS growth, based on solid in-force profit growth, higher income on capital, lower new business strain, good expense gains and continued share buybacks, primarily from MFC and SLF, partially offset by a stronger Canadian dollar, and lower investment gains and fee income. Our Q1/08 EPS estimates are based on a C$/US$ exchange rate of 1.0000 versus an average rate of 1.0053 for the quarter and the current rate of 1.0057.

In this preview, we discuss four industry-wide conditions that are important to all four insurers: credit and equity markets, low long-term interest rates, currency and buybacks. The last section of the report discusses each company independently.

Equity & Credit Markets – Some Light Turbulence

One of the major drivers in lifeco earnings over the last five years has been the strong equity markets. Earnings from lifecos are increasingly sensitive to events in the equity markets, as the percentage contribution from wealth management (versus protection) has almost doubled since 2000. The average of the S&P 500 fell 5.3% year over year, while the average S&P/TSX Composite was up 2.2% on a year-over-year basis. Accordingly, year-over-year growth in average equity market levels should be a positive for Q1/08 earnings in Canada, with lower levels of investment gains from the U.S. operations. The quarter-over quarter change in the average composites was down 9.7% for the S&P 500 and 4.5% for the S&P/TSX Composite. This hinders future fee income growth and may require some additional reserves to support segregated fund guarantees.

On the credit side, U.S. subprime (and Alt-A) mortgage exposure in the Canadian lifecos is low, averaging 0.8% of total assets versus a U.S. average of 3.7%. We expect that credit will continue to deteriorate given the writedowns that have been taken by the global investment banks and the negative outlook on the global economy. However, widening credit spreads in Canada and the U.S. should help the life insurers improve portfolio yields. For a full discussion of credit quality at the Canadian lifecos, please see the most recent Life Insurance Register dated April 3, 2008.

Long-Term Interest Rates – Long Rates Continue to Decline

Long-term interest rates, as represented by the 10-year government bond yields, have been on a downward trend over the last year. The average 10-year rate for the first quarter of the 2008 has fallen by 37 basis points year over year to 3.73% in Canada and 104 basis points to 3.64% in the U.S. Partially offsetting some of the recent weakness in long-term rates, credit spreads continue to widen. Lower long-term interest rates pose a variety of challenges to life insurers, most important of which is the impact on the discount rates used to calculate policyholder reserves and premiums charged on new products.

Interestingly, the Canadian Asset Liability Method (CALM) used to prospectively calculate policy holder reserves, as defined by the Consolidated Standards of Practice of the Canadian Institute of Actuaries, describes the best estimate risk-free ultimate reinvestment rate (URR), beyond 40 years into the future, as the average of the 60- and 120-month moving averages of long-term risk-free yields. In our case, we have proxied the long term yields with the 10-year government bond yield. While a discussion of CALM is beyond the scope of this preview, we believe that there are some noteworthy observations:

• The CALM URR does not exhibit the same volatility as the actual rate.

• Despite falling rates, the Canadian lifecos have successfully managed to grow earnings through this environment since 2002.

• While current interest rates are below the URR, investors should note that a number of adjustments are applied to this URR to derive the valuation URR used in the calculation of actuarial liabilities. These adjustments include assumptions on credit spreads (net of defaults) and additional provisions for risk of asset depreciation (C1 risk) and interest rate mismatches (C3 risk), all subject to thr lifeco’s current investment strategy and worst-case scenario. When applied, these adjustments will reduce the URR, refl ecting the conservative nature required in valuing long-tailed liabilities.

• To the extent that the valuation URR is below the current rate, a margin of safety exists that can mitigate the requirement for additional reserve increases.

Under Canadian GAAP, reserves are “fair valued” quarterly and, as a result, refl ect some impact of the decline in long-term interest rates. In addition, since pricing new policies is based on assumed investment returns, low long-term interest rates reduce potential future investment return assumptions and hence increase the cost of insurance. While it is difficult to isolate the impact of low long-term interest rates in any given quarter or year, we believe that the current rate environment creates a long term earnings growth headwind for the life insurance industry.

Stronger Currency

The Big 3 Canadian lifecos generate approximately 21–47% of total earnings in Canada and the balance is generated outside of Canada, primarily in the U.S., or in U.S. dollar-based jurisdictions. We estimate that the U.S. and U.S. dollar-based jurisdictions accounted for 27–65% of total earnings a year ago and last quarter.

At the extremes, Manulife has the most U.S. dollar exposure and Industrial Alliance has the least. We estimate the average C$/US$ exchange rate of 1.0053 in Q1/08 versus 1.1717 a year ago, 0.9803 last quarter and the current rate of 1.0057. It is important for investors to remember that the currency fluctuations are a translation issue rather than an economic issue.

Our 2008E EPS assume an average exchange rate of 1.0000 C$/US$ versus the current exchange rate of 1.0057 C$/US$. Earnings sensitivities to different F/X rates are shown in Table 4. In the past we have adjusted our exchange rate forecasts after quarterly results have been released. Of note, our EPS sensitivity
analysis to changes in exchange rates has historically projected too severe an impact on lifeco earnings.

While the fluctuations in exchange rates have a short-term translation impact on earnings, the stronger Canadian dollar provides the Canadian lifecos with a more valuable currency to make acquisitions. We expect the Big 3 Canadian lifecos to remain very active in the U.S. market. Specifically, we expect that MFC would entertain large acquisitions such as Principal Financial Group, Lincoln National or Ameriprise, among others. SLF may also consider these types of deals but may be more willing to acquire blocks of business rather than entire companies. We believe SLF’s tolerance for larger deals (i.e. above US$1–2 billion) has increased. With the acquisition of Putnam, GWO is likely to focus on this integration over the next year but would probably continue to make relatively smaller 401(k) acquisitions.

Share Buybacks

The continued deterioration of the global credit environment, coupled with the weak first-quarter results of global conglomerate General Electric, Wachovia, Merrill Lynch, Citibank and UBS, and the JP Morgan bailout of Bear Stearns, has led to a less than positive outlook for the Financial Services sector. Canadian banks have essentially stopped or dramatically slowed their buybacks during the last six months. Year to date, only Royal Bank has bought back 1.2 million shares. However, the Canadian lifecos continue to maintain balance sheets that support the return of capital to shareholders through buybacks, with MFC and SLF being the most active participants. For the first two months of 2008, SLF and IAG have repurchased 0.5 million and 0.4 million shares, respectively, and MFC is estimated to have repurchased approximately 8 million shares. The sustained buyback activity among the lifecos has led to total payout ratios (dividends + buybacks) that were significantly higher than the banks’ in 2007.

Company-Specific Comments

Sun Life – Credit Strong; Watching Earnings in Canada and U.S. Insurance

Sun Life (SLF) will report its Q1/08 earnings on Tuesday, May 6. We are projecting a modest increase of 2% in EPS to $0.98 (mean estimate is $1.01) from $0.96 in Q1/07. Our estimates are based on modest growth expectations from Canada, improved (lower) new business strain in U.S. individual insurance and a modest reduction in the weighted average shares outstanding. We believe that investors will focus on conditions in the capital markets, new business strain levels in U.S. insurance, scale efficiencies in U.S. group, total company sales levels and net flows in U.S. VA and MFS.

Q4/07 results were largely below market expectations mainly due to modest growth in Canada and reserve strengthening in its run-off reinsurance operations in the Corporate segment. The benefits of the new AXXX funding structure in the U.S. and strong earnings at MFS and Asia were unable to offset these items. Sales results were mixed in the quarter, with solid growth in life and health offset by weaker results in wealth management. The company did provide excellent disclosure on its bond portfolio and exposures to different sectors, and we maintain our view that SLF’s balance sheet remains very strong.

In Q4/07, the U.S. VA segment experienced net redemptions of US$89 million, reflecting a lapse spike on legacy annuity products, which did not incorporate any of the product features found in the company’s successful (and well-received) Income ON Demand VA. With the increased volatility in the equity markets, we expect to see moderating wealth management sales and AUM growth in the quarter, although the company’s Income ON Demand VA should still generate attractive sales growth, given the lack of competition from its U.S. peers with similar product features. We suspect that the market volatility may also hinder net flows at MFS in the quarter. Pre-tax margins at MFS should migrate back to the mid-30s from 40% in Q4/07.

Inforce profits and income on capital should be a steady contributor of earnings in the quarter and benefits from finalizing its AXXX funding structure should continue to support earnings in U.S. insurance. As well, scale efficiencies from the EGB acquisition in U.S. group should help offset the seasonality in group claims that the company experiences each first quarter.

Despite the short-term earnings headwinds created by the volatile equity markets, uncertainty on credit (in conjunction with lower interest rates) and appreciation in the Canadian dollar, we still expect to see modest growth in EPS for the quarter. Although acquisition opportunities currently remain sparse, it may take another 6–12 months of volatile equity markets and/or bad credit to rejuvenate M&A activity, particularly in the U.S. SLF remains Market Perform rated.

Manulife – Global Leader Well Positioned for Consolidation

Manulife (MFC) is scheduled to report Q1/08 earnings on Thursday, May 8 and we are projecting EPS of $0.70 (mean estimate is $0.72), up 4% from $0.67 the same quarter last year. We are projecting inforce profit growth from Canada and Asia and U.S. Protection. Equity market volatility will slow AUM growth and may create temporary earnings headwinds for wealth management businesses in the U.S. and Japan. Earnings growth in the U.S. operations may also face a tough comparison in Q1/08 versus Q1/07 due to an unsustainable level of favourable investment gains JH fixed products group from last year.

We upgraded MFC to Outperform from Market Perform, reflecting the strength of its balance sheet, strong sales performance over the last two quarters of 2007 across all product lines in all jurisdictions, an attractive global platform, and the financial and operational ability to capitalize on consolidation opportunities in an uncertain market. Q4/07 results were well above consensus estimates and our expectations. Noteworthy in the quarter was the continuation of strong investment gains, this time in the U.S. protection business. While the timing and sustainability of these gains is difficult to predict, the sales momentum and inforce profit growth potential provide a solid foundation for earnings growth going forward. MFC also remained active in its share buyback program, repurchasing 56.4 million shares during 2007 for a total of $2.2 billion.

Credit experience remains strong at MFC, and asset quality remains better than expected. However, given the continued decline in the equity and credit markets, investment spread gains have likely moderated as well as asset growth in its wealth management businesses. Sales growth may be a challenge in the quarter, but steady inforce profit growth and interest on capital should help mitigate (at least partially) the situation. Moreover, MFC should remain active in its share buyback program.

Wealth management sales in Asia may face a difficult environment given the recent equity market volatility in the Asian markets. In the U.S., VA sales competition remains high; however, we hope to see good VA sales given the very encouraging net flows over the past few quarters and strong demand for its U.S. Income Plus for Life rider. JH RPS also launched a new Guaranteed Income for Life rider on its 401(k) plans at the start of April, which should help boost RPS sales in the coming quarters. In Japan, MFC posted strong sales last quarter, but the sales outlook for Q1/08 will be impacted by the changes in Japan’s financial disclosure laws. GMWB sales in Canada have been very promising over the past several quarters; however, given the poor RRSP season, wealth management sales in Canada may have also moderated.

We continue to believe that MFC has the most attractive long term outlook for all the large Canadian financial services companies given its global reach and strong competitive positions in Asia and the U.S. Short-term earnings headwinds include the volatility in the global credit and equity markets, and low long term interest rates could be a long-term headwind to earnings.

Because of MFC’s global diversification, the rising Canadian dollar may also moderate earnings growth; however, U.S. acquisitions will become cheaper. MFC has an estimated $3 billion in excess capital plus additional leverage capacity (not to mention the ability to issue shares) to fund large acquisitions. While large acquisition targets dominate the market view on MFC, we would not be surprised to see MFC make smaller acquisitions in the 401(k) market and mutual fund segments in the U.S. MFC remains rated Outperform.

Of note, MFC does have some indirect exposure to auction rate preferred shares in nine closed-end funds with total AUM of approximately US$6 billion. These closed-end funds were sold to retail and institutional investors in the U.S. through John Hancock. The auction rate preferred share market has come under stress, and seven of these closed-end funds have exposure totalling approximately US$1.8 billion. Currently, we do not believe that MFC has any obligation, or intention, to support these closed-end funds. Nonetheless, management’s view on this issue is likely to be scrutinized during the quarter.

Great-West Life – Putnam Dominates Perceptions Despite Generating Only 6% of Earnings

Great-West Life (GWO) is expected to report its Q1/08 earnings on Thursday, May 1. We are projecting EPS growth of 5% to $0.60 (mean estimate is $0.64) from $0.57 at Q1/07. Canada and Europe are expected to report another good quarter and the U.S. should show modest growth with increases from financial services, partially offset by languishing performance at Putnam.

On April 1, GWO announced that it completed the sale of its U.S. healthcare operations to CIGNA for US$2.25 billion. While we expect that investors are likely to remain focused on Putnam’s issues and fund performance, we believe the Canadian and European results should remain strong. Growth in premiums and deposits in Canada have been very good for the company over the last 12 months and similar trends remain in Europe with last quarter’s acquisition of a block of Standard Life’s U.K. payout annuities. Aside from Putnam, GWO’s U.S. financial services operation remains acquisitive, particularly in the 401(k) space.

Equity market volatility, however, has slowed the growth in AUM at Putnam and net flows will remain an issue, and are unlikely to show any sustained improvement until the end of 2009 at the earliest. It appears that Putman mutual funds experienced $4.6 billion in net outflows in Q1/08. Despite the U.K. acquisition last quarter, European sales in Q4/07 were down, primarily driven by lower sales of savings products in the U.K. and Isle of Man due to the uncertainty created by proposed changes in taxes in the U.K. on certain products offered in the Isle of Man. We doubt that sales are likely to rebound until further clarity is provided on any tax changes by the U.K. government.

GWO’s asset portfolio remains strong. Gross impaired and net impaired assets continued to decline last quarter. Although GWO has the highest exposure to monoline wrapped bonds ($3.5 billion) in the lifeco group, over half of the exposure (58%) is in Europe and does not cover structure financed transactions but mainly traditional utilities, water and other municipal services. If the monoline wraps disappear, we estimate that this could have a financial impact of up to $25–30 million—a very manageable impact on $3.5 billion in earnings.

We continue to rate GWO Outperform, based on strong growth outlooks in Canada and Europe, valuation improvement in the U.S. business as it focuses more on financial services rather than healthcare, and attractive valuation based on relative P/E and relative yield. Although Putnam is faced with challenges, it represents less than 6% of GWO’s total earnings, and the remaining 94% of GWO’s business operations are performing well (see our report entitled Putnam Concerns Weigh on Share Price but May Be Overdone, dated April 10, for our views on the Putnam acquisition).

Industrial Alliance – Benefits of Canada Only Franchise

Industrial Alliance (IAG) is scheduled to release results on Wednesday, May 7. We are projecting a 4% increase in EPS to $0.75 (mean estimate is $0.80) from $0.72 in the same quarter last year. Our estimates are based on steady contributions from both of IAG’s main operating segments: individual insurance and individual wealth management. Although sales and AUM growth may languish, lower fee income and investment gains should be offset by inforce profit growth and income on capital.

IAG’s balance of earnings continues to improve, as wealth management is increasingly contributing to earnings since the Clarington acquisition, and we expect to see further penetration outside of Quebec.

IAG continues to improve its insurance new business strain by shifting its sales mix from level cost of insurance (COI) universal life (UL) to yearly renewable term (YRT) COI UL. Q4/07 new business strain decreased to 46% of first-year sales; below the target of 50–55%.We expect to see strain levels maintained within the company’s target range in the medium term. IAG launched its own version of an individual GMWB segregated fund in December 2007. However, given the recent volatility in the equity markets, and competition from MFC’s and SLF’s GMWB products, sales may be off to a slow start. Moreover, given the slow RRSP season, overall wealth management sales may face a tough comparison versus Q1/07.

On April 9, Canaccord announced that it would repurchase, at par, $138 million of non-bank ABCP held by its smaller investors, increasing the likelihood of the Montreal Accord being approved, with the final vote scheduled for April 25. As part of the repurchase, Canaccord would use an external market bid for the restructured notes, which we estimate to be approximately 68 cents on the dollar. IAG currently values its non-ABCP holdings at 85%. If IAG were to take an additional 15% writedown, we estimate that this would result in an after-tax EPS reduction of $0.13. To be clear, our EPS estimates do not include any writedowns beyond what IAG disclosed in Q3/07.

Despite a challenging operating environment in Q4/07, IAG continued to generate good operating EPS growth of 10%, total company premiums and deposits were up 10%, individual life sales rose 20% and quarterly VNB rose 16%. Moreover, with relatively little exposure to the U.S., we expect IAG to maintain its strong credit profile. We continue to believe that IAG has attractive growth prospects in Canada and should remain a core holding for small and mid-cap portfolios. IAG remains Outperform rated.

TD Bank Update on Commerce Bancorp Acquisition

BMO Capital Markets, 22 April 2008


TD held a conference call to discuss the details of its acquisition of Commerce Bancorp. While the operating news was positive, the bank’s capital ratios have been more strained than originally expected.


Slightly Negative. With the strong relative performance of TD shares, we are taking the opportunity to downgrade them to Market Perform.


Our forecasts are unchanged.


We are reducing our target price to $71 from $75, to reflect the weaker balance sheet. Our target multiple is lowered by about half of one multiple point (12.3x 08E cash EPS).


We have long been fans of the TD Bank, and the stock price performance has been strong in absolute and relative terms. We believe that the additional leverage from the Commerce Bank deal increased the risks slightly, and we are downgrading the shares to Market Perform.

Details & Analysis

Over the past 12 months, TD shares have outperformed their peers and are down 5%, compared to a decline of 18% in the bank index. The next-best-performing large bank is down 12%. Furthermore, since our upgrade in November 2002, TD shares have doubled while the bank index is up 70%; again, TD has been the best-performing large bank stock. Today, we are downgrading TD shares to Market Perform. While we remain comfortable in our earnings forecasts, the bank’s capital position is now meaningfully weaker than those of the other large Canadian banks. Over the past year, we have viewed TD as our “recession resistant bank” with excess capital and a low risk business model. Now, with a Tier 1 ratio that will struggle to remain above 8% over the next 12 months (as a result of the combined effect of the Commerce Bank deal and Basel II implementation), we no longer view the bank in this light.

TD Bank held a conference call yesterday to give an update on its acquisition of New Jersey-based Commerce Bancorp (CBH). The transaction, totalling US$8.4 billion, closed on March 31, 2008. Management continues to be very positive on the deal. The Bank reiterated its original estimate for cost synergies of US$310 million by the end of 2009. Including these synergies, and some tax benefits arising from the transaction, TD’s U.S. P&C Banking segment should contribute roughly US$250 million per quarter (starting in Q3/08). For fiscal 2008, TD increased its segment earnings forecast to US$750 million from US$700 million despite higher loan losses and continued margin pressure. For 2009, the US$1.2 billion earnings estimate remained unchanged. These forecasts exclude US$420 million of restructuring charges, the majority of which will be taken in 2008 and 2009. When the dust settles, management anticipates this segment to contribute between 20% and 25% of total Bank earnings. It is impressive that the bank will still meet its estimates despite the deterioration in the U.S. economy.

From a credit perspective, TD provided further detail on its U.S. securities and loan portfolios. Within its US$26 billion investment portfolio, the bank holds US$9.2 billion worth of mortgage-backed securities (including US$3.7 billion worth of non-agency Alt-A MBS). These securities were marked-to-market as of March 31, and management indicated they believe the adjustments made to fair value were largely temporary. The bank remains comfortable with the portfolio’s credit quality.

Within the loan portfolio, the $30 billion commercial book appears to be performing relatively well. Some weakness has been experienced in the “residential for sale” portfolio, which makes up 6% of the overall portfolio—about $1.8 billion. The US$16 billion consumer book is made up of roughly 50% home equity loans. Management indicated that these loans are almost entirely bank-originated and 76% of them are secured with loan-to-value that exceeded 80% at origination. It is worth noting that the majority of the bank’s loan book is based in the U.S. Northeast, a region of the country that has been less impacted by the economic downturn than the Southern U.S. or California. That being said, the deteriorating credit environment is expected to increase loan losses to a run-rate of $75 million per quarter—up from a current range of $40–50 million.

However, the news was negative on the capital front. Tier 1 after the deal will be 8.75–9%, and that is before the 180bp capital hit that TD will take in the first quarter of 2009 from Basel II. TD Bank has, in the recent past, operated with one of the better capital ratios in the Canadian banking system. As we indicated in our report of last week on Basel II, TD will face more pressure than its peers from the staged introduction of the new Basel II capital rules. We believed that there was still enough buffer from existing capital to offset these pressures. What is clear from yesterday’s presentation is that the Commerce acquisition has consumed about 60 bp more of incremental capital than was originally projected. In most cases, this is a rounding error. But when a bank will already be at the bottom end of its peer group range, this is material. We are confi dent that TD can manage around this, and that with its strong funding base, there is solid underpinnings to the capital. However, we can no longer point to TD as having a relatively strong balance sheet. It is reasonable to adjust the multiple applied to TD’s shares. In this case, we are lowering our target multiple by half a multiple point.

From a technical perspective, the additional pressure on capital for the CBH close has come from worse than expected marks on the securities book (which has increased goodwill) and higher-than-expected risk-weighting on the balance sheet.

The Commerce Bank deal positions the bank well for growth in the U.S. Given management talent, the solid market positions and the potential for synergies, the integration with Banknorth and CBH should go well. Having said that, the lower capital position means there is less margin for error. We remain cautious that although Canadian banks are some of the best capitalized in the World, and the Canadian economy should outperform that of the U.S., there are still material pressures on all banks from a funding and capital perspective. We would rather err on the side of caution, and we are downgrading the shares to Market Perform.
RBC Capital Markets, 22 April 2008

TD Bank revised its earnings target for its U.S. P&C Banking segment, and the revised numbers are generally higher than what we expected. There is room for us to increase our earnings estimates if management delivers on its targets.

• The bank increased its earnings target from $700 million to a minimum of $750 million in fiscal 2008, and left its 2009 net income target unchanged at $1.2 billion. Our earnings estimate for the segment is $605 million in 2008 and $1.1 billion in 2009.

• The bank estimates segment earnings of $130 million in Q2/08 (which does not include Commerce Bancorp results) and a run-rate earnings of $250 million in Q3/08 (including Commerce Bancorp results reported with a one-month lag).

• The $250 million of earnings is split $130 million from Banknorth and $80 million Commerce, and includes tax optimization strategies, higher credit loss expectations for a slowing economy, and narrower deposit spreads due to competition.

• Management's outlook for earnings in 2008 reflects higher segment earnings and lower than expected funding costs.

• Management expects the proforma efficiency ratio to be about 63% initially, and expects improvements from deal synergies but does not intend to jeopardize its customer service

• Restructuring and integration charges of US$420 million pre-tax is expected to be recognized through 2008 and 2009. (At announcement the charges were expected to be US$490 million)

• Management expects to realize cost synergies of US$310 million by end of 2009, which is the same amount it expected at the announcement of the acquisition. The bank also hope to gain from revenue synergies down the road, and its wealth strategy (which TD Ameritrade is a part of) will likely work in tandem with TD Commerce.

• TD's integration plan appears to be on track, including the rebranding of most branches in 2008 and 2009.

• The transaction is expected to dilute earnings per share by 10 cents in 2008 and is neutral in 2009, which is what we originally modeled.

Fair value adjustments impacted goodwill

Negative fair value adjustments on securities and loan books were higher than originally expected due to high liquidity premiums in the current market and, in our view, a deteriorating economic picture, but management believes the intrinsic value of many securities are higher.

• The transaction value at March 31 was US$7.5 billion, down from $8.4 billion at announcement due to the decline in TD's share price. However, the accounting purchase price uses the $8.4 billion value at announcement, and goodwill is expected to be $5.8 billion.

• Markdowns were greater than originally expected and reduced Commerce Bancorp's book value.

New capital ratios lower than we expected

We expected the Tier 1 ratio, which was 10.9% at Q1/08 under Basel II, to come down with the closing of the acquisition of Commerce and the changes in capital calculations for TD Ameritrade at the end of the year. But management's Tier 1 ratio forecast of 8.0% at year end including all adjustments is lower than our 8.5% estimate at fiscal year end.

• The capital impact of the Commerce transaction was about 200 basis points, which was higher than previously disclosed estimate of 120-145 basis points. Approximately half of the difference came from fair value adjustments recorded at closing, and half was due to higher-than-expected risk weighted assets from Commerce Bancorp.

Management stated that it is comfortable with a projected 8.0% Tier 1 ratio, but we believe it gives them very little room for slippage against profitability estimates. If the year goes as management plans, then we believe TD can improve the ratio quickly after Q4 because TD generates about 30-40 basis points of Tier 1 capital per quarter.

U.S. credit environment not good but TD expects to be a positive outlier

From a credit perspective, TD "will not be able to outrun a recession" but it is comfortable with its exposures and have provisioned for higher losses. This is the area that most concerns us versus management estimates.

• TD Bank expect higher credit losses, mainly as a result of a change in methodology for small business loans. Otherwise, non-performing loans were down QoQ at both TD Banknorth and Commerce.

• Run rate quarterly provision for credit losses of $75 million in Q3 through 2009 with Commerce is higher than normalized $40-45 million range, but the bank believes its credit performance will be better than peers.

• Marking the loan book to fair value at the closing of the transaction increases goodwill but decreases the need for provisions for credit losses in the near term.

Consumer loan portfolio (proforma $16 billion outstanding):

• The bank expects higher consumer loan losses as delinquencies are trending up, but within acceptable levels.

• Made up of: 48% home equity (just over half is from Commerce), 29% residential mortgage, 14% indirect auto and 9% other.

• In the HELOC portfolio, there is limited exposure to high loan-to-value collateral, with 76% of the home equity secured portfolio
having less than 80% loan-to-value at origination.

Commercial loan portfolio (proforma $30 billion outstanding):

• Made up of: 36% Investment real estate, 8% manufacturing, 8% health care, 7% retail trade, 6% wholesale, 5% finance/insurance,
31% other.

• Geography: 22% Massachusetts, 20% Metro NY, 18% Metro Pennsylvania, 17% North New England, 23% other.

• The bank noted that it had previously tightened underwriting standards and focuses on working out non-performers.

• The residential for sale portion (6% of total outstanding) of the investment real estate portfolio was highlighted as having some weakness, but other sectors appear to be performing as expected with no material negative trends.

Investment portfolio markdowns higher than expected

The negative marks on Commerce portfolios were higher than management originally expected. The bank stated that it did not sell any of Commerce's Alt-A book because it believes the intrinsic value is higher and future earnings will benefit from keeping it.

Investment portfolio ($26 billion) consists of:

• Mortgage-backed securities (non-agency Alt-A $3.7 billion and non-agency Jumbos $5.5 billion): majority older vintage (2005 or earlier), all securities remain AAA-rated and collateral 100% fixed rate mortgages with no rate reset features. TD states that it reviewed and stress tested in detail, and market value discounts are in excess of TD's worst case credit losses.

• The Alt-A portfolio, which was not sold at closing, was $4.7 billion at December 31, which implies a $1 billion writedown at closing.

• Asset-backed securities ($8.7 billion): asset pools consist of prime credit cards, prime autos, and government-backed student loan trusts. All are AAA-rated tranches of established securitization programs (predominantly sponsored by large US money centre banks), and there appears to be liquidity for these in current markets.

• Short-term agency discount notes ($7.8 billion): issued by government sponsored entities.

• Municipal bonds ($0.4 billion): terms less than a year.

Commerce updates at March 31, 2008:

• Deposit growth was 8% YoY and 1% QoQ. This growth rate is well below Commerce's historical average, probably due to funding pressure in wholesale markets leading larger banks to increase deposit rates in the retail market. Deposit margins continue to narrow reflecting competition.

• Loan growth was up 12% for consumer and up 16% for commercial. Loan spreads are widening.


TD (Outperform, Average Risk): Our 12-month price target of $69 is based on a price to book methodology. Our P/B target of 1.8x in 12 months is in the middle of our target for banks given its relatively lower exposure to headline risks and leading domestic retail franchise, offset by a lower ROE. It implies an approximate forward multiple of 10.8x earnings, compared to the 5-year average forward multiple of 12.2x.
Scotia Capital, 22 April 2008

TD Confirms US$310M in Synergies

• TD held a conference call on Monday, April 21, 2008 to discuss the financial implications of the Commerce Bancorp transaction which closed on March 31, 2008.

• TD reconfirmed synergies of US$310 million pre-tax to be realized by the end of 2009. Restructuring charges are estimated at US$420 million to be taken over the next two to three years.

U.S. P&C Earnings - 2008E Increased to $750M; 2009E $1.2B Unchanged

• TD provided earnings estimates for its new U.S. Personal & Commercial Banking segment which will include TD Banknorth and Commerce Bancorp. Q2/08 earnings excluding the Commerce Bancorp acquisition are expected to be $130 million versus $127 million in the previous quarter. Earnings for fiscal 2008 are estimated at $750 million up from the previous estimate of $700 million. The new estimate implies run rate earnings of $250 million per quarter for the segment with TD Banknorth contributing $130 million and Commerce Bancorp contributing $80 million with $40 million being made up by synergies. Fiscal 2009 earnings are forecasted to be $1.2 billion, unchanged from the previous estimate.

• The purchase price as of the announcement date of the transaction is $8.4 billion; however, TD estimates the economic value of the transaction to be $7.5 billion. The difference in values is due to the decline in TD's share price since October 2, 2007, the date the transaction was recorded.

• The purchase price of $8.4 billion represents 17.5x Commerce Bancorp estimated run rate earnings of $480 million (including synergies). The economic value of $7.5 billion represents 15.6x estimated run rate earnings.

Net Book Value - $1.5 Billion

• Based on the $8.4 billion transaction price, goodwill is estimated to be $5.8 billion with intangibles valued at $1.1 billion for a total of $6.9 billion. Based on an economic value of $7.5 billion, goodwill is estimated to be $4.9 billion or $6.0 billion including $1.1 billion in intangible assets.

• Therefore, the net book value of the transaction is $1.5 billion with the purchase price representing 5.6x net book value and the economic value representing 5.0x net book value.

• The net book value is lower than management originally estimated due to a fair value adjustment that was $400 million greater than originally estimated. This was partially offset by a greater-than-expected value of intangibles due to liquidity premium on core deposits.

Tier 1 Ratio Estimated to be 8.0% by End of 2008

• Management indicated on the conference call that the Tier 1 ratio at the end of fiscal 2008 is estimated to be 8.0% (including the impact of TD Ameritrade and Basel II), versus the bank group at 9.9%. The Commerce Bancorp transaction impacted the Tier 1 ratio by 200 bp, approximately 60 bp more than originally estimated. The Commerce Bancorp transaction added $30 billion to risk-weighted assets. An increase in risk-weighted assets contributed to half of the decline in Tier 1 and the fair value adjustment accounted for the other half.

Securities Portfolio Update

• TD provided an update on Commerce Bancorp's securities portfolio. The assets in the portfolio total $26.1 billion with $7.8 billion in short-term agency discount notes, $8.7 billion in asset-backed securities, $9.2 billion in mortgage-backed securities and $0.4 billion in municipal bonds. These values have been mark-to-market and represent fair value.

• Management stressed the restructuring process was largely for the purpose of mitigating interest rate risk and not credit risk as the majority of the portfolio remains rated AAA. All the securities are classified as available-for-sale.

TD Commerce Bank - America's Most Convenient Bank

• Both TD Banknorth and Commerce Bancorp will be rebranded as TD Commerce Bank in the U.S. TD plans to open an additional 25-35 new stores in the next year as well as refurbish existing TD Banknorth branches.

• TD is marketing the new TD Commerce Bank as "America's Most Convenient Bank".


• We view the acquisition of Commerce Bancorp as positive from a strategic standpoint and necessary to improve the bank's return on its U.S. retail platform. However, the price was very high in the context of the market. The transaction is negative in terms of the larger-than expected reduction of Tier 1 capital and higher fair value adjustments. Overall TD's favourable earnings mix with 85% of earnings from retail banking and strength of TDCT operating platform, we believe, will be the main driver of long-term share outperformance.

• Our earnings estimates are unchanged at $5.95 per share for 2008 and $6.70 per share for 2009. Our 12-month share price target is unchanged at $95 per share representing 16.0x our 2008 earnings estimate.

• Maintain 2-Sector Perform rating.

15 April 2008

BMO Sees Buying Opportunities in US

Reuters, Nicole Mordant, 15 April 2008

Bank of Montreal expects the tough economic environment in the United States to create acquisition opportunities for its U.S. operations for at least the next 12 months, executives at Canada's fifth-biggest bank said on Tuesday.

"We believe with the current environment, there will be more opportunities at better prices than in the past and we are monitoring these very closely," said Ellen Costello, chief executive of Harris Bankcorp, BMO's U.S. retail bank.

Costello said several banks in the U.S. Midwest, Harris's key market, were either in trouble because of their exposure to problem areas of the real estate market, or were preoccupied with internal issues.

"All of these things represent opportunities for us that are unprecedented," she said during a half day of presentations to investors and analysts in Toronto.

Asked if BMO and Harris were interested in National City Corp, a troubled Midwest bank that is effectively on the sales block, BMO Chief Executive Bill Downe told Reuters: "We have an active group that is constantly talking to other banks, so when something pops up in the newspaper I am pretty confident that we have done background work...It is a matter of degree."

Downe said there was no rush to make a purchase as the opportunities coming out of this tight credit cycle were likely to be around for at least a year.

The Wall Street Journal reported last week that Bank of Nova Scotia, Canada's third-biggest bank, had jumped into the bidding for National City, a Cleveland, Ohio-based lender that is suffering from mortgage-related losses in the hard-hit Ohio and Michigan real estate markets.

Downe said that with 8,000 banks in the United States, there will certainly be consolidation. The Midwest is also a more fragmented banking market than many other areas.

Harris and BMO have experienced a rise in provisions for credit losses because of exposure to the weakening U.S. housing market, but executives said the hit was much lower than at their competitors.

"Our exposure to U.S. developer and investor-owned real estate is well below the peer group, which should help us as we move through the cycle," said Tom Flynn, BMO's recently appointed group chief risk officer.

BMO is also scouting for small acquisitions in private banking and asset management in the United States, Gilles Ouellette, chief executive of BMO's private client group said.

In Canada, wealth management prospects are hard to find and tend to be expensive, he said.
Financial Post, Duncan Mavin, 15 April 2008

Bank of Montreal's top U.S. executive says banks in the Midwest are cheap right now thanks to the credit crunch and buying them is "a key priority."

"We believe with the current environment there will be more opportunities and at better prices than in the past," said Ellen Costello, chief executive of BMO's Chicago-based Harris Bankcorp Inc. subsidiary.

The banking market in and around Chicago is fragmented and ripe for consolidation, she added.

Harris completed a deal for First National Bank & Trust in Indiana last year and announced the acquisitions of Ozaukee Bank and Merchants and Manufacturers Bancorporation, Inc. in Wisconsin. The BMO unit now has 270 branches in the Midwest, and about 1.2-million customers, compared with 982 BMO branches in Canada, and more than 7-million domestic BMO customers.

Ms. Costello's comments at a BMO investor day in Toronto come after BMO CEO Bill Downe told the Financial Post earlier this month he would be in a position to "take advantage" of the turmoil in the U.S. banking sector in the second half of 2008.

"There is going to be some pressure on mid-sized regional banks [in the United States] and that will create opportunities for consolidation," Mr. Downe said.

The BMO chief is not the only Canadian bank that is eyeing opportunities in the region. Mr. Downe could find one of his Canadian peers has become a big rival in the U.S. Midwest if Bank of Nova Scotia follows through on its interest in Cleveland-based National City Corp. It emerged last week that Scotiabank is one of several banks in negotiations to possibly acquire all or a part of the 1,400 branch bank, which operates throughout the Midwest. (NCC moved into Harris' Chicago heartland when it bought 82-branch MAF Bancorp Inc. in the area last year.)

Analysts say Scotiabank could buy a meaningful stake in NCC for as little as US$1-billion since NCC's stock price has plummeted in recent months on fears about its book of bad loans. Speaking at the BMO investor conference, Mr. Downe refused to be drawn on questions about why BMO was not named among potential bidders for NCC, although he said BMO is focused on "high quality" banks.

If Scotiabank, or a big U.S. bank, buys into NCC, it will be following quickly on the heels of Bank of America, which also muscled in on BMO's Chicagoland turf last year when it bought LaSalle Bank. Harris executives say one benefit to them from that transaction has been that some former employees of LaSalle have moved over to Harris. Ms. Costello said a shakeup in ownership in NCC could have a similar effect, sending "talent" over to Harris.

Scotiabank Favours Latin America & Asia Over US

Bloomberg, Sean B Pasternak, 15 April 2008

Bank of Nova Scotia, Canada's second-largest bank, will look at ``opportunities'' in the U.S. although expansion there isn't a priority, Vice Chairman and Chief Administrative Officer Sabi Marwah said.

``We think we have several other places to invest,'' Marwah said in an interview in Toronto today after announcing a partnership with Western Union Co., the biggest U.S. money- transfer business.

Scotiabank may buy ``at least a stake'' in Cleveland-based National City Corp., the ninth-biggest U.S. bank, according to a report April 10 in the Wall Street Journal. Marwah declined to comment on the report. National City has a market value of almost $5 billion.

Acquisition priorities include Mexico, Central America, South America and the Caribbean, although the bank wouldn't rule out U.S. purchases, he said. Scotiabank has operations in 50 countries, and gets about a third of its profit from outside Canada.

``We are strong on a relative basis compared to our U.S. peers, and when those opportunities arise, we never say never,'' Marwah said. ``We're going to do it on our terms, and what works for us, fits into our strategy. And that hasn't changed.''

Marwah said that buying asset managers in Canada would be a ``high priority'' for Scotiabank. The bank owns the smallest mutual-fund franchise by assets among the five main Canadian banks.
The Globe and Mail, Tavia Grant, 15 April 2008

Bank of Nova Scotia calls itself Canada's most international bank, and it's looking to get even more global.

Scotiabank remains on the acquisition prowl, principally in Mexico, the Caribbean and other parts of Latin America. The U.S., where valuations are becoming more attractive, is not a priority though, Sabi Marwah, vice chairman and chief administrative officer, said in an interview Tuesday.

His comments came amid reports that Scotia is interested in National City Corp., a troubled Cleveland-based bank, which would mean a $5-billion foray into the U.S. retail banking market.

Opportunities in the U.S. are “opening up,” and Scotiabank is looking at them, but “the U.S. is not priority No. 1 at all,” Mr. Marwah said.

He said parts of Asia remain interesting for the bank. India and China are tough markets to enter because of their regulatory environment, but the bank is keen on boosting its presence in other Asian markets. It already owns about one-quarter of Thanachart Bank, Thailand's eighth largest bank, with the option of boosting that stake, “so we will look to build on that presence,” Mr. Marwah said.

It may also boost its presence in Malaysia and Taiwan, but “we will do it on our terms and what works for us.”

Another “high priority” continues to be building Scotiabank's market share in Canadian wealth management, he added. The bank snapped up wealth management DundeeWealth Inc. in January.

Mr. Marwah was speaking in Toronto, at an announcement that the bank will partner with Western Union Co. to offer money transfer services to its customers across the country. The new service will be available online or through any of Scotia's 1,000 branches, where people can send money to 200 countries around the world.

Canadians send about $5-billion a year in remittances, Western Union estimates.

14 April 2008

Diverging Analysts Opinions on Bank Stocks

Financial Post, Jonathan Ratner, 14 April 2008

If you’ve done well with Canadian financials during the past few weeks, congrats. But its time to sell at least some of the Canadian bank stocks you’re holding, says one analyst, because waiting to see what the earnings from U.S. banks look like may cost you.

Recent market optimism is misplaced and another round of securities losses and a weaker earnings outlook for U.S. banks will continue to weigh on valuations there, according to Dundee Securities’ John Aiken, who said this will infect Canadian banks as well. However, he does not believe they will have to raise additional common equity or cut dividends.

While the analyst admits that valuations are cheap and very attractive for long-term investors, he expects continued pressure during the next six months will yield a much better entry point.

“We firmly believe that investors should take some early gains and sell into this rally,” Mr. Aiken said of Canadian bank stocks.

Investor behaviour has shown that incremental write-downs and capital infusions both at U.S. and European banks have been viewed positively at times, due to hopes that the end may be near as balance sheet relief arrives. But “Don’t kid yourself, more pain is coming,” and the earnings outlook for this sector is weak, Mr. Aiken told clients in a note.

He believes that consensus earnings estimates are too high and will need to come down to better reflect declining wholesale revenues and “rising provisions from deteriorating credit quality as a result of U.S. recession.” As a result, he said true price-to-earnings ratios are higher than they appear.

While Mr. Aiken is more confident in the Canadian banks given their ability to withstand significant pre-tax write-downs, he cut his second earnings estimates for each of Canada’s Big 6 banks as a result of “the significantly weaker environment for capital issuances and merger and acquisition activity.” He forecasts that each of their advisory revenues for the coming quarter will match their weakest level of the past four years. Even if the BCE deal closes– the only major M&A action around – it is expected to be included in the banks’ third quarter earnings. And as for trading revenues, Dundee’s expectations that the market volatility will subside somewhat later in the year, likely means declines there too.

Mr. Aiken said he is more concerned near-term about names like Royal Bank, Toronto-Dominion and Bank of Montreal since they have U.S. retail exposure, but feels that all of the Big 6 will experience deteriorating credit quality. BMO, Bank of Nova Scotia and National Bank meanwhile, were cited as having more risk given their higher levels of business lending exposure. He has increased his provisions for credit losses for all of the banks and expects others will do the same.

Mr. Aiken continues to rate BMO, CIBC and Royal at "sell," but cut TD, Scotia and National to "neutral" from "buy."
Financial Post, Jonathan Ratner, 11 April 2008

Loan loss provisions may rise and earnings growth may moderate to 5% to 10%, but UBS analyst Peter Rozenberg doesn’t think this will have a negative impact on earnings per share (EPS) at Canadian banks. Instead, it is projected capital market revenues that may lead to a decline in EPS.

But he suggested this risk will be likely be captured by the second or third quarter. And given that the market is increasingly discounting peak provisions, Mr. Rozenberg thinks bank stocks will eventually re-rate higher and have largely bottomed.

“Credit costs are increasing but remain stable,” he told clients in a note, adding that the structural underpinnings for significant credit losses are not evident. The analyst also noted that business loan provisions would have to quadruple to match the levels of previous peaks.

So while returns on equity (ROE) are expected to decline as economic growth slows, provisions rise, capital market revenues dip and de-leveraging continues, Mr. Rozenberg continues to think valuations are attractive given this contained credit risk. In fact, while price-to-book ratios for Canadian bank stocks are relatively high at 2.0 times versus 1.2x for their U.S. counterparts, ROEs are nearly twice as high.

However, the analyst did note that there has been a 94% correlation between the performance of Canadian and U.S. banks during the past 12 months. And while the U.S. backdrop continues to be negative, “banks typically lead recoveries and monetary and fiscal policies have been aggressive with more action likely, although details are still lacking,” he said.

Mr. Rozenberg estimates the downside risk for Canadian bank stocks at 10%, but with upside at 20% to 25% for the next year.

11 April 2008

Scotiabank Eyes US Acquisition

The Globe and Mail, Tara Perkins, 11 April 2008

Bank of Nova Scotia, Canada's most international bank, is considering diving in to the lucrative but troubled U.S. banking sector.

Scotiabank has long focused on building its network in Mexico, Central America and the Caribbean, and more recently in Asia. Now it is sticking its neck out to take a look at National City Corp., a Cleveland-based bank that's been stung by the U.S. housing crisis. It has a network that stretches through Ohio, Florida, Illinois, Indiana, Kentucky, Michigan, Missouri and Pennsylvania.

Analysts were cautiously optimistic about the prospect.

“If there were ever a time to do it, now would be the time,” CIBC World Markets analyst Darko Mihelic said.

“If Scotiabank's buying this, they're going to buy it for a great price,” he said. “When you combine that with the typical Scotiabank due diligence, it's probably going to be a good thing for Scotia.”

National City said at the start of the month that its board was reviewing a range of strategic alternatives and had hired Goldman Sachs as an adviser. Its stock has plunged 75 per cent in the past year, and it appears to be under pressure to recapitalize or find a buyer before it reports its first-quarter earnings on April 22, said National Bank Financial analyst Rob Sedran.

The Wall Street Journal first reported yesterday that Scotiabank has joined a relatively small list of U.S. banks and private equity firms that have expressed an interest in buying a stake in the bank or doing a full takeover. KeyCorp and Fifth Third Bancorp have made offers while New York private equity firm Corsair Capital LLC is considering one, the report said.

Scotiabank declined to comment on the report, but industry sources confirmed the bank is interested. And its lack of a retail banking network in the U.S. might give it an advantage over U.S. rivals who would have to close branches and cut employees because of overlap.

A deal would propel Scotiabank into consumer banking in the U.S.

The bank “has a reputation as a shrewd acquirer, which we believe makes this interest understandable,” Mr. Sedran said in a note to clients. The big challenge will be accurately assessing how much risk National City carries.

“Obviously, National City is struggling,” Mr. Sedran wrote. “However, if it can be recapitalized and stabilized, the long-term strategic advancement would be significant.”

Bank of Montreal analyst Ian de Verteuil estimates National City might need an equity infusion of about $4-billion. “This is the upper end of what we believe [Scotiabank] would be prepared to invest,” he wrote in a note to clients.

Numerous analysts said National City's Midwest presence meshes nicely with Bank of Montreal's U.S. bank, Harris Bank. They suggested that BMO is missing an opportunity because of its problems related to the credit crunch. But they also suggested that, if Scotiabank does the deal, a combination with BMO could be more likely down the road.

“Scotia had long ago been interested in buying BMO. If [Canadian bank] mergers ever do come back, I think that that would in fact make it more plausible for Scotia to buy BMO,” Mr. Mihelic said. Federal rules currently prohibit Canada's big banks from merging.
Reuters, Nicole Mordant, 11 April 2008

A stake in troubled bank National City Corp could be a shrewd and cheap way to give Bank of Nova Scotia its first foothold in U.S. retail banking, analysts said on Friday.

The Wall Street Journal reported late on Thursday that Canada's second biggest bank has jumped into the bidding for National City, which is under regulatory pressure to bolster its capital, or find a buyer, before reporting quarterly results this month.

Scotiabank spokesman Frank Switzer said the Toronto-based bank doesn't comment on rumor or speculation.

But analysts said the report was likely true, even though Scotiabank's strategy for expanding its retail banking operations internationally has excluded the United States in favor of countries in Latin America and the Caribbean.

"It is a little off strategy for Scotiabank to be looking at National City. But Scotia has also said if they do go into the United States it will likely be by buying into a distressed asset," said CIBC analyst Darko Mihelic.

"Scotia buys stuff all over the world at distressed prices and their due diligence is extremely strong. Taken together, I would be supportive of a deal, as long as the price is right," Mihelic told Reuters.

Shares of Scotiabank fell harder than those of its peers on the Toronto Stock Exchange, closing down C$1.21, or 2.6 percent, at C$45.52 on Friday, amid a broad selloff.

The Wall Street Journal said Scotiabank, which has a market value of about C$46 billion ($45 billion), is eyeing at least a stake in National City.

Ohio-based National City has seen its market value plunge 48 percent this year to about $5 billion under the strain of mortgage losses, exposure to the hard-hit Ohio and Michigan real estate markets, and a badly timed foray into Florida.

Its shares fell 46 cents, or 5.2 percent, to $8.45 on the New York Stock Exchange on Friday.

"National City would probably view Scotiabank as a white knight that would allow a recapitalization of the bank without the culture clashes that would arise from an in-market merger," BMO Capital Markets analyst Ian de Verteuil said in a note to clients.

He suggested that National City could need a capital infusion of about $4 billion, which he believed was the "upper end" of what Scotiabank would be prepared to invest.

A handful of U.S. banks and private-equity firms already have expressed interest in helping to shore up National City's balance sheet, the Journal said.

On April 1, National City said its board was reviewing a range of strategic alternatives.

Blackmont Capital analyst Brad Smith said it would make sense for Scotiabank to start off with a minority interest to get "better plugged into" the U.S. market.

Scotiabank's peers, such as Royal Bank of Canada and Toronto-Dominion Bank , already have sizable retail operations in the United States although analysts differ on how successful those forays have been.

There has been much speculation recently in Canada on whether the big domestic banks, which have weathered the global credit crunch much better than their U.S. counterparts, might look for bargains down south.

Corsair Capital LLC, a New York private-equity firm focused on the financial-services sector, is also considering making a bid for National City, the Journal said.

Fifth Third Bancorp and Cleveland rival KeyCorp have also been mentioned as interested parties.
Financial Post, Jonathan Ratner, 11 April 2008

Reports that the Bank of Nova Scotia has joined private equity players in the bidding for a stake in troubled Cleveland-based lender National City Corp. may come as little to surprise to some, since the Canadian bank may be in a more secure position for a major acquisition than some of its U.S. rivals that have been hit by the credit crisis.

Scotiabank is also the most international of Canada’s banks, so it may be trying to establish a retail and commercial banking presence in the U.S. like its domestic rivals.

National City, with a market cap of roughly US$5.5-billion, has demonstrated several distress signals related to the U.S. housing and subprime mortgage slump, said Desjardins Securities analyst Michael Goldberg. It also cut its most recent quarterly dividend by 49% and on April 1 announced that Goldman Sachs had been hired as an advisor to review strategic alternatives.

But if Scotiabank is considering an investment in National City, Mr. Goldberg thinks it would be an opportunistic move, not a strategic one like its investment in Japan’s Shinsei Bank because the risks are too unclear and the franchise is mediocre. National City looks like it needs an injection of capital, much like lender Washington Mutual Inc., which raised US$7-billion this week after its subprime loan losses drained its capital.

Scotiabank also has risk management expertise that could be valuable to National City, Mr. Goldberg said in a note to clients, adding that both of these roles could prove very lucrative to the Canadian bank.

In a time when the market is very nervous about retail banking in the U.S., such a move would be a major strategy shift. But Jason Bilodeau, analyst at TD Newcrest, said he is giving management the benefit of the doubt given its strong track record and ability to “scrub the books” on acquisitions. He called National City an “interesting” asset for Scotiabank to start with given its challenging balance sheet and loan book.

So while investors may be skeptical about a deal, “strategically it makes sense to us to buy assets when others are weakened and looking to sell,” the analyst said in a note, adding that Scotiabank has an estimated $4 to $5-billion of excess capital on hand. However, given the current environment, they may want to maintain a solid cushion.

Mr. Bilodeau also thinks other Canadian banks will become more active in buying U.S. retail assets as prices come down, with Bank of Montreal and Royal Bank expected to lead the way.

09 April 2008

Scotia Capital Modestly Reduces EPS Estimates of Life Insurance Cos


• We're doing a little housekeeping with respect to our EPS estimates, reflecting updated economic data as at the end of Q1/08, and slightly revised economic assumptions going forward.

What It Means

• We're reducing 2008 EPS estimates for GWO and MFC each by 1% in 2008, and reducing SLF by 2%. We're reducing 2009 EPS estimates for GWO, MFC and SLF each by 1%. We're leaving IAG unchanged.

• We've reduced our estimate for an average YOY change in the S&P500 from down 3% to down 4%. We're leaving our average expected YOY change in the S&P/TSX at down 1%. This implies the S&P/TSX is relatively flat throughout the remainder of 2008, and the S&P500 is up 8% by the end of 2008, consistent with our strategist. Should the S&P500 remain flat throughout the rest of 2008 we could reduce our EPS estimates by a further 3% for GWO, 5% for MFC and 2% for SLF.

• We've modified FX assumptions to reflect a weaker GBP (hurts GWO) and a stronger JPY (helps MFC).

• We've also reduced SLF EPS by $0.05 in 2008 to reflect the negative impact of widening credit spreads on BV guarantees on U.S. fixed annuity business.;

08 April 2008

2008 League Table

Financial Post, Barry Critchley, 8 April 2008

RBC Capital Markets, the investment banking arm of Royal Bank, has emerged, yet again, as the country's leading underwriter for Canadian corporate and government issuers in the annual league tables compiled by the Financial Post. On a full credit to lead manager/book-runner basis -- see attached table for an explanation for the terms used in compiling the tables -- RBC led 202 deals for its clients in 2007. Those deals raised $40.81-billion. In 2006, when RBC was also the winner, the firm was lead manager or ran the books for 264 deals, which raised $41.59-billion.

"We are pleased to be recognized in this fashion. We are pleased to see our clients recognize us and give us their business. That's what our whole organization is focused on, earning that privilege," said Chuck Winograd, the chairman of RBC Capital.

In all, Canadian issuers raised $223.26-billion of capital last year in 1,999 deals. Those financings were done in both the domestic and international markets. And they include all the forms of financing that meet the criteria set up by the FP.

In 2006, the comparative numbers were 1,959 deals and $202.58-billion. Accordingly, in 2007, issuers raised 10% more capital than they did the year before -- on about 3% more deals.

Debt was, by far and away, the most popular form of capital raised last year. In total, corporations and governments raised $167.52-billion in 526 deals.

Of that amount, corporations raised $86.45-billion. Accordingly, a mere $55.83-billion (or about 25% of the total capital raised) was in the form of equity.

As with the 2006 rankings, TD Securities was the runner up in 2007, behind RBC on a full credit to lead manager basis. TD led 107 deals which raised $30-billion.

CIBC World Markets won the bronze medal. It ran the books on 183 deals -- second behind RBC -- which raised $25.7-billion.

These three firms were comfortably ahead of the rest of the pack.

Rounding out the top 10 are three Canadian bank-owned firms -- BMO Capital Markets, Scotia Capital and National Bank Financial.

Four foreign firms also appear in the top 10: Merrill Lynch, Citigroup, Barclays Bank and Deutsche Bank. Merrill, the largest of the foreign dealers operating in Canada, was the leading non-Canadian firm: 29 deals which scooped up $13.4-billion.

07 April 2008

Scotia Capital Again Recommends Aggressively Buying Bank Stocks

Scotia Capital, 7 April 2008

Banking Siege - Nine Months and Counting - Buy Banks

• The Banking Siege is into its ninth month and counting. Canadian Bank stocks continue to be extremely volatile reacting to every gyration in the credit markets. Bank stocks have been under constant downward pressure since the credit crisis began in August 2007 re-coupling with U.S. Banks at a time when we believe decoupling would be in order.

• The bank index has rebounded 11% from the lows reached on March 17 (Bear Stearns Rescue). The Bear Stearns Failure/Rescue we believe is an important step for the market in grinding through the financial and credit crisis. In fact a financial failure is usually needed before any stability is achieved. Prior to the recent bounce the bank index was down 16% year-to-date. The bank index remains in underperformance territory down 7% year-to-date versus the market's decline of 1% with BMO a major outlier down 16%.

• The bank group's release of solid first quarter operating earnings with modest writedowns has done little to ease market fears about future asset writedowns, balance sheet risk and earnings levels in an economic downturn. Consequently, Canadian bank stocks are being impacted, not surprisingly, by the negative global sentiment towards the financial services sector. Investors have a heightened awareness of systemic risk and are pricing for it.

• What we underestimated was the global players' exposure and leverage contained within to the U.S. sub-prime market and how negatively it could impact credit markets and liquidity and the degree of investor panic towards the sector indiscriminately. We suspect that the volatility and panic has been enhanced by large pools of capital in hedge funds especially influential in periods of fearful and illiquid markets.

• We view Canadian banks' balance sheets as strong. We expect future asset writedowns to be modest and expect bank earnings to be resilient in a recession with ROE a conservative 15% plus. Dividends we believe are safe with dividend growth moderating in 2008 before returning to double digit growth levels as stability is restored in the credit markets.

• Bank first quarter operating earnings were solid with extremely high return on equity of 22%, although operating earnings did decline 2% YOY after five years of 15% growth.

• Bank cumulative writedowns as at January 31, 2008 have been relatively modest representing only one quarter of bank earnings with writedowns at RY, TD and BNS nominal.

• Despite relatively strong earnings, low exposure to high risk assets, modest writedowns and generally solid fundamentals, Canadian bank stocks have seen major declines in their market capitalizations by a magnitude not seen before. This may be the largest discount for systemic risk in history.

• The bank group market capitalization decline for Canadian Banks has been very sharp in contrast to its writedowns. (Bank Quarterly Review, First Quarter 2008). Bank market capitalization has declined by $62 billion against writedowns of $4.7 billion or 13x.

• Excluding CIBC, the market capitalization decline is 24x (writedown ratio) the writedowns for the bank group as at January 31, 2008. If we set a writedown ratio at an aggressive 6x the market would be discounting a further $9 billion in bank writedowns which does not seem feasible given their exposure to the high risk assets.

• The writedown ratio in the LDC crisis in early 1980s and in the Commercial Real Estate debacle in the early 1990s was 1.8x and 2.3x respectively. If we apply these types of ratios the market would be discounting future losses of $34 billion which we believe is not feasible.

• Future loan losses in a recession are a very valid concern. Loan loss provisions for the bank group in 2007 were $2.8 billion or a modest 27 bp of loans. We believe that 2006 was the trough and that loan losses will rise steadily over the next five years. However we believe that loan losses will peak at much lower levels than historical norms due to major loan mix shifts and the impact to earnings will be much lower than the past due to lower leverage, higher capital levels and larger earnings base. If loan loss provisions double to $5.6 billion in the next three to four years the earnings drag is 9%. The market in our view has already discounted extreme scenarios. If we were to triple LLPs in the next five to ten years to $8.4 billion or incremental drag of $5.6 billion pre-tax ($3.6 billion after-tax) this seems pale by comparison to the market capitalization decline over the past nine months.

• The market capitalization decline as of the date (March 10, 2008) of our first publication of the writedown ratio analysis was $76 billion with the decline being $82 billion as at March 17 (Bear Stearns Rescue). Sentiment, fear and short interests we believe are the major share price drivers.

• As highlighted in our Short Interest Report (February 12, 2008), short interest in Canadian Banks has increased to meaningful levels in the past year versus negligible short interest in the last credit scare of 2002 (Telco/Cable/Power/Power Generation).

Canadian/U.S. Banks - Re-coupling - Why?

• It is interesting that the Canadian and U.S. Bank Index correlation (R2) has been historically very high at 96% but significantly decoupled over the past five years with low correlation of 34% based on what we believe is significant differences in operating performance. However since the current credit crisis began in August 2007 the correlation has increased to 83% as the market has not differentiated between Canadian and U.S. Banks despite significant differences in balance sheet risk, earnings and banking environments.

Bank Valuation - Already Discounting a Recession

• In our view bank valuations are already discounting a recession. The banks trailing P/E multiple declined to a low of 9.4x on the Bear Stearns Rescue (March 17, 2008) slightly above the Asia Crisis bottom in 1998 of 8.9x. The bank current trailing P/E multiple is 10.6x similar to the bottom in Telco/Cable Credit crisis in 2002.

• Bank P/E multiples are extremely compelling at 10.4x and 9.3x on our 2008 and 2009 estimates. Our estimates have some modest vulnerability to continued grid lock in the credit markets and slowing economy.

• Bank P/E multiples are a 7% discount to U.S. banks despite higher return on equity, higher capital, lower exposure to high risk areas and a more favorable banking and economic environment. The bond market and the currency markets have revalued Canada favorably versus the U.S. over the past 15 years. But not the equity markets. Yet?

• Bank dividend yields relative to bonds continue to be near all time highs at 121% or 5.8 standard deviations above the mean. Bank dividend yield versus the TSX, Pipes and Utilities are also at all time highs.


• We continue to recommend aggressively buying bank stocks at these levels. As fear subsides, we expect share prices to move up sharply. We see strong fundamentals and compelling valuation.

• We would recommend moving to your maximum allowable weightings in bank stocks. We have only buys and strong buys in the bank group with no sells or holds on an absolute return basis.

• Maintain our 1-Sector Outperforms on RY and CWB. Maintain 2-Sector Performs on TD, CM and NA. Maintain 3-Sector Underperform on BMO and LB.

• Our stock picks in order of preference are RY, CWB, TD, CM, NA, BMO, LB.