Scotia Capital, 6 May 2008
Overview
• Banks begin reporting second quarter earnings May 27. We are trimming our 2008 and 2009 earnings estimates 2% and 3%, respectively, due to slowing economic activity and difficult capital markets. Return on equity is expected to remain in the 20% range.
• We are expecting second quarter earnings to decline 2% YOY and 5% QOQ due to a drag from the appreciating Canadian dollar (Exhibit 14) and lower wholesale banking earnings. We expect ROE to remain high at 20.5% for the quarter. We expect MTM writedowns to be modest except for CM. CM could potentially recognize a $1 to $2 billion MTM this quarter with the market factoring in some of this.
• We expect earnings momentum (Exhibit 5) to remain negative in Q3 shifting to positive growth in Q4/08. The reacceleration in earnings momentum in Q4 is expected to be a catalyst for dividend increases.
• Bank stocks have bounced nicely from the March 17 (Bear Stearns rescue) lows but they still have a lot of upside.
• Canada's superior banking system, solid economy with well capitalized banks with high quality balance sheets is a competitive advantage.
• We continue to recommend aggressively buying the bank stocks.
Banks Begin Reporting Second Quarter Earnings May 27
• Banks begin reporting second quarter earnings, with Bank of Montreal (BMO) and Bank of Nova Scotia (BNS) on May 27, followed by Toronto-Dominion Bank (TD) and Laurentian Bank (LB) on May 28, Canadian Imperial Bank of Commerce (CM), National Bank (NA) and Royal Bank (RY) May 29 and Canadian Western (CWB) closing out reporting June 5. Scotia Capital’s earnings estimates are highlighted in Exhibit 1.
Trimming 2008 and 2009 Earnings - ROE 20%+
• We are trimming our 2008 and 2009 earnings estimates for the bank group by 2% and 3% (Exhibit 2), respectively due to economic deterioration and difficult capital markets environment. Scotia Capital Economics has lowered its 2008 GDP forecast to 1.3% from 1.5% and 2009 to 1.9% from 2.0%.
Retail NIM Attempting to Stabilize?
• Domestic retail banking earnings are expected to be relatively solid this quarter, although, net-interest income may decline sequentially due to fewer days in the quarter. The retail net interest margin continues to have very difficult YOY comparisons, with the margin expected to decline 14 bp YOY in Q2. If the retail NIM stabilizes in the 280 bp range we expect YOY comparisons (Exhibit 13) to improve substantially in Q4/08. We expect the retail net-interest margin to show signs of stabilizing in the quarter after essentially declining since 2001 (briefly stabilizing slightly in 2005 and 2006). We expect RY and TD to lead the bank group in retail banking revenue and earnings growth, given the strength and size of their platforms.
Narrower Credit Spread/Steeper Yield Curve - Bodes Well for Overall NIM
• The prime-BA spread has returned to more normal levels at 165 bp up from 154 bp in the previous quarter but similar to 166 bp a year earlier. The credit spreads have improved recently and the yield curve has steepened which should help the banks overall net interest margin going forward. The BA-T-Bill spread improved immensely declining from the record high of 215 bp (March 17) to 58 bp. This level is still higher than the normal 20-30 bp range.
Wealth Management - Solid but Muted Growth
• Wealth management earnings are expected to be weak due to a decline in retail brokerage activity and lower growth in mutual fund assets. Year-over-year comparisons may be difficult as the 2007 RRSP season was the strongest on record and market activity was robust. Although equity markets were down versus a year earlier with the exception of the S&P/TSX, average bank mutual fund assets increased 5%. The growth in AUM may result in modest year-over-year improvement in Wealth Management earnings. Comparisons will become less difficult beginning in Q3/08.
• RY led the industry in net sales this quarter with solid LTA sales and very strong money market net sales.
International Banking - Negative Impact from Appreciating C$
• International earnings are expected to remain under pressure this quarter as the result of the appreciating Canadian dollar. The Canadian dollar appreciated (Exhibit 14) an average of 13% versus the U.S. dollar and 10% versus the Mexican peso from a year earlier. We expect the currency drag to lessen by Q3/08 and be fully removed by the fourth quarter.
• TD Ameritrade is expected to contribute C$67 million or C$0.09 per TD share in the second quarter versus C$0.12 per share in the previous quarter and C$0.10 per share a year earlier.
• Second quarter earnings are expected to include RY's acquisition of Alabama National which closed on February 25, 2008 while TD's acquisition of Commerce Bancorp will not be reflected until Q3/08 earnings are released.
Wholesale - Last Quarter of Meaningful Writedowns
• Wholesale earnings are expected to be weak again this quarter due to lower capital markets activity and continuing writedowns in the trading book although modest.
• We expect trading revenue to be weak due to continued market volatility and increased risk aversion on the part of the banks. The lower number of M&A deals is also expected to be a drag on earnings. The number of M&A deals that closed in the quarter declined 12% sequentially and 6% from a year earlier and the value of closed deals was flat QOQ and declined 39% from a year earlier. The value and number of pending M&A deals declined 24% and 12%, respectively.
• CM remains the one bank with the potential for significant further writedowns. Our guesstimate is that CM could take an additional writedown of $1 to $2 billion ($650 million to $1.3 billion after-tax or $1.70 per share to $3.40 per share) on its hedged and unhedged CDO exposure. The other Canadian banks are expected to have modest writedowns. We believe this quarter will represent the last quarter of meaningful writedowns for the bank group.
LLPs to Increase Modestly
• On a quarterly basis, we expect loan loss provisions to increase to $1,200 million or 0.42% of loans (Exhibit 15) for the bank group up 16% sequentially and 77% from a year earlier. Although the growth rates are high the incremental loan loss provisions from a year earlier are a moderate $523 million. We believe loan loss provisions are very manageable. We expect LLPs to peak in 2010-2012.
Dividend Increases on Hold until Q4/08
• TD increased its dividend 4% to $2.36 per share from $2.28 per share in Q1/08, the only bank to do so. We believe dividend increases will be put on hold for Q2 and Q3. Dividend increases are expected to resume in the last quarter of 2008 with the potential for dividend increases in the 5%-10% range across the board. This would coincide with the reacceleration of earnings growth in Q4/08 after three quarters of negative earnings growth due to the appreciation of the Canadian dollar.
Recommend Aggressively Buying Banks at These Levels
• Canadian banks are currently trading at 11.0x 2008 earnings estimates and 9.9x 2009 earnings estimates, near all time lows. We remain overweight the bank group and recommend aggressively buying bank stocks. Our order of preference remains RY, CWB, TD, CM, NA, BMO and LB.
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Overview
• Banks begin reporting second quarter earnings May 27. We are trimming our 2008 and 2009 earnings estimates 2% and 3%, respectively, due to slowing economic activity and difficult capital markets. Return on equity is expected to remain in the 20% range.
• We are expecting second quarter earnings to decline 2% YOY and 5% QOQ due to a drag from the appreciating Canadian dollar (Exhibit 14) and lower wholesale banking earnings. We expect ROE to remain high at 20.5% for the quarter. We expect MTM writedowns to be modest except for CM. CM could potentially recognize a $1 to $2 billion MTM this quarter with the market factoring in some of this.
• We expect earnings momentum (Exhibit 5) to remain negative in Q3 shifting to positive growth in Q4/08. The reacceleration in earnings momentum in Q4 is expected to be a catalyst for dividend increases.
• Bank stocks have bounced nicely from the March 17 (Bear Stearns rescue) lows but they still have a lot of upside.
• Canada's superior banking system, solid economy with well capitalized banks with high quality balance sheets is a competitive advantage.
• We continue to recommend aggressively buying the bank stocks.
Banks Begin Reporting Second Quarter Earnings May 27
• Banks begin reporting second quarter earnings, with Bank of Montreal (BMO) and Bank of Nova Scotia (BNS) on May 27, followed by Toronto-Dominion Bank (TD) and Laurentian Bank (LB) on May 28, Canadian Imperial Bank of Commerce (CM), National Bank (NA) and Royal Bank (RY) May 29 and Canadian Western (CWB) closing out reporting June 5. Scotia Capital’s earnings estimates are highlighted in Exhibit 1.
Trimming 2008 and 2009 Earnings - ROE 20%+
• We are trimming our 2008 and 2009 earnings estimates for the bank group by 2% and 3% (Exhibit 2), respectively due to economic deterioration and difficult capital markets environment. Scotia Capital Economics has lowered its 2008 GDP forecast to 1.3% from 1.5% and 2009 to 1.9% from 2.0%.
Retail NIM Attempting to Stabilize?
• Domestic retail banking earnings are expected to be relatively solid this quarter, although, net-interest income may decline sequentially due to fewer days in the quarter. The retail net interest margin continues to have very difficult YOY comparisons, with the margin expected to decline 14 bp YOY in Q2. If the retail NIM stabilizes in the 280 bp range we expect YOY comparisons (Exhibit 13) to improve substantially in Q4/08. We expect the retail net-interest margin to show signs of stabilizing in the quarter after essentially declining since 2001 (briefly stabilizing slightly in 2005 and 2006). We expect RY and TD to lead the bank group in retail banking revenue and earnings growth, given the strength and size of their platforms.
Narrower Credit Spread/Steeper Yield Curve - Bodes Well for Overall NIM
• The prime-BA spread has returned to more normal levels at 165 bp up from 154 bp in the previous quarter but similar to 166 bp a year earlier. The credit spreads have improved recently and the yield curve has steepened which should help the banks overall net interest margin going forward. The BA-T-Bill spread improved immensely declining from the record high of 215 bp (March 17) to 58 bp. This level is still higher than the normal 20-30 bp range.
Wealth Management - Solid but Muted Growth
• Wealth management earnings are expected to be weak due to a decline in retail brokerage activity and lower growth in mutual fund assets. Year-over-year comparisons may be difficult as the 2007 RRSP season was the strongest on record and market activity was robust. Although equity markets were down versus a year earlier with the exception of the S&P/TSX, average bank mutual fund assets increased 5%. The growth in AUM may result in modest year-over-year improvement in Wealth Management earnings. Comparisons will become less difficult beginning in Q3/08.
• RY led the industry in net sales this quarter with solid LTA sales and very strong money market net sales.
International Banking - Negative Impact from Appreciating C$
• International earnings are expected to remain under pressure this quarter as the result of the appreciating Canadian dollar. The Canadian dollar appreciated (Exhibit 14) an average of 13% versus the U.S. dollar and 10% versus the Mexican peso from a year earlier. We expect the currency drag to lessen by Q3/08 and be fully removed by the fourth quarter.
• TD Ameritrade is expected to contribute C$67 million or C$0.09 per TD share in the second quarter versus C$0.12 per share in the previous quarter and C$0.10 per share a year earlier.
• Second quarter earnings are expected to include RY's acquisition of Alabama National which closed on February 25, 2008 while TD's acquisition of Commerce Bancorp will not be reflected until Q3/08 earnings are released.
Wholesale - Last Quarter of Meaningful Writedowns
• Wholesale earnings are expected to be weak again this quarter due to lower capital markets activity and continuing writedowns in the trading book although modest.
• We expect trading revenue to be weak due to continued market volatility and increased risk aversion on the part of the banks. The lower number of M&A deals is also expected to be a drag on earnings. The number of M&A deals that closed in the quarter declined 12% sequentially and 6% from a year earlier and the value of closed deals was flat QOQ and declined 39% from a year earlier. The value and number of pending M&A deals declined 24% and 12%, respectively.
• CM remains the one bank with the potential for significant further writedowns. Our guesstimate is that CM could take an additional writedown of $1 to $2 billion ($650 million to $1.3 billion after-tax or $1.70 per share to $3.40 per share) on its hedged and unhedged CDO exposure. The other Canadian banks are expected to have modest writedowns. We believe this quarter will represent the last quarter of meaningful writedowns for the bank group.
LLPs to Increase Modestly
• On a quarterly basis, we expect loan loss provisions to increase to $1,200 million or 0.42% of loans (Exhibit 15) for the bank group up 16% sequentially and 77% from a year earlier. Although the growth rates are high the incremental loan loss provisions from a year earlier are a moderate $523 million. We believe loan loss provisions are very manageable. We expect LLPs to peak in 2010-2012.
Dividend Increases on Hold until Q4/08
• TD increased its dividend 4% to $2.36 per share from $2.28 per share in Q1/08, the only bank to do so. We believe dividend increases will be put on hold for Q2 and Q3. Dividend increases are expected to resume in the last quarter of 2008 with the potential for dividend increases in the 5%-10% range across the board. This would coincide with the reacceleration of earnings growth in Q4/08 after three quarters of negative earnings growth due to the appreciation of the Canadian dollar.
Recommend Aggressively Buying Banks at These Levels
• Canadian banks are currently trading at 11.0x 2008 earnings estimates and 9.9x 2009 earnings estimates, near all time lows. We remain overweight the bank group and recommend aggressively buying bank stocks. Our order of preference remains RY, CWB, TD, CM, NA, BMO and LB.
