Scotia Capital, 23 June 2008
Earnings Resilience Continues - Grinding It Out
• The Banking Siege is now into its 11th month and still counting, although it continues to show signs of easing. The bank index has rebounded 16% from the lows reached on March 17, The Bear Stearns Rescue, which we believe is the beginning of a major bull market in bank stocks.
• The Canadian banks, except for CM, have avoided the carnage that has besieged many of the global banks. Canadian banks cumulative writedowns as at Q2/08, including BMO’s natural gas trading losses, have totalled $10.9 billion, with CM representing 60% of these writedowns. Thus excluding CM, Canadian bank cumulative writedowns represented less than one quarter of earnings or 3% of book value. TD and RY have stood out from their global peers and Canadian competitors with cumulative writedowns at 0% and 4% of book value, respectively. We expect this quarter will be the last quarter of noticeable mark-to-market (MTM) writedowns with recoveries not out of the question over the next few years.
• The earnings performance of Canadian banks has been relatively resilient in a very difficult environment as they have been grinding it out. On an operating basis after a five-year run of successive 15%+ growth, we expect earnings to decline a modest 2% in 2008 before growth returns to 11% in 2009. On a quarterly basis Q2/08 represented the second straight quarter of modest negative earnings growth, with -2% in Q1 and -5% in Q2, with Q3 expected to be - 7% before earnings momentum is expected to turn positive in Q4 with growth estimated at 6%. Thus the bank group is grinding through three quarters of modest negative earnings momentum while maintaining strong capital positions and near-record profitability. Retail banking earnings have remained very strong with wholesale earnings tumbling, especially in Q2/08.
• The banks earnings performance is actually quite admirable given the 15% year-over-year appreciation of the Canadian dollar, which impacts approximately one-third of bank earnings and the 10 to 15 basis points (bp) year-over-year decline in the retail net interest margins, as well as the difficult wealth management and wholesale banking operating environment.
• The solid underlying earnings for the bank group have resulted in at least one Canadian bank increasing its common dividend in every single quarter since the credit crisis began. Although the increases have been modest, it bodes well. The dividend payout ratio is 46% on 2008 operating earnings and 42% on 2009 earnings estimates. We expect Q4/08 positive earnings momentum to be a catalyst for broad-based dividend increases for the bank group.
• Canadian bank market capitalization declines have been extreme compared with writedowns and relatively low exposure to high-risk assets. Canadian bank market capitalization has declined $40 billion (excluding CM) on writedowns of $6.7 billion after tax, for a market capitalization decline ratio (MCDR) of 15.9x. MCDR is market capitalization decline as a multiple of after-tax writedown. We believe the MCDR at 15.9x is high versus the modest 8.4x MCDR for a group of global banks, especially when Canadian banks have much lower residual risk in their balance sheets. The MCDR is also high compared to levels of 1.8x to 2.3x during the LDC and CRE crisis of the 1980s and 1990s.
• The Banking Siege has presented one of the best buying opportunities in decades to participate in the major bull market in bank stocks. Canadian bank stocks have been impacted, not surprisingly, by the negative sentiment towards the financial services sector. Investors have a heightened awareness of systemic risk and are pricing for it.
• We believe sentiment, although negative, is beginning to shift, as global players are taking major writedowns and shoring up capital positions. We believe Canada has a structural advantage versus U.S. banks and other global players. The solid fundamentals in our residential mortgage market set Canada apart from many countries. The dominance of Canadian banking franchises in a number of business lines and the extremely low penetration from monolines presents a competitive advantage.
• Higher loan losses, we believe, through an economic downturn are absorbable. We expect loan loss provisions to peak in the 65 bp or $7 billion range in 2010/2011 versus our 2008 and 2009 forecasts of $4.6 billion and $5.3 billion, respectively. The earnings drag is expected to be 8% over a two- or three-year period, which we believe is readily absorbable. The retail net interest margin is arguably a more important earnings variable as a 10 bp shift in the retail margin impacts earnings 3%. Interestingly, the retail net interest margin has declined from 3.65% in 2001 to the recent level of 2.88% for a significant 77 bp decline. Thus bank earnings would have been over 20% higher today all things being equal, which of course they are not. The margin decline was driven by loan and deposit mix shifts, competition, deposit cost floors, and spikes in wholesale funding costs. Of the positives from Q2/08 earnings was the firming up of the retail net interest margin, which actually increased 2 bp sequentially although it was down 12 bp year over year. We expect a firmer to perhaps expanding margin to be a catalyst for positive earnings surprises in 2009.
• Bank valuations in our view are already discounting a recession. Bank P/E multiples are at extremely attractive levels at 11.2x, 11.2x, and 10.0x, trailing, 2008 and 2009 operating earnings estimates, respectively. The bank P/E multiples appear to have bottomed at 9.4x trailing, on March 17 (Bear Stearns Rescue), slightly above the 9.0x level during the Asia crisis in 1998 and below the 10.9x bottom during the Telco/Cable/Power crisis in 2001. We believe the trend line for bank P/E multiples continues to be 16x, and the current stress testing (credit crisis and recession) is in fact needed to push the multiple through previous highs. The 16x target multiple is based on a 5% ten-year government bond yield. If bond yields were to increase to 6% based on inflation concerns, the target multiple would be in the 14x range, 25% higher than current valuation.
• Canadian bank P/E multiples relative to U.S. banks have improved to a 7% premium versus a discount of 5% to 10% since the credit crisis began. We continue to believe Canadian banks should trade at a 10% to 15% premium based on lower balance sheet risk, high profitability, and a less volatile and risky banking system.
• The bank P/E multiples relative to the TSX are 63%, in line with the historical mean but below our 80% to 90% target, which is based on periods of similar bank fundamentals.
• Bank dividend yields relative to bonds remain at unheard-of levels (until the current credit crisis) at 109% or 4.6 standard deviations above the mean. The peak was 7.0 standard deviations above the mean on March 17, when fear and panic were at their highest. The market was beginning to discount a total global financial collapse. We continue to believe dividends are safe and broad-based dividend growth will begin in Q4/08.
• Bank dividend yield versus the overall equity market is an astounding 2.3x versus a historical mean of 1.4x and not far off the spike to 2.8x from the Nortel/High-Tech bubble in 2000. Bank dividend yields are also at record levels versus Pipes & Utilities and Income Trusts.
• We continue to recommend aggressively buying bank stocks at these levels. As fear subsides, we expect share prices to move up sharply. We expect the negative drag from flow of funds to reverse. Flow of funds has not been helpful for bank share price performance as $12.7 billion has gone into money market funds in the first five months of 2008, with domestic equities recording net redemptions of $3.4 billion and domestic balance inflows anaemic at $207 million. In addition, the resource sectors have been red hot attracting funds, which is not expected to last forever. The short interest in Canadian banks that peaked in late 2007 and early 2008 continues to decline, removing some downward share price pressure.
• In terms of stock selection we continue to favour RY and TD, which we consider to be the high-quality banks with the strongest operating platforms, and which consistently and continually reinvest in their businesses. These banks have the highest profitability, strongest balance sheets, and growth prospects. These three banks substantially outperform over the long term.
• They have also performed exceptionally well through the recent crisis operationally and share-price wise. TD, and RY share prices are down 11%, and 18%, respectively, from their all-time highs. CM, BMO, and NA share prices have declined 40%, 37%, and 19%, respectively, from their all-time highs.
• We continue to recommend maximum allowable weightings in bank stocks based on overall fundamentals and valuation. Even the weakest bank looks compelling from an investment perspective. We have only BUYS and STRONG BUYS in the bank group with no SELLS or HOLDS on an absolute return basis. High-quality balance sheets, strong funding and liquidity, high profitability, compelling valuation, and the major structural advantages from our banking system and economy support our very bullish stance towards bank stocks.
• We maintain our 1-Sector Outperforms on RY and CWB, 2-Sector Performs on TD, NA, and CM, with 3-Sector Underperforms on BMO and LB.
• Our order of preference is: RY, CWB, TD, NA, CM, BMO, and LB.
RY 1-Sector Outperform – Canadian Banking Earnings Momentum; U.S. & International Represents 5% of Earnings
• RY reported solid domestic banking results up 15% year over year. Insurance earnings doubled from a year earlier while banking-related earnings increased a respectable 7%. U.S. & International earnings were disappointing this quarter, declining 30% due to increased loan loss provisions related to the banks' Builder Finance portfolio. Although U.S. & International earnings were disappointing, the segment only represented 5% of the bank’s total earnings. We believe that RY will continue to achieve above-average profitability based on the strength of its retail and wealth management platform, and that increases in LLPs will be absorbable.
CWB 1-Sector Outperform – High Growth Prospects – Lower Premium
• CWB continues to have a high growth profile, generating loan and deposit growth of 20%+ in the high growth economies of Alberta and British Columbia. Despite the high growth profile, CWB’s P/E premium has narrowed versus the bank group. In fact, CWB’s relative valuation is the most attractive it has been in five years.
TD 2-Sector Perform – Wholesale Represented 9% of Earnings; ROE Dilution from CBH Acquisition
• TD is well positioned with its strong domestic retail banking platform, nominal exposure to high-risk assets, and low reliance on wholesale earnings. The Commerce Bancorp acquisition is dilutive to return on equity with some integration risk, although we expect the company to manage through the integration and difficult U.S. operating environment. We maintain a 2-Sector Perform on the shares of TD as we expect higher earnings growth from RY and BNS. TD also has a significantly lower Tier 1 ratio pro forma fiscal year-end 2008.
NA 2-Sector Perform – Reliant on Wholesale
• NA remains heavily reliant on wholesale earnings. In Q2/08 wholesale earnings represented 34% of total earnings, the highest of the bank group. Growth in retail and wealth management has been modest. Asset quality remains relatively strong with very low impaired loan formations.
CM 2-Sector Perform – Retail Earnings Decline
• We believe the second quarter represented the last quarter of meaningful writedowns on U.S. sub-prime CDOs. However, after the dust settles we are concerned about the earnings power of CIBC World Markets and to a lesser extent CIBC Retail Markets. CM’s restructured wholesale platform has contributed a modest 10%-15% over the last two quarters versus 20%+ prior to Q1/08. CM’s retail banking earnings were disappointing this quarter despite a higher retail net interest margin and slightly lower loan losses.
BMO 3-Sector Underperform – Off-Balance Sheet Risk High; Low Profitability
• We maintain a 3-Sector Underperform on BMO based on the bank’s lower earnings growth outlook, lower profitability, higher off-balance sheet risk, and relatively weak operating platforms. BMO’s loan loss provisions have recently spiked to 36 bp of loans and are expected to remain at these elevated levels. Impaired loan formations also spiked. We believe a 15%-20% discount to the bank group is warranted.
LB 3-Sector Underperform – High Securitization Gains; Underlying Earnings Weak
• We maintain a 3-Sector Underperform on LB based on the bank’s lower profitability, moderate loan growth outlook, and relatively high P/E multiple versus the bank group. Year-to-date, LB has had very large securitization gains representing 22% of earnings. We believe earnings growth from securitization gains is not sustainable at these levels and that earnings momentum is slowing after a number of years of recovery.
Earnings Resilience Continues - Grinding It Out
• The Banking Siege is now into its 11th month and still counting, although it continues to show signs of easing. The bank index has rebounded 16% from the lows reached on March 17, The Bear Stearns Rescue, which we believe is the beginning of a major bull market in bank stocks.
• The Canadian banks, except for CM, have avoided the carnage that has besieged many of the global banks. Canadian banks cumulative writedowns as at Q2/08, including BMO’s natural gas trading losses, have totalled $10.9 billion, with CM representing 60% of these writedowns. Thus excluding CM, Canadian bank cumulative writedowns represented less than one quarter of earnings or 3% of book value. TD and RY have stood out from their global peers and Canadian competitors with cumulative writedowns at 0% and 4% of book value, respectively. We expect this quarter will be the last quarter of noticeable mark-to-market (MTM) writedowns with recoveries not out of the question over the next few years.
• The earnings performance of Canadian banks has been relatively resilient in a very difficult environment as they have been grinding it out. On an operating basis after a five-year run of successive 15%+ growth, we expect earnings to decline a modest 2% in 2008 before growth returns to 11% in 2009. On a quarterly basis Q2/08 represented the second straight quarter of modest negative earnings growth, with -2% in Q1 and -5% in Q2, with Q3 expected to be - 7% before earnings momentum is expected to turn positive in Q4 with growth estimated at 6%. Thus the bank group is grinding through three quarters of modest negative earnings momentum while maintaining strong capital positions and near-record profitability. Retail banking earnings have remained very strong with wholesale earnings tumbling, especially in Q2/08.
• The banks earnings performance is actually quite admirable given the 15% year-over-year appreciation of the Canadian dollar, which impacts approximately one-third of bank earnings and the 10 to 15 basis points (bp) year-over-year decline in the retail net interest margins, as well as the difficult wealth management and wholesale banking operating environment.
• The solid underlying earnings for the bank group have resulted in at least one Canadian bank increasing its common dividend in every single quarter since the credit crisis began. Although the increases have been modest, it bodes well. The dividend payout ratio is 46% on 2008 operating earnings and 42% on 2009 earnings estimates. We expect Q4/08 positive earnings momentum to be a catalyst for broad-based dividend increases for the bank group.
• Canadian bank market capitalization declines have been extreme compared with writedowns and relatively low exposure to high-risk assets. Canadian bank market capitalization has declined $40 billion (excluding CM) on writedowns of $6.7 billion after tax, for a market capitalization decline ratio (MCDR) of 15.9x. MCDR is market capitalization decline as a multiple of after-tax writedown. We believe the MCDR at 15.9x is high versus the modest 8.4x MCDR for a group of global banks, especially when Canadian banks have much lower residual risk in their balance sheets. The MCDR is also high compared to levels of 1.8x to 2.3x during the LDC and CRE crisis of the 1980s and 1990s.
• The Banking Siege has presented one of the best buying opportunities in decades to participate in the major bull market in bank stocks. Canadian bank stocks have been impacted, not surprisingly, by the negative sentiment towards the financial services sector. Investors have a heightened awareness of systemic risk and are pricing for it.
• We believe sentiment, although negative, is beginning to shift, as global players are taking major writedowns and shoring up capital positions. We believe Canada has a structural advantage versus U.S. banks and other global players. The solid fundamentals in our residential mortgage market set Canada apart from many countries. The dominance of Canadian banking franchises in a number of business lines and the extremely low penetration from monolines presents a competitive advantage.
• Higher loan losses, we believe, through an economic downturn are absorbable. We expect loan loss provisions to peak in the 65 bp or $7 billion range in 2010/2011 versus our 2008 and 2009 forecasts of $4.6 billion and $5.3 billion, respectively. The earnings drag is expected to be 8% over a two- or three-year period, which we believe is readily absorbable. The retail net interest margin is arguably a more important earnings variable as a 10 bp shift in the retail margin impacts earnings 3%. Interestingly, the retail net interest margin has declined from 3.65% in 2001 to the recent level of 2.88% for a significant 77 bp decline. Thus bank earnings would have been over 20% higher today all things being equal, which of course they are not. The margin decline was driven by loan and deposit mix shifts, competition, deposit cost floors, and spikes in wholesale funding costs. Of the positives from Q2/08 earnings was the firming up of the retail net interest margin, which actually increased 2 bp sequentially although it was down 12 bp year over year. We expect a firmer to perhaps expanding margin to be a catalyst for positive earnings surprises in 2009.
• Bank valuations in our view are already discounting a recession. Bank P/E multiples are at extremely attractive levels at 11.2x, 11.2x, and 10.0x, trailing, 2008 and 2009 operating earnings estimates, respectively. The bank P/E multiples appear to have bottomed at 9.4x trailing, on March 17 (Bear Stearns Rescue), slightly above the 9.0x level during the Asia crisis in 1998 and below the 10.9x bottom during the Telco/Cable/Power crisis in 2001. We believe the trend line for bank P/E multiples continues to be 16x, and the current stress testing (credit crisis and recession) is in fact needed to push the multiple through previous highs. The 16x target multiple is based on a 5% ten-year government bond yield. If bond yields were to increase to 6% based on inflation concerns, the target multiple would be in the 14x range, 25% higher than current valuation.
• Canadian bank P/E multiples relative to U.S. banks have improved to a 7% premium versus a discount of 5% to 10% since the credit crisis began. We continue to believe Canadian banks should trade at a 10% to 15% premium based on lower balance sheet risk, high profitability, and a less volatile and risky banking system.
• The bank P/E multiples relative to the TSX are 63%, in line with the historical mean but below our 80% to 90% target, which is based on periods of similar bank fundamentals.
• Bank dividend yields relative to bonds remain at unheard-of levels (until the current credit crisis) at 109% or 4.6 standard deviations above the mean. The peak was 7.0 standard deviations above the mean on March 17, when fear and panic were at their highest. The market was beginning to discount a total global financial collapse. We continue to believe dividends are safe and broad-based dividend growth will begin in Q4/08.
• Bank dividend yield versus the overall equity market is an astounding 2.3x versus a historical mean of 1.4x and not far off the spike to 2.8x from the Nortel/High-Tech bubble in 2000. Bank dividend yields are also at record levels versus Pipes & Utilities and Income Trusts.
• We continue to recommend aggressively buying bank stocks at these levels. As fear subsides, we expect share prices to move up sharply. We expect the negative drag from flow of funds to reverse. Flow of funds has not been helpful for bank share price performance as $12.7 billion has gone into money market funds in the first five months of 2008, with domestic equities recording net redemptions of $3.4 billion and domestic balance inflows anaemic at $207 million. In addition, the resource sectors have been red hot attracting funds, which is not expected to last forever. The short interest in Canadian banks that peaked in late 2007 and early 2008 continues to decline, removing some downward share price pressure.
• In terms of stock selection we continue to favour RY and TD, which we consider to be the high-quality banks with the strongest operating platforms, and which consistently and continually reinvest in their businesses. These banks have the highest profitability, strongest balance sheets, and growth prospects. These three banks substantially outperform over the long term.
• They have also performed exceptionally well through the recent crisis operationally and share-price wise. TD, and RY share prices are down 11%, and 18%, respectively, from their all-time highs. CM, BMO, and NA share prices have declined 40%, 37%, and 19%, respectively, from their all-time highs.
• We continue to recommend maximum allowable weightings in bank stocks based on overall fundamentals and valuation. Even the weakest bank looks compelling from an investment perspective. We have only BUYS and STRONG BUYS in the bank group with no SELLS or HOLDS on an absolute return basis. High-quality balance sheets, strong funding and liquidity, high profitability, compelling valuation, and the major structural advantages from our banking system and economy support our very bullish stance towards bank stocks.
• We maintain our 1-Sector Outperforms on RY and CWB, 2-Sector Performs on TD, NA, and CM, with 3-Sector Underperforms on BMO and LB.
• Our order of preference is: RY, CWB, TD, NA, CM, BMO, and LB.
RY 1-Sector Outperform – Canadian Banking Earnings Momentum; U.S. & International Represents 5% of Earnings
• RY reported solid domestic banking results up 15% year over year. Insurance earnings doubled from a year earlier while banking-related earnings increased a respectable 7%. U.S. & International earnings were disappointing this quarter, declining 30% due to increased loan loss provisions related to the banks' Builder Finance portfolio. Although U.S. & International earnings were disappointing, the segment only represented 5% of the bank’s total earnings. We believe that RY will continue to achieve above-average profitability based on the strength of its retail and wealth management platform, and that increases in LLPs will be absorbable.
CWB 1-Sector Outperform – High Growth Prospects – Lower Premium
• CWB continues to have a high growth profile, generating loan and deposit growth of 20%+ in the high growth economies of Alberta and British Columbia. Despite the high growth profile, CWB’s P/E premium has narrowed versus the bank group. In fact, CWB’s relative valuation is the most attractive it has been in five years.
TD 2-Sector Perform – Wholesale Represented 9% of Earnings; ROE Dilution from CBH Acquisition
• TD is well positioned with its strong domestic retail banking platform, nominal exposure to high-risk assets, and low reliance on wholesale earnings. The Commerce Bancorp acquisition is dilutive to return on equity with some integration risk, although we expect the company to manage through the integration and difficult U.S. operating environment. We maintain a 2-Sector Perform on the shares of TD as we expect higher earnings growth from RY and BNS. TD also has a significantly lower Tier 1 ratio pro forma fiscal year-end 2008.
NA 2-Sector Perform – Reliant on Wholesale
• NA remains heavily reliant on wholesale earnings. In Q2/08 wholesale earnings represented 34% of total earnings, the highest of the bank group. Growth in retail and wealth management has been modest. Asset quality remains relatively strong with very low impaired loan formations.
CM 2-Sector Perform – Retail Earnings Decline
• We believe the second quarter represented the last quarter of meaningful writedowns on U.S. sub-prime CDOs. However, after the dust settles we are concerned about the earnings power of CIBC World Markets and to a lesser extent CIBC Retail Markets. CM’s restructured wholesale platform has contributed a modest 10%-15% over the last two quarters versus 20%+ prior to Q1/08. CM’s retail banking earnings were disappointing this quarter despite a higher retail net interest margin and slightly lower loan losses.
BMO 3-Sector Underperform – Off-Balance Sheet Risk High; Low Profitability
• We maintain a 3-Sector Underperform on BMO based on the bank’s lower earnings growth outlook, lower profitability, higher off-balance sheet risk, and relatively weak operating platforms. BMO’s loan loss provisions have recently spiked to 36 bp of loans and are expected to remain at these elevated levels. Impaired loan formations also spiked. We believe a 15%-20% discount to the bank group is warranted.
LB 3-Sector Underperform – High Securitization Gains; Underlying Earnings Weak
• We maintain a 3-Sector Underperform on LB based on the bank’s lower profitability, moderate loan growth outlook, and relatively high P/E multiple versus the bank group. Year-to-date, LB has had very large securitization gains representing 22% of earnings. We believe earnings growth from securitization gains is not sustainable at these levels and that earnings momentum is slowing after a number of years of recovery.
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Financial Post, Duncan Mavin, 23 June 2008
Canadian Imperial Bank of Commerce may be forced to raise more capital after another of the bank’s monoline counterparties ran deeper into trouble, said Blackmont Capital analyst Brad Smith.
CIBC has already taken $6.7-billion in writedowns on structured products linked to the U.S. subprime mortgage market. It will likely take another $1-billion hit in the third quarter of 2008 after XL Capital Assurance was downgraded by rating agency Moody’s, Mr. Smith said.
XLCA is a subsidiary of monoline SCA, with which CIBC has about $3.3-billion in exposure. In addition, the bank has about $25-billion in structured products that are not related to the subprime mortgage market.
Mr. Smith notes that the bank can withstand further losses on its remaining subprime exposure, and has a strong balance sheet after raising $2.9-billion in dilutive equity earlier this year. But additional losses in its $25-billion book of of non-subprime investments could push the bank to go back to the market for more capital, he said.
Blackmont Capital rates CIBC stock “hold” with a 12-month target price of $74.00
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Canadian Imperial Bank of Commerce may be forced to raise more capital after another of the bank’s monoline counterparties ran deeper into trouble, said Blackmont Capital analyst Brad Smith.
CIBC has already taken $6.7-billion in writedowns on structured products linked to the U.S. subprime mortgage market. It will likely take another $1-billion hit in the third quarter of 2008 after XL Capital Assurance was downgraded by rating agency Moody’s, Mr. Smith said.
XLCA is a subsidiary of monoline SCA, with which CIBC has about $3.3-billion in exposure. In addition, the bank has about $25-billion in structured products that are not related to the subprime mortgage market.
Mr. Smith notes that the bank can withstand further losses on its remaining subprime exposure, and has a strong balance sheet after raising $2.9-billion in dilutive equity earlier this year. But additional losses in its $25-billion book of of non-subprime investments could push the bank to go back to the market for more capital, he said.
Blackmont Capital rates CIBC stock “hold” with a 12-month target price of $74.00
