19 February 2009

Preview of Banks' Q1 2009 Earnings

Scotia Capital, 19 February 2009

Banks Begin Reporting February 25

• Banks begin reporting first quarter earnings with Toronto Dominion (TD) on February 25, followed by Canadian Imperial Bank of Commerce (CM), National Bank (NA), and Royal Bank (RY) on February 26, Bank of Montreal (BMO) and Bank of Nova Scotia (BNS) on March 3, Laurentian Bank (LB) on March 4, and Canadian Western (CWB) closing out reporting on March 5. Scotia Capital’s earnings estimates are highlighted in exhibit 1, consensus earnings estimates/target prices in exhibit 2, and conference call information in exhibit 4.

Negative Earnings Momentum – ROE 17.2%

• We expect first quarter operating earnings to decline 12% year over year (YOY) and 2% sequentially due to retail margin pressure, increasing loan loss provisions, and modest dilution from equity issues. These negative factors could be partially offset by improving wholesale spreads, a depreciating Canadian dollar, and increased investment banking activity. This is expected to be the sixth straight quarter of negative earnings momentum. Operating ROE is expected to remain solid at 17.2%, with the higher ROE banks’ profitability at 18% plus.

• Reported earnings are expected to double from a year earlier due to the moderating of writedowns from the record $4.4 billion in Q1/08.

• We are forecasting an 11% earnings decline in 2009 and a 5% increase in 2010. Return on equity is expected to be 16.3% in 2009 and 16.0% in 2010. Our earnings estimates reflect recession level loan loss provisions (LLPs).

• We expect dividend increases to remain on hold throughout most of 2009 due to increased focus on capital positions, continued difficulty in credit markets, and short-term uncertainty. We believe that the market is currently pricing in a 35% probability of dividend cuts for the bank group; however, we believe that bank dividends are safe. In addition, we believe that dividend increases could resume as early as the fourth quarter of 2009, with RY the most likely to increase.

• We expect overall writedowns this quarter to be modest compared with Q4/08 and Q1/08. The potential writedowns this quarter are highlighted in Exhibit 3.

• We expect loan losses in Q1/09 to increase to $1.8 billion or 0.57% of loans, which represents a 75% increase from $1,033 million or 0.37% of loans a year earlier and an 18% increase from $1,531 million or 0.48% of loans in the previous quarter. We expect LLPs to accelerate throughout 2009, totalling $8.0 billion or 61 basis points (bp) of loans and ultimately peaking in 2010 at $9.7 billion or 70 bp of loans. We expect banks to be able to grow earnings while absorbing these higher credit losses over the next several years. Interestingly, banks have recorded strong absolute and relative returns in the face of rising LLPs in each of the past three credit cycles, which seems counterintuitive.

• Canadian banks grew book values by 14% in 2008, despite $10 billion in writedowns. After issuing $5.2 billion in common equity in early fiscal 2009, we expect that book values will continue to grow in 2009 as a result of capital build from earnings and foreign currency translation from a depreciating Canadian dollar. We expect charges to other comprehensive income (OCI) from available-for-sale (AFS) securities to be moderate in 2009.

• Bank dividend yields have spiked to as high as 7.5%. The bank dividend yield relative to 10-year government bonds is an astonishing 10.4 standard deviations from the mean. The bank dividend yield relative to the TSX is 2.3 standard deviations above the mean. The market is clearly discounting dividend cuts. We expect catalysts to a bank stock rally will be stability in the U.K. and U.S. banking systems and continued solid earnings from the Canadian banks, and once the market feels comfortable with sustainability of dividends, the stocks will likely rally sharply.

• Canadian banks are well capitalized, with high-quality balance sheets, diversified revenue mix, a solid long-term earnings growth outlook, low exposure to high-risk assets, and compelling valuations on both a yield and P/E multiple basis.

• We are downgrading NA to 2-Sector Perform from 1-Sector Outperform based on significant relative outperformance and relative P/E multiple expansion. We are upgrading LB to 2-Sector Perform from 3-Sector Underperform based on weak relative performance and low relative P/E multiple.

• We continue to recommend overweight bank stocks. We have a 1-Sector Outperform rating on Royal Bank and CWB, with 2-Sector Perform ratings on BMO, and CM, and a 3-Sector Underperform rating on TD. Our order of preference has shifted to RY, CWB, NA, BMO, LB, CM and TD.

Retail Net Interest Margin Compression

• The retail net interest margin is expected to come under significant pressure, as continuous rate cuts by the Bank of Canada have reduced prime to 3.00%, the lowest level in history. We view this as entering the “Red Zone” (Exhibit 9), which begins to structurally impact bank margins and profitability. The banks’ decision to reduce prime in line with the Bank of Canada rate reduction is negative for bank earnings and will likely be fully felt in the second fiscal quarter. We believe the prime rate descent, with deposit costs being at or very close to their floor, creates enormous retail margin pressure, especially on TD with its deposit mix.

• Banks with a large percentage of demand and notice deposits such as TD, BMO, and NA will be more susceptible to margin compression. We are forecasting a 10 bp decline in retail net interest margin in 2009, which is expected to negatively impact bank group earnings by 4%.

• Retail margin pressure may be eased somewhat by favourable transfer pricing from Treasury, as wholesale spreads have widened out in the first quarter of 2009. The average prime-BA spread in Q1/09 improved significantly to 1.82% from 1.47% in the previous quarter and 1.54% a year earlier.

Bank Capital Positions Strong

• The Canadian banks raised nearly $9.5 billion in Tier 1 capital throughout Q1/09 ($5.2 billion in common shares, $3.2 billion in preferred shares, and $1.1 billion in innovative Tier 1), bringing the bank group total Tier 1 ratio to 10%. Canadian banks, we believe, have strong Tier 1 capital levels and should be able to increase easily to the 11%-13% range over the next few years without issuing further equity, but rather via internally generated capital and preferred shares and innovative capital issuance. We estimate that bank net earnings in fiscal 2009 would add 80 bp with preferred share and innovative capacity being 230 bp.

LLPs Increasing – Expect 2010 Peak at 70 bp

• On a quarterly basis, We expect loan losses in Q1/09 to increase to $1.8 billion or 0.57% of loans (Exhibit 12), which represents a 75% increase from $1,033 million or 0.37% of loans a year earlier and an 18% increase from $1,531 million or 0.48% of loans in the previous quarter. We expect more significant upticks in LLPs from NA since their loss ratios lagged the bank group in 2008.

• We are forecasting LLPs of $8.0 billion or 61 bp of loans in 2009 and $9.7 billion or 70 bp of loans in 2010. We continue to forecast a peak LLP level this cycle of 70 bp, lower than 1982 at 1.00%, 1992 at 1.61%, and 2002 at 0.87%. However, it is important to compare peak LLPs with consideration to the major shifts in loan mix. Our LLP forecasts are based on a bottom-up approach of loan type by bank with credit card loss ratios at 5.0%, unsecured personal loans at 2.0%-3.0%, corporate and commercial at 0.50%-0.75%, CRE at 1.0%, and U.S. CRE Construction at 5.0%. These loss ratios are derived using historical peaks by loan category in conjunction with comparing unemployment levels, non-financial corporate debt levels, single name limits, industry concentration, and equity levels in real estate.

Wealth Management Earnings to Remain Weak

• Wealth management earnings are expected to be weak in Q1/09 and remain lacklustre for most of 2009 due to significant declines in AUM, lower retail brokerage revenue, and a shift into lower-margin money market funds.

• The Canadian bank group’s average mutual fund AUM declined 12% sequentially in the first quarter. AUM declines were largely the result of equity markets declining 35%-40% from a average AUM of 15%, with CM, NA, and TD each declining 12%. RY fared better, with a decline of 11%.

• In addition, money market funds accounted for 25% of total bank AUM as at the end of Q1/09 versus only 17% a year earlier. Although the banks have been the main beneficiaries of inflows into money market funds, the shift in fund mix reduces profitability, as money market funds are lower-margin products.

U.S. & International Banking

• U.S. banking earnings will benefit from the significant depreciation of the Canadian dollar in the first quarter; however, earnings are expected to be depressed due to higher LLPs. The Canadian dollar depreciated (Exhibit 11) an average of 19% versus the U.S. dollar and an average of 10% from the previous quarter. This currency move would result in a positive earnings pickup of 1.4% for the bank group, with TD, RY, and BMO having the greatest exposure to the U.S. dollar.

• We remain concerned about the earnings power of BMO’s, RY’s, and TD’s U.S. subsidiaries. Declining prime rate, increasing cost of deposits, rising loan loss provisions, a weakening U.S. consumer, and competition from government-supported institutions make the U.S. banking environment a difficult one for Canadian banks. We expect U.S. and international banking platforms to underperform for the bulk of 2009 and 2010.

Wholesale Earnings to Improve

• Wholesale earnings are expected to improve in Q1/09 due to the widening of wholesale spreads, high volume of activity in secondary financing, the demise of U.S. competition, slight improvement in credit markets, and a typical seasonal high in trading revenue in the first quarter.

• Underwriting and advisory fees are expected to be very strong, as secondary financing increased 18% from a very strong Q1/08 and increased fivefold from the previous quarter. There was also a slight pickup in IPO activity after a benign Q4/08. M&A activity remained weak this quarter as the value of closed and pending deals in the quarter declined 76%.

• Trading revenue and brokerage commissions are expected to be strong, as TSX trading volume improved from a year earlier by 33% due to extreme volatility in equity markets in what is traditionally a seasonally high quarter for trading revenues.

First Quarter Highlights

• Bank of Montreal is expected to report operating earnings of $1.26 per share versus $1.21 per share a year earlier, an increase of 4% YOY and 6% sequentially. Reported earnings are expected to be $1.02 per share including an estimated $200 million ($130 million after-tax or $0.24 per share) in writedowns on U.S. conduit – Fairway. We expect Canadian P&C earnings growth momentum to continue to improve in Q1/09 and U.S. P&C earnings to continue to underperform. Wealth Management earnings are expected to be extremely weak, driven by large declines in AUM. Wholesale earnings are expected to improve due to a pickup in capital markets activity.

• Canadian Imperial Bank of Commerce is expected to report operating earnings of $1.59 per share, a decline of 21% YOY and an increase of 1% sequentially. Reported earnings are expected to be $1.25 per share including an estimated $200 million ($130 million after-tax or $0.34 per share) in writedowns on the bank’s collateralized loan obligations (CLOs) and U.S. residential mortgage market (RMM) portfolio. We expect wholesale earnings to improve sequentially due to an increase in capital markets activity but to be down YOY due to the bank’s shift towards a more risk-averse strategy. Retail banking earnings are expected to be under pressure as a result of margin compression and increased loan loss provisions. Revenue growth is expected to remain a challenge.

• National Bank is expected to report operating earnings of $1.25 per share in the first quarter, a decline of 14% YOY and 8% from the previous quarter. Reported earnings are expected to be $0.84 per share including an estimated $100 million ($65 million after-tax or $0.41 per share) in writedowns on $248 million of loan commitments (sub-prime with no recourse) on non-bank ABCP ineligible under the Montreal Accord. NA also has $828 million (no sub-prime with recourse for first 30%) in loan commitments for non-bank ABCP eligible under the Montreal Accord. We expect Retail and Wealth Management earnings to be flat YOY and wholesale banking earnings to improve slightly. Trading revenue, which has been surprisingly strong, near record levels over the past few quarters, may continue to be supportive to earnings. We expect loan loss provisions to increase.

• Royal Bank is expected to report operating earnings of $1.04 per share, a decline of 7% from a year earlier, but an increase of 3% quarter over quarter (QOQ). Reported earnings are expected to be $0.99 per share including an estimated $100 million ($65 million after-tax or $0.05 per share) in writedowns on the bank’s bank-owned life insurance (BOLI) and trading securities. Solid earnings growth is expected from RY’s Retail and Insurance platforms, despite a projected increase in loan loss provisions. Wealth Management is expected to be weak this quarter due to the equity market sell-off. We expect RBC Capital Markets earnings to improve due to the increase in capital markets activity. U.S. and International earnings are expected to remain weak due to continued high loan loss provisions and difficult operating environment.

• Toronto-Dominion Bank is expected to report operating earnings of $1.14 per share, a decline of 21% YOY and 7% sequentially. Reported earnings are expected to be $1.07 per share including an estimated $100 million ($65 million after-tax or $0.08 per share) in writedowns on the bank’s credit trading book. Retail earnings momentum is expected to slow due to margin compression and increase in loan loss provisions. Domestic wealth management earnings are expected to be weak. TD Ameritrade is expected to contribute C$77 million or C$0.09 per share versus C$0.07 per share in the previous quarter and C$0.12 per share a year earlier. U.S. P&C Banking earnings are expected to be under pressure due to a difficult operating environment and an increase in loan loss provisions. Wholesale earnings are expected to improve, although recently have represented only 10% of TD Bank’s total earnings.
Financial Post, Eoin Callan, 19 February 2009

Canadian banks face a steady erosion of their profitability in the coming months as the economy slows and more loans go bad, according to Brad Smith at Blackmont Capital.

“Given the rapid pace of deterioration in North American employment and the anticipated knock-on effect on credit performance, we are compelled to again reduce our expectations for near-term earnings for Canada’s major banks,” said the analyst.

The warning comes after a precipitous decline in Canadian bank shares, which have slid about 40 per cent in the last year amid a crisis in the financial system that has dragged the global economy into recession.

“Notwithstanding the substantial efforts of central bankers and politicians, the economic consequences of the credit dislocation that has prevailed for a now unprecedented 18 months runs the very real risk of being more severe and potentially lasting longer than current consensus expectation,” said Mr. Smith.

Blackmont is anticipating an increase of 15% in funds set aside by Canadian banks to cover credit losses. Mr. Smith has also detected “significant credit deterioration” last quarter at the U.S. affiliates of Canadian banks.

The firm has also diagnosed a slowdown in the growth of lending to consumers, with “aggregate personal and commercial loans outstanding reported by domestic chartered banks declin[ing] $23-billion or 1.8% sequentially in the three months ended December 31, 2008.”

The drop “is assumed to reflect increased securitization volumes as domestic banks availed themselves of the opportunity to sell insured mortgages to the [Canada Mortgage Housing Corporation] through the $75 billion facility established by the government in the fall of 2008,” Mr Smith said in a note to clients. “While upward revisions to cyclical credit provisioning levels contribute the bulk of the earnings estimate decline, roughly 3-4% results from the recent issuance of a raft of preferred, innovative, and common share capital designed to ensure that Canadian banks remain well capitalized relative to many of their global peers,” he added.
Financial Post, Jonathan Ratner, 19 February 2009

Mortgage insurer MBIA Inc.’s announcement on Wednesday that it is separating its traditional municipal business from its more troubled line of insuring structured-finance products serves as a reminder of potential losses at two Canadian banks.

“In reorganizing its corporate structure to improve its ability to continue to write public finance credit insurance, MBIA has necessarily undermined the claims paying ability of its structured finance insurance subsidiary and provided a mechanism that may be replicated by other monoline insurers facing similar loss pressure in their structured finance insurance pools,” said Blackmont Capital analyst Brad Smith in a note to clients.

Based of fourth quarter disclosures, he estimates that a worst case loss potential from direct MBIA credit default swap counterparty exposure for Royal Bank and CIBC could be $2.20 and $2.80 per share, respectively.

While Royal’s monoline exposure is limited, Mr. Smith noted that CIBC has more than $10-billion of net notional exposure to a wide variety of monlines, “many of which continue to struggle under the pressure of their structured finance related CDS exposures.”

Despite what the analyst said is an increased likelihood of a “manageable” writedown of Royal’s remaining MBIA exposure, he maintained a “buy” rating and $42 per share price target on the stock. This is a reflection of Mr. Smith’s view that the bank’s scale and diversity will help it emerge from this stressed environment with new opportunities to resume growth.

However, the higher potential monoline related loss exposure at CIBC had the analyst reiterating a “hold” and $46 price target on the stock.
TD Securities, 18 Feburary 2009

Group suffering under weight of global financial fears. Relative valuations and broad concerns around the health of the global economy and the financial services industry continue to weigh heavily on the group.

Q1 results could offer some respite. We do not think Q1 will be received as poorly as Q4 which saw a number of negative pre-announcements, sizeable write-downs, cautious guidance and rising concerns around capital levels. Trends will still be modest, but the quarter is likely to play much better compared to the on-going challenges seen elsewhere.

Capital levels remain in focus. Look for management to try and control asset growth and hoard internally generated capital. Overall, capital levels look comfortable pro-forma recent issues.

Write-downs likely to be less traumatic. Lower balances and increased accounting flexibility should see smaller write-downs even as markets weaken. There will still be hits and CIBC is still likely to be among the largest.

Credit remains our key focus. We expect credit conditions to continue to deteriorate and credit costs to climb toward cyclical peaks over the coming year. U.S./International exposures are likely to continue to be the most problematic, creating challenges for BMO, BNS and RY.

CIBC our best idea for the times. Expectations are low and write-downs/capital are becoming less of an issue. Meanwhile, the core operating business mix is attractive in our view (85% retail) and is delivering at a respectable pace and the bank’s credit picture looks better than most.
Blackmont Capital

• BMO target price cut to $32 from $36
• CIBC target price cut to $46 from $50
• National Bank target price cut to $37 from $44
• RBC target price cut to $42 from $45
• Scotiabank target price cut to $36 from $40
• TD Bank target price cut to $40 from $63
Financial Post, Jonathan Ratner, 17 February 2009

Bank of Nova Scotia may have avoided problems associated with the mark-to-market and off-balance sheet phase of this cycle, but expectations that it will face more headwinds from the weak credit environment has prompted a downgrade.

BMO Capital Markets analyst Ian de Verteuil reduced his rating on the stock from “market perform” to “underperform” and lowered his price target from $36 to $29. His 2009 and 2010 earnings per share forecasts also fall from $3.45 and $3.95 to $2.60 and $2.35, respectively.

The analyst noted that Bank of Nova Scotia trades at an average price to book value but a premium price-earnings ratio. He told clients this reflects the Street’s confidence that this credit cycle will be different for Scotiabank