12 February 2009

RBC CM: Still Too Early to Buy Banks

RBC Capital Markets, 12 February 2009

We are lowering our estimated 2009 EPS by a median of 7% based primarily on higher retail loan loss expectations, and reiterating our message that it is still too early to buy Canadian bank shares.

• The reason for our greater concern since we last updated our loan loss forecasts (in early December) is that the Canadian employment reports that have come out since have been much more negative than anticipated.

• We have lowered our 2009E EPS estimates by a median of 7%, and they are now 11% below consensus estimates.

• While we have high conviction that loan losses will rise and that the street's EPS estimates need to be revised down, we also have high conviction that the banks are in better shape to go through a credit cycle than in the early 1990s, given their higher capital positions and reduced exposure to lending in general (and particularly to business lending).

We continue to believe that it is too early to buy Canadian bank stocks based on: 1) valuations that are not overly cheap on a historical basis considering the economic environment we think the banks will face, 2) our expectation for continued pressure on profitability due to both a slowing economy and credit/funding markets that remain challenged, and 3) our belief that the street needs to lower its profitability estimates.

For investors that need to be in Canadian banks, we favour the shares of:

• National Bank - less exposure to Ontario and the U.S., cleaner securities book and off-balance sheet exposures, and valuation at the low end of the group;

• Royal Bank - capital strength, strong core earnings base and headline risk that we believe is better reflected in valuation than for some peers.
Financial Post, Eoin Callan, 11 February 2009

Bay Street is likely to suffer less than Wall Street as global economic conditions worsen and international banks continue to grapple with bad loans and toxic assets, according to UBS. Researchers at the Swiss bank “expect Canadian banks to continue to outperform their global peers given superior asset quality, capital, liquidity, and return on equity.”

While shares in U.S. and Canadian banks both hit historical lows in January, UBS points out that Bay Street banks have suffered a 38% fall while Wall Street bank stocks have fallen 66%.

Researchers at the investment bank say they “remain negative on the outlook for global banks due to a weaker economy,” but see less risk lurking in the books of Canadian banks.

“Exposure to high risk toxic assets is fundamentally lower in Canada,” according to the UBS team.

The researchers also point to several other key metrics that indicate a healthier banking system, including more stringent underwriting standards for home loans. The bank points out that Canadian banks are less leveraged than international peers, with a “a low loan-to-deposit ratio of 78% versus 83% in the U.S., 96% in the U.K.”.

In particular, the bank argues investors should not use the same conservative metrics to evaluate the riskiness of Canadian banks that are in vogue for measuring U.S. banks. U.S. investors have been increasingly ignoring measures of banks’ capital reserves that are based on elaborate systems of risk-weighting arrived at by executives and regulators.

Instead, they have been stripping balance sheets down to so-called tangible common equity, because “all assets have become more risky in this environment”, making “risk weightings less reliable, according to UBS.

Using this risk-averse metric, Canadian banks look significantly less well capitalised. But UBS argues this is misleading. It points to a number of conditions in Canada that, including strong earnings flows.

“We think that earnings are the most important cushion for credit losses,” the researchers say, adding: “therefore their implicit pro forma capital levels are higher than their US peers regardless of what number is used.”
Financial Post, David Pett, 9 February 2009

Investors will likely be pleased with upcoming first quarter bank earnings, but according to one of the Street’s more pessimistic onlookers, the results may only represent a temporary calm before the storm, which has ripped apart the sector these past eighteen months, blows wild once again.

“The first quarter’s earnings should be reasonably benign, which in this environment may be viewed as a huge positive,” said John Aiken, analyst at Dundee Capital Markets. “That said, we believe that the first quarter will likely be a near-term anomaly.”

The analyst said the banks as a group should benefit in Q1 from stable net interest margins, strong capital markets revenues due to numerous financial services
secondary offerings, and credit quality that, “whild still deteriorating, has yet to fall off the cliff.”

Unfortunately, Mr. Aiken thinks it is just a matter of time until credit quality does in fact fall off a cliff, and predicts the second half of 2009 will see accelerating loan loss provision growth.

In addition, he said recessionary headwinds will put future earnings to the test and fuel concerns about the banks’capital strength and also whether dividend payout ratios can be sustained.

“Thus we maintain that the challeging environment will carry on in the near term, and reiterate our cautionary stance on the sector to focus on downside protection until the full extent of credit deterioration can be better assessed,” he wrote.

In the meantime, Mr. Aiken upgraded his ratings on Bank of Nova Scotia, Toronto-Dominion Bank and Royal Bank of Canada from “sell” to “neutral.” Given their depressed values, he thinks all three banks can benefit near term from a stable first quarter.

The analyst continues to rate Canadian Imperial Bank of Commerce and Bank of Montreal “sell” and National Bank of Canada a “buy.”