10 March 2009

Scotia Capital: Bank Earnings Reinforce Sustainability of Dividends

Scotia Capital, 10 March 2009

• Canadian banks release of first quarter results reinforces their status as the global bank model. The market’s comfort with the sustainability of bank dividend levels should be increasing given the solid first quarter results. However, Canadian bank stocks are facing global valuation contagion driven by fear and panic. Bank earnings this quarter absorbed further mark-to-market writedowns in their trading and available-for-sale (AFS) books as well as absorbing higher loan losses. Book value growth was double digit, with strong underlying operating earnings. The major earnings drivers were exceptional wholesale earnings, aided by large trading revenue, that are not fully sustainable and solid results from retail banking. In addition to earnings resilience, the bank group remained extremely well capitalized with Tier 1 ratio of 10.1% and TCE to RWA at 7.4%.

• Mark-to-market (MTM) losses remained high this quarter at $2.0 billion after tax, essentially flat from the previous quarter but down from $2.9 billion a year earlier.

• The MTM writedowns this quarter reflect a further widening of corporate bond spreads by 45 basis points (bp), higher CDS spreads, and an 11% decline in equity markets. This quarter was more benign than the fiscal fourth quarter where spreads widened 130 bp and equity markets tumbled 28%. Thus we believe the banks were much more proactive this quarter in managing and reducing risk in their portfolios in order to redeploy capital towards more profitable and less risky businesses.

• The bank group’s fully loaded return on equity after all writedowns was 11.3% in the first quarter, with operating return on equity of 18.3%.

• Bank earnings this quarter also absorbed a doubling of loan loss provisions (LLPs) to $2.1 billion from $1.0 billion a year earlier. Loan loss provisions this quarter were modestly higher than our forecast of $1.8 billion. LLP levels at 66 bp this quarter are up from 48 bp in the previous quarter and 37 bp a year earlier. Loan loss provision levels were particularly high in U.S. Personal and Commercial for BMO, RY, and TD. We have increased our 2009 LLP forecast to $8,510 million, or 65 bp, from $8,000 million, or 61 bp. Our 2010 LLP forecast has also increased modestly to $9,900 million, or 73 bp, from $9,700 million, or 70 bp.

• We believe that RY and NA reported the strongest results this quarter, followed by BMO, TD, and BNS with CM the weakest. In terms of domestic bank earnings including wealth management, BNS led with growth of 17%, with BMO at 2%, RY and NA flat, and TD and CM lagging with declines of 9% and 16%, respectively.

• RY and BMO earnings levels were driven by impressive results from wholesale, with these business units outearning their respective domestic retail businesses for the first time, we believe, in history. In our opinion, wholesale earnings or trading revenue this quarter are not sustainable at these levels, but the trend of growing earnings power from wholesale versus retail is very much intact; in fact it is just beginning. The reduction in capacity in wholesale and the major dislocation of this market has created significant opportunities. At the same time, retail is facing the structural difficulties and revenue/earnings/ margin pressures from very low interest rates. The concern about retail margins has only been exacerbated by the January 20, 2009, 50 bp reduction in prime and the further 50 bp rate reduction announced March 3, 2009. The impact of low interest rates (2.5% prime rate) will be very evident, we believe, in the second quarter.

• Canadian banks continue to suffer from valuation contagion as they are being priced in a global context of widespread chaos in financial and banking markets. Bank dividend yields have spiked to 7.6% versus 10-year government bond yields of 3.0%. Clearly, the market continues to heavily discount bank dividends despite solid financial performance thus far during the banking siege, and despite not only a 50-year track record of sustainability of dividends but a 10% CAGR, double the growth rate of the overall equity markets.

• Bank P/E multiples have declined to 6.5x, not seen since the early 1990s when the 10-year bond yield was 10% and bank ROEs dropped to below 6%, half the fully loaded ROE of 12% recorded in fiscal 2008. In the early 1990s, Canadian banks had double the exposure to commercial real estate than their U.S. counterparts had, with far greater concentration by name and project.

• We are optimistic that banks will be able to weather the recession, growing their book values and recording double digit return on equity. The Canadian banks are also exhibiting controlled offence by reinvesting in their businesses for future growth, acquiring small business units and select teams of people, as well as looking for opportunities that do not risk the bank.

• We believe that a major bank rally is pending. The crisis of confidence needs to subside before any sustained rally is possible. We believe a bank rally will follow some signs of stability in the U.S. and U.K. banking systems and continued reporting of solid quarterly results by Canadian banks. First quarter earnings calmed some fears about dividends, and as investors’ confidence in the sustainability of dividends increases, we expect share prices to be revalued more in line with fundamentals and earnings power of these companies. The low yield on government bonds and attractive yields on bank dividends will eventually be the major catalysts, in our opinion. We expect a significant positive revaluation of Canadian banks versus global peers as we believe Canadian banks will maintain their dividends and grow their business through this crisis.

• Also Canadian banks are now a recognizable part of global bank indices. Canadian banks now represent 12% of the MSCI Global Bank Index and nearly 11% of the FTSE Global Bank Index (RY sixth largest weight in this index).

• Canadian banks have been virtually ignored over the past number of decades given their insignificant weightings on global bank indices. However, with the global banking meltdown, Canadian banks have increased to 10.8% of the FTSE Global Bank Index, up from an insignificant 1.9% in 2000. Therefore it was easy to ignore Canadian banks in 2000 but, given the recent weightings, global bank funds at least have to make the decision not to own Canadian banks. Canadian banks do not have the beta of a number of global banks but we don’t know if that should necessarily be an investment deterrent.


• We remain overweight the bank group with a bias towards wholesale business versus retail as the area of strongest growth over the next several years. We believe RY (1-Sector Outperform) is the best positioned of the Canadian bank group in terms of the breadth and depth of its wholesale platform as well as its favourable retail deposit mix, which is expected to show relative strength due to the very low level of interest rates that we believe will place greater pressure on the other banks in the group.

• Our stock selection is based on the theme of leverage to wholesale versus retail. We believe the low level of interest rates will place greater pressure on retail net interest margins while wholesale margins have and should improve. Retail loan losses are expected to trend much higher versus historical peaks of the early 1980s and early 1990s with corporate and commercial loan losses trending lower than previous peaks.

• We have a 1-Sector Outperform rating on RY with a 2-Sector Perform rating on National Bank, Bank of Nova Scotia, Bank of Montreal, Canadian Western Bank, and Laurentian Bank. Our 3-Sector Underperforms are Toronto-Dominion Bank and Canadian Imperial Bank.

• Our stock selection in order is RY, NA, BNS, BMO, CWB, LB, TD, and CM.