29 May 2009

TD Bank Q2 2009 Earnings

• BMO Capital Markets raises target price from $56 to $60
• Dundee Securities raises target price from $51 to $54
• Genuity Capital Markets raises target price from $60 to $61
• National Bank Financial raises target price from $50 to $55
• RBC Capital Markets has a target price of $75
• Scotia Capital has a target price of $60
• TD Securities raises target price from $59 to $62
• UBS Securities raises target price from $53 to $54
Scotia Capital, 29 May 2009

Q2/09 Earnings Solid - Strong Wholesale

• Toronto-Dominion Bank (TD) reported operating earnings of $1.23 per share, slightly better than expected. Operating earnings declined 7% from a year earlier. ROE was 11.9% versus 15.3% a year earlier, which is expected to be a bank group low due to dilution from the Commerce Bancorp acquisition. However, return on risk weighted assets (RRWA) was solid at 2.09%.

• Incremental securitization revenue added $0.10 per share to TD earnings. Thus, excluding the incremental securitization revenue underlying earnings would be $1.13 per share versus operating earnings of $1.23 per share.

• Strong wholesale results and securitization revenue helped offset a decline in earnings in the US (spike in loan losses), flat earnings at TDCT, and weak wealth management earnings.

• Reported cash earnings were $0.82 per share including a $134 million after-tax or $0.16 per share loss on economic hedge related to reclassified AFS debt securities, $50 million after-tax or $0.06 per share restructuring charge related to Commerce Bancorp, $44 million after-tax or $0.05 per share loss in fair value of CDS hedging the corporate loan book, $39 million after-tax or $0.05 per share settlement of TD Banknorth shareholder litigation, and an increase in general allowance of $110 million or $77 million after-tax or $0.09 per share.

Canadian P&C Earnings Increase 1%

• Canadian P&C earnings increased a modest 1% to $589 million from $582 million a year earlier.

• Retail net interest margin increased 12 bp sequentially and decreased 2 bp from a year earlier to 2.94%.

• Revenues increased by 6.7% YOY to $2.3 billion, and expenses increased 4.4% to $1.1 billion.

• Loan securitization revenue was very high at $184 million versus $91 million a year earlier.

Card service revenue increased 31% YOY to $152 million.

• LLPs increased to $286 million from $266 million in Q1/09 and from $191 million a year earlier.

Total Wealth Management Earnings Decline 31%

• Wealth Management earnings, including the bank’s equity share of TD Ameritrade, declined 31% to $126 million.

Canadian Wealth Management Earnings Decline

• Domestic Wealth Management earnings declined 32% YOY to $78 million due to a significant decline in assets under management, lower average fees earned, and net interest margin compression.

• Operating leverage was negative 12.4%, with revenue declining 5.4% and expenses increasing 7.0%.

• Mutual fund revenue declined 23% to $164 million from a year earlier.

• Mutual fund assets under management (IFIC, includes PIC assets) declined 12% YOY to $51.9 billion.

TD Ameritrade – Earnings Decline 28%

• TD Ameritrade contributed $48 million, or $0.06 per share, to earnings in the quarter versus $77 million, or $0.09 per share, in the previous quarter and $67 million, or $0.09 per share, a year earlier. TD Ameritrade’s contribution represented 4% of total bank earnings.

U.S. P&C Earnings Decline Sequentially

• U.S. P&C earnings, which now includes the contribution from Commerce, declined quarter over quarter t $281 million, or $0.33 per share, from $307 million, representing 24% of total bank earnings. This compares with an earnings contribution of $130 million, or $0.17 per share, a year earlier before the Commerce Bancorp acquisition.

• Loan loss provisions in the US spiked 45% QOQ to $201 million or 1.24% of loans versus $139 million in the previous quarter ($78 million in Q4/08). Loan losses in the US have nearly tripled thus far in fiscal 2009.

• Net interest margin declined 4 bp from the previous quarter and 15 bp from a year earlier to 3.58% as the bank competes aggressively for deposits.

• The bank is expected to incur a US$50 million FDIC special deposit premium charge in Q3/09.

U.S. Platforms Combine to Represent 32% of Earnings

• U.S. P&C and TD Ameritrade contributed $329 million, or $0.39 per share, in the quarter, representing 32% of total bank earnings in the second quarter.

Wholesale Banking Earnings Strong

• Wholesale banking earnings were strong, increasing 86% to $173 million from $93 million a year earlier but were down from $265 million the previous quarter.

Trading Revenue – Remains Strong

• Trading revenue was very strong at $412 million versus $622 million in the previous quarter and $101 million a year earlier.

• Interest rate and credit trading revenue was very strong at $165 million versus a loss of $93 million a year earlier and a gain of $274 million in the previous quarter. Equity and other trading revenue declined to $93 million from $99 million a year earlier and from $171 million in the previous quarter. Foreign exchange products trading revenue increased to $154 million from $95 million a year earlier and $177 million in Q1/09.

Capital Markets Revenue

• Capital markets revenue was $374 million versus $337 million in the previous quarter and $332 million a year earlier.

Security Gains

• Security gains were a loss of $168 million or $0.13 per share versus a loss of $205 million or $0.16 per share in the previous quarter and a gain of $110 million or $0.09 per share a year earlier. The bank has exited its head office security portfolio, freeing up capital.

Unrealized Surplus – $75 million

• Unrealized surplus increased to $75 million from $47 million in the previous quarter and from $746 million a year earlier.

Loan Loss Provisions

• Specific LLPs increased to $546 million, or 0.93% of loans, from $232 million, or 0.43% of loans, a year earlier. TD increased general allowances by $110 million ($77 million after tax or $0.09 per share).

• We are increasing our 2009 LLP estimate to $2,100 million, or 0.85% of loans, and our 2010 LLP estimate to $2,300 million, or 0.89% of loans, from $1,800 million and $2,100 million, respectively, due to loan quality deterioration in the US.

Loan Formations Remain High

• Gross impaired loan formations increased to $927 million from $575 million a year earlier and from $990 million in the previous quarter. Net impaired loan formations increased to $633 million from $341 million a year earlier and $693 million in the previous quarter.

• Gross impaired loans increased to $1,875 million or 0.78% of loans from $1,543 million or 0.65% of loans in the previous quarter. Net impaired loans were negative $303 million.

Tier 1 Capital – Solid 10.9%

• Tier 1 ratio (Basel II) was 10.9% versus 10.1% in the previous quarter. Total capital ratio was 14.1% versus 13.6% in the previous quarter.

• Tangible common equity to risk weighted assets (TCE/RWA) was 9.0% versus 7.8% in the previous quarter, while common equity to RWA was significantly higher at 18.1% versus 16.7% in the previous quarter.

• Book value growth was 3% sequentially, aided by foreign exchange translation gains from the declining Canadian dollar more than offsetting AFS writedowns.

• Risk-weighted assets increased 12% from a year earlier to $199.7 billion as a result of the Commerce Bancorp acquisition, and declined 6% quarter over quarter.

Recent Events

• On February 6, 2009, TD announced that it would increase its holding in TD Ameritrade by 5% to 45% from approximately 39.9%. In September 2006, the bank entered into an agreement for a financial hedge for the potential purchase of 27 million shares of TD Ameritrade. On February 5, 2009, TD amended the hedge agreement to provide settlement in TD Ameritrade shares instead of cash. The cost of the financial hedge was US$515 million, or $19.07 per share, versus the recent price range of $12-$13 per share. TD expects no material impact to earnings or capital levels since the hedge, which was established in 2006, has been consolidated in the bank’s financial statements.


• We are increasing our 2009 and 2010 earnings estimates to $5.00 and $5.40 per share from $4.85 and $5.10 per share, respectively, due to improved net interest margin and stronger wholesale earnings.

• Our share price target remains unchanged at $60 per share, representing 12.0x our 2009 earnings estimate and 11.1x our 2010 earnings estimate.

• TD is rated 3-Sector Underperform.

Scotiabank Q2 2009 Earnings

• BMO Capital Markets raises target price from $35 to $37
• Desjardins Securities cuts target price from $45.50 to $41.50
• National Bank Financial raised target price from $34 to $38
RBC Capital Markets has a target price of $53
• TD Securities has a target price of $46
• UBS Securities raises target price from $40 to $42
TD Securities, 29 May 2009

Q2/09: Weathering Downturn; Well Poised for Growth

Yesterday, the bank reported core cash FD-EPS of C$0.96 vs. TD Newcrest C$0.75 and consensus C$0.80.


Neutral. Helped by strong trading, the quarter was well through expectations on an adjusted basis. We are seeing clearer signs of credit deterioration (now including the wholesale book), but evidence suggests the bank continues to be pro-active in managing risk and building reserves. We remain comfortable that the platform will weather the downturn and it should emerge well poised for growth.


Actually one of the best Domestic results. Potentially lost in the mix of yesterday's results, Scotia again turned in one of the best Domestic results of the group (see Exhibit 1). While suffering from the industry wide slowdown, we continue to view Scotia's domestic positioning as materially improved over the past year and becoming a strength going forward.

Keeping ahead of the credit curve. The much anticipated deterioration in the corporate/commercial books has now materialized in the reported numbers as Scotia Capital recorded its first significant PCL in recent memory. Overall, we continue to expect significant PCL growth through year-end. However, we continue to believe the team has been proactive in anticipating and managing its exposure and related reserves. Case in point, with the cover of strong capital markets results, the bank added to generals and established a sectoral related specifically to its auto exposure.

Weathering the downturn and well positioned for recovery. The current downturn hurts the bank's corporate credit exposure and International business. However, we believe management has been proactive in preparing for the cycle. We expect the bank to weather the current conditions and emerge well poised to capitalize on a recovery scenario benefiting from its strong wholesale lending presence and well positioned International platform.

Conference Call Highlights

• Cautious tone on acquisitions. Management downplayed interest in immediate term acquisitions, suggesting continued discipline in reviewing the ample potential targets, primarily in the International portfolio.

• Tax rate to ease. The quarter actually saw a slightly higher than expected tax rate of around 31%. Going forward it is expected to run closer to 21-24%

• Acceptable capital levels. While lower on an absolute basis versus peers, management feels the bank is comfortably capitalized relative to its risk and ongoing earnings/ROE prospects.

Results Highlights (year-on-year growth unless stated)

• Domestic. A relative bright spot again this quarter. The segment was flat year-on-year, with decent revenue growth (+5%) and good operating leverage offset by PCL growth (including general and sectoral reserve build). As we have seen elsewhere, Wealth Management had a difficult quarter.

• International. Decent revenue growth at +13%, but expansion/investment driven growth and higher credit costs crimped bottom-line which was roughly flat.

• Capital Markets. A strong quarter that was on par with the strength of Q1 helped by trading revenues, offsetting an uptick in credit costs as the segment saw its first meaningful PCL expense in recent memory at C$109 million in specifics (plus sectoral for a total of C$159 million) reflecting the impairment of a handful of credits largely related to U.S. real estate.

• Other/Corporate. Continues to reflect higher funding costs driving elevated losses and the reported write-down on AFS securities, but pressure eased over Q1/09.

Operating Outlook. Despite the beat on the quarter we are leaving our outlook unchanged. Specifically, we expect trading income to be less robust in back half of the year, loan volume growth to moderate and credit costs to remain elevated.

Segment Outlook. Lower trading revenues and continued PCL growth is likely to reduce Capital Markets income through 2H09. PCLs will also keep pressure on Domestic, where growth rates should weaken materially as the bank cycles 2H08 strength. International remains difficult to forecast (currency, PCLs, NIE etc, etc), but on balance we expect the contribution to ease through 2H09.

Credit Outlook. Based on Q2 developments, we expect to see credit to continue to deteriorate through the year and sustain significant PCLs. In particular, we are expecting further impaired development in the corporate portfolio. We maintain that overall, credit should be manageable in the context of the bank given decent reserves and ongoing earnings.

Capital Outlook. With ratios slightly below its peers, we expect Scotia to continue to manage capital judiciously. However, we believe management is not uncomfortable with where current levels stand and concerns of an equity raise now seem quite remote.

Justification of Target Price

Our Target Price reflects a discount to our estimate of equity fair value 12 months forward (based on our views regarding sustainable ROE, growth and cost of equity), implying a P/BV on the order of 2.25x.

Key Risks to Target Price

1) The continued weakening of the U.S. dollar, 2) country and political risk in its international markets such as Mexico, 3) integration challenges associated with its recent and future acquisitions and 4) adverse changes in the credit markets, interest rates, economic growth or the competitive landscape.

Investment Conclusion

We remain comfortable that the platform will weather the downturn and it should emerge well poised for growth.
Bloomberg, Sean B. Pasternak, 28 May 2009

Bank of Nova Scotia, the Canadian bank that’s expanded in about 50 countries, probably won’t make additional acquisitions amid the recession as it sets aside more money for bad loans.

“We have to be prudent in how we grow the bank,” Chief Financial Officer Luc Vanneste said today in an interview in Toronto. “In this environment, I think you’ll see more on the organic side than you will via acquisition.”

Scotiabank, which has spent about $4.2 billion on acquisitions in the last two years to expand in Peru, Chile and Thailand, will still look at deals, though “we have an onus to our shareholders to appropriately deploy the capital that we have,” Vanneste said.

The bank reported earlier today that second-quarter profit fell 11 percent after loan-loss provisions more than tripled. Net income in the period ended April 30 fell to C$872 million ($783 million), or 81 cents a share.

Vanneste said loan-loss reserves will probably rise until at least early next year.

“We see the world improving, but I think that we will still have several quarters of what I’ll call elevated provisions for credit losses,” he said.

CIBC Q2 2009 Earnings

• BMO Capital Markets cuts target price from $60 to $54
• Credit Suisse cuts target price from $49 to $48
• Desjardins Securities cuts target price from $66 to $62
• Dundee Securities cuts target price from $55 to $52
• Macquarie Securities cuts target price from $57 to $55
• National Bank Financial raises target price from $54 to $55
• RBC Capital Markets has a target price of $95 (yup, Andre-Philippe Hardy has a 12-month target price of $95 for CIBC)
• Scotia Capital has a target price of $68
• TD Securities cuts target price from $68 to $60
Scotia Capital, 29 May 2009

Q2/09 Earnings - in Line - Underlying Weak

• CM reported a decline in cash operating earnings of 11% to $1.44 per share, in line. Earnings were driven by stronger wholesale earnings and high security gains. Operating ROE was 21.0%.


• Reported cash earnings were a loss of $0.21 per share, after net charges on structured credit, MTM on derivatives and other items of $1.65 per share.

• Earnings at CIBC Retail Markets were disappointing, declining 21% YOY due to a decline in retail net-interest margin and a rise in LLPs. CIBC World Markets earnings were $203 million, up more than double from a year earlier.

• AFS/FVO gains remained high contributing $0.32 per share to earnings.

• Earnings estimates and share price target unchanged.


• CM has not covered its common dividend in five out of the past six quarters. Maintain 3-Sector Underperform based on negative earnings momentum at CIBC Retail Markets.
Bloomberg, Doug Alexander and Sean B. Pasternak, 25 May 2009

CIBC World Markets ousted TD Securities as the top equities trader for the first time in six years as Canadian banks use a rebound in trading to help replace profits lost to bad loans.

Canadian Imperial Bank of Commerce’s investment bank was the top trader by volume on the Toronto Stock Exchange for the past three months, taking almost a fifth of the market in April, according to data from TMX Group Inc., the exchange owner. TD Securities had been the top trader every month since 2003.

Canadian banks, which begin reporting second-quarter results tomorrow, will probably post a surge in trading revenue as global markets recover from the worst economic crisis since the Great Depression. Canada’s benchmark Standard & Poor’s/TSX Composite Index rose 7.2 percent in the quarter ended April 30, outpacing the 5.7 percent increase in the S&P 500 Index.

Trading fees at the six biggest banks will more than double to C$2.62 billion ($2.3 billion), said Sumit Malhotra, an analyst at Macquarie Capital Markets in Toronto.

CIBC, Canada’s fifth-biggest bank, hired three exchange executives, including former executive vice-president Rik Parkhill, as it ramped up electronic trading to win business from Toronto-Dominion Bank and other rivals.

“The placement of Rik gives them a definite inside edge in terms of TSX and how it trades,” said John Aiken, a bank analyst at Dundee Securities Inc. in Toronto. “This is a strategic move by CIBC and it effectively has taken place almost overnight.”

The surge won’t be enough to increase overall profits, which will plunge on higher provisions for bad loans and falling demand for credit in the country’s first recession since 1992, analysts said.

Canadian banks will report that profit before one-time items dropped 17 percent on average, the sixth straight quarterly decline, said Malhotra. Bank of Montreal, the No. 4 bank, is the first lender to report, at about 7:30 a.m. tomorrow.

Canadian Imperial is among the banks benefiting from the trading rebound, surpassing TD Securities in February, according to TMX data. Simone Philogene, a spokeswoman for Toronto- Dominion, declined to comment.

CIBC hired former exchange Chief Executive Officer Richard Nesbitt to head its investment bank in January 2008. Parkhill followed in August after the owner of the Toronto Stock Exchange bought the Montreal Exchange derivatives market.

“If you look at who’s running the show, it makes obvious sense,” Genuity Capital Markets analyst Gabriel Dechaine said. “Having the exchange background, their view is very different from the traditional brokerage executives.”

CIBC is focusing on electronic trading for money managers and traders to reduce costs and exploit split-second price discrepancies. Those customers tap the Toronto exchange, and alternative trading systems such as Pure Trading and Chi-X Canada, as well as marketplaces in the U.S.

Toronto-based CIBC spent a decade building systems to take advantage of automated trading, which is gaining on the traditional block trading dominated by Canadian banks. Electronic trading accounts for 15 percent of volume on the Toronto exchange, up from almost nothing a year ago, according to TMX. Block trades are orders of 10,000 shares or more worth at least C$100,000.

“We adapted rapidly to the market structure changes that are under way in Canada and developed products and services that allowed our clients to trade more efficiently,” said Parkhill, CIBC’s head of cash equities. “The market is changing, and either you embrace change or you become a victim of it.”

Even with the gains, CIBC has the smallest trading business among the country’s six biggest lenders. The bank’s second- quarter trading revenue was about C$85 million, a 27 percent increase from the year earlier, according to Darko Mihelic, a CIBC bank analyst. Royal Bank of Canada, the biggest bank, will probably report revenue 10 times higher, he said. The revenue figures include fixed-income, currency and stock trading.

“The all-important question is how profitable is this trading for CIBC, and that’s yet to be seen,” Aiken said.

CIBC rose C$2.08, or 3.9 percent, to C$55.78 at 4:10 p.m. in Toronto Stock Exchange composite trading, leading a surge among Canada’s biggest banks. Bank of Nova Scotia rose 2.3 percent, followed by a 2.1 percent increase for Toronto- Dominion, a 1.7 percent rise for Bank of Montreal and a 0.95 percent gain for Royal Bank.

Trading gains won’t be enough to offset rising loan defaults among the country’s biggest banks with unemployment at a seven-year high of 8 percent.

Canadian banks may set aside C$2.26 billion for bad loans, more than double the amount from a year ago, according to BMO Capital Markets analyst Ian de Verteuil.

“We’re still nervous about that particular area, as unemployment is rising and consumers have pretty much maxed out their credit cards,” said John Kinsey, who helps manage about C$1 billion at Caldwell Securities Ltd. including bank shares. “It’s only going to get worse.”

Bank of Montreal may say that profit before one-time items fell 28 percent to 86 cents a share, according to de Verteuil.

Toronto-Dominion, Bank of Nova Scotia, CIBC and National Bank of Canada report results May 28. Toronto-Dominion may say profit fell 11 percent to C$1.17 a share on lower asset- management fees, de Verteuil said.

Bank of Nova Scotia, Canada’s No. 3 bank, may say profit fell 10 percent to 87 cents a share on higher loan losses and a decline in asset-management fees, he said. Montreal-based National Bank may report per-share profit fell 14 percent to C$1.21 on higher trading and credit losses. Canadian Imperial’s profit probably fell 12 percent to C$1.43 a share on lower investment-banking earnings.

Royal Bank’s profit may be unchanged at C$1.05 a share, excluding $850 million in writedowns announced last month.

National Bank Q2 2009 Earnings

Scotia Capital, 29 May 2009

Q2/09 Better Than Expected - Wholesale Strong

• National Bank of Canada (NA) reported a 9% increase in operating earnings to $1.53 per share, above our estimate of $1.30 per share. Earnings were driven by extremely strong trading revenue, particularly from fixed income, as well as higher security gains and securitization revenue. Operating return on equity for the quarter was 19.4% versus 20.2% a year earlier.


• Operating earnings were boosted by larger securitization revenue in Q2/09 of $100 million versus $58 million a year earlier representing a $0.17 per share incremental gain. Thus underlying earnings prior to incremental securitization revenue were $1.36, still better than expected.

• Reported earnings were $1.41 per share including a $20 million after tax or $0.12 per share charge consisting mainly of losses on economic hedge transactions.


• We maintain our 2-Sector Perform rating, with NA having relatively low credit risk, solid relative retail momentum, and higher leverage to wholesale, which we believe has a favourable outlook.

27 May 2009

BMO Q2 2009 Earnings

RBC Capital Markets, Andre-Philippe Hardy, 27 May 2009

Q2/09 results exceeded our low expectations, led by lower than expected loan losses and taxes. Capital ratios were higher than estimated and core pre-tax, pre-provision profitability was in line with our normalized estimates for 2010.

• Forgetting expectations, results reflect a difficult environment, with a core ROE of 12.3% and reported EPS that remain below the dividend.

• Reported cash EPS of $0.63 were above our $0.46 estimate; many unusual items affected results and core earnings power was above $0.63 in our view (closer to $0.95-$1.00).

The reasons for our Outperform rating remain. The biggest worry of a few months ago (the dividend being cut given a high payout ratio) has become less of a worry as the economic outlook has improved and capital markets have shown signs of stabilization. BMO has more capital than other banks, which will allow it over time to recognize some of the losses it might have to take in its off balance sheet vehicles, in our view. The bank has one of the largest exposures to U.S. lending and gross impaired loans continued to climb in Q2/09, but other banks are also likely to see increasingly higher losses, as Canadian credit is deteriorating also and U.S. credit losses are spreading beyond early problem areas. As a result, credit is likely to be less of a negative for BMO relative to peers in 2009.

• Our 2009 core cash EPS estimate of $3.60 is up marginally from our prior $3.50 forecast. Our normalized 2010 EPS estimate (i.e., using normal loan losses rather than predicted) remains just above $5.50.

• As is our customary practice, we will undertake a full review of earnings estimates, ratings and target prices for all of the banks we cover as part of the industry review we will publish once all banks have reported. Directionally, the results were largely in line with trends we expected going into the quarter for the industry for (1) credit (pressure primarily from U.S. exposures, Canadian consumer deterioration, stable Canadian commercial exposures), (2) capital markets (YoY growth, QoQ decline), (3) wealth management (YoY declines). In Canadian retail banking, margins were higher than we had anticipated, but loan growth was lower.
Financial Post, Scott Deveau, 27 May 2009

Despite beating the Street’s expectations this week with its first quarter result, Blackmont Capital analyst Brad Smith downgraded the stock to a “sell” Wednesday.

BMO reported adjusted diluted cash earnings per share of 93¢ Tuesday, 3¢ ahead of consensus.However, Mr. Smith warned of some issues going forward.

BMO’s ratio of allowances to trailing two-year net write-offs fell to 87% from 102% in the first quarter, their lowest level since 1996, he noted.

In addition, its structured investment vehicle exposure, which now totals US$7.9-billion in funding/commitments, could “very likely pressure earnings and capital in the coming quarters, as assets are currently valued at a US$1.9-billion discount to commitments," he said.

The recent outperformance of the bank’s share price also has it trading at 6% premium to its peers, and its highest level since October 2007.

“Based on its premium valuation, ongoing SIV exposure, and the inadequacy of the bank’s allowance levels, we are reducing our investment recommendation on BMO,” Mr. Smith said.

He maintained his $32 price target, but reduced the stock’s rating from a “hold” to a “sell.”

19 May 2009

Preview of Banks' Q2 2009 Earnings

Scotia Capital, 19 May 2009

Banks Begin Reporting May 26

• Banks begin reporting second quarter earnings with Bank of Montreal (BMO) on May 26, followed by Laurentian Bank (LB) on May 27, Bank of Nova Scotia (BNS), Canadian Imperial Bank of Commerce (CM), National Bank (NA), and Toronto Dominion (TD) on May 28, Royal Bank (RY) on May 29, and Canadian Western (CWB) closing out reporting on June 4. 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.

Moderate Negative Earnings Momentum – Solid Profitability

• We expect second quarter operating earnings to decline 8% year over year due to an expected doubling of loan loss provisions and lower retail net interest margin. Loan loss provisions are expected to increase to $2.3 billion or 0.71% of loans for the quarter versus $1.1 billion or 38 basis points (bp) a year earlier. The retail net interest margin is expected to decline to the 2.50% range from 2.83% a year earlier.

• Operating return on equity is expected to be 16.1% for the second quarter, down from 19.9% a year earlier. TD’s return on equity has dropped significantly post the acquisition of Commerce Bancorp to 13.2% in Q1/09 down from 19.7% in Q1/08 and 20.6% in fiscal 2007. TD’s return on risk-weighted assets remained relatively high, but its ROE has meaningfully lowered the overall bank group’s return on equity.

• High loan loss provisions and retail margin pressure are expected to be partially offset by a substantial improvement in the wholesale net interest margin and the depreciation of the C$. The wholesale margin has widened significantly as measured by the prime one-month BA spread; as well, banks have been active in repricing their loan book.

• The retail margin pressure stems mainly from the low level of interest rates and the interest rate floor with respect to personal demand and notice deposits. Also, competition for retail deposits remains stiff, which really hasn’t shifted all that much. However, the repricing of some retail lending products is expected to partially offset some of the margin pressure, although we expect the asset repricing to lag the impact of the significant reduction in prime rate that will be in full force in the fiscal second quarter.

• Bank prime rate averaged 2.64% in the second fiscal quarter versus 3.65% in the first quarter and 5.37% a year earlier. The average prime rate is projected at 2.25% for the third fiscal quarter, assuming no further rate cuts by the Bank of Canada. The low level of interest rates, we believe, represents the biggest risk to bank earnings over the next several years, especially to the retail-banking-dependent banks. The credit cycle will likely negatively impact earnings, but is very much anticipated by the market and we believe is manageable and perhaps more cyclical than the structural issue of low interest rates for any extended period of time.

• Reported earnings are expected to increase a modest 4%, or 43% excluding RY’s pre announced goodwill impairment charge, as mark-to-market (MTM) losses decline to a guesstimate of $1.9 billion after-tax ($0.9 billion ex RY’s goodwill impairment charge) versus $2.2 billion a year earlier.

• We are forecasting a 7% earnings decline in 2009 and a 7% increase in 2010. Return on equity is expected to be 16.9% in 2009 and 16.6% in 2010. Our earnings estimates, we believe, reflect recession level loan loss provisions (LLPs) (see our May 11 report titled The Credit Cycle).

• The fear about how safe Canadian bank dividends are seems to have passed, or at least subsided, as the market is now more balanced in looking at underlying fundamentals. The market, we believe, is shifting to a more fundamental approach with a focus on earnings power and P/E multiples as opposed to capital/solvency and market value to tangible book as a valuation matrix. The release of the much-feared Stress Tests results in the U.S. has calmed market fears. That is not to say that a number of global banking systems that have fundamental issues will not suffer some type of dilution in the near to medium term. However, the reduced fear about the collapse of the U.S. banking system has taken a lot of pressure off Canadian bank stocks that have been suffering from valuation contagion compounded by “agents of fear” and aggressive investor views that the Canadian system has massive leverage and that the only way to value a bank stock is market to tangible book.

• Bank stocks outperformed the TSX in calendar 2008 by a narrow margin and are outperforming by a wide margin thus far in 2009 recovering some of the underperformance from the 2007 commodity-led TSX.

• We continue to be proponents of earnings power and P/E to value bank stocks. The sustainability of bank dividends and the resumption of superior dividend growth will be a catalyst for significantly higher bank share prices.

• On a P/E multiple basis, the banks have bounced off the 6.0x bottom. We would have expected in the absence of valuation contagion for bank P/E multiples to have bottomed at 9.0x, similar to the Asian crisis. We continue to expect bank P/E multiple expansion through 2012, similar to that experienced post the 2002 cycle. We expect bank P/E multiples to expand back to 14x in the next few years and eventually 16x.

• Bank valuation remains compelling on both a dividend yield and P/E multiple basis despite the 54% increase in bank share prices since the February 23, 2009, bottom. Bank P/E multiples are slightly above 9.0x, with significant expansion expected. Bank dividend yields are 5.4% or 1.8x relative to the 10-year government bond yield, which is 5.3 standard deviations above the mean. This ratio peaked at the unheard-of level of 10.1 standard deviations above the mean.

• 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 remain overweight the bank group based on strong fundamentals and compelling valuations.

• We have a 1-Sector Outperform rating on Royal Bank, with 2-Sector Perform ratings on NA, BMO, BNS, LB, and CWB, and 3-Sector Underperform ratings on CM and TD. Our order of preference continues to be biased towards strong wholesale banks, with RY best positioned for growth. Order of preference RY, NA, BMO, BNS, CWB, LB, CM, and TD.

BNS – Scotiabank Mexico Contribution Declines

• Scotiabank Mexico reported Q1/09 consolidated net income of $43 million (MXN$488 million), a 53% decline from a year earlier and a 3% decline from the previous quarter. Revenue increased 2% from a year earlier, and operating leverage was positive 5%. Scotiabank Mexico’s contribution to BNS, after adjustments for Canadian GAAP, is $54 million or $0.05 per share versus $63 million or $0.06 per share in the previous quarter and $80 million or $0.08 per share a year earlier.

RY Announced US$850 Million Goodwill Impairment Charge

• On April 16, 2009, RY announced that it expects to record a US$850 million ($1,020 million or $0.72 per share) goodwill impairment charge on its International Banking segment in the second quarter ending April 30, 2009. The impairment charge is the result of the prolonged economic difficulties in the U.S., in particular the deterioration of the U.S. housing market, and the decline in market value of U.S. banks.

TD – TD Ameritrade Earnings

• TD Ameritrade (AMTD) reported a 26% decline in earnings to US$0.23 per share from US$0.31 per share a year earlier due to the weak net interest margin and a 17% decline in fee-based balances. Earnings were in line with consensus. TD Bank estimates TD Ameritrade’s contribution this quarter to be $48 million or $0.06 per TD share versus $0.09 per share in the previous quarter and $0.09 per share a year earlier. TD Increases Stake in TD Ameritrade by 5%

• TD announced that it will increase its holding in TD Ameritrade by 5% to 45% from approximately 39.9%. In September 2006, the bank entered into an agreement for a financial hedge for the potential purchase of 27 million shares of TD Ameritrade. On February 5, 2009, TD amended the hedge agreement to provide settlement in TD Ameritrade shares instead of cash. The cost of the financial hedge was US$515 million or US$19.07 per share versus the recent price range of US$12-$13 per share.
Financial Post, 19 May 2009

The Canadian bank earnings season is on us once again, and UBS Securities analyst Peter Rozenberg is projecting a 20% decline in earnings per share compared to the same quarter a year ago, when the banks were enjoying a better operating environment.

"Green shoots aside, the economic outlook that underpins bank earnings has continued to deteriorate with more negative GDP, and higher unemployment," he wrote in a note to clients.

Mr. Rosenberg noted that loan pricing is increasing and funding costs have come down, but low interest rates continue to hurt margins. Another issue is provisions for credit losses. They will continue to increase, but Mr. Rozenberg thinks they should be largely discounted by the market already. He is predicting an 88% increase year-over-year.

On the positive side, he pointed out that the outlook for capital markets has improved because of all the industry consolidation, wider trading spreads and improved financial markets. He also wrote that wealth management revenues should improve because of rising fund inflows, and he expects the banks to demonstrate improved expense control.

On an individual basis, Mr. Rozenberg prefers Bank of Nova Scotia because of its "higher than average domestic growth, higher than average international growth, higher than average returns, the best leverage to higher [net interest margins], and potential for acquisitions." He also believes Canadian Imperial Bank of Commerce continues to offer excellent value because of its high returns on equity (over 20%), and low risk.

He recently downgraded Royal Bank of Canada and Toronto-Dominion Bank based on their recent price appreciation.

"Following a 60% rebound, bank valuations appear closer to neutral," he wrote."
Financial Post, Eric Lam, 13 May 2009

With Canada's big banks set to report their second quarter results later this month, Desjardins Securities sees another tough quarter for earnings as the economic slowdown continues.

Desjardins analyst Michael Goldberg expects earnings per share results from the Big Six to be down in 2009 and recover in 2010.

"But the outcome could be much worse in the event of our alternate, more severe credit cycle scenario," he said in a note to clients. "We remain concerned that investors would be deeply alarmed by the much higher level of [non-performing loan] formations under this scenario."

Mr. Goldberg acknowledges that there has been a widespread global rally between February and April, during which time Canadian bank stocks jumped 23.4%. So far in the month of May, banks are up 9%.

"A key reason for the increase in bank stock prices has been that the fear of potential dividend cuts has abated," he said.

For Mr. Goldberg, the real cause for concern is credit deterioration. With high unemployment levels, more bankruptcies and falling house prices, the credit environment in Canada and the United States will remain turbulent at least through 2010.

"It will get worse before it gets better," he said. Mr. Goldberg has developed two possible scenarios for non-performing loan formations. The first projects NPLs of about $10.4-billion or 0.83% of average loans in 2009 and about $7.8-billion or 0.61% in 2010. The second is substantially darker, suggesting $31.5-billion in NPLs (2.5% of loans) in 2009 and $16.2-billion (1.25%) in 2010.

However, NPL formation in Canada is still much better than in the United States, he said.

Overall, Mr. Goldberg sees the possibility of major differences beyond the second quarter of 2009 depending on how serious the credit downturn gets. For now, the strong rally from dividend confidence has convinced him to increase target prices for all banks in the Big Six except for the Bank of Nova Scotia.

Here's a summary of his recommendations:

• Bank of Montreal target price to $47.50 from $39; Hold-average risk
• Bank of Nova Scotia target price $45.50 unchanged; Top Pick-average risk
• CIBC target price to $66 from $59; Hold-average risk
• National Bank of Canada target price to $53.50 from $42; Hold-average risk
• Royal Bank of Canada target price to $50 from $41.50; Hold-average risk
• TD Bank target price to $65.50 from $54; Top Pick-average risk
Financial Post, Eric Lam, 12 May 2009

It took a while, but one of Canada's most bearish anaylsts on banks is finally relenting and riding the valuation wave.

Sort of.

"For those who were smart enough not to listen to our advice, we do not believe that investors should take profits on bank shares quite yet," Dundee Securities analyst John Aiken wrote in a note to clients Tuesday. "We advocate increasing exposure to the banks as a near-term trade."

Mr. Aiken, who maintains "sell" ratings on all major Canadian banks except for TD Bank and the National Bank of Canada (he's neutral on them) expects "reasonably strong" second-quarter results from Canadian financials thanks to the "rubber-stamp approval" of U.S. banks through the recent stress tests.

However, Mr. Aiken is still negative on banks long-term.

"The economy still sucks," he wrote. "Despite appearing to have the momentum of a runaway freight train, the rise of the Canadian banks will have to slow at some point."

Mr. Aiken warns that the economy is still weakening, and investors have not seen the full brunt of the U.S. and global recession.

As well, the operating environment for banks is undergoing a fundamental revision. On top of expected future regulations, banks will not be able to take advantage of revenue streams such as securitizations that were prevalent before the credit crisis, leading to lower profitability overall.

"Also, do not forget that the various forms of capital issued by the banks to prop up Tier 1 capital ratios reduces overall profitability to common shareholders," he wrote.

Investors should be wary of current valuation multiples for the Big Six, which are well above 10x in 2009 and 2010 consensus estimates, especially when the "sentiment pendulum" swings back in the other direction. Mr. Aiken reiterates his majority "sell" ratings for banks but suggests investors should wait in the near term before dropping banks from their portfolios.

"Did we mention that the economy still sucks?" he wrote.
The Globe and Mail, Steve Ladurantaye, 12 May 2009

Desjardins Securities raised its target prices for Canadian banks Tuesday, forecasting a 10 per cent increase in profits in the coming year and declaring dividend cuts unlikely.

“Since February, bank stock prices have risen 40 per cent because the fear of dividend cuts has subsided,” analyst Michael Goldberg wrote in a note to clients. “Accordingly, we are increasing our target prices.”

He raised his target on Bank of Montreal by 21 per cent to $47.50, CIBC by 11 per cent to $66, National Bank by 27 per cent to $53.50, TD Bank by 21 per cent and Royal Bank by 20 per cent to $50. He left his target for Bank of Nova Scotia rated his top pick – unchanged at $45.50. He has “hold” ratings on the other banks.

Canadian banks have been punished since October, when the world's financial system was shocked by mounting losses and the bankruptcy of Lehman Brothers. The financial subindex on the Toronto Stock Exchange has rebounded 60 per cent from its March lows, but it is still 25 per cent below highs set in June.

Avenue Investment portfolio manager Paul Harris said it's too soon for investors to buy into the Canadian banks. The economy is still shedding jobs, losses are likely to increase and credit remains tight.

“This is a credit-driven recession, and you don't come out of that as easily as people seem to think,” said Mr. Harris, who owns both TD and Royal Bank in his portfolios. “To believe that the banks will all recover tomorrow is naive – after the last recession, the banks moved sideways for almost four years.”

Mr. Goldberg considered two scenarios when setting his target – the first was the 10 per cent increase in profits in 2009 compared to 2008. In his alternate scenario, bad loans would drive profit down 8 per cent compared to 2008.

“The probability of the base case or something close to it is still higher than the alternate scenario, but the probability of the alternate scenario is high enough, in our view, that it puts a lid on further improvement in relative yields,” he said. “Keep in mind that we see minimal prospects for dividend increases under our base case in the coming year and none under the alternate scenario.”

Plunging share prices had sent bank yields soaring, with Bank of Montreal's dividend yield near 11 per cent earlier this year as its shares bounced off a 52-week low of $24.05. They have since recovered to $43.95, bringing the yield in the 6.5 per cent range. Canadian banks traditionally yield closer 4 per cent.

Mr. Goldberg said the only bank likely to raise its dividend is TD, which he said could increase its annual payout to $2.48 from $2.44.

Earlier this month, RBC Dominion Securities Inc. analyst Andre-Philippe Hardy upgraded Canadian banks, despite his belief that loan losses will continue to deepen in 2009.

“The key to investing in bank shares is not to look at the immediate future for earnings but rather at whether the outlook for future earnings is improving – which we believe it is,” he said, as he estimated share prices could increase by as much as 80 per cent in the next two years.

Mr. Harris said the upgrades have been driven by the rapid appreciation of bank shares as investors anticipated a swift economic recovery, leaving the analysts in a difficult position as clients look to benefit from the runup.

“They are pretty much screwed,” he said. “People are so worried about jumping on, but as an investment, it still doesn't make any sense. They are issuing a tonne of equity, and their balance sheets aren't in great shape.”
TD Securities, 8 May 2009

• We are now less enthusiastic on the group following a strong run. Fears of acute industry problems appear to have eased materially – and appropriately so in our view. In a strong tape, the stocks have rallied 60%+ off their troughs and are up nearly 25% YTD - delivering solid relative outperformance. We rolled forward our Target Prices and from current levels we expect more normal returns – on the order of 10-15% over the coming 12 months.

• Shifting to market weight and downgrading National Bank. Against these prospects, and facing ongoing operating challenges and lingering uncertainties, we are shifting to Market-Weight from our previous Over-Weight stance. We are also downgrading National Bank to Hold from Buy following its industry leading performance year-to-date.

• Shifting CIBC to Buy from Action List Buy – still a solid idea. We are taking CIBC off the Action List following 25% returns since early December, but it remains a solid idea in our view. We continue to view TD and Scotia as attractive ideas under a recovery scenario.

• Outperformance v LifeCos has been dramatic. The Large-Cap Canadian banks have dramatically outperformed the LifeCo space by some 30%+ over the past year. That said, we are maintaining our relative preference for banks in light of the standing industry concerns of our LifeCo analyst Doug Young.

• Q2 should continue to see softer earnings. We believe underlying trends remain under-pressure. Help from strong trading results again this quarter are unlikely to sway our view on the operating outlook.

Q1 reporting provided some relief for the group with better than expected results, helped by some fairly strong trading numbers. The stocks responded quite positively for the most part and, supported by recent easing of fears/uncertainty globally, they have outperformed in a strong equity market recovery. At current levels, we are now less enthusiastic about the group than we have been in recent months.

We believe the strong recovery (60%+ from the group’s February lows) and firmer valuations now reflect a much more balanced view of the group. Fears around things like massive write-downs, significant capital raises and industry wide dividend cuts appear to have subsided; appropriately in our view.

That said, we continue to view the current operating environment and outlook as quite challenging. A number of asset exposures remain under pressure, while most underlying business trends continue to moderate and a significant credit cycle is just beginning. Finally, risks and uncertainties for the industry globally remain pronounced.

We are shifting to a Market-Weight stance from our previous Over-Weight view. From current levels, we would expect total returns to be closer to a more normal 10%-15% range over the coming 12-months.

There is no change in our operating outlook or estimates. We still expect the group to weather the downturn relatively well and emerge in a strong competitive position. However, tough conditions will weigh on earnings, book value growth and further multiple expansion. This limits the prospect of further significant relative outperformance in the coming months in our view.

We expect tough conditions to be evident again in Q2 results with moderating trends in core banking operations, rising credit costs and likely further write-downs. We anticipate strong trading revenues may offer some coverage again this quarter, but we believe market expectations are more aware this time around and we remain ultimately critical of their sustainability and value to ongoing earnings.

With this report we are downgrading National Bank to Hold from Buy following its industry leading 50%+ appreciation year-to-date. We are also shifting CIBC to Buy down from Action List Buy following returns on the order of 25% since early December.

We continue to highlight CIBC as a solid idea in the current environment as 1) its retail operations continue to deliver reasonable earnings, 2) the bank continues to manage its risks/exposures and 3) CIBC looks to be relatively well positioned with respect to credit (notwithstanding its credit card exposures).

We also continue to view Scotia and TD as two high quality operating platforms both of which are well positioned to capitalize on an improving global growth outlook and credit cycle (which we expect to come into view in 2H09).

Notwithstanding the strong relative outperformance by the banks over the LifeCos, we are maintaining our preference as our LifeCo analyst, Doug Young, continues to note significant challenges including 1) equity market sensitivity/earnings volatility 2) underappreciated credit risk and 3) sensitivity to low interest rates.

13 May 2009

Regulation Didn't Save Canada's Banks

The Wall Street Journal, Marie-Josée Kravis, 13 May 2009

Canada's five largest banks would pass the U.S. government stress test brilliantly. They were profitable in the last quarter of 2008, are well capitalized now, and have had no problems raising additional private capital. On average only 7% of their mortgage portfolios consisted of subprime loans (versus 20% in the U.S.). And no major Canadian bank has required direct government infusions of capital.

Advocates of increased regulation of U.S. financial markets have concluded that more stringent rules governing leverage and capital ratios account for Canada's impressive performance. They champion such measures here. In a Toronto speech earlier this year about reforming the U.S. banking system, former Fed chairman and Obama administration adviser Paul Volcker said the model he is considering "looks more like the Canadian system than it does the American system."

Nevertheless, Canadian banks operate in a very different context. Copying the Canadian banking system in this country, without understanding how its banking and housing sectors operate, would be a mistake.

Start with the housing sector. Canadian banks are not compelled by laws such as our Community Reinvestment Act to lend to less creditworthy borrowers. Nor does Canada have agencies like Fannie Mae and Freddie Mac promoting "affordable housing" through guarantees or purchases of high-risk and securitized loans. With fewer incentives to sell off their mortgage loans, Canadian banks held a larger share of them on their balance sheets. Bank-held mortgages tend to perform more soundly than securitized ones.

In the U.S., Federal Housing Administration programs allowed mortgages with only a 3% down payment, while the Federal Home Loan Bank provided multiple subsidies to finance borrowing. In Canada, if a down payment is less than 20% of the value of a home, the mortgage holder must purchase mortgage insurance. Mortgage interest is not tax deductible.

The differences do not end there. A homeowner in the U.S. can simply walk away from his loan if the balance on his mortgage exceeds the value of his house. The lender has no recourse except to take the house in satisfaction of the debt. Canadian mortgage holders are held strictly responsible for their home loans and banks can launch claims against their other assets.

And yet Canada's homeownership rate equals that in the U.S. (Both fluctuate, in the mid to high 60% range.)

For obvious political reasons, debate in Washington spotlights the need for future financial regulation while glossing over the role of government housing and other regulatory policies in the current crisis. This is dangerous: Without a thorough review of relevant government housing policies, laws and regulations, layering new reforms on top of our current system may only set the stage for another housing crisis in the future.

In response to the current crisis the Canadian government has thus far bought about $55 billion (Canadian) of insured loans from financial institutions (a substantial sum, given that Canada's economy is one-tenth the size of the U.S. economy). It has also played a central role supporting the availability of credit and removing potentially distressed assets from bank balance sheets. Still, these interventions have not arrested a substantial slump in Canadian GDP. Last week the Bank of Canada announced that first quarter 2009 GDP had fallen 7.3%. Bank of Canada Governor Mark Carney (Canada's Ben Bernanke) explained the sharp slowdown in growth: "[I]f we had to boil it down to one issue, it is the slowness with which other G-7 countries have dealt with the problems in their banks."

When it comes to comparing the track record of the U.S. and Canadian banking systems, it is worth noting that Canada's regulations did not prohibit the sale or purchase of asset-backed securities. Early in this decade, Canada's Toronto-Dominion bank was among the world's top 10 holders of securitized assets. The decision to exit these products four to five years ago, Toronto-Dominion's CEO Ed Clarke told me, was simple: "They became too complex. If I cannot hold them for my mother-in-law, I cannot hold them for my clients." No regulator can compete with this standard.

Tighter leverage limits in Canada may have dimmed the incentives for its banks to pursue securitization as brashly as their American counterparts. But regulations cannot take all the credit. Even with leverage ratios held on average at 18 to 1 (versus 26 to 1 for U.S. commercial banks and up to 40 to 1 for U.S. investment banks), Canadian banks would not be as healthy as they are had they not disposed of their more problematic securitized assets four to five years ago. Nothing in Canada's regulations banned risk-taking. Good, prudent management prevented excess.

Those who blame financial deregulation for the breakdown of U.S. markets should note that Canada shed its version of Glass-Steagall more than 20 years ago. Major banks thereafter rapidly bought and absorbed investment banks.

At that time, Canada established the Office of the Superintendent of Financial Institutions (OSFI) to provide common, consistent and more centralized regulation for federally regulated banks, insurance companies and pension funds. To this day OSFI is almost obsessively concerned with risk management, leaving social and economic objectives, such as access to affordable housing and diversity, to institutions better-suited to attain those goals.

Those desirous of importing Canadian banking regulations to the U.S. should first delve more deeply into the actual practices of our northern neighbor's housing and financial system. Choosing selectively often leads to choosing poorly.

12 May 2009

The Credit Cycle - Banks Positioned to Outperform

Scotia Capital, 11 May 2009

• Canadian banks continue to be impacted by the credit cycle as loan loss provisions rise and fall with the economic tide. The major question is how vulnerable are Canadian banks to the current credit cycle from an earnings and capital perspective and how are bank stocks likely to perform on an absolute and relative basis. In this report, we attempt to compare and contrast the current credit cycle with past cycles, taking into account macroeconomic factors and micro-factors such as loan mix and concentration.

• However, before looking in detail at the current credit cycle, we attempt to put the Canadian banking industry in an historical context. Canada has been known, we believe, from a global perspective as a small and concentrated banking market with undue loan concentration, especially from a corporate lending perspective. The one blemish in Canada’s now recognized enviable banking system has been undue loan concentration, which has historically overshadowed the underlying strength of the bank system.

• Canada has traditionally had significantly higher exposure to high-risk assets/loans than its global peers, with the exception of the current cycle. As a multiple of common equity, Canadian banks’ exposure to lesser developed countries (LDC) loans was 10.9x the exposure level of U.S. banks in 1982, with commercial real estate (CRE) exposure being 2.5x its U.S. counterparts in the early 1990s and Telco exposure 6.7x larger. The high exposure to high-risk assets was further compounded by single name concentration within these high-risk sectors, especially CRE in the early 1990s. Canadian banks had single name exposure as high as 35% of common equity in 1985 and 20% in 1992 with single name exposure now estimated at only 2% of common equity, with very few exceptions.

• The Canadian banking system’s historical leverage to credit and concentration can be reflected by the fact that the Canadian banking system absorbed $40 billion in loan loss provisions from 1984 to 1994 on a common equity base of only $14 billion. The 1984 to 1994 period was the darkest days for credit in Canadian banking, which included massive LDC provisions in the 1980s, particularly 1987, and the equally devastating commercial real estate provisions of the early 1990s.

• Interestingly, despite major credit blowups, particularly from the 1984 to 1994 period, Canadian banks have managed to grow their earnings and dividends by an impressive 10% CAGR over the past 50 years, which speaks to the core strength of the banking system. Bank share prices have also substantially outperformed over the long term.

• The Canadian banking system was transformed with the acquisition of the major investment dealers in the late 1980s (no Glass-Steagall Act) and subsequent acquisitions of the major trust companies in the early 1990s, which assisted in the significant reduction in corporate credit dependency. Thus the evolution of our current strong banking system with a diversified revenue mix, balanced operating platforms, and sound effective regulation.

• This cycle, Canada has less than half the exposure to high-risk assets such as sub-prime and structured products versus their global peers, which is a significant reversal of fortunes. As a consequence of the relatively low exposure to high risk-assets this cycle, Canadian banks have comfortably maintained their dividend levels versus global banks that have cut or essentially eliminated their dividends to survive, in addition to accepting government aid.

• The strength of the Canadian system was tested in 2008 with the market crisis as structured products and trading securities values plummeted and mark-to-market losses skyrocketed globally. Canadian banks’ relatively low exposure to toxic securities allowed the banks to report a fully loaded return on equity of 12% in 2008 after all writedowns, and allowed banks to grow their book values by double digits and pay their dividends, which reached yields never seen before versus both government and corporate bond yields.

• The Canadian banks’ operating performance in 2008 resulted in the banks outperforming the TSX, a rarity in global markets, although this is of little consolation given the poor absolute returns driven by global valuation contagion. Canadian banks are also comfortably outperforming the TSX thus far in 2009.

• The current credit cycle began in earnest in late 2008 and early 2009, and the major focus now is what level will loan losses peak at and the banks’ ability to absorb these losses from an earnings and capital perspective, and bank share price performance through the credit cycle. The key issues in deriving peak loan losses are what will be the severity and duration of the economic slowdown and the risks and mix of the banks’ loan portfolios.

• In analyzing the credit cycle, we look at both macroeconomic variables and micro-factors such as loan mix, sector and name concentration, and risk management including credit or underwriting standards. We also compare and contrast the current credit cycle with the past three cycles, particularly the 1983 and 1992 cycles, as the 2002 cycle was probably the only one in history not initiated by a decline in the economy as measured by two consecutive quarters of negative GDP.

• The macroeconomic variables we focus on are the unemployment rate, debt levels for households and non-financial corporations, pre-tax corporate profits, housing affordability, equity in real estate, house price declines, as well as depth and breadth of the economic retreat (GDP) and Canada’s fiscal position. The macroeconomic variables are used in conjunction with historical loss ratios, impaired loan levels, and micro-factors such as loan mix and concentration to derive expected loss ratio by loan type bank by bank in order to compute an overall expected peak loss ratio.

• We believe the positive impact of Canadian banks’ lower loan concentration and lower leverage to credit will be evident this credit cycle. We believe that banks’ leverage to credit has declined successively over the past 20 or 30 years and, combined with lower loan concentration and higher underwriting standards in Corporate, should more than offset higher consumer loan losses and perhaps the risk of a more severe recession than 1982 and 1991. Canadian banks, we believe, are positioned to outperform through this credit cycle.

• Our analysis has loan loss provisions peaking this cycle in 2010 at $10 billion, or 76 basis points (bp) of loans (82 bp on Q1/09 loan balances), for return on equity of 16%. We believe that fiscal 2008 ROE of 12% (14% excluding CIBC) fully loaded after large mark-to-market writedowns will be the bottom in profitability this cycle. The 12% ROE included $13 billion in mark-to-market losses and $5 billion in credit losses. Thus, banks have an $18 billion or so cushion to maintain a 12% ROE. So with peak loan losses expected at $10 billion, we expect positive ROE momentum off the 2008 level. If unemployment were to spike into uncharted territory in the 14%-16% range, loan losses could increase to the extremes of $17 billion, or 135 bp level, for a modest return on equity of 11%.

• The three previous loan loss provision peaks were 1983 at 100 bp, 1992 at 161 bp (80 bp excluding CRE/O&Y), and 2002 at 106 bp (87 bp excluding TD’s sectoral), with trough LLPs in the 22-25 bp range in 1988, 1997, and 2006.

• The credit cycle has tended to be five years from trough to peak and another five years from peak to trough, resulting in loan losses peaking approximately every 10 years. Loan loss provisions also typically peak one year after the bottoming of the economy (negative GDP).

• Historical patterns would place the next peak in loan losses in the 2010-2012 time period. The fallout from the dramatic implosion of Wall Street (sub-prime/structured products/CDS) has no doubt accelerated the global economic decline.

• Our $10 billion expected peak is based on retail loan losses (personal loans and credit cards) of $4.4 billion-$6.1 billion representing 137-191 bp of loans, significantly higher than past cycle peaks of approximately 140 bp. We expect corporate and commercial loan losses to be in the $3.3 billion-$5.6 billion range, or 65-111 bp below previous peaks of 200 bp due to lower corporate debt levels, higher credit standards, and lower industry and single name concentration. We expect residential mortgage loss ratios to increase to the 11-16 bp range versus the previous peak of 7 bp in the early 1990s.

• The major macroeconomic factors that should result in overall loan losses being contained well within the context of historical provision levels are expected unemployment rates, non-financial corporate debt levels, corporate pre-tax profit decline rate, and equity levels in household real estate.

• Our peak loan loss ratio for this cycle, we believe, is consistent with past peaks’ loss ratio factoring in loan mix, loan concentration, underwriting standards, and macro-factors. Our loss ratio of 76 bp for 2010 compares to 100 bp in 1983, 80 bp in 1992 (excluding CRE/O&Y), and 87 bp in 2002 (excluding TD’s sectoral). In terms of loan mix, residential mortgages now represents 35% of the loan portfolio versus 29% in 1992 and 13% in 1983, and given the very low loss ratio on these loans, it lowers the bank overall loss ratio substantially. Thus, excluding residential mortgages, our loss ratio peak this cycle is estimated at 125 bp versus 114 bp in 1992 (excluding CRE/O&Y concentration) and 114 bp in 1983. In addition, retail loans have grown to 60% of total loans versus 23% in 1982, thus much lower leverage to corporate lending. Also, on the corporate loan loss side, we see the lower sector concentration, lower single name exposure, lower corporate debt levels, and lower decline in pre-tax corporate profits versus past cycles as supportive of lower loss ratios from corporate and commercial.

• Bank pre-tax, pre-provision earnings are estimated in the $36 billion range and have increased from the $3 billion level in 1982, representing an impressive CAGR of 9% (exhibit 4). A $10 billion peak in loan losses would equate to a return on equity of 15% to 16%. Loan loss provisions of $10 billion are estimated to peak at 25% of pre-tax, pre-provision earnings and 11% of revenue and 9% of common equity, significantly below previous cycles. In terms of absorbability of loan losses, the pre-tax pre-provision earnings would allow the banks to take a charge of 340 bp (excluding insured mortgages), which we believe is three to four times higher than past peaks and the current plausible peak provision levels.

• We conclude that Canadian banks are in the best shape in 50 years to absorb credit losses based on broad fundamentals. Bank profitability (exhibits 2, 3) on a return on equity or return on risk-weighted assets basis is near historical highs, and the revenue base (exhibits 6) is more diversified. In addition, leverage to credit has declined materially and the loan portfolio is lower risk with less sector and single name concentration. Capital levels are at the highest levels in history despite the market hysteria and panic and stampede to deleverage.

• We also conclude that bank shares can outperform during the credit cycle and that the banking system has never been this well positioned on an absolute basis and relative basis to U.S. and U.K. banks. Bank stocks have outperformed in the past three credit cycles, managing to record positive absolute and relative returns in the face of rising credit losses, which is counterintuitive and contrary to popular belief. The current credit cycle is thus far the exception, which we attribute to valuation contagion mainly from the banking crisis in the U.S. and U.K. and the fact that the cycle is not over. Interestingly, bank stocks’ major underperformance is typically not credit cycle related but commodity/asset bubble related. The three years where banks recorded the greatest underperformance, and by a wide margin, are 1979 (commodities), 1999 (Nortel/Tech), and 2007 (commodities).

• In summary, we expect banks to outperform over the next several years despite the credit cycle, recovering some of its underperformance from the commodity spike in 2007 and valuation contagion of 2008. In the absence of valuation contagion, we would have expected bank P/E multiples to have bottomed at 9.0x, similar to the 1998 Asia crisis as opposed to 6.5x at the March 9, 2009, bottom. We expect bank P/E multiple expansion through 2012 similar to that experienced post the 2002 credit cycle. We expect bank P/E multiples to expand back to 14x in the next few years and eventually 16x. The sustainability of bank dividends and the resumption of superior dividend growth will be a catalyst for significantly higher bank share prices. We remain overweight the bank group based on strong fundamentals and depressed valuations.

Increasing Bank Target Prices - Remain Overweight - RY Top Pick

• We are increasing our target prices for the Canadian banks by 18% (exhibit 26) based on a
higher target P/E multiple of 12.7x versus our previous 10.7x.

• We expect bank P/E multiples to continue to recover as the market focuses on fundamentals as opposed to fear and hysteria and valuation contagion is expected to be less of a factor as investors refocus on earnings power and P/E multiples as opposed to capital, solvency, and MV/BV ratios.

• We expect significant P/E multiple expansion over the next few years.

• We remain overweight the bank group with RY (1-Sector Outperform) remaining our top pick as we believe that the bank is the best positioned for growth.

08 May 2009

Great-West Lifeco Q1 2009 Earnings

Scotia Capital, 8 May 2009

• EPS of $0.35, below our $0.45 estimate and consensus of $0.45, due to higher-than-expected credit hit of $0.17 (virtually all U.K. hybrid related) versus our $0.03 estimate.


• The U.K. hybrid hit was entirely due to an increase in actuarial provisions for default related to recent rating agency downgrades. The MV of these fell in the quarter (to $660 million from $1.1B), as credit spreads widened, but could reverse as spreads contract. Slippage in ratings in this portfolio was not immaterial, and if all BBB fell to below BBB we estimate a $0.10 EPS-$0.15 EPS hit.

• Putnam net flows improve over last two quarters but margins remain weak.

• Sales somewhat mixed, Europe was weak.


• We reiterate our 1-SO rating and $27 target, primarily based on attractive valuation, at 8.3x 2010E EPS, and excellent track record. We suspect the noise with respect to credit issues, primarily U.K. hybrid related, will dissipate as spreads continue to contract.

Manulife Q1 2009 Earnings

Scotia Capital, 8 May 2009

• EPS of negative $0.67 missed our negative $0.40 estimate. Consensus was negative $0.35.


• $0.17 EPS commercial real estate hit (an increase in actuarial provision for default) accounted for the bulk of the miss, and we put underlying EPS at $0.52. Sales were mixed.

• Despite the miss on credit, credit is still very good. The commercial real estate hit related to an increase in capitalization rates extrapolated across the entire portfolio, and was not due to any change in risk profile. Bulk of the other credit hit ($0.12, versus our $0.08 estimate) was due to increase in provision for default related to RMBS portfolio, as company uses much more conservative ratings than those used by Moody's/S&P.

• Management is focused on de-risking the company, while, we believe, not losing market share in the process, and continuing to improve an already strong capital position. MCCSR of 228% at Q1/09, likely over 250% at current market levels.


• Attractive valuation at 8.1x 2010E EPS, minimal credit exposures and the most torque by far to improving equity markets; we reiterate 1-SO.

Q1/09 Misses On Higher Credit Hits

• EPS missed at negative -0.67; we peg underlying EPS at $0.52. EPS loss of $0.67 versus our negative $0.40 estimate and consensus of negative $0.35. A $0.17 EPS commercial real estate hit accounted for the bulk of the miss, and we put underlying EPS at $0.52 (see Exhibit 1). Source of Earnings Analysis puts underlying earnings at $0.48 (Exhibit 4).

• Despite the miss on credit, credit is still very good. The $0.17 commercial real estate hit was the result of an accelerated review, which extrapolated the rise in capitalization rates conservatively across the entire portfolio (which is only $6.5B or 3% of invested assets, 60% of which is in the U.S.), resulting in an increase in actuarial provisions for default (entirely cap rate related as there has been no change in characteristics of commercial real estate portfolio, with occupancy rates unchanged at 93%, virtually no leverage, mostly high quality urban office towers, average lease term 5.6 years). The remainder of miss was due to slightly larger than expected credit hits ($0.12 versus our $0.08 estimate). The bulk of the credit hits in Q1/09 were due to increased actuarial provisions for default related to the RMBS portfolio (which in total is just $750 million or just 0.4% of invested assets) as a much tougher internal ratings standard than S&P/Moody's was applied. Credit continues to look good at MFC. The concentration of fixed income securities trading below 80% of cost for more than six months is just 1.4%, significantly below GWO (5.6%) and SLF (4.9%) and in line with IAG at 1.3%. Gross unrealized losses on fixed income securities are just 8% of the carrying value (as opposed to 11% for GWO and 18% for SLF).

• Focus is on de-risking the company for now. MFC is getting its house in order in terms of minimizing its higher than average sensitivity to equity markets through product changes and hedging initiatives. We certainly agree this is prudent. A strategic review of how to accelerate growth in core businesses, as well as new markets/geographies, is in early stages. We do not believe the company will lose market share or distribution shelf space as it, like most other current financial institutions, gets its house in order. MFC's organic growth and acquisition track record have been exceptional.

• We may not see 16% ROE until 2011 - the same story for all lifecos. We see 15% ROE next year, below MFC's 16% hurdle rate in 2010E (Exhibit 3). With weaker equity markets than historically (we're assuming equity markets end 2009 with the S&P 500 at 950, and then climb just 8% to 1,025 in 2010, still below levels at the end of 2003), a significantly lower level of realized gains, the drag from significant excess capital, and no share buyback to lift EPS and ROE, we expect ROE's for all lifecos to remain under historical averages in 2010. Until we see long term average ROE's we expect P/E multiples for the group will be below average. Long term average forward P/E multiples are 11.8x for the group and about 12.7x for MFC. At 8.1x 2010E MFC is at 65% of its long term average, and we suspect it could lift to about 85% of its long term average, or about 10.8x 2010E one year out, for a target of $30.

• Sales mixed. Canadian individual life sales were down 4%, in line with the market, U.S. VA sales were down 19%, better than the market (down 29%), Canadian individual wealth management sales were up 6% (better then peers), U.S. individual insurance sales were down 43% over a very good Q1/08, but were flat versus Q1/07. We do not believe efforts to de-risk the company's variable annuity and segregated fund products have in any way diminished relative market share positioning.

• Capital position very strong. 228% MCCSR, above our 218% estimate, and likely at 257% based on current markets (suggests about $4.5B in excess capital above 200%). A reinsurance deal in the quarter boosted the ratio by 8 points. We estimate the S&P 500 would have to srop below 600 before the ratio would fall below the bottom end of its 180%-200% target range.
The Globe and Mail, Tara Perkins, 5 May 2009

With Manulife Financial Corp. disclosing another $1-billion-plus loss, its new chief executive officer says the worst of the stock market plunge is over but he will boost the insurer's financial cushion nevertheless.

Donald Guloien, who picked up the reins of North America's biggest insurer yesterday, is signalling that the company has learned lessons from the bruising it is taking because of its massive exposure to global stock markets.

He said in an interview yesterday that he wants to see the company's capital ratio increase further until it is clear that the global economy has stabilized.

His focus on building high capital levels for a rainy day marks a slight departure from his predecessor, Dominic D'Alessandro, who has retired. While Mr. D'Alessandro oversaw the raising of $4.3-billion of debt and equity to shore up Manulife's capital base when markets plunged in the fourth quarter, he also railed against what he deemed to be the too-strict capital requirements of regulators.

At the company's annual meeting yesterday, he described the calculations Manulife is required to make. “We must, for regulatory capital purposes, assume that markets will decline by a further 25 per cent with no recovery for 10 years,” Mr. D'Alessandro said. “The regulatory treatment of exposures related to what are essentially individual pension plans is very harsh, in my opinion.”

Manulife was hurt again this quarter by the large stock portfolio it holds as a result of its variable annuity and segregated funds business.

(Those products are akin to private pension plans for individual investors, in which Manulife takes a customer's money, invests it, and promises payments down the road. When markets drop, the insurer must build up capital and reserves to protect against any shortfall in the amount it has promised to pay customers in the future.)

Since late last year, the shortfall between the amount it has guaranteed customers and its portfolio supporting the business has widened, growing to $30-billion at the end of March. As a result, Manulife boosted its reserves to $7.7-billion. (Most of the payments are not due for decades.) Mr. D'Alessandro emphasized that the money the company is putting aside may be returned to the profit column if markets improve. That could bode well for Mr. Guloien, who until yesterday was the company's chief investment officer.

“The main cause of pressure on earnings and capital – weak equities – has reversed and the outlook for [the second quarter] is much brighter,” RBC Dominion Securities Inc. analyst André-Philippe Hardy said in a note to clients.

Mr. Guloien said he thinks “the economy will continue to be challenged for a bit longer period of time, but that the stock market is pretty much bouncing off a bottom.”

While that doesn't mean it won't dip, he believes the general trend will be upwards. “Certainly when it hit around 700 it was hitting the bottom for sure,” he said, referring to the S&P 500 benchmark U.S. stock index. Economic recovery will come next.

“But in terms of capital management and other activities, we can't take that for granted,” he quickly added.

The S&P 500 fell 12 per cent in the first quarter, and the TSX/S&P composite index ended the period down 2 per cent. Manulife posted a loss of $1.9-billion in the fourth quarter of last year when equity markets had steeper declines.

Rival Sun Life Financial Inc. reported a $213-million loss Thursday, down from a year-ago profit of $533-million.Great-West Lifeco Inc. earned $326-million, down from $654-million. All were hit by stock market declines.

The key measure of an insurer's financial cushion, known as its MCCSR ratio (minimum continuing capital and surplus requirements), must stay above 150 per cent. Manulife said its ratio was 228 per cent at the end of March. Great-West's was 205 per cent and Sun Life's was 223 per cent.

Manulife's overriding emphasis on capital levels will not prevent it from making acquisitions, Mr. Guloien said. “It obviously means the funding of acquisitions would have to be more heavily oriented towards the equity side than it would normally be. It's not like we have excess capital sloshing around that we could use for an acquisition.”

“Our first priority in these unsettled times is to ensure our financial position continues to be strong,” he told shareholders at the annual meeting. “But we also have an unparalleled opportunity over the next five years to be the consolidator, taking advantage of the current disorder amongst financial institutions worldwide.”
The Globe and Mail, 5 May 2009

Canadian life insurance companies could lose up to $1.6-billion in 2009, CIBC World Markets estimates, but they should remain adequately capitalized with the worst already behind them.

“We are approximately 80 per cent confident in our conclusion that lifecos are well capitalized for difficult equity/credit markets,” analyst Darko Mihelic wrote in a report. “Even if lifecos need some extra capital, we believe it would not be overly material to investors unless the environment was in a truly catastrophic state.”

CIBC put the companies through two stress-test scenarios, with the $1.6-billion in losses forming the “worst case.” This would translate into a 33-per-cent hit in the expected profits from Manulife Financial, Sun Life Financial Inc., Great-West Lifeco Inc. and Industrial Alliance Insurance And Financial Services Inc.

Under the slightly more optimistic “bad case,” he forecast the insurers would lose $890-million – which would account for 18 per cent of expected 2009 earnings.

“Our analysis suggests that the Canadian lifecos might have seen the worst year in 2008 from a credit losses perspective,” Mr. Mihelic said.

Here are five highlights from his report:

1) All of the company's passed the test. Mr. Mihelic used “minimum continuing capital and surplus requirements” ratios as a measure of health, with a rating of 100 meaning an insurer has adequate capital to meet its obligations. Regulators want the company's to have a target above 150 per cent. Under the worst-case scenario, Manulife's reading would be 173 per cent, Industrial Alliance's would be 176 per cent, Great-West would be at 188 per cent and Sun Life's would be at 214 per cent

2) Credit downgrades and impairment charges may not hit the worst-case number, but “the most likely scenario” would mean losses of $1.3-billion – 25 per cent of estimated 2009 earnings. The companies lost a collective $1.5-billion in 2008.

3)The losses in 2008 were made worse by the fall of Lehman Brothers, AIG and Washington Mutual, which should suggest 2009 will be a slightly “better” year. “We estimate that in 2009 loss rates will decrease for all of the lifecos with Sun Life and Industrial Alliance posting the largest decrease and Great-West experiencing only a very modest drop in loss rates.”

4) The Canadian lifecos have better credit quality than their U.S. counterparts. “As a result, the Canadian lifecos might be better positioned to ‘survive' this credit crunch. Additionally, the Canadian lifecos have some accounting flexibility that is not permitted [in the U.S.].”

5) Industrial Alliance's investments have the highest level of credit quality, he said. “Perhaps surprisingly, it is difficult to distinguish between Sun Life's and Manulife's invested assets credit quality. History hurts Sun Life, but when viewed solely on exposure and assuming some degree of reversion to the mean, Manulife's portfolio appears weaker. Industrial Alliance, however, currently has the lowest capital ratio.”

First-quarter earnings for Manulife (an expected loss of 33 cents a share), Sun Life (a loss of 1 cent) , and Great-West (a profit of 47 cents) are out Thursday, while Industrial Alliance reports Friday (a profit of 57 cents). All estimates for from ThomsonOne Analytics.

Sun Life Q1 2009 Earnings

RBC Capital Markets, Andre-Philippe Hardy, 8 May 2009

Sun Life: Q1/09 EPS below expectations but good upside potential/downside risk protection

Q1/09 core EPS fell short of our estimate primarily driven by increases in actuarial reserves related to interest rates as the impacts of equity markets and credit were in line with our expectations. Regulatory capital levels were as expected; remaining high. Sun Life remains well capitalized and its stock offers investors an attractive combination of upside reward with more limited downside risk than the stocks of some of its peers.

Q1/09 core EPS of ($0.33) compared to our ($0.09) estimate, consensus estimates of ($0.01) and EPS of $0.93 in Q1/08.

• GAAP EPS of ($0.38) include $0.05 in restructuring costs aimed at lowering expenses.

• The after-tax impact of equity markets was $0.58 per share, close to our estimate of $0.51 per share.

• The after-tax impact of credit/impairments ($0.44 per share) was close to our estimate of $0.49 per share. Actual impairments were low in the context of challenged credit and equity markets and the size of the company's investment portfolio. Increases in reserves related to downgrades accounted for $0.30 of the $0.44.

• SLF increased actuarial reserves related to interest rates as well as an internal reinsurance transaction, which cost the company $0.17. If long term interest rates stay low, we believe that all lifecos will be pressured to increase reserves over time, although timing is difficult to predict.

Excluding the impacts of credit and equities and other unusual items, EPS would have been approximately $0.86, close to the company's recent “earnings power” (which we continue to believe that Sun Life will not earn in the near term, not accounting for lifts from equity markets in good quarters).

• We have increased our 2009 estimated EPS by $0.08 to $2.40. The increase in our estimated EPS reflects (1) the Q1/09 shortfall versus our estimates, (2) a more conservative view of experience gains related to asset fair value, credit impairments and group claims, which are more than offset by (3) the positive impact on earnings of the increase in equity markets seen so far in Q2/09.

o We believe there could be further credit hits in Q2/09 as downgrades continue and defaults are likely to rise and we expect group claims experience to be negatively impacted by rising unemployment.

o The rebound in equity markets (global markets are up 12-16% since the end of March) should more than offset, though.

o A 10% move in equity markets would have an impact on net income of $250-325 million ($0.45-$0.58 per share), according to management’s disclosed sensitivities.

• Our 2010 EPS estimate reflects a ROE of 10.6%, which is below what we would expect the company to earn in a normal year, reflecting our lack of clarity on near term earnings.

Capital ratios were line with our expectations, remaining high. We believe that Sun Life remains better capitalized than its peers, particularly when considering sensitivity to equity markets.

• The MCCSR ratio was 223% - versus our expectations for 220%-230%. The RBC ratio of 357% was slightly higher than the company’s target of 300-350% and well above the regulatory minimum of 200%.

• We believe that the company has additional capital at the holding company level that has not been down-streamed to the regulated entities, including the recent $500 million debt issue.

• We expect the recent downward pressure on the MCCSR ratio to abate in Q2/09 given the upward move in equity markets.

• The MCCSR sensitivity to equity markets is low relative to peers but it has increased on the downside - with 10% declines in equity markets now estimated to affect the MCCSR by 8%. A 10% upward move in equity markets would increase the MCCSR by 5%. Equity markets alone are not likely to cause the firm to raise capital as we believe a MCCSR ratio of 180% is appropriate, but even a 200% ratio seems unlikely to be reached only because of declines in equity markets.

• Flexibility has declined, however given the issues of capital securities in the last year, and reported losses which have offset the gain from the sale of CI. Debt and preferred shares now represent 27.0% of capital – up from 23.4% in Q1/08 but still at the lower end of the group.

• While the company’s number one objective is balance sheet strength, we believe that Sun Life is interested in taking advantage of current market disruptions to bulk up its U.S. presence. We also believe that Sun Life would ideally like to buy good assets from distressed sellers than buy entire companies. In that context, this is not something we would expect U.S. lifecos to agree to until their backs are up against the wall.

Credit-related hits were driven by downgrades more than by impairments. The investment portfolio was a drag on earnings, as discussed above, as Sun Life was not immune to global weakness in credit markets. If isolating writedowns and downgrades, the size of the credit-related earnings impact was low in the context of challenged credit and equity markets and the size of the company's investment portfolio

• The after tax impact of impairments ($34 million for credit and $42 million for equities) is in the context of a $104 billion investment portfolio. The impairments are net of the expected quarterly benefit of $40 million that results from the $160 million in additional credit reserves set aside in Q4/08 for 2009.

• Sun Life provided added disclosures around commercial mortgages, which provide us with comfort as we believe that U.S. commercial real estate will be a very challenged asset class. The company estimates an average loan to value of only 55% based on 2008 revaluations. Commercial mortgages amount for 15% of Sun Life’s investment portfolio. For holdings of commercial mortgage backed securities (which account for just under 2% of the investment portfolio) 80% were originated prior to 2006.

• We continue to believe that Sun Life and other Canadian lifecos’ earnings will be negatively impacted by the credit environment; but that they have the capital so do so and equity-related hits should abate.

• Unrealized losses on bonds rose $1 billion to $10 billion - a slower rate of increase than in the prior quarter. Credit spreads have tightened since Q1/09 ended, which should be helpful. Fixed income securities that have traded below 80% of cost for more than six months totaled $2.9 billion ($0.3 billion in AFS, $2.6 billion in available for sale), compared to $1.8 billion in Q4/08.

We were surprised by the vigor of the company’s sales, which were for some products were not as bad as we thought and for some other products were outright solid. We suspect that, outside of Canada, the company is probably perceived as financially strong which at the margin would help sales.

• In Canada segregated funds sales were up 17%, group benefits 97% and group retirement 32%. Only individual insurance sales were down, falling 17%, which compares to a range of -3% to -7% for peers.

• In the U.S. core individual sales rose 15%, as did employee benefit sales, fixed annuities jumped from $90 million in Q1/08 to $407 million, and domestic VA sales rose 8%. VA sales appear particularly strong in the context of industry sales. Fixed annuity sales are expected to decline, as we believe that the company sold an unusually large amount of fixed annuities in the quarter in order to replace maturing liabilities and keep related assets that it finds attractive.

• Value of new business (which is measured on a trailing 12 months basis) was down 26%, however, in contrast with the sales trends as margins implicitly declined. We believe that the decline in margins was driven by low interest rates, volatile equity markets and the increased cost of hedging. MFS set up to benefit from eventual rebound in mutual fund sales. MFS’ YoY assets under management and revenues were severely impacted by equity market declines and, as is typical of assets management companies, operating leverage worked against them, causing significant operating margin compression (although margins held up surprisingly well on a sequential basis given market declines). However, investment performance relative to peers, combined with sales that we would have expected to be weaker in these weak equity markets, leads us to believe that MFS will be well positioned when equity markets turn to benefit from rising AUM, rising sales and rising margins.

• Q1/09 average AUM declined 33% YoY, driven primarily by declines in equity markets. The revenue decline that resulted from the AUM declines, combined with negative operating leverage (the operating margin declined from 35% in Q1/08 to 21%), drove a drop in net income from US$59 million to US$23 million.

• Gross sales of mutual funds declined from $4.9 billion to $4.1 billion but redemptions declined faster so net sales improved by $1.3 billion to ($0.6 billion).

• Gross sales of institutional products dropped from $4.9 billion in Q1/09 to $3.9 billion, but net sales improved by $1.7 billion to $0.8 billion as outflows shrank.

• Three-year mutual fund performance as measured by Lipper is strong with 93% of U.S. retail fund assets ranked in the top half of their Lipper Category Average.

Embedded value rose as currency and the sale of CI offset credit and equity-related hits.

• Embedded value per share was disclosed at $31.16 – up from $30.14 in the prior year, as the negative impact of experience variances and changes in assumptions was offset by the positive impact of currency, the gain on sale of CI and expected growth of in force business and new sales.

• In theory, if actuarial assumptions were 100% accurate and the company never generated another dollar of sales, the present value of future cash flows from business sold in the past is $31.16, which implies that the current share price is cheap (or embedded value is about to fall…) as it implicitly assumes that the company will not ever create value from new sales. Canadian lifeco stocks have not historically traded on embedded value however.