Tuesday, May 19, 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.