Scotia Capital, 29 July 2009
P/E Recovery to Continue
• Canadian banks are turning in a spectacular year thus far in terms of share price performance with the bank index up 42% year-to-date and up 90% from the late February lows. The P/E multiple has recovered from the low 6.0x (valuation contagion U.S. pricing of Canadian bank stocks) in late February to the current 11.6x on LTM operating earnings.
• The major bank rally has happened at breathtaking speed and it is natural to expect some retracement in bank share prices or at least a consolidation phase. However, given the attractive dividend yield of 4.4% that is now viewed as safe, the low return from Treasuries, and bank underlying earnings power with operating earnings nearing the bottom for the cycle, we believe the P/E multiple will continue to expand at the same time the earnings outlook is improving. We are therefore increasing our share price targets based on a target multiple of 13.3x our 2010 earnings estimates versus our previous target of 12.6x on 2009E EPS. We expect the P/E multiple to expand into the 13x to 14x range before consolidating similar to post the tech meltdown in 2002.
• We would expect further P/E multiple expansion to the 14x to 16x range after a six to twelve month period of consolidation as the market would likely need further confirmation of the longer term level of profitability and strength of underlying fundamentals. We continue to use the Graham & Dodd P/E Matrix as guide with a 5% long term growth rate and bond yields of 5% to 6% equating to our 14x to 16x target P/E multiple range.
• In the near to medium term we expect bank valuations to be given a boost as the earnings outlook improves based on net interest margin expansion (loan book repricing, steep yield curve) as well as the realization that loan losses are peaking and the descent will be played out over the next several years through the economic recovery.
Increasing Target Prices
• Thus our new 12 month target for the bank index increases 16% to 25,000 based on a 13.3x P/E multiple on our 2010 earnings estimates for total expected one year return of 25%. We are increasing our target prices on BMO, BNS, CM, NA, RY, TD and CWB to $60, $55, $75, $70, $65, $70 and $20, respectively, with LB unchanged. Our revised target prices are highlighted in Exhibit 1.
Earnings Power and ROE Momentum Favours RY and BNS
• In terms of bank fundamentals earnings power has remained strong and capital levels are robust. The bank group return on equity on a fully loaded basis after all mark to market writedowns is 11% year-to-date in 2009 with operating return on equity very solid at 17.7% despite near peak loan loss provisions.
• If we exclude the impact of security gains and the entire positive income statement impact of securization the operating ROE for 2009 YTD slips to 16.3% from 17.7%. If we further adjust the loan loss provisions ratio to an average or normalized loss ratio of 43 bp from 83 bp, the underlying or core ROE would be 18.5% for 2009 YTD for the bank group led by RY and BNS at 21.3% and 18.9% respectively. Thus we believe the level of bank profitability and earnings power is supportive to higher P/E multiples especially given the level of interest rates and supportive dividend yield.
Minimal Regulatory Changes Required
• In addition capital levels are high with Tier 1 ratio of 10.8%, CE/RWA of 11.1% and TCE/RWA of 7.6%. We estimate net earnings after dividends represent a capital build of 90 basis points per annum with Canadian banks continuing to have full access to the capital markets for capital and funding.
• The Canadian banking system is now generally viewed as being among the strongest in the world with no major changes needed in terms of regulation and structure. However Canadian banks will likely be modestly impacted by the global push for lower leverage, higher liquidity, increased amount and quality of capital, pro-cyclicality requirements, and higher capital allocated to various activities.
• Canadian banks profitability or return on equity would be reduced if higher capital requirements were introduced beyond the high levels they already have. The impact of profitability of an immediate 200 bp increase in Tier 1 via common equity bringing the Tier 1 ratio up to 13% (funds held in liquid Treasuries - improving liquidity) would be to reduce ROE by 2% to 3%, thus ROE downside is to the 15% to 16% range (assumes no repricing of products and activities impacted). Thus we believe the highly profitable, low risk Canadian model will continue post the global financial markets reformation.
• Bank valuation remains very attractive on a dividend yield basis, although dividend yields are down from their lofty heights to a still very attractive 4.4% and remain in the strong buy range against government bonds or the equity markets. Bank dividend yield relative to 10 year bonds is 2.9 standard deviations above the mean. If this ratio was to revert to one and two standard deviations, bank stocks would need to increase 55% and 21%, respectively, assuming no dividend increases and a constant bond yield.
Recommendation - Remain Overweight the Group
• In conclusion, Canadian banks are well capitalized with high quality balance sheets, a diversified revenue mix, a solid long term earnings growth outlook, low exposure to high risk assets and compelling valuation on both a yield and P/E multiple basis. We remain Overweight the bank group.
• Our order of preference continues to be biased towards strong wholesale banks with wealth management earnings momentum expected to improve. Our order of preference is RY, BMO, BNS, CWB, NA, LB, TD and CM.
Bank Significant Outperformance
• Thus far in 2009 the bank index has increased 42%, outperforming the S&P/TSX by 24%. This compares to slight outperformance in 2008 of 3% and underperformance of 15% in 2007 (commodity bubble), the third worst year for bank stocks. The other major years of bank underperformance were in 1979 (commodity bubble) and 1999 (Nortel/tech bubble). If bank share price performance remains intact for the remainder of the year this will be the fourth highest outperformance in 50 years on a total return basis.
Third Quarter Update
• Banks begin reporting third quarter earnings with BMO on August 25, followed by CIBC on August 26, NA, TD and RY on August 27, BNS on August 28, and LB and CWB closing out reporting on September 3.
• We are looking for a 14% decline in earnings year over year and 2%, sequentially. Return on equity for the bank group is expected to be 16.5% with mark-to-market writedowns moderating.
P/E Recovery to Continue
• Canadian banks are turning in a spectacular year thus far in terms of share price performance with the bank index up 42% year-to-date and up 90% from the late February lows. The P/E multiple has recovered from the low 6.0x (valuation contagion U.S. pricing of Canadian bank stocks) in late February to the current 11.6x on LTM operating earnings.
• The major bank rally has happened at breathtaking speed and it is natural to expect some retracement in bank share prices or at least a consolidation phase. However, given the attractive dividend yield of 4.4% that is now viewed as safe, the low return from Treasuries, and bank underlying earnings power with operating earnings nearing the bottom for the cycle, we believe the P/E multiple will continue to expand at the same time the earnings outlook is improving. We are therefore increasing our share price targets based on a target multiple of 13.3x our 2010 earnings estimates versus our previous target of 12.6x on 2009E EPS. We expect the P/E multiple to expand into the 13x to 14x range before consolidating similar to post the tech meltdown in 2002.
• We would expect further P/E multiple expansion to the 14x to 16x range after a six to twelve month period of consolidation as the market would likely need further confirmation of the longer term level of profitability and strength of underlying fundamentals. We continue to use the Graham & Dodd P/E Matrix as guide with a 5% long term growth rate and bond yields of 5% to 6% equating to our 14x to 16x target P/E multiple range.
• In the near to medium term we expect bank valuations to be given a boost as the earnings outlook improves based on net interest margin expansion (loan book repricing, steep yield curve) as well as the realization that loan losses are peaking and the descent will be played out over the next several years through the economic recovery.
Increasing Target Prices
• Thus our new 12 month target for the bank index increases 16% to 25,000 based on a 13.3x P/E multiple on our 2010 earnings estimates for total expected one year return of 25%. We are increasing our target prices on BMO, BNS, CM, NA, RY, TD and CWB to $60, $55, $75, $70, $65, $70 and $20, respectively, with LB unchanged. Our revised target prices are highlighted in Exhibit 1.
Earnings Power and ROE Momentum Favours RY and BNS
• In terms of bank fundamentals earnings power has remained strong and capital levels are robust. The bank group return on equity on a fully loaded basis after all mark to market writedowns is 11% year-to-date in 2009 with operating return on equity very solid at 17.7% despite near peak loan loss provisions.
• If we exclude the impact of security gains and the entire positive income statement impact of securization the operating ROE for 2009 YTD slips to 16.3% from 17.7%. If we further adjust the loan loss provisions ratio to an average or normalized loss ratio of 43 bp from 83 bp, the underlying or core ROE would be 18.5% for 2009 YTD for the bank group led by RY and BNS at 21.3% and 18.9% respectively. Thus we believe the level of bank profitability and earnings power is supportive to higher P/E multiples especially given the level of interest rates and supportive dividend yield.
Minimal Regulatory Changes Required
• In addition capital levels are high with Tier 1 ratio of 10.8%, CE/RWA of 11.1% and TCE/RWA of 7.6%. We estimate net earnings after dividends represent a capital build of 90 basis points per annum with Canadian banks continuing to have full access to the capital markets for capital and funding.
• The Canadian banking system is now generally viewed as being among the strongest in the world with no major changes needed in terms of regulation and structure. However Canadian banks will likely be modestly impacted by the global push for lower leverage, higher liquidity, increased amount and quality of capital, pro-cyclicality requirements, and higher capital allocated to various activities.
• Canadian banks profitability or return on equity would be reduced if higher capital requirements were introduced beyond the high levels they already have. The impact of profitability of an immediate 200 bp increase in Tier 1 via common equity bringing the Tier 1 ratio up to 13% (funds held in liquid Treasuries - improving liquidity) would be to reduce ROE by 2% to 3%, thus ROE downside is to the 15% to 16% range (assumes no repricing of products and activities impacted). Thus we believe the highly profitable, low risk Canadian model will continue post the global financial markets reformation.
• Bank valuation remains very attractive on a dividend yield basis, although dividend yields are down from their lofty heights to a still very attractive 4.4% and remain in the strong buy range against government bonds or the equity markets. Bank dividend yield relative to 10 year bonds is 2.9 standard deviations above the mean. If this ratio was to revert to one and two standard deviations, bank stocks would need to increase 55% and 21%, respectively, assuming no dividend increases and a constant bond yield.
Recommendation - Remain Overweight the Group
• In conclusion, Canadian banks are well capitalized with high quality balance sheets, a diversified revenue mix, a solid long term earnings growth outlook, low exposure to high risk assets and compelling valuation on both a yield and P/E multiple basis. We remain Overweight the bank group.
• Our order of preference continues to be biased towards strong wholesale banks with wealth management earnings momentum expected to improve. Our order of preference is RY, BMO, BNS, CWB, NA, LB, TD and CM.
Bank Significant Outperformance
• Thus far in 2009 the bank index has increased 42%, outperforming the S&P/TSX by 24%. This compares to slight outperformance in 2008 of 3% and underperformance of 15% in 2007 (commodity bubble), the third worst year for bank stocks. The other major years of bank underperformance were in 1979 (commodity bubble) and 1999 (Nortel/tech bubble). If bank share price performance remains intact for the remainder of the year this will be the fourth highest outperformance in 50 years on a total return basis.
Third Quarter Update
• Banks begin reporting third quarter earnings with BMO on August 25, followed by CIBC on August 26, NA, TD and RY on August 27, BNS on August 28, and LB and CWB closing out reporting on September 3.
• We are looking for a 14% decline in earnings year over year and 2%, sequentially. Return on equity for the bank group is expected to be 16.5% with mark-to-market writedowns moderating.
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TD Securities, 28 July 2009
U.S. banking results provided some relief for the market relative to mixed expectations heading into earnings season. However, broadly speaking underwriting activity and trading were key sources of strength, while credit and core P&C banking trends continue to reflect ongoing challenges. Issues around troubled assets and related write-downs have moved to the background.
• There remains an inordinate amount of noise in reported results. However, in this report we do our best to summarize the key trends in the U.S. results and draw out some implications for the Canadian banks.
• Credit remains a key focus and we review the U.S. loan books of the Canadian banks. U.S. results appear to support our view that credit conditions are likely to continue to deteriorate (albeit potentially at a slower pace). To date the biggest concerns have been around some specific exposures (largely related to U.S. housing construction). To us, focus will shift to broader deterioration across commercial portfolios going forward.
• We expect U.S. loan books to continue to account for a disproportionate amount of credit costs (up to 50% of PCLs in some cases). All that said, we continue to view aggregate credit costs as manageable for the industry.
• Looking to capital markets, the U.S. results seem to confirm that market conditions remain very favorable for certain trading and investment banking activities. We expect this to continue to carry through the Canadian results and we expect another strong quarter. However, we note that a stellar equity underwriting quarter (driven by recapitalizing the U.S. banking sector) was a key contributor to the U.S. experience.
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U.S. banking results provided some relief for the market relative to mixed expectations heading into earnings season. However, broadly speaking underwriting activity and trading were key sources of strength, while credit and core P&C banking trends continue to reflect ongoing challenges. Issues around troubled assets and related write-downs have moved to the background.
• There remains an inordinate amount of noise in reported results. However, in this report we do our best to summarize the key trends in the U.S. results and draw out some implications for the Canadian banks.
• Credit remains a key focus and we review the U.S. loan books of the Canadian banks. U.S. results appear to support our view that credit conditions are likely to continue to deteriorate (albeit potentially at a slower pace). To date the biggest concerns have been around some specific exposures (largely related to U.S. housing construction). To us, focus will shift to broader deterioration across commercial portfolios going forward.
• We expect U.S. loan books to continue to account for a disproportionate amount of credit costs (up to 50% of PCLs in some cases). All that said, we continue to view aggregate credit costs as manageable for the industry.
• Looking to capital markets, the U.S. results seem to confirm that market conditions remain very favorable for certain trading and investment banking activities. We expect this to continue to carry through the Canadian results and we expect another strong quarter. However, we note that a stellar equity underwriting quarter (driven by recapitalizing the U.S. banking sector) was a key contributor to the U.S. experience.
