29 August 2009

BMO's Bill Downe

Toronto Star, Rita Trichur, 28 August 2009

It doesn't take long to figure out what makes Bill Downe tick.

Minutes into a talk with him, the Bank of Montreal's president and chief executive officer pitches me on switching my mortgage to his bank. He tells his public relations chief to make a note of my renewal date. Midway through a talk with him, he brings it up again.

"In fact, I'm hoping after we've converted your mortgage, when you are standing on the soccer field and your little guy is playing, you might ask the person next to you: `Say, where do you bank? Are you happy?'" Downe said, sporting a rascally grin.

Downe takes a personal interest in customer relations and credits that type of old-fashioned service for turning around a bank that only two years ago was considered a laggard.

This is a story about how Canada's oldest bank got its groove back and the man who made it happen. After two tumultuous years, BMO is regaining its self-confidence. And at age 192, it finally knows what it wants to be when it grows up – a traditional bank.

Enter Downe, a man who shatters the stereotype of the stodgy Bay Street banker. For an interview this week, the 57-year-old makes himself at home in a cubicle in the branch at First Canadian Place. When a passing customer recognizes him, he quips that he's in his new office.

Reflecting on the past two years, he concedes BMO had its "fair share" of challenges. His saving grace was never promising shareholders a silver bullet. Instead, he devised a long-term plan to get back on track.

"Coming through a period like the one that we've just come through gives you an opportunity to not only test yourself but test your colleagues," he said. "And I think we've been extraordinarily successful in a demanding environment."

The accolades didn't always flow.

Rewind to early 2007, when BMO was still reeling from two botched merger attempts – one with Royal Bank of Canada in 1998 and the other with Bank of Nova Scotia in 2002. Some say it took too long for BMO's top management team to let go of the possibility of a big merger.

In the meantime, its mainstay personal and commercial business suffered from neglect. And while outgoing CEO Tony Comper began the overhaul, Downe was left to do the heavy lifting.

Problem is, from the day he took the reins in March 2007, Downe was doing damage control. His inauspicious start was marked by the bank's first earnings decline in six quarters.

By April, Downe was busy putting out a new fire after disclosing commodity-trading losses involving U.S. brokerage Optionable Inc. The scandal cost BMO $853 million.

The global credit crunch hit that summer. Suddenly, BMO's profitability was being tripped up by a slew of debt-related writedowns of $2.84 billion since 2007. BMO missed most of its annual targets for 2007 and 2008. As the economy soured, its stock price nose-dived, hitting a low of $24.05 in February 2009. That's a far cry from April 18, 2007, when it reached $72.75.

Earlier this year, its dividend yield topped 10 per cent, fuelling speculation of a potential cut.

With their shareholdings in the toilet, some investors chastised the bank in March for awarding Downe a 9 per cent raise, increasing his compensation to about $6.38 million in a year when BMO's profits fell by more than 7 per cent. About a week after announcing his pay packet, Downe voluntarily gave up some $4.1 million. Other bank CEOs made similar gestures amid the tough economic climate.

For much of that time, it seemed as if BMO's old French moniker of "Baie Maux," or "Bay of Pains," was starting to ring true again. Nonetheless, industry rivals credit Downe for maintaining a steady hand throughout the turmoil.

"I think Bill, to his credit, has just sort of put his head down and worked his way through issues," said Gordon Nixon, chief executive of Royal Bank.

Fast-forward to the present and even hardened BMO naysayers are applauding. Not only did its third-quarter profit climb nearly 7 per cent from last year, it set aside less money to cover bad loans.

During its May-to-July quarter, BMO's domestic retail bank recorded a 15 per cent increase in loans compared with the same period last year. It gained market share in both personal deposits and commercial banking.

It did so partly by staying focused on its customers during the recession, including a concerted effort to teach them how to save money and pay down debt. And as its rivals tightened credit for commercial clients, BMO signalled that it was open for business. It beefed up on commercial bankers and designated dedicated commercial districts in Toronto, Montreal and Vancouver.

"We tip our hats to BMO's management team, which has done an excellent job of generating much stronger (and higher quality) earnings than we had anticipated," John Aiken of Dundee Capital Markets wrote in a note to clients.

Ask Downe about his business strategy going forward and he circles back to good customer service. That includes warm welcomes and sincere "thank yous" – even from the top dog himself. Downe is known for calling irate customers and promoting BMO to complete strangers on the street.

"I came down Bay Street in a taxi last Wednesday and the cab driver dropped me off right here," he said. "And I asked him where he banked and he told me. And I asked him what it would take for us to have the opportunity to be his banker. And I tell ya what, he warmed right up and said he would think about it."

Two weeks before that, he gave the hard sell to a Chicago cab driver who was thinking about getting a mortgage with its Harris Bank. He didn't tell either about his position with the bank.

"There isn't anyone that I wouldn't approach. If the president of the bank across the street (Rick Waugh) came along, I'd ask him if we could have his business, too," he said gesturing at the Bank of Nova Scotia.

That's no put-on, say those who know him.

"I'd be surprised if he didn't ask you for business," remarked Bob Bissett, senior vice-president of commercial banking for the Greater Toronto Area.

While he likes to portray himself as a customer advocate, Downe has been accused of having a tin ear on one issue this past year. In March, the bank hiked interest rates on personal lines of credit by one percentage point at a time when the Bank of Canada was cutting interest rates.

BMO blamed the rate hike on "changing market realities" and increases in the cost of raising funds. Funding costs, however, have come down from crisis levels and customers are still smarting over the move.

That beef aside, Finance Minister Jim Flaherty says Canadians ought to take pride in Downe's contributions throughout the financial crisis. In particular, he notes Downe's vast knowledge of the U.S. banking system, acquired during postings with U.S.-based Security Pacific Bank and BMO in Los Angeles, Houston, Denver and Chicago.

"That's been quite helpful in terms of our discussions concerning what was happening in the United States during the height of the credit crisis and what actions we should take in Canada."

Still, Downe is not about to sit on his laurels. While he's optimistic about the outlook, he maintains an air of caution. "You have to remember that in the rear-view mirror, two years looks like just a moment," he said. "Going ahead 90 days seems like a very long time."

28 August 2009

TD Bank Q3 2009 Earnings

Scotia Capital, 28 August 2009

Q3/09 - Strong Results - TD Securities Record Earnings - Upgrading to 2-Sector Perform

• Toronto-Dominion Bank (TD) third quarter operating earnings were strong, driven by record wholesale banking earnings, and record earnings at TDCT, partially offset by weak results from U.S. P&C with Wealth Management earnings down YOY but rebounding sequentially. Loan loss provisions were lower sequentially with slightly higher impaired loan formations particularly in the U.S. ROE was 14.3% with RRWA of 2.55%.

• TD's cash operating earnings increased 3% to $1.47 per share, well above our estimate of $1.20 per share and consensus due to record wholesale banking results driven by record trading revenues. Wholesale banking earnings tripled from a year earlier and almost doubled from the previous quarter with TDCT earnings increasing 5%. Reported earnings were $1.16 per share including restructuring charge, general reserve, and losses from hedges.

• We are increasing our 2009 and 2010 earnings estimates to $5.35 and $5.70 per share from $5.00 and $5.40 per share, respectively, due to strength in wholesale business although not sustainable at current level in our opinion. We are also increasing our share price target to $80 from $70 per share, representing 14.0x our 2010 earnings estimate.

• We are upgrading TD to 2-Sector Perform from 3-Sector Underperform due to less-than-expected deterioration in the U.S. business and improvement in the earnings power of its wholesale business, aided by the bank's high counterparty credit rating.

Items of Note

• Reported cash earnings were $1.16 per share including $43 million after-tax or $0.05 per share loss on economic hedge related to reclassified AFS debt securities, $70 million after-tax or $0.08 per share restructuring charge related to Commerce Bancorp, $75 million after-tax or $0.09 per share loss in fair value of CDS hedging the corporate loan book, $35 million after-tax or $0.04 per share charge from FDIC special assessment, and an increase in general allowance of $65 million or $46 million after-tax or $0.05 per share.

Canadian P&C Earnings Increase 5%

• Canadian P&C's solid performance was primarily driven by strong volume growth in personal and business deposits, and real estate secured lending. However, the bank indicated that volume growth is expected to slow down and LLPs are expected to continue to rise.

• Canadian P&C earnings increased 5% to $677 million from $644 million a year earlier.

• Retail net interest margin increased 2 basis points (bp) sequentially and declined 2 bp from a year earlier to 2.96%.

• Revenues increased by 8.2% year over year (YOY) to $2.5 billion, and expenses increased 3.6% to $1.2 billion.

• Card service revenue increased 13% YOY to $197 million.

• LLPs increased to $290 million from $286 million in Q2/09 and from $194 million a year earlier.

Total Wealth Management Earnings Decline 19%

• Wealth Management earnings, including the bank’s equity share of TD Ameritrade, declined 19% to $163 million.

Canadian Wealth Management Earnings Decline

• Domestic Wealth Management earnings declined 25% YOY to $95 million due to a significant decline in assets under management and administration, lower average fees earned, net interest margin compression, and lower margin loans.

• Operating leverage was negative 8.4%, with revenue declining 7.7% and expenses increasing 0.7%.

• Mutual fund revenue declined 19% to $183 million from a year earlier.

• Mutual fund assets under management (IFIC, includes PIC assets) declined 8.1% YOY to $56.2 billion.

TD Ameritrade – Earnings Decline 8%

• TD Ameritrade contributed $68 million or $0.08 per share to earnings in the quarter versus $48 million or $0.06 per share in the previous quarter and $74 million or $0.09 per share a year earlier. TD Ameritrade’s contribution represented 5% of total bank earnings.

U.S. P&C Earnings Decline 11%

• U.S. P&C earnings, which now include the contribution from Commerce Bancorp, declined to $242 million or $0.28 per share from $273 million a year earlier, representing 17% of total bank earnings. U.S. P&C earnings declined for the third straight quarter due to a higher Canadian dollar and higher credit losses. Gross impaired loans increased 9% sequentially to $961 million while net impaired loans increased 6% sequentially to $748 million.

• Loan loss provisions in the U.S. declined 9% QOQ to $183 million or 1.24% of loans versus $201 million in the previous quarter and $76 million a year earlier.

• Net interest margin declined 18 bp from the previous quarter and 52 bp from a year earlier to 3.40% due to lower interest rates and increased levels of impaired loans.

• The bank incurred a $55 million ($35 million after-tax or $0.04 per share) FDIC special assessment charge this quarter.

U.S. Platforms Combine to Represent 22% of Earnings

• U.S. P&C and TD Ameritrade contributed $310 million or $0.36 per share in the quarter, representing 22% of total bank earnings in the third quarter, down from a high of 29% in Q1/09.

Wholesale Banking Record Earnings

• Wholesale banking earnings continue to impress as strong customer activity, wider margins, higher liquidity, and normalized pricing in credit markets positively impacted interest rate, credit and FX trading, and capital market fee revenues.

• Wholesale banking earnings were very strong, increasing 89% sequentially to $327 million from $173 million the previous quarter, and up significantly from $102 million a year earlier.

Trading Revenue – Record

• Trading revenue remains very strong at $633 million versus $412 million in the previous quarter and $139 million a year earlier.

• Interest rate and credit trading revenue was very strong at $440 million versus a loss of $102 million a year earlier and a gain of $165 million in the previous quarter. Equity and other trading revenue declined to $39 million from $68 million a year earlier and from $93 million in the previous quarter. Foreign exchange trading revenue increased to $154 million from $77 million a year earlier and was flat from Q2/09.

Capital Markets Revenue

• Capital markets revenue was $389 million versus $374 million in the previous quarter and $365 million a year earlier.

Security Gains

• Security gains were a loss of $90 million or $0.07 per share versus a loss of $168 million or $0.13 per share in the previous quarter and a gain of $14 million or $0.01 per share a year earlier.

Unrealized Surplus – $177 million

• Unrealized surplus increased to $177 million from $75 million in the previous quarter and declined from $698 million a year earlier.

Securitization Revenue and Economic Impact

• Loan securitization revenue declined significantly in the quarter to $92 million from $184 million in the previous quarter, although up modestly from $77 million a year earlier.

• Securitization economic impact was a positive $48 million pre-tax or estimated $31 million after-tax or $0.04 per share, significantly lower than the previous quarter impact of $0.12 per share. Securitization activity is recorded in the Corporate segment.

Loan Loss Provisions

• Specific LLPs declined to $492 million or 0.80% of loans versus $546 million or 0.93% of loans the previous quarter, although they continue to run ahead of $288 million or 0.50% of loans a year earlier. However, excluding the currency impact, U.S. LLPs increased slightly to US$163 million from $161 million. Total LLPs were $557 million, which included a general allowance of $65 million ($46 million after tax or $0.05 per share).

• We are reducing our 2009 & 2010 LLP estimates to $2,030 million or 0.82% of loans and $2,100 million or 0.82% of loans from $2,100 million and $2,300 million, respectively.

Loan Formations Remain High

• Gross impaired loan formations increased to $969 million from $927 million in the previous quarter. U.S. gross impaired loan formations increased to US$387 million from US$288 million in the previous quarter. Net impaired loan formations declined to $603 million from $633 million in the previous quarter.

• Gross impaired loans increased to $1,947 million or 0.80% of loans from $1,875 million or 0.78% of loans in the previous quarter. Net impaired loans were negative $306 million.

Tier 1 Capital – Solid 11.2%

• Tier 1 ratio (Basel II) was 11.2% versus 10.9% in the previous quarter. Total capital ratio was 14.7% versus 14.1% in the previous quarter.

• Tangible common equity to risk-weighted assets (TCE/RWA) was 9.3% versus 9.0% in the previous quarter, while common equity to RWA was flat at 18.1% from the previous quarter.

• Book value increased 10% from a year earlier to $40.27.

• Risk-weighted assets increased 3% from a year earlier to $189.7 billion but declined 5% QOQ.

RBC Q3 2009 Earnings

Scotia Capital, 28 August 2009

Earnings Estimate and Target Price

• We are increasing our 2009 and 2010 earnings estimate to $4.40 per share and $4.80 per share from $4.15 per share and $4.65 per share, respectively due to strength in its core earnings particularly in Capital Markets.

• We are increasing our 12-month share price target to $75 from $65, representing 17.0x our 2009 earnings estimate and 15.6 x our 2010 earnings estimate.

Third Quarter Results

• Canadian Banking earnings declined 5% to $671 million from a year earlier. Retail NIM declined 24 bp year over year and 7 bp sequentially to 2.71%. Insurance earnings were $167 million, an increase of 22%. Wealth Management earnings moderated declining 11% to $179 million but rebounded 30% sequentially. RBC Capital Markets increased 50% to $622 million (excluding writedowns) due to very strong trading revenue. International Banking recorded a loss of $43 million.

Canadian Banking Earnings Decline 5%

• Canadian Banking earnings declined 5% to $671 million from $710 million a year earlier due to a decline in retail net interest margin and higher loan loss provisions.

• Revenues in the Canadian Banking segment increased 1.6%, with non-interest expenses declining 1.4% from a year earlier, resulting in positive operating leverage of 3.0%.

• Loan loss provisions (LLPs) declined 3% to $340 million from $351 million in the previous quarter.

Canadian Retail NIM Declines 24 basis points

• Retail NIM declined 24 bp year over year (YOY) and 7 bp sequentially to 2.71%.


• Insurance earnings were strong at $167 million versus $113 million in the previous quarter and $137 million a year earlier.

Wealth Management Earnings Decline 11%, Rebound Sequentially

• Wealth Management cash earnings declined 11% to $179 million from $201 million a year earlier due to large declines in AUM, but improved 29% sequentially from $139 million.

• Revenues were flat year over year with operating expenses increasing 2.5% for negative operating leverage of 2.5%.

• U.S. Wealth Management revenue improved 18%, with Canadian Wealth Management declining 15%, and Global Asset Management declining 13%.

• Mutual fund revenue declined 19% from a year earlier to $335 million. Mutual Fund assets (IFIC) declined 6.4% from a year earlier to $101.6 billion including PH&N.

International Banking Remains in Loss Position, LLPs Improve QOQ

• International Banking recorded a loss of $43 million versus a loss of $97 million in the previous quarter and net income of $37 million a year earlier. The loss position was driven by the continued high level of LLPs although down from the previous quarter. LLPs were $230 million in the quarter, down 20% from Q2 level of $289 million but up significantly from $137 million a year earlier. LLPs remained at an extremely high level of 2.80% of loans and are expected to remain high throughout the remainder of 2009 and into 2010.

• Net interest margin increased 16 bp from a year earlier, and 21 bp sequentially to 3.88%.

RBC Capital Markets Earnings Very Strong

• RBC Capital Markets earnings increased 50% (excluding writedowns) to $622 million, up from $415 million a year earlier due to very strong trading revenue.

Underlying Trading Revenue Very Strong at $1.5 Billion

• Trading revenue remains high at $1,476 million (excluding writedowns) versus $1,414 million in the previous quarter and $717 million a year earlier. The high trading revenue we believe is being driven by structural factors (U.K. and U.S. platforms) as well as cyclical.

• Trading revenue was extremely high in all products: interest rate, credit and equities, and foreign exchange.

Capital Markets Revenue

• Capital markets revenue was $636 million versus $568 million in the previous quarter and $588 million a year earlier.

• Securities brokerage commissions declined 2% to $337 million from $345 million a year earlier, with underwriting and other advisory fees at $299 million, increasing by 23%.

Security Losses Negligible

• AFS security loss was $57 million or $0.03 per share versus a loss of $0.03 per share in the previous quarter and nil per share a year earlier.

• Unrealized security surplus was a deficit of $629 million versus a deficit of $1,786 million in the previous quarter.

Securitization Net Income Declines

• Securitization net income impact declined to $47 million or $0.02 per share versus $354 million or $0.16 per share in the previous quarter.

Loan Loss Provisions Stabilize

• Specific loan loss provisions (LLPs) were $709 million or 0.99% of loans versus $751 million or 1.07% of loans in the previous quarter and $334 million or 0.47% of loans a year earlier. The bank recorded a $61 million general provision ($40 million or $0.03 per share) relating to U.S. banking. Total loan loss provisions were $770 million or 1.07% of loans.

• LLPs in Canadian Banking declined 3% sequentially to $340 million from $351 million. Credit card loss ratio increased to 4.67% from 4.37% in the previous quarter but remains substantially below CM at the 7.44% level. Specific LLPs in International Banking declined 20% QOQ to $230 million or 2.80% of loans from $289 million or 3.08% of loans.

• Our 2009 and 2010 LLP estimates are unchanged at $2,800 million or 0.99% of loans and $2,600 million or 0.88% of loans, respectively.

Loan Formations Decline

• Gross impaired loan formations declined to $1,229 million from $1,800 million in the previous quarter but increased from $753 million a year earlier. Gross impaired loans declined 1% quarter over quarter (QOQ) to $4,158 million or 1.46% of loans versus $4,217 million or 1.46% of loans in the previous quarter.

• Net impaired loan formations declined to $600 million from $1,467 million in the previous quarter. Net impaired loans declined to $1,246 million or 0.44% of loans from $1,341 million or 0.46% of loans.

Tier 1 Ratio Very Strong at 12.9%

• Tier 1 capital was very strong at 12.9% versus 11.4% in the previous quarter and 9.5% a year earlier due partially to a 9% sequential decline in risk-weighted assets mainly from currency impact.

• Risk-weighted assets declined 4% year over year to $243.0 billion. Market-at-risk assets were flat YOY and declined 12% QOQ to $17.6 billion.

• The common equity to risk-weighted assets (CE/RWA) ratio was 12.7% versus 11.2% in the previous quarter and 10.4% a year earlier.

Additional Disclosure on High-Risk Assets

• The bank provided additional disclosure on its exposure to U.S. sub-prime CDOs of ABS, RMBS, and U.S. insurance and pension solutions. The notional and fair value exposures to these areas as well as writedowns are detailed in Exhibit 2. We believe that RY has a good handle on exposure and that cumulative and potential writedowns are manageable.
Financial Post, Jonathan Ratner, 27 August 2009

The relative strength of Royal Bank’s third quarter results should be repeatable in future quarters, according to Dundee Securities analyst John Aiken, who upgraded the stock to Neutral from Sell and boosted his price target from $40 to $54.

He told clients to expect the bank’s absolute and relative valuation multiples to increase coming out of the quarter, but continues to believe absolute valuations for the banks as a whole are too high. As a result, the analyst finds it difficult to rate any banks a Buy, although he is tempted to for some, like Royal, on a relative basis.

Mr. Aiken remains concerned about how rising unemployment in Canada and the United States will impact retail and corporate credit quality in the next year.

He does have one major complaint against Royal – the level of trading revenues, which came in at $1.6-billion for the quarter, or roughly 21% of all revenue.

“We continue to believe that Royal’s earnings quality is dampened by the significant level of revenues generated by its trading activities,” the analyst wrote. “However, RY’s trading revenues continue to be frustratingly less volatile than its peers, despite their absolute size.”

Mr. Aiken thinks the market will look beyond this and focus on the bank’s comment regarding the “decline in the pace of credit deterioration” in its U.S. portfolios.

While corporate loan quality improved marginally in the quarter, he noted that retail credit continues to deteriorate and will continue to be impacted by unemployment levels. However, the analyst pointed out that Royal’s balance sheet strength provides a significant cushion.
The Globe and Mail, Tara Perkins, 27 August 2009

Canadian banks, bolstered by surprisingly strong demand for housing and robust trading businesses, are breaking profit records in the midst of a recession.

Royal Bank of Canada, National Bank of Canada and Toronto-Dominion Bank all reported earnings that topped analysts' expectations yesterday.

The first two actually managed to churn out higher profits than ever before despite the economic gloom.

“At the beginning of 2009 I would have found it hard to believe that by the third quarter I'd be talking about year-over-year increases in our earnings per share, even after issuing shares last year,” said Toronto-Dominion Bank chief executive officer Ed Clark. “But it certainly looks like we're going to be there.”

Serious questions remain about the sustainability of the banks' trading revenues, and the damage that rising unemployment levels will inflict on loans such as credit cards and corporate lines of credit.

But this quarter's earnings are the clearest evidence to date that the big banks are not only weathering the downturn but, in many ways, prospering without the aid of government equity and other forms of support that banks in other countries are receiving.One of the reasons for the sector's stellar performance is the surprising strength of the Canadian resale housing market.

It has been helping to keep both the economy and bank profits aloft, Mr. Clark suggested yesterday.

Mortgages are the largest component of the banks' personal and commercial loan portfolios.

TD held $52.1-billion of Canadian mortgages in the latest quarter and $53.5-billion in home equity lines of credit, up from $44.8-billion and $49.1-billion, respectively, in the prior quarter.

“The Canadian economy's come through I would say an almost surprisingly robust spring mortgage season across the country,” said David McKay, the head of Royal Bank's Canadian lending business. “I think as long as unemployment trends stabilize, and Canadians get back to work, you should see relatively strong growth.”

That's allowing the banks to wean themselves off the programs that the government did roll out.

At the height of the crisis last fall, Ottawa introduced a new program to buy mortgages from the banks in order to lower their funding costs and allow them to make more loans. That program is scheduled to end next month, and markets have improved to the point that Royal Bank, for one, had much less need for it in the latest quarter, said chief financial officer Janice Fukakusa.

The bank sold $18.3-billion worth of residential mortgages to that program and the Canada Mortgage Bond program in the first three quarters of the fiscal year, but only $2.3-billion of those were sold in the latest quarter.

The improved funding conditions should help further support bank profit margins in the coming quarters.

One area where the banks' earnings are potentially more precarious is trading revenues, which were a key profit driver for each of the three that reported yesterday. National Bank pulled in trading revenue of $164-million, well above its six-quarter average of $120-million, noted Credit Suisse analyst Jim Bantis. Royal Bank's trading revenues amounted to $1.6-billion, or nearly 21 per cent of its overall revenue, noted Dundee Securities analyst John Aiken.

The trading revenues stem partially from the high degree of volatility in the markets, and many analysts question whether the banks can maintain those levels. Mr. Clark himself suggested it's unlikely, telling investors to expect earnings from TD Securities, the bank's capital markets business, to be lower in the future.

Royal Bank CEO Gordon Nixon said that capital markets businesses tend to be the first to rebound coming out of a recession. Profits from wealth management and basic banking will take more time to improve to the same degree, he suggested.

However, both he and executives at TD also noted that with markets stabilizing, more financial institutions, particularly U.S. banks, are resuming their trading operations or kicking them up a notch, creating competition that could take some of the wind out of the Canadian banks' sails.

Mr. Nixon pointed out that Royal Bank earned $1-billion even without its investment banking and capital markets activities. “So I wouldn't characterize us as the Goldman Sachs of the north,” he said, referring to the U.S. bank that has long thrived off of trading activity.

National Bank Q3 2009 Earnings

Scotia Capital, 28 August 2009

• National Bank (NA) operating earnings increased 17% to $1.79 per share, substantially above expectations. Operating ROE was 22.2% with RRWA of 1.99%. Reported earnings were $1.78 per share including a $1 million after-tax or $0.01 per share charge related to holding ABCP.


• NA third quarter earnings were extremely strong driven by record results from the Financial Markets segment, solid retail bank earnings, offset by weak Wealth Management Earnings. Earnings were also supported by very low loan loss provisions.


• We are increasing our 2009E and 2010E EPS to $6.35/share and $6.40/share from $5.55/share and $6.00/share, respectively, based on the strong wholesale platform and lower-than-expected credit losses. We are increasing our share price target to $75 from $70, representing 11.7x our 2010 earnings estimate.

• We upgraded NA to 2-Sector Perform intraday yesterday due to its stellar results, high credit quality, and record results from wholesale.

27 August 2009

CIBC Q3 2009 Earnings

Scotia Capital, 27 August 2009

Q3/09 Earnings Weak, Higher Loan Losses, Revenue Challenged

• Canadian Imperial Bank of Commerce (CM) third quarter earnings were disappointing due to significant deterioration in credit quality and spike in loan losses that overshadowed the improvement in the net interest margin and strong capital ratio. In addition, the bank disclosed that it is facing a potential and substantial tax reassessment from 2005 related to the Enron settlement, once again reminding the market of the bank's legacy and propensity for risk and negative financial surprises. The high credit losses in the quarter and Enron reminder appears to have lowered the market confidence about the emergence of a "De-risked CIBC". We believe CM remains the most revenue challenged of the bank group. On the positive side, reported earnings appear to be stabilizing with the bank covering its common dividend for the first time in fiscal 2009 with a payout ratio of 84% (64% on operating).

• CM reported a decline in cash operating earnings of 18% to $1.36 per share below our estimate and consensus of $1.41 per share due to a spike in loan loss provisions and lower security gains. Higher-than-expected loan losses reduced earnings by $0.14 per share. However, quality of earnings improved due to significantly less reliance on security gains at $0.05 per share versus $0.32 per share last quarter.

• Specific LLPs spiked to $422 million or 1.01% of loans from $329 million or 0.83% of loans in the previous quarter and $203 million or 0.46% of loans a year earlier. Total LLPs were $547 million or1.31% of loans including a general provision of $42 million and $83 million of loan losses within the leveraged loan and other run-offs portfolio that the bank identified as an item of note.

• CIBC Retail Markets earnings continued to disappoint, declining 22% YOY due mainly to credit losses and decline in revenue, with CIBC World Markets earnings more than doubling from a year earlier and now representing 30% of operating earnings.

Items of Note

• Reported cash earnings were $1.04 per share, including items of note/charges totaling $0.32 per share (see Exhibit 1). Total charges included $155 million ($106 million after-tax or $0.27 per share) on mark-to-market losses on credit derivatives in CIBC's corporate loan hedging program, $95 million ($65 million after-tax or $0.17 per share) gain on structured credit run-off activities, $83 million ($56 million after-tax or $0.15 per share) loan losses within the leveraged loan and other run-off portfolios, $42 million ($29 million or $0.07 per share) general provision, and additional net recoveries of $3 million after-tax or nil per share.

Retail Markets Earnings Decline 22%

• Earnings at CIBC Retail Markets were disappointing at $431 million, a decline of 22% YOY due to a doubling of loan loss provisions and decline in revenue.

• Retail loan loss provisions increased 16% quarter over quarter (QOQ) and 89% YOY to $423 million. The major weakness in the portfolio was credit cards, with a loss ratio of 7.4%, a new Canadian record.

• Retail Markets revenue declined 1.3%, with non-interest expense declining 3.8%. Wealth Management revenue declined 19%, with FirstCaribbean revenue increasing 2%. Wealth Management and FirstCaribbean represented 14% and 7% of Retail Markets revenue, respectively.

• Deposit and payment fees improved 1% YOY to $199 million. Card fees were $80 million compared with $85 million in the previous quarter and $81 million a year earlier.

• Mutual fund revenue, which is contained in Wealth Management revenue, declined 20% from a year earlier to $166 million. Mutual fund assets (IFIC) declined 14% YOY to $43.0 billion. Investment management and custodian fees declined 20% from a year earlier to $103 million.

Canadian Retail NIM Improved

• Retail net interest margin (NIM) (loan balances restated) increased a significant 35 basis points (bp) sequentially and 2 bp from a year earlier to 2.80%.

CIBC World Markets

• CIBC World Markets earnings were $181 million, down from $222 million in the previous quarter but up from $77 million a year earlier.

• Corporate and investment banking revenue doubled to $221 million from $110 million a year earlier.

Underlying Trading Revenue Strong

• Trading revenue (excluding writedowns) was strong this quarter at $219 million versus $178 million in the previous quarter and $121 million a year earlier. Strong trading revenue was driven by fixed income with solid support from foreign exchange and equity.

Capital Markets Revenue

• Capital markets revenue was $254 million versus $218 million in the previous quarter and $202 million a year earlier.

• Underwriting and advisory fees were $132 million in the quarter versus $112 million in the previous quarter and $68 million a year earlier.

Security Gains Moderate

• AFS/FVO gains included in operating earnings moderated to $32 million or $0.05 per share from $186 million or $0.32 per share in the previous quarter, but were higher than the $1 million or nil per share a year earlier.

Unrealized Security Deficit

• The unrealized security deficit improved to $244 million at quarter-end versus a deficit of $720 million in the previous quarter and a surplus of $417 million a year earlier.

Corporate and Other Business Segment

• The corporate and other segment recorded a loss of $48 million versus a loss of $80 million in the previous quarter and a gain of $33 million a year earlier.

• Securitization revenue declined in Q3/09 to $113 million versus $137 million in the previous quarter and $161 million a year earlier. The bank calculated the net income statement impact at a loss of $31 million in Q3/09 versus a gain $25 million in Q2/09.

Loan Loss Provisions Spike

• Specific LLPs spiked to $422 million or 1.01% of loans from $329 million or 0.83% of loans in the previous quarter and $203 million or 0.46% of loans a year earlier. Total LLPs were $547 million or 1.31% of loans including a general provision of $42 million and $83 million of loan losses within the leveraged loan and other run-offs portfolio that the bank identified as an item of note.

• The increase in loan losses was due mainly to credit cards and personal lending, leveraged loans and other run-off portfolios, and U.S. real estate finance business. Credit card loss ratio hit a Canadian record at 7.4%.

• Retail LLPs were $423 million with CIBC World Markets LLPs at $46 million, with the corporate segment recording a $47 million recovery.

• We are increasing our 2009 LLP estimates to $1,400 million or 0.84% of loans from $1,300 million or 0.79% of loans. We are reducing our 2010 LLP estimate to $1,400 million or 0.81% of loans from $1,500 million or 0.88% of loans, respectively.

Impaired Loans Increase

• Gross impaired loans increased 32% to $1,668 million or 1.00% of loans in the quarter versus $1,263 million in the previous quarter and $889 million a year earlier. Gross impaired loans increased materially in the quarter in the business lines of publishing, printing & broadcasting, and real estate and construction.

• Net impaired loans were negative $312 million versus negative $505 million in the previous quarter and negative $595 million a year earlier.

Loan Formations Increase

• Gross impaired loan formations increased to $967 million this quarter from $541 million in the previous quarter and $328 million a year earlier. Net impaired loan formations also increased to $741 million from $407 million in the previous quarter and $206 million a year earlier.

Tier 1 Ratio 12.0%

• Tier 1 ratio increased to 12.0% from 11.5% in the previous quarter, due mainly to the 3% sequential decline in risk-weighted assets.

• The common equity to risk-weighted assets (CE/RWA) ratio was 9.2% compared with 8.9% in the previous quarter and 9.1% a year earlier.

• Total risk-weighted assets declined 3% sequentially and YOY to $115.4 billion, while market-at-risk assets declined 32% sequentially and 41% YOY to $1.7 billion.

• Book value was flat QOQ and declined 2% YOY to $27.87 per share.

Enron Settlement - Tax Reassessment?

• On August 5, 2009, Canada Revenue Agency (CRA) issued draft reassessments proposing to disallow the deduction of the 2005 Enron settlement payments of approximately $3 billion. CIBC is contesting. If entirely successful, CIBC would recognize an additional tax benefit of $214 million or $0.56 per share, plus interest. If entirely unsuccessful, CIBC would incur a tax expense of $826 million or $2.17 per share plus interest. If entirely unsuccessful this would result in a 70 bp reduction in Tier 1 Capital bringing CIBC's ratio down to 11.3%.


• We are trimming our 2009 earnings estimate to $5.90 per share from $6.00 per share due to higher-than-expected loan loss provisions in Q3/09. Our 2010 earnings estimate remains unchanged at $6.30 per share.

• Our 12-month share price target remains unchanged at $75, representing 12.7x our 2009 earnings estimate and 11.9x our 2010 earnings estimate.

• We maintain our 2-Sector Perform rating based on stabilizing earnings base and leverage to lower loan losses as the credit cycle turns, offset by weak revenue growth outlook and weaker operating platforms.
Financial Post, John Greenwood, 26 August 2009

Four years after Canadian Imperial Bank of Commerce paid a record $3-billion settlement to disentangle itself from Enron litigation, the spectre of the failed U.S. energy trader has come back to haunt Canada's fifth-largest bank.

CIBC disclosed Wednesday that it is preparing to go to court with the Canada Revenue Agency to defend its position that the settlement is tax-deductible.

If the bank wins it will recognize a tax benefit of $214-million, but if the government prevails CIBC could end up having to pay $826-million.

"This is not a small amount to CIBC, representing roughly 8% of its book value," said Jim Bantis, an analyst at Credit Suisse.

The matter was disclosed in CIBC's third-quarter results.

Speaking on a conference call with analysts, Gerry McCaughey, chief executive, said CIBC has for some time been "anticipating reassessment would be probable" but went public after it became almost certain on Aug. 5 that the CRA would challenge the deduction.

CIBC reported net income for the third quarter of $434-million, or $1.02 a share, up from $71-million (11¢) last year.

At the same time, the bank made total loan loss provisions of $547-million in the quarter, more than double the comparable figure for last year and significantly higher than analysts expected.

The results came out a day after Bank of Montreal kicked off earnings season with earnings that were well ahead of analyst estimates.

Shares in CIBC declined 5.3%, ending the day at $65.01 after diving nearly 10% at the opening of trading on the Toronto Stock Exchange.

John Aiken, an analyst at Dundee Capital Markets, said he was "disappointed" by CIBC's rising loan loss provisions. "Based on BMO having almost everything going right, you start to believe that this is what to expect and that the [troubled economy] is not going to bite the banks but CIBC demonstrated a very different experience," he said.

Total revenue for the quarter was $2.86-billion, up from $1.9-billion a year ago. Canada's fifth largest bank had a Tier 1 ratio of 12% and declared a dividend of 87¢ for the current quarter.

Of Canada's major banks CIBC suffered the worst from the financial crisis, with about $10-billion of writedowns related to structured credit products over the past 18 months.

The quarter contained some good news on that front as there were no major writedowns.

In the three months ended July 31, CIBC did have $155-million of mark to market losses on credit derivatives due to narrowing spreads in the bank's loan hedging portfolio. This was partly offset by a $95-million gain on what the bank called structured credit runoff activities.

With worst of the red ink from credit derivitives mostly behind it, Mr. McCaughey said CIBC sees securitization as an opportunity. At its peak, the bank had about $17-billion of assets in its securitization trusts, which has since been run down to about $4-billion.

Bank officials said conditions in the market suggest demand for securitized products is re-emerging along with profit margins.

The results come a day after the Bank of Canada warned that the recovery in the Canadian economy could be derailed by a soaring loonie. The bank's deputy governor Timothy Lane said on Tuesday that the BOC may have to intervene to halt the rise.

Analysts said that of all the major banks CIBC is particularly sensitive to changes in economic conditions because of its high exposure to consumer credit cards. As a rule, consumers are much more likely to default on their credit cards than other forms of debt such as mortgages and car loans.

CIBC's retail markets business reported net income of $416-million, down 26% from last year because of deteriorating economic conditions and rising loan losses.

In wholesale banking, CIBC had a net profit of $86-million, compared with a loss of $541-million for the same period last year. The improved result was primarily due to gains in structured credit operations.

On the conference call, Mr. McCaughey said the bank is on the lookout for growth opportunities but declined to comment specifically on rumours earlier this month that the bank is looking to acquire a minority stake in an Irish bank.

26 August 2009

BMO Q3 2009 Earnings

TD Securities, 26 August 2009

Looking for a C$1.00 run rate; modest ROE. There were a few gives/takes on the quarter (see Exhibit 5). We are increasingly reluctant to look through general reserves here (given we are in the midst of a credit downturn, and coverage ratios at BMO are thin). We see Q3/09 at C$0.95 and remain comfortable with our C$4.00 number for 2010. However, this still implies a relatively modest 12-13% ROE; a constraint to valuation in our view and management will have to find ways to rev-up earnings and/or deploy capital more aggressively.

Updating Apex. Quarter saw a small net charge of C$8 million. BMO has now hedged the first C$515 million of losses on their exposure under the funding facility (up to C$1.03 billion) and hedged their C$815 million in exposure to the medium term notes.

Updating Links/Parkland. As at Q3/09, the amounts drawn on the liquidity facilities increased to US$6.4 billion for Links and €622 million for Parkland relative to market values of US$5.6 billion and €598 million respectively (up slightly). Management continues to believe the capital notes offer sufficient first loss protection. No reserves have been taken at this point.

Quarterly Highlights (growth is year on year unless noted)

• Canadian P&C - A solid bottom-line.
NI was up 13% (adjusting prior periods for re-class of insurance to Wealth) on 8% revenue growth (+10% NII, +4% Other). Margins continue to drive the revenue story, improving 33bp over Q3/08 helped by improved funding, rate environment, loan mix and re-pricing.

Earning Assets in the segment were down slightly. In managed balances, personal loans grew a strong 15%, but mortgage balances were down nearly 2% (ongoing exit of broker network). Cards were +4% and Commercial loans were flat.

Commercial continues to be a strong revenue driver with 17% growth helped by re-pricing in the loan book, with Cards +11% while Personal was a modest +2%.

• U.S. P&C. Decent revenue growth at 10% (on back of improved loan spreads, deposit retention and gains on sale of mortgages) offset by higher credit costs. NI was down 11%.

• Wholesale. Driven mostly by strong trading numbers in interest rate products, NI was up 20%. The quarter also saw several capital markets related adjustments that largely offset.

• Wealth/Insurance. Adjusting for an income tax recovery, NI was down 22%. Top line growth was down 8% reflecting continued challenges in equity markets.

Operating Outlook. Our updated Q4/09 adds C$0.02 (primarily on slightly lower PCLs). 2010 remains unchanged at C$4.00. Key drivers in 2010 are a move to peak credit costs in 1H10 and some easing of Trading/Capital markets revenues while NIMs trend slightly higher from current levels. With above normal capital levels, ROE is likely to remain modest (12-13%). More aggressive volume growth/capital deployment offer potential upside to our forecast.

Segments. Canadian P&C appears positioned to deliver at a slightly higher pace. We assume modest uptick in Q4. The addition of Insurance (including a full quarter of the AIG acquisition) has lifted Wealth which should be helped by improving markets. Wholesale has room to ease following a very strong Trading quarter.

Credit. Encouraging trends as Gross Formations continue to ease. GILs declined with further write-offs and decent recoveries. However, the GILs/Loans ratio ticked up slightly and coverage ratios remain relatively thin. We remain concerned about U.S. Consumer Loans (US$16 billion, 10% of Total Loans) where delinquency ratios continued to climb and U.S. C&I/Commercial Real Estate (US$17.8 billion, 11%/US$4 billion, 2%) where we expect conditions to deteriorate over the coming quarters. We took down our Q4 PCL estimate slightly, but still expect credit costs to remain elevated.

Capital. The bank is over-capitalized, helped by lower RWA (including some favorable FX moves). Management expects ratios to decline as growth picks-up through 2010 and/or additional acquisition driven growth.

Justification of Target Price

In determining our Target Price we establish a Fair Value P/BVPS multiple based on our expectations regarding long-term sustainable ROE, growth and COE. Our expectations currently stand at 13.0%, 3.0% and 10.25% respectively implying a Fair Value P/BVPS multiple on the order of 1.55x.

Key Risks to Target Price

1) Additional losses or write-downs from key risk exposures 2) significant competition in the Chicagoland market and 3) adverse changes in the credit markets, interest rates, economic growth or the competitive landscape.

Investment Conclusion

Despite decent earnings, we still see relatively modest ROE (12-13%). At 1.7x book, the stock looks fully priced to us and we have made no changes to our 2010 estimates or Target. Maintain Hold.
Scotia Capital, 26 August 2009

• BMO reported a 5% decline in cash operating earnings to $1.05 per share significantly above consensus of $0.95 per share but below our estimate of $1.16 per share due mainly to a loss from securitization.


• Underlying earnings were extremely strong at $1.18 per share adjusted for securitization losses, security losses, CDS hedge loss, mark-to-market loss on balance sheet hedge, FDIC special assessment, P&C Canada severance costs, CVA gains, a tax recovery in the Private Client Group and a restructuring charge reversal. We estimate the December 2008 equity issue diluted earnings this quarter by $0.07 per share.

• Reported cash earnings were $0.98 per share including a general allowance of $60 million ($39 million after-tax or $0.07 per share).

• Earnings were led by BMO Capital Markets with YOY growth of 16%, P&C Canada at 13%, with Private Client Group earnings declining 4% and P&C U.S. earnings declining 11%.


• Strong underlying earnings, absence of capital charges of note, stabilizing credit, improving net interest margin, and large capital position support higher valuation. We reiterate our 1-Sector Outperform rating.
Financial Post, David Pett, 26 August 2009

Looking for quality not quantity, some analysts are expressing concern about Bank of Montreal's future profits in the wake of better-than-expected third quarter results that sent markets soaring on Tuesday.

"We believe earnings quality continues to be below average," said Brad Smith, Blackmont Capital analyst.

"In particular, we are concerned about the adequacy of credit allowances and the sustainability of reported net interest margins, which have benefited heavily from the steepening of the yield curve.

With BMO shares trading at valuations modestly higher than its peers, Mr. Smith thinks the market is not adequately discounting for the noted risks to BMO's future earnings, dividend growth and profitability.

"This leaves us little choice but to maintain our Sector Underperform investment rating and $43.00 per share target price."

Of the 16 analysts covering Bank of Montreal, five have Sell ratings, seven have Hold ratings and four analysts recommend the bank as a BUY.

Jim Bantis, Credit Suisse analyst, also reiterated his Underperform rating on the stock, but did raise his target price from $36 to $42 to reflect an increase in his 2010 earnings forecast.

"We note that despite this quarter’s record revenues ($2.98 billion) and low tax rate (16%), earnings momentum remains flat and profitability remains challenged (only a 12% ROE)," he told clients in a research note.

He said BMO's current valuation ignores reduced earnings power due to continued balance sheet de-leveraging, increasing credit losses from the bank’s US commercial mortgages and C&I loan portfolio, and unsustainable trading revenues.

18 August 2009

Preview of Banks' Q3 2009 Earnings

Scotia Capital, 18 August 2009

Banks Begin Reporting August 25

• Banks begin reporting third quarter earnings with Bank of Montreal (BMO) on August 25, followed by Canadian Imperial Bank of Commerce (CM) on August 26, National Bank (NA), Toronto Dominion (TD), and Royal Bank (RY) on August 27, Bank of Nova Scotia (BNS) on August 28, and Laurentian Bank (LB) and Canadian Western (CWB) closing out reporting on September 3. Scotia Capital’s earnings estimates are highlighted in Exhibit 1, consensus earnings estimates in Exhibit 2, and conference call information in Exhibit 3.

Earnings Nearing Cyclical Bottom?

• We expect third quarter operating earnings to decline 14% year over year and 2% sequentially. The year-over-year decline in earnings is due mainly to an 81% increase in loan loss provisions and a decline in net-interest margin, partially offset by strong wholesale banking earnings. The sequential decline in earnings is mainly due to lower expected trading and securitization revenue.

• Interestingly, bank operating earnings have handily beaten consensus estimates over the past several quarters; however, these beats have been generally discounted due to continued noise with respect to mark-to-market writedowns and the fact that trading and securitization revenue have been the main drivers in positive earnings surprises. There has also been a lot of uncertainty about what sustainable trading revenue levels are. At the same time, earnings have absorbed high loan losses and a fall-off in wealth management earnings. In terms of trading revenue, we believe that there is both a cyclical and structural component to the high level of trading revenue, with the split very difficult to ascertain with any degree of accuracy. We suspect the market is attributing most of the trading gains as cyclical, with very little structural consideration. However, from a directional perspective, we see a structural expansion in trading revenue due to the expansion of bank trading platforms and activity, less market capacity and competition, and favourable market conditions that may persist for some time (it may take years to fully revert to the mean), which are all expected to lead to higher structural or sustainable trading revenue.

• We expect third quarter bank index operating earnings to be 410, which we believe is at or near the cyclical bottom, with bank operating earnings having retraced back to Q2/06 levels. We expect a modest pickup sequentially in earnings for Q4/09 to 432, which would be flat YOY; thus, Q3/09 would mark the bottom in bank operating earnings.

• We believe that post the spectacular bank stock rally, the market is now discounting that both loan loss provisions and mark-to-market writedowns are manageable. However, we do not believe the market is discounting the possibility that we may be nearing the peak in loan losses this cycle, or that mark-to-market losses could drop precipitously, or the potential positive impact of net-interest margin expansion.

• Operating return on equity is expected to be 16.5% for the third quarter, down slightly from 17.1% in Q2/09 and down more materially from 20.0% a year earlier.

• Loan loss provisions in Q3 are expected to increase to $2.6 billion or 0.83% of loans, slightly higher than the Q2 level of $2.5 billion or 0.83% of loans, but significantly higher than $1.4 billion or 47 basis points (bp) a year earlier. The growth rate in quarterly loan loss provisions is expected to be 4.6% in Q3/09, down from the peak growth in Q1/09 of 36%. We believe that the bank group is nearing peak sequential loan loss levels.

• We expect a substantial reduction in mark-to-market writedowns this quarter and actual gains in the AFS OCI account (although FX translation will be negative for OCI), due to a number of factors. The corporate bond spreads have improved dramatically to 248 bp from 429 bp in the previous quarter, with the LCDX Index (Corporate Debt/LBO Proxy) increasing 17% from the Q2 levels and the ABX-BBB flat at 3.0. In addition, CDS spreads have improved remarkably in the past quarter, narrowing by 50% to 60% for Citigroup, JP Morgan, Barclays, and Goldman Sachs. In terms of the two main monoline insurers, CDS spreads were somewhat stable, with MBIA narrowing (improving) by 3% and Ambac widening by 28% (there is not a linear relationship with respect to probability of default). The magnitude of potential mark-to-market writedowns has declined in general to a guesstimate of $100 to $300 million per bank, if any (except NA with negligible writedown potential).

• The banks’ overall net-interest margin has the potential to positively surprise due to the steep positive yield curve, loan repricing, deposit surge from money market funds, continuing wide wholesale margin, and easing of liquidity pressures. Personal deposits funded 96% of retail loans in Q2/09, up from the historical low of 81% in 2007 and 88% in 2008. The yield curve steepened 32 bp in Q3 to 322 bp (91-day vs. 10-year) and contracted slightly by 7 bp (2-year vs. 10-year), although it remained attractive at 204 bp.

• Bank prime rate averaged 2.25% in the third fiscal quarter versus 2.64% in Q2/09, potentially squeezing the margin; however, the banks have aggressively repriced their loan book to mitigate this pressure. The absolute low level of interest rates continues to be a major concern in terms of bank profitability. Thus, any signal that there will be no further rate reductions and there may perhaps be moderate, orderly incremental increases in interest rates would be viewed very favourably for bank profitability.

• We continue to forecast a 7% earnings decline in 2009 and a 9% increase in 2010. Return on equity is expected to be 17.0% in 2009 and 17.3% in 2010.

• The fear concerning whether Canadian bank dividends are safe has subsided, and the market is now more balanced in looking at underlying fundamentals, earnings power, and P/E multiples. However, the recent Manulife dividend cut did cause some slight extrapolation to Canadian banks and questioning of the safety of Canadian bank dividends, which we believe has no basis. We not only continue to believe that Canadian bank dividends are safe, but also believe that dividend increases are on the horizon. Canadian banks have a significant opportunity to elevate their status and receive a premium from the equity markets for the soundness of their operating platforms and business models.

• We believe that there is a major scarcity of reliable attractive yield in the marketplace. A number of global banks are no longer paying meaningful dividends. Canada’s largest insurance company cut its dividend by 50%; the high yield income trust market is drawing to a close in Canada, thus Canadian banks’ dividend track record stands out (see report titled “Four Decades of Dividend Growth,” March 2002). Further rewarding shareholders for holding their stock via early dividend increases would, we believe, drive this point home with investors and be supportive to higher (premium) valuations.

• Bank stocks have increased 44% year-to-date 2009, substantially outperforming the TSX, which has increased 21%. Despite the share price performance, we believe valuation remains attractive at 11.2x 2010 earnings estimates, especially if earnings are near their cyclical bottom. 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 reach 16x.

• Bank dividend yields also remain very attractive at 4.3% or 124% relative to the 10-year government bond yield, which is 3.0 standard deviations above the mean. Bank dividend yields are also attractive against equities at 0.8x the TSX Equity Index versus a 1.4x historical mean and a 1.1x level recorded from 1956 to 1978.

• The sustainability of bank dividends, scarcity of reliable yield, and the resumption of superior dividend growth are expected to be the catalysts for significantly higher bank share prices.

• We quoted Peter L. Bernstein and Robert D. Arnott’s research in our report titled, “Four Decades of Dividend Growth” (March 2002); they conclude that dividends have been the most significant contributor to total equity returns (dividends represented 63% of total equity returns from 1802 to 2001).

• 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 valuations on both a yield and P/E multiple basis. We remain overweight the bank group.

• We have a 1-Sector Outperform rating on RY and BMO, with 2-Sector Perform ratings on BNS, CM, LB, and CWB, and 3-Sector Underperform ratings on NA and TD. Our order of preference is RY, BMO, BNS, CM, CWB, LB, TD, and NA.

BNS – Scotiabank Mexico Contribution Improves Modestly QOQ

• Scotiabank Mexico reported Q2/09 consolidated net income of $32 million (P$372 million), a 60% decline from a year earlier and a 26% decline from the previous quarter. Earnings declined YOY due to higher loan loss provisions, a P$371 million before-tax loss on sale of a P$860 million credit card portfolio, and a gain on sale on the Mexican Stock Exchange IPO a year earlier. This was somewhat offset by a decline in the effective tax rate to 13% from 31% a year earlier and 38% in the previous quarter, due to lower earnings in the quarter and favourable timing differences.

• Scotiabank Mexico’s contribution to BNS, after adjustments for Canadian GAAP, is $61 million or $0.06 per share, versus $54 million or $0.05 per share in the previous quarter, and $104 million or $0.10 per share a year earlier. The adjustment to Canadian GAAP includes a reversal of the loss on partial sale of credit card portfolio, as the loss was recognized in the previous quarter.

TD – TD Ameritrade Earnings Improve Sequentially

• TD Ameritrade (AMTD) reported a 12% decline in earnings to US$0.30 per share from US$0.34 per share a year earlier due to the weak net interest margin and higher expenses, but increased 30% sequentially. Earnings were slightly above consensus. TD Bank estimates TD Ameritrade’s contribution this quarter to be $68 million or $0.08 per TD share versus $0.06 per share in the previous quarter and $0.09 per share a year earlier.

TD Pre-Announced an FDIC Special Assessment Charge for Q3/09

• On May 28, 2009, TD pre-announced a US$50 million FDIC special assessment charge based on 5 bp of total assets less Tier 1 Capital as at June 30, 2009. This charge translates into C$0.04 per share. We estimate that similar charges for BMO and RY would be approximately US$20 million (C$0.04 per share) and US$15 million (C$0.01 per share), respectively.
Financial Post, Eric Lam, 18 August 2009

With Canadian banks reporting their results next week, analyst forecasts continue to roll in. Next up is James Bantis of Credit Suisse, who warns that the pendulum of investor sentiment has swung from too bearish in February to too bullish now.

"Earnings quality in the first half of 2009 was poor, relying on unusually high trading revenue to offset credit challenges," he said in a note to clients. "Looking ahead, credit provisions are expected to accelerate well into the first half of 2010 whereas trading revenue levels may be close to peaking."

Mr. Bantis expects operating earnings to be down 16% on average from the third quarter of 2008, with a considerable downside risk gross impaired loans are forecasted to rise by 10% to 15%.

Credit Suisse has also compiled a brief summary of what to expect from each bank:

•Bank of Montreal: Underperform, EPS 93 cents (in line with consensus), Target Price $36
•Bank of Nova Scotia: Neutral, EPS 84 cents (3 cents above consensus), Target Price $34
•CIBC: Underperform, EPS $1.35 (3 cents below consensus), Target Price $48
•National Bank: Neutral, EPS $1.32 (2 cents below consensus), Target Price $48
•Royal Bank: Neutral, EPS 93 cents (2 cents above consensus), Target Price $37
•TD Bank: Neutral, EPS $1.20 (1 cent below consensus), Target Price $44
Financial Post, Eric Lam, 17 August 2009

With the Bank of Montreal set to announce its third quarter results next week, Blackmont takes a quick look at what to expect for the latest earnings season for Canada's Big Six.

Overall, Brad Smith, analyst, forecasts per share profits will be about 15% below 2008 levels, close to the median consensus forecast of 16%.

"As has been the case for much of the past 12-18 months, credit provisioning decisions will have a meaningful impact on reported profits," Mr. Smith said in a note Monday. "Moreover, it remains to be seen if the banks see fit to increase loss allowances relating to their domestic loan books that have migrated to a more consumer focus in recent years."

Consumer lending has always shown great resilience, but recent pressure on employment and income levels has seen a steep climb in consumer bankruptcies, he said.

Other than earnings, credit loss development and capital positioning are important factors to consider for investors, Mr. Smith said.

As for individual banks, the Bank of Nova Scotia has the best chance of posting a "positive surprise" given its stable credit profile in Mexico, while the Bank of Montreal's weak performance in its U.S. personal and commercial segment and lower-than-expected securitization revenue are likely to depress results.
TD Securities, 13 August 2009

Canadian Banks: A Closer Look - Personal Loan Market

• Defining the credit risks. The third in a series of in-depth reports, we look at the Personal Loan books of the Canadian banks and the outlook for credit losses. We continue to expect credit costs to climb materially in 2009 and 2010, but we maintain our view that expenses will be manageable.

• Personal Loans - a significant driver of credit expense. Our outlook reflects some C$5.3 billion in PCLs relating to Personal Loans in 2010 out of our total estimate of C$9.8 billion for the Large-Cap Canadian banks. This is against our estimate of pre-tax, pre-provision profit of roughly C$35 billion.

• HELOCs - unlikely to be a source of credit stress. The Canadian HELOC exposures are of relatively high quality and should see minimal losses. U.S. exposures are higher risk but represent relatively small portfolios.

• Credit Cards - likely to see relatively intense losses. On a managed basis, trends have been deteriorating across the board with losses running 5-6%. We continue to expect loss rates to ultimately reach high single digits.

• Other Personal Loans - a mixed bag. Sub-prime auto loans and unsecured Lines of Credit, for example, should see elevated losses, but they are a smaller portion of the book. Overall, we expect low single digit losses here.

• CIBC dealing with cards; BMO looks thinly reserved. With the largest Cards book, CIBC is seeing significant credit deterioration, but the bank is well reserved and appears to be managing the downturn. Overall, BMO stands out as having relatively thin reserves. We do not see the Personal Loan portfolio as overly problematic, but it does have some pockets of lower quality U.S. exposures.

Executive Summary

The Personal Loan books of the Canadian banks have deteriorated, and are likely to continue to be a source of relatively intense credit losses. This should drive an estimated C$5.3 billion in PCLs in 2010. However, trends remain reasonably well controlled and the expected material uptick should be manageable.

In this, the third in a series of in-depth reports on the outlook for credit, we detail the industry’s credit exposure to the Personal Loan market (which we define as personal lending excluding traditional residential mortgages which we covered in a previous report - “A Closer Look – Canadian Residential Mortgage Market,” dated April 23, 2009).

Included in this portfolio are Home Equity Lines of Credit (HELOCs), Credit Cards and Other Personal Loans (i.e. unsecured loans/Lines of Credit, investment loans, auto loans etc). Importantly, we consider loan and credit exposure on a managed basis; that is including, where possible, direct securitization exposure. Overall, personal lending represents just below 25% of the managed loan books of the Large-Cap Canadian banks on average.

• HELOCs. A fairly significant portfolio for some banks of total managed loans (TD has a reported exposure of nearly 25%). The Canadian exposures are of relatively high quality, in our view, (helped by the existence of a robust mortgage insurance framework in Canada) and recent performance data continues to suggest minimal losses. Some select U.S. based exposures are likely to see elevated losses, but they are relatively small. Conditions are likely to continue to slip from current levels, but HELOCs are unlikely to be a material source of credit stress for the Canadian banks in our view.

• Credit Cards. Card exposure varies materially across the banks, but peaks at approximately 7% of managed loans at CIBC. Credit cards are likely to see some of the most intense loss rates of any portfolio and we have already seen significant deterioration. We expect losses to continue to track unemployment higher toward a high single digit pace. This will move the industry to levels at or slightly above historical peaks.

• Other Personal Loans. This segment represents a fairly large catch-all ranging from low risk personal investment loans to higher-risk sub-prime auto loans. Trends have been relatively muted to date, but losses are likely to continue to climb driven by higher risk categories. Historical data is particularly sparse for this segment, but we assume PCL rates will reach upwards of 250-300bp.

Overall, we see PCL rates relating to Personal Loans running on the order of 200bp over the coming year, driving some C$5.3 billion in PCL expense in 2010 out of our total estimate of C$9.8 billion for the Large-Cap Canadian Banks. This is against our roughly C$35 billion in pre-tax, pre-provision profits. In this context, we maintain that the current cycle will be manageable. We continue to expect to see losses peak in 1H10.

Looking across each of the names, while all should manage the downturn, there are a range of specific issues for each bank;

Our Take on the Names:

BMO. Overall, the bank is relatively thinly reserved (a function of a high quality book and aggressive charge-offs according to management). In our view, there are no grave issues in the Personal Loan book at BMO, but they do have a small book of lower quality U.S. HELOC loans which should continue to deteriorate.

Scotiabank. The key concern remains the bank’s international portfolio of credit card and consumer finance loans primarily in Mexico and Latin America respectively. Although credit costs have increased, trends have begun to show some signs of moderation over recent quarters.

CIBC. The key exposure at CIBC is clearly the bank’s outsized credit card portfolio. Conditions here have deteriorated in recent quarters and we expect them to get worse. However, the bank has been tightening underwriting standards, managing collection efforts, and increasing credit reserves in anticipation of higher losses. Furthermore, the most recent data points from the bank’s securitization trust suggests trends are moderating with delinquency and credit loss rates improving month over month in June 2009 (echoing similar comments from management in their Q2/09 conference call).

National Bank. In our view, National will likely continue to see above average credit performance with limited areas of concern. The Personal Loan portfolio benefits from an entirely domestic and largely Quebec focus as well as among the smallest concentrations of credit card lending.

Royal Bank. We do not believe the bank has material areas of concern within their Personal Loan book. Although Royal has a sizeable credit card portfolio, it is still relatively small at just 4% of the bank’s managed portfolio and the performance trends to date have been relatively good (although it is unclear how aggressive/conservative the bank has been in building reserves against future card losses).
Financial Post, David Pett, 14 August 2009

With third quarter earnings results looming, BMO Capital Markets analyst Ian de Vertueil fine-tuned a couple of his Canadian bank recommendations this week, putting Bank Of Nova Scotia and Bank of Montreal back on the same playing field.

To start, the analyst upgraded Scotiabank from Underperform to Market Perform while increasing his 2009 cash earnings per share estimate for the bank from $2.90 to $3 and his 2010 cash EPS estimate from $2.55 to $2.65. Mr. Verteuil's price target on the stock climbs from $41 to $42.

"Since we downgraded Scotiabank six months ago, the shares have underperformed the bank group by 8%," he said in a note to clients. "We continue to believe the bank will feel more credit headwinds in the short term from its corporate loan book both in North America and internationally, but the underperformance highlights that much of this is reflected in the share price."

Mr. de Vertueil now also has a Market Perform rating on Bank Of Montreal shares, after downgrading the stock from Outperform and lowering his price target from $56 to $53. He noted that BMO is relatively expensive on earnings but still trades at a discount to the overall group on price to book.

"Since our upgrade a year ago, the shares have outperformed the group, up 9% versus the bank index, which is essentially flat," he said.

"At the time of our upgrade, we thought the concerns on the bank’s off-balance sheet exposure were overdone. We don’t expect any material surprises in the quarter, but we think that most of the sentiment shift on the stock has now occurred. Given the bank’s limited leverage to a more stable credit environment, we believe that a downgrade is warranted."

Overall, Mr. de Verteuil expects Canadian banks to report solid third quarter earnings.

"On a reported basis, we believe that results will be well up from a year earlier, but this entirely reflects the fact that CIBC is comparing with a very weak quarter of a year earlier. Exclusive of CIBC, the group’s reported earnings will be down about 4% versus a year earlier," he wrote.
Financial Post, John Greenwood, 14 August 2009

The impact of rising loan losses at the Canadian banks will be cushioned by stronger trading and underwriting revenues in the third quarter, according to RBC Capital Markets analyst Andre-Philippe Hardy.

Over the past year the banks have been hammered by the credit crunch but as conditions start to stabilize and net interest margins move up the banks will feel the benefit when they post their results starting on August 25.

“We are positive on Canadian bank shares given that indicators of futureprofitability are trending in the right direction, and the banks have enough revenue and capital in our view to handle the impact of challenging economic conditions on loan losses over the next 6 - 12 months,” Mr. Hardy said.

He pointed to National Bank as the player facing the fewest headwinds since it has almost no exposure to the United States and limited operations in the hard-hit province of Ontario.

Meanwhile a report from Desjardins Securities analyst Michael Goldberg warns of a below normal quarter at the banks with continued credit issues.

“US banks have finished reporting their second quarter results, and we believe that the highlights are likely to be mirrored in Canadian third-quarter earnings on a much smaller scale,” Mr. Goldberg said.

Despite the gloomy economy, global financial markets have shown significant improvement since the dark days of March, with rising equity markets helping to buoy bank profits.

Mr. Goldberg said he expects stronger equity markets and narrowing credit spreads to drive higher trading revenue but at the same time warned of underlying concerns over credit quality both in the US and Canada.

“Although we do not believe that the problems in Canada will get near as bad as in the US, we believe that credit quality for the Canadian banks will get worse before it gets better,” he said.

14 August 2009

Gordon Nixon: Legacy at a Crossroads

The Globe and Mail, Tara Perkins, 14 August 2009

The good news: Royal Bank of Canada escaped the Big Red Blush. Canada's largest bank never fell head over heels for subprime mortgages, nor was it seduced into any of the other risky trysts that have been coming back to haunt banks around the world since the financial crisis began.

So why did RBC's latest quarter produce the bank's first loss in 15 years?

That would be the bad news. The loss reflects a $1-billion writedown in the value of Royal Bank's U.S. banking operations. It's an acknowledgment that the bank's stateside strategy is, as ever, stuck in neutral.

Unlike writedowns relating to toxic exposures, this charge didn't mar the bank's precious capital levels. But that doesn't make it any more palatable to chief executive officer Gordon Nixon, who has been sweating over the States since his first day on the job.

It was eight years ago that Mr. Nixon, then a wunderkind investment banker, took charge at Canada's biggest bank. His predecessor had just bought a U.S. bank, and it fell to Mr. Nixon to make the purchase work.

Less than two months after Mr. Nixon's ascension, 9/11 walloped the economy. The U.S. bank has been a headache for him ever since.

At 52, Mr. Nixon is one of the longest-serving chief executives among the world's top banks. He was named Canada's Outstanding CEO of the Year in 2007, and he has since cemented his reputation by keeping his company grounded while the financial crisis shook the foundation of world's banking system. Investors have rewarded him: By market value, Royal Bank is now the world's 12th-biggest bank. (The distinction, it must be said, is partly owed to the shrinking value of many major banks.)

But its U.S. bank, now called RBC Bank, could still make or break Mr. Nixon's legacy.

The U.S. market has always proven problematic for foreign banks, his included. But now, thanks to a crisis that has cast more than 300 institutions onto regulators' watch list of “problem banks,” a buyer's market beckons – and, arguably, a once-in-a-generation opportunity to build a major presence in U.S. banking.

Mr. Nixon has always been cautious – too cautious, many have said – about beefing up RBC Bank. When he has taken action, the record has been mixed. Royal Bank's most recent expansion attempt, a $1.6-billion (U.S.) takeover of Alabama National Bancorporation, has turned out to be what one analyst calls “a disaster.” Redeeming the U.S. banking strategy won't be easy.

“Up until now, it is the only strategy that everyone, even Royal probably, would admit has failed for the company,” says Darko Mihelic, an analyst at CIBC World Markets. “Other strategies within wealth management and capital markets have proven successful over time, and this one has failed.”

Mr. Nixon confronts a choice between exiting the U.S. consumer lending business, or growing it. “You're either admitting you made a mistake and you're exiting, or you are stubbornly refusing to admit that you made a mistake and you're going to plow more money into it,” Mr. Mihelic says. “Either way, it's not a great outcome.”

Mr. Nixon dismisses the exit option as “very unlikely.” He sees a third alternative: “Also very much on the table is that we continue to just build a smallish but very strong regional bank.”

But that's the strategy, observers point out, that got Royal Bank into its quandary in the first place.

“Focusing on [improving] returns is a good short-term strategy but not necessarily a good long-term strategy,” says Edward Jones analyst Craig Fehr. “I think growth is an important part of this puzzle, and I think that's largely going to come through acquisitions.”

Sumit Malhotra, an analyst at Macquarie Capital Markets, is skeptical. “Given the historically low rates of return associated with regional banking in the U.S., perhaps the bigger issue is whether [Royal Bank's] management wants to get bigger in this business,” he says.

Growth by necessity

While industry executives are loath to admit it, the Canadian banking market is so mature it's sprouting hair in its ears. With room for growth limited, market share changes among the big five are often just give-and-take skirmishes fought with fierce pricing incentives. Royal Bank is so tapped out in Canada that it's muscling up against the legal lines that prevent it from selling insurance, in some locations offering that service and banking in adjacent storefronts.

So RBC wants to increase the proportion of its business that's coming from abroad. Immediately to the south lies the world's biggest banking market, an elusive pot of gold that's led many banks over the rainbow.

As the financial crisis has illustrated, banking is a different game in the U.S. In contrast to the concentrated, orderly Canadian industry, more than 8,000 institutions are battling for customers in a market that is still tinted with cowboy capitalism: Mortgage rules are looser, capital requirements are lower, and many regional banks thrive simply by arbitraging the difference between short-term and long-term interest rates.

Canadian banks have pulled through the global crisis with high marks precisely because they didn't take many of the risks that were once so profitable for their counterparts in other countries. With regulators around the world moving to tighten and harmonize banking rules, Canadian banks might now find it easier to go head-to-head with incumbents in the American market.

Royal Bank made its first real foray into U.S. consumer and small-business banking (known as “retail” banking) just months before Mr. Nixon stepped into the CEO role in 2001. His predecessor, John Cleghorn, had just paid $2.3-billion (U.S.) for Centura Banks Inc. At that price, the mid-sized lender, with 241 branches and 3,600 employees in the Carolinas and Virginia, was the largest foreign acquisition that a Canadian bank had ever made.

But Centura's results disappointed right out of the gate, and Mr. Nixon inherited the challenge of making the gamble pay off. Mr. Nixon was careful – or timid, in critics' view – from the start. In the first year he took a look at, but passed up, batches of branches that were put up for sale by Wachovia Corp. and Huntington Bancshares Inc.

In 2005, Mr. Nixon presciently sold off Royal Bank's U.S. mortgage origination business, RBC Mortgage Co., which it had acquired (as Prism Mortgage Co.) in 2000. It was the type of operation that helped trigger the financial crisis with overaggressive mortgage sales tactics. Indeed, late last year, the U.S. government alleged that between 2001 and 2005, RBC Mortgage Co. falsified documentation in support of mortgage loan applications, leading to a $10.71-million settlement.

The decision to abandon RBC Mortgage likely saved Royal Bank's U.S. banking business from a much grimmer fate. Most of the mortgage company's assets were sold to New Century Mortgage Corp., the subprime mortgage lender whose 2007 bankruptcy was one of the pivotal events of the crisis.

Rather than play hot potato with risky mortgages, RBC decided to focus on bread-and-butter lending, the type of business it thrives on in Canada. With Centura's network limited largely to rural areas and small towns, RBC Bank aimed to add strength in cities.

During 2006 and 2007, the bank made three more modest acquisitions that expanded its southeastern footprint. First was the takeover of an Atlanta-based bank with 26 branches and offices. That was followed by a move into Alabama with the purchase of 39 AmSouth branches for roughly $400-millionUS or Canadian?. And then, also in Alabama, came a bigger role of the dice.

Alabama beckons

On a damp September day two years ago, Mr. Nixon met with John Holcomb III, the CEO of Alabama National Bancorporation. The encounter was the culmination of a dance that had begun the prior December, when Scott Custer, head of RBC's U.S. bank, phoned Mr. Holcomb and broached the idea of buying his company.

In the interim, Alabama National had become a more eager seller, as mortgage defaults and home foreclosures rose, and credit quality deteriorated in some of its key markets, such as Florida and Alabama itself. For its part, Royal Bank had become a more eager buyer as the prospective price of the acquisition dropped.

So, on a day when U.S. regulators put out an unusual notice urging financial institutions to cut some slack for borrowers who couldn't afford their mortgages any more, Mr. Nixon, Mr. Custer and Peter Armenio, then in charge of RBC's U.S. and international strategy, sat down with Alabama National's executive team in Toronto, and agreed to the final terms of a $1.6-billion (U.S.) takeover.

Thirty-six per cent of Alabama National's loan portfolio was in real estate construction, with a further 28 per cent in commercial mortgages – the very stuff that has since caused so much destruction on the balance sheets of some U.S. regional banks.

Since the deal, the value of U.S. banks have plummeted.

“Regret is a difficult word,” Mr. Nixon says when asked about the timing of the purchase. “If we had acquired Alabama National today, it would have been just as strategic, but we would have acquired it at a very different valuation. If you look at any investment that has been made in the last 15 years in the United States, there have been few dollars that have been good investments.”

About seven months after Royal Bank announced the purchase, Mr. Nixon unveiled a management shakeup, his second in four years. This one saw Mr. Armenio retire and Jim Westlake, who had previously run RBC's Canadian retail banking operation, named head of international banking and insurance.

“Our short-term financial performance has not been pleasant,” Mr. Westlake acknowledged in a July interview from Atlanta.

With its street strength now standing at 430 branches in six southeastern states, RBC Bank last year ranked 31st by deposits among U.S. banks, according to data from SNL Securities. (Larger rivals that compete in the region include SunTrust Banks Inc., Regions Financial Corp. and BB&T Corp., which ranked seventh, ninth and 10th nationally.)

The Southeast has been disproportionately hit by real estate pain, but Mr. Westlake says the region is still the country's strongest growth market for banks in the long term, thanks to favourable demographic trends. What's more, the U.S. “is still the largest banking market in the world, and one where we intend to do well in the future.”

This spring, Royal Bank drafted a three-phase turnaround plan for RBC Bank that it hopes to complete within two years.

A better record on lending is a key part of the fix. RBC Bank represents a mere $30-billion (Canadian) of Royal Bank's $680-billion in assets and, roughly in keeping with those numbers, its U.S. loans are only 15 per cent of the total. But in the latest quarter, the U.S. caused more than half of Royal Bank's loan losses.

U.S. acquisitions

If its stateside salvation is to be realized through acquisitions, RBC must figure out how to capitalize on the fire sale expected in the industry – and how to not get burned by it.

It won't be easy, as the record shows. While Mr. Nixon has been accused of thinking too small, buying big is no guarantee of success, either. Toronto-Dominion Bank has spent roughly $20-billion (U.S.) in recent years to build up a U.S. bank with roughly $73-billion in deposits – but its most recent major acquisition was done at near the top of the market and it's still unclear whether the strategy will pay off.

Canadian Imperial Bank of Commerce, which is now in early stage discussions about taking a stake in a troubled Irish bank, may be looking overseas in part because its own U.S. forays have been disastrous. A decade ago, the bank tried to build a U.S. retail bank by putting branches in grocery stores, but pulled the plug on the experiment after hundreds of millions of dollars in losses. And Bank of Montreal has had its own struggles with Harris Bank, despite the latter's well-established market position in the U.S. Midwest.

Still, there's no denying that the price of expansion is far more reasonable now than when RBC and TD made their earlier deals. For example, SunTrust Banks Inc., the regional rival that is a favourite of the analysts who are pushing Royal Bank to make an acquisition, has $116-billion of deposits and a market value of roughly $10.5-billion; not long ago, it was worth $30-billion.

Mr. Nixon subscribes to estimates that as many as 1,000 banks will fail as customers buckle under the weight of their debts.

“We think we can position our bank in the United States very well as the U.S. evolves and restructures,” he says during a July interview in his office in Toronto. “The $64,000 question is, what does that mean strategically?”

He figures he's got some time to answer the question. The U.S. government's capital infusions into the nation's 19 largest banks has alleviated the pressure to consolidate. Banks that have been bailed out by the government or refinanced have bought themselves some time, and “it's very unlikely you're going to see a significant amount of acquisition activity in the near future,” Mr. Nixon says.

When the opportunities do ripen, Mr. Nixon says it might result in an acquisition or a merger – or perhaps selling RBC Bank to a U.S. bank that Royal Bank takes a stake in. “We want to have the flexibility to have lots of options available to us,” Mr. Nixon says.

No sooner does he make that declaration than Mr. Nixon acknowledges that his position sounds a bit “wishy washy.” But he doesn't mind the rap. In his view, his patience and caution has served the bank well so far. Many Royal watchers agree.

“They faced a lot of pressure prior to the crunch to make a big splash in the U.S., and they chose not to,” says Peter Routledge, senior vice-president of financial institutions at Moody's. “Sometimes a good strategic decision is what you decide not to do.”

“If I were Gord, I would feel vindicated that I resisted pressure from analysts and investors to make an acquisition at what turned out to be the peak of the market,” says Rob Wessel, a former bank analyst and industry expert.

But the peak is ancient history now. And Royal Bank is well positioned to be an acquirer. Its capital ratio sits at 11.4 per cent, having risen from 9 per cent in just six months. (The regulatory minimum is 7 per cent.) “We are significantly overcapitalized,” Mr. Nixon says. “We can grow our businesses and our balance sheet over the next number of years. A lot of our international competitors are going to have to either raise a tremendous amount of equity or shrink their balance sheets.”

The majority of analysts who follow RBC say Mr. Nixon is wise to take a bit of time to see how U.S. prospects shake out. But, they add, he can't wait too long.

“My view is that, if your stock is performing this well anyways, take your time and make the right decision,” says Mr. Mihelic, the CIBC analyst. But if the recovery occurs more quickly than expected, opportunities will start to dry up, he adds. In this scenario, the bank's window of opportunity could be as short as six to 12 months.

Mr. Nixon believes that the financial crisis will be followed by a golden age for banks. It's a relatively rare view, and one that might make him inclined toward having a larger U.S. presence. But he will not be rushed.

“I'm not sure that everyone will see that," he says (of the coming golden era). “We want to make sure we participate in a very smart way.”

07 August 2009

Manulife Q2 2009 Earnings

Scotia Capital, 7 August 2009


• MFC reported $1.09 EPS, versus our $0.45 estimate and consensus of $0.70. Dividend was cut 50% as part of MFC's plan to build "fortress" capital levels.


• 50% dividend cut was very disappointing - it's now up to MFC to prove it can service this capital better and that a reduced dividend is a better long-term value proposition. At least the dividend cut was done from a position of strength - MCCSR at 242% (likely 255% based on current markets, highest we've ever seen it) - and in no way suggests the company is in difficulty.

• We peg Q2/09 underlying EPS in the $0.48 range (lower than our $0.52 estimate), which would correspond to a 12% ROE for the quarter - credit risk profile remains excellent. Sales were weak over a strong Q2/08.

• We're lowering our 2010 EPS estimate to $2.35 from $2.58.


• With the dividend cut and weaker sales, MFC is becoming a show me story, but at 9.5x 2010E EPS there's excellent valuation support for what we believe is still a very strong global franchise.

Dividend Cut Was Disappointing

• 50% dividend cut was very disappointing - it's now up to MFC to prove it can service this capital better and that a reduced dividend is a better long term value proposition. Claiming to want to build "fortress" capital levels from a position of strength, the dividend was cut. And while talked about as being essentially last on the list of potential means of fortifying MFC's already high capital levels (outside of an equity raise), actually going ahead with it was unexpected and disappointing.

• At least the dividend cut was done from a position of strength - MCCSR at 242% (likely 255% based on current markets, highest we've ever seen it) - and in no way suggests company is in difficulty. This dividend cut was in no way a sign of weakness, and, if the objective is to build capital to record levels to provide a cushion larger than we've ever seen to protect from downside risk and support growth of what is likely now more capital intensive products, then certainly a dividend cut is the most cost effective means of achieving this objective. We estimate the current MCCSR (255% as of today's markets) can withstand a 27% decline in equity markets before the ratio hits 200%. The dividend cut adds 10 points annually to the MCCSR.

• We peg Q2/09 underlying EPS in the $0.48 range (lower than our $0.52 estimate), which would correspond to a 12% ROE for the quarter - credit risk profile remains excellent. Exhibit 1 details the development. MFC's credit risk profile remains impressive. With just $0.13 EPS in credit hits in Q2/09, the company did significantly better than SLF ($0.78 EPS) and GWO ($0.27). Gross unrealized losses on fixed income securities below 80% of amortized cost for more than six months are 2.5% of the bond portfolio, faring much better than SLF (5.8%) and GWO (4.3%).

• We're lowering our 2010 EPS estimate to $2.35 from $2.58, in part to reflect lower-than-expected underlying EPS in the quarter, and in part to reflect management's comments on "normalized earnings" (suggested to be $0.46 to $0.52). The "normalized earnings", which in no way should be construed as guidance, assume 2% market appreciation per quarter and include no experience gains/losses and no assumption changes, which, together have accounted for $0.65 in EPS on average annually since 2004 (largely experience gains over the company's conservative assumptions). We believe it is highly unlikely these will be eliminated in 2010, even a level of 1/2 or 1/4 the $0.65 average is possible, in our opinion. As well, our estimates assume the S&P 500 will end 2010 at 1,150, 10% higher than management's 2% per quarter appreciation from June 30, 2009 levels. 2010E ROE is 13.3%.

• More noise in Q3/09. A Q3/09 review of all assumptions, the most significant change being policyholder lapse as it relates to VA/seg fund guarantees, should result in an estimated charge not to exceed $0.30 EPS. We expect other reserve-related lapse and interest charges (but, because of a different methodology, not nearly to the same extent as SLF's expected $0.90 EPS hit), to result in an additional $0.30 EPS hit.

• Weak sales over a strong Q2/08. U.S. VA sales were down 31% as MFC de-risks this portfolio (it believes it is ahead of its peers) and U.S. individual insurance sales down 29% (but progressively improving month over month). Canadian sales were mixed. Asia was strong.