05 August 2009

Scotia Capital Changes Banks' Ratings

Scotia Capital, 5 August 2009

Banks - Rating Changes

• We have changed our ratings on a number of banks. We have changed BMO and CM and downgraded NA.

• Bank rating changes are: upgrading BMO to 1-Sector Outperform from 2-Sector Perform, upgrading CIBC to 2-Sector Perform from 3-Sector Underperform and downgrading NA to 3-Sector Underperform from 2-Sector Perform.

BMO - Upgrading to 1-Sector Outperform

• We have upgraded BMO to 1-Sector Outperform from 2-Sector Perform based on the continued strengthening of its operating platforms, leverage to a turn in the credit cycle given its industry high loan losses, and expected positive earnings surprises.

• BMO's Canadian retail operation is expected to continue to recover from years of underperformance based on the launch of new product initiatives, upgrade of retail facilities, and aggressive repricing of the loan book.

• BMO is also well positioned with its strong wholesale operating platform to benefit from the high profits being generated due to repricing of risk, improving capital markets, and reduced capacity and competition.

• We believe BMO's earnings are relatively high quality with negligible reliance on securitization revenue and security gains, despite a large unrealized surplus. BMO also stands to benefit from leverage to lower loan losses going forward as loan losses for the bank appeared to have peaked in Q3/08 on a quarterly basis. BMO loan loss provisions for 2009 YTD represented 35% of operating income (pre-tax, pre-provision earnings) versus NA at 9%.

• Our earnings estimate for Q3/09 for BMO is $1.16 per share versus consensus of $0.93 per share, thus we are expecting a positive earnings surprise this quarter.

• BMO valuation is attractive using normalized earnings. Based on normalized earnings, 2009 YTD excluding security gains/securitization revenue and normalized loan losses, BMO is trading at only 10.2x earnings versus 14.9x for NA using the same basis.

CM - Upgrading to 2-Sector Perform

• We have upgraded CM to 2-Sector Perform from 3-Sector Underperform due to significant share price underperformance trailing NA by an astonishing 57% year-to-date and the bank group by 14%.

• CM underperformance has certainly been warranted given the level of market-to-market writedowns, weak retail banking earnings, lack of revenue growth, reliance on security gains and the puzzling decline in its net interest margin especially relative to the bank group. CIBC loan loss provisions for 2009 YTD represented 25% of pre-tax, pre-provision earnings, in line with the bank group.

• However, given the improvement in credit spreads we expect market-to-market losses to moderate with some potential for recovery over the next year. In addition, the stock would likely react favourably to a reversal in its net interest margin (perhaps some bad hedges roll off?). An improved net interest margin may help the very weak earnings profile of the retail bank.

• Earnings expectations for CIBC remain low with a high degree of uncertainty but the probability of a positive earnings surprise is increasing and given the share price underperformance we believe an upgrade is warranted.

NA - Downgraded to 3-Sector Underperform

• We have downgraded NA to 3-Sector Underperform from 2-Sector Perform based on 90% increase in its share price year-to-date versus CIBC's gain of only 33% and the bank group's 47%.

• NA's strong share price performance has been warranted given its consistent earnings production through the credit cycle (with the exception of non-bank ABCP) and its negligible exposure to the U.S. NA's consistent earnings have been driven by its strong and relatively large wholesale platform, superior credit performance, continued strong trading revenue, high security gains and strong earnings from securitization. We also believe NA share price has benefitted from not being listed in New York.

• However going forward we believe NA will likely give back some of its superior share price performance. If we look at estimated normalized earnings for 2009 YTD adjusting for security gains, securitization revenue, and loan losses, NA is trading at a significant P/E premium to the bank group at 14.9x. NA loan loss provisions 2009 YTD represent only 9% of pre-tax, pre-provision earnings versus the bank group at 24% and BMO at 35%.


• We remain overweight the bank group and expect the P/E recovery to continue. We believe bank fundamentals remain strong including high capital levels, strong underlying profitability with earnings near the cyclical bottom. Dividend yields remain extremely attractive and dividend increases, we believe, are on the horizon.

• Our order of preference is now: RY, BMO, BNS, CM, CWB, LB, TD and NA.
Reuters, 4 August 2009

Canadian banks face a substantial risk to future credit performance from the stressed job markets in the United States, and to a lesser extent domestically, and their loan-loss provisioning levels appear ill-equipped to absorb it, Blackmont Capital said.

Toronto-Dominion Bank and Bank of Montreal may deliver double-digit negative total returns as their above-average U.S. credit exposures will weigh on valuation for the foreseeable future, analysts Brad Smith and Richard McCormick said in a note.

They, however, raised their price targets on six Canadian banks, including Royal Bank of Canada , and said RBC and Bank of Nova Scotia offer the most appealing combination of future growth and current capital stability.

Despite their price target increases, the analysts maintained their cautious outlook for credit in the near term, and for bank equity valuations in the medium term.

"Our cautious stance reflects the continuing high level of uncertainty with respect to the timing of a recessionary bottom and the elevated risk of an extended period of lethargic economic activity," the analysts said.

Beyond the credit-related challenges, they see the need for a substantial rethink of domestic bank business models to reflect and better align future activities with a more stringent regulatory capital regime and a lower acceptable financial leverage environment going forward.
Financial Post, Jonathan Ratner, 4 August 2009

Since touching all-time lows early in the year, the price-to-earnings (P/E) ratio for Canadian banks stocks has made substantial gains. The S&P 500’s relative P/E is currently around 0.78, which means the bank sector multiple is quickly closing in on historical highs, according to Blackmont Capital analyst Brad Smith.

He raised his one-year target P/E for the Canadian bank sector to 11.5 times from 8.0x previously. As a result, the analyst’s median return expectations for the sector move to roughly flat, up from an anticipated decline of nearly 30% reflected in previous future valuation estimates.

Mr. Smith highlighted Royal Bank and Bank of Nova Scotia as the names that offer “the most appealing combination of future growth and current capital stability.” This is reflected in his premium valuation expectation for both.

“Toronto-Dominion Bank and Bank of Montreal are expected to deliver double-digit negative total returns, reflecting our continuing view that their above-average U.S. credit exposures will weigh on valuation for the foreseeable future,” the analyst said.

But despite making substantial increases to his price targets on each of Canada’s Big Six banks, the uncertainty linked to timing the bottom of a recession and the risk of an extended economic slowdown, has Mr. Smith cautious on the near-term outlook for credit and the medium-term outlook for bank equity valuations.

“In the near term, we continue to view stressed labour market conditions in the US and to a lesser extent domestically, as representing a substantial risk to future credit performance, a risk for which current bank loan loss provisioning levels appear to be ill-equipped to absorb,” he said.

And beyond these credit-related challenges, Mr. Smith thinks domestic banks need to rethink their business models to better align future plans with what is likely to be a more stringent regulatory capital regime and an environment where the acceptable level of financial leverage is lower.

Summary of Blackmont’s ratings:

Bank, new target, rating, old target
BMO, $43, underperform, $32
BNS, $46, sector perform, $36
CIBC, $64, sector perform, $46
National, $58, sector perform, $37
RBC, $53, outperform, $42
TD, $53, underperform, $38