15 September 2009

Review of Banks' Q3 2009 Earnings

Scotia Capital, 15 September 2009

Earnings Stellar – Inflection Point – Outlook Improving

• Canadian banks reported stellar third quarter earnings, substantially better than Street estimates. This was the third straight quarter of beating estimates, but it was by far the largest beat. Based on the strength of third quarter earnings it appears that Q2/09 was the bottom for the cycle on an operating earnings basis, with Q1/08 the bottom of the cycle on a reported earnings basis, including all writedowns. The banks’ previous quarterly results (Q2) provided some optimism that earnings were near the cyclical bottom based on an improved outlook for the net interest margin, credit cost absorption, and sequential improvement in wealth management, which were all fully delivered in the third quarter with added strength from the continued high level of trading revenue.

• Thus, it appears the Canadian banks have weathered the banking siege in a strong fashion. The quarterly bottom in reported return on equity would be 10.5% in Q1/08 and 17.1% in Q2/09 on an operating basis. This reinforces the strength of the Canadian banking system and the banks’ business models.

• The most significant development this quarter, we believe, was the improvement in the net interest margin, which reversed an eight-year descent. The positive impacts of loan repricing, a steep yield curve, lower funding costs, and lowering of liquidity costs were instrumental in improving the banks’ NIM. This represents an important inflection point and bodes well for bank earnings going forward. The potential beginning of a trend of expanding bank net interest margins is not expected to be meaningfully interrupted in the event interest rates begin to rise, especially if they rise in a controlled and orderly fashion.

• Another potential positive inflection point this quarter was on credit, as gross impaired loan formations declined for the second consecutive quarter and loan loss provisions were flat with the previous quarter, suggesting loan losses may be peaking at the $10 billion annualized rate. Thus, we believe loan loss provisions should start to decline by the last half of 2010.

• The banks’ main earnings driver in the third quarter continued to be wholesale banking, with record results due mainly to the continued high level of trading revenue supported by very modest loan losses. Retail banking results were also solid in the quarter, although muted by relatively high retail loan losses, particularly in credit cards. Wealth management earnings rebounded sequentially and are expected to show strong momentum off the bottom.

• The banks reported a fully loaded return on equity after all writedowns and adjustments of 16.3%, with operating return on equity of 18.6% despite what we believe are near-peak loan losses.

• The market, we believe, has discounted bank earnings strength in the first two quarters of 2009, citing low quality due to high trading and securitization revenue. However, if we balance this out somewhat with the probability that a portion of the very strong trading revenue has a structural component and is not all cyclical, and that banks are arguably absorbing peak loan losses, weak wealth management earnings, and generally booking security losses in their available-for-sale securities portfolio, we conclude that earnings quality is only marginally lower. Also, we believe the actual income statement/net income impact of trading and securitization revenue (exhibits 15 and 16) is much lower than the market is generally factoring in. Thus, we conclude third quarter earnings were stellar with reasonable quality and that bank earnings are poised to rise.


• Bank stocks have increased 50% year-to-date 2009, substantially outperforming the TSX, which has increased 24%. Despite the share price performance, we believe valuations remain attractive on both a dividend yield and a P/E multiple basis.

• Dividend yields of 4.1% are compelling, especially with the prospects of dividend increases as early as the next several quarters and the particularly low yield on government bonds. 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.

• Bank P/E multiples have rebounded to 12.3x trailing from the 6.0x low reached in late February. We estimate the valuation contagion overshoot was three to four multiple points. We believe fundamentals support higher valuation as the market refocuses on fundamentals and earnings power.

• We continue to expect bank P/E multiple expansion similar to that experienced post the 2002 cycle. We expect bank P/E multiples to expand to 14x trailing over the next 12 months and eventually reach 15x to 16x. Thus, with P/E multiple expansion and bank earnings bottoming, we believe this bodes well for continued strong share price gains over the next several years.

• In summary, we believe the positive earnings outlook that is unfolding and the continued high profitability will lead to dividend increases, complemented by low yields on treasuries, and will be supportive to continued expansion or recovery in bank P/E multiples. We do not expect meaningful share price resistance and consolidation until the bank P/E recovers to the 14x range, allowing for a further 28% ROR from the bank group.

• We continue to recommend an overweight position in bank stocks based on strong fundamentals and attractive valuation. In terms of stock selection, RY continues to be a standout given the strong reinvestment, competitive positioning in all its major business lines, and resulting industry-high profitability and capital.

• We have 1-Sector Outperform ratings on RY and BMO, with 2-Sector Perform ratings on BNS, CWB, LB, TD, and NA, and a 3-Sector Underperform rating on CM. Our order of preference is RY, BMO, BNS, CWB, LB, TD, NA, and CM.
Financial Post, David Pett, 11 September 2009

Investors anxious for Canadian banks to start raising their dividends should not hold their breath, says Desjardins Securities analyst Michael Goldberg.

"The impact on operating profit of unsustainably high trading revenue and sustained pressure on loan loss provisions, we do not believe that earnings quality or quantity are yet sufficient to support dividend increases," he said in a note to clients.

Mr. Goldberg added that future dividend increases are dependent on the direction of capital regulation.

"If we assume that OSFI maintains its current minimum standards of 7% Tier 1 and 10% total capital and that the banks will want to maintain a comfortable margin of safety above that level (because the consequences of falling below it are so draconian), then this is another reason for banks not to increase their dividends and it may not even justify issuiing more common equity to strengthen that margin of safety," he wrote.
TD Securities, 8 September 2009

• Q3/09 well through expectation. Exceptional trading results helped drive bottom-line numbers that were 21% better than expected on average. We are most encouraged by the credit trends which were broadly better than feared. Domestic P&C banking segments were also solid.

• Hard to see outsized returns. Outsized returns come on the back of outsized earnings growth or upward revaluation. We see limited prospects for either from current levels with the group seemingly already pricing in what we expect will be a relatively shallow earnings trough in 1H10.

• Introducing 2011 estimates. Our visibility is pretty limited that far out, particularly given what we view as heightened uncertainty around the macro outlook. Nonetheless, we are comfortable that credit costs will decline materially and that offers potentially significant bottom-line leverage for the group.

• Credit largely on pace. In most cases, the pace of deterioration appears to be easing and the outlooks are generally steady. We still expect conditions to deteriorate further (particularly on the commercial side), with losses ultimately peaking in 1H10. We still see credit topping out comfortably below the peaks of prior downturns.

• Staying with leverage to the recovery. We think Scotia and TD continue to offer the best leverage to a positive turn in economic growth. Both are trading at reasonable valuation in our view, but we see more potential for upward revaluation in TD (as ROE improves over time).

Executive Summary

Q3/09 results were largely better than expected, helped by exceptionally strong Trading/Wholesale results. These trends are likely to ease, but credit and core domestic P&C banking were also generally good. The stocks rebounded through results season, outperforming slightly. We are comfortable with how the fundamental story is unfolding. From here we still see valuation as the biggest constraint to outsized returns. We remain market weight.

Q3/09 results were largely better than expected with four out of the six Large-Cap Canadian Banks beating consensus estimate by an average of more than 21%. Through earnings week, the stocks were up roughly 4%, slightly outperforming the local index.

We made relatively minor changes on the quarter with no rating changes. We raised our estimates and Target Prices across Royal, National Bank and TD Bank. We reduced our estimates slightly at CIBC (target unchanged). Consensus estimates continue to rebound.

The composition of the results was still a bit questionable again this quarter, with strong trading results accounting for a large portion of the out-performance. Most management teams referred to the pace of trading results as unsustainable, noting that they are already seeing some softening.

Credit was also very encouraging. Most names reported inline or better than expected PCLs and most were still running below our assumed run rate for 2010 (we only increased our PCL estimates meaningfully in the case of CIBC). Furthermore, the underlying trends were generally encouraging with the pace of deterioration starting to slow. We also note that most banks appear to be well reserved.

We were also encouraged by the solid momentum evident in most P&C banking platforms, with particularly good volume growth which suggests good revenue momentum heading into 2010.

Overall we are comfortable with how the core fundamental story is unfolding. Domestic banking is enjoying a bit more momentum than we had expected, but we suspect some of the volume growth reflects the effect of lower rates and pent-up demand driving a bit of bounce in the housing/mortgage market. We expect trends to moderate in the coming quarters. Credit should also continue to deteriorate (particularly in commercial portfolios). However, the situation seems well in hand based on the underlying trends and management outlook. We expect credit costs to peak in 1H10, slightly above current run rates, and comfortably below prior peaks.

With this report we are rolling out our first look at 2011 estimates. It is still a ways off, but we have focused on what we expect will be the biggest single driver of what we believe will be an earnings recovery, and that is declining credit costs. As a result, we see 2011 EPS up in the order of 25-30% across the group. We remain market weight on the group. The biggest constraint to outsized returns in our view is valuations. The group is currently trading at 2.1x book value which is above the 15-year average of 1.8x book. In our view, a move toward peak valuations would require a more favorable environment than we currently expect (i.e. stronger economic growth and fewer risks). We see average returns on the order of 5-20%, including an average dividend yield of 4.4%.

In terms of stocks, our stance remains the same. We want to remain positioned with the best operating leverage to a recovering global economy. In our view Scotia and TD are the best ideas in this approach. Scotia suffered from some credit disappointment on the quarter with an uptick in GILs in the International commercial loan book. However, the issues appear to be quite concentrated (the rest of the book actually improved) and the related costs are likely manageable (the Q3/09 PCL run rate was still below our standing assumptions for 2010). Ultimately we believe Scotia will manage the credit downturn (likely better than feared) and will be well served by its favorable International positioning and corporate/commercial lending business.

TD saw a strong quarter with positive trading results helping to offset higher credit costs (but came in below expectations) and we see good upside in a recovery scenario. Credit trends remain well controlled and although we believe the bank will face greater pressure in the coming quarters, they will likely remain manageable in the context of the banks largely stable and sizeable Domestic Retail earnings base. In our view, the bank’s U.S. strategy will be key to the outlook of the stock and the integration of the U.S. platform is nearly complete. We believe TD will be able to generate greater value from its U.S. Retail franchise and offer potentially higher ROEs (and valuation multiple) in a recovery scenario.

CIBC remains the most interesting name to watch in our view. The quarter offered a new source of disappointment with surprising credit losses coming out of its leveraged loan book and deterioration in its U.S. commercial real estate business. However, the bank is exceptionally well capitalized with potential sizeable recoveries over the coming years with a large retail platform, although it is underperforming expectations under very tight risk management.

01 September 2009

Scotiabank Q3 2009 Earnings

BMO Capital Markets, 1 September 2009

For the quarter ended July, the Canadian bank sector reported operating earnings that were roughly unchanged from a year ago, compared to Street expectations of a double-digit percent decline. Much better-than-expected trading revenues, and to a lesser extent smaller-than-expected loan loss provisions, keyed the upside surprise. We are adding to our bank holdings in order to keep our sector weight at market.

As our positions in the TD, RBC, BMO and National are relatively full, we have added a new and small position in Scotiabank. Scotiabank was recently upgraded to Market Perform from Underperform, with Ian de Verteuil raising his earnings per share forecast to $3.28 for fiscal 2009 and $3.20 for fiscal 2010. Scotiabank is the only Canadian bank with material operations in emerging markets. While this is a solid positive over the long run, it appears that the credit cycle is still ahead of us in those markets.
TD Securities, 31 August 2009

Last Friday, the bank reported core cash FD-EPS of C$0.96 vs. TD Newcrest of C$0.82 and consensus at C$0.84.


Neutral. A good quarter, but it failed to meet the very high bar set by the group. Credit was the biggest concern with a sizeable PCL charge, although it was still below our 2010 run rate. In our view, management is being conservative, and credit issues appear fairly concentrated. Wholesale/Trading was a big help, but Domestic continues to impress. International should provide leverage in a recovery scenario. No change in estimates or Target Price. In our view, the stock offers decent upside on one of the best platforms in the group. Reiterate Buy.


Domestic momentum continues. The bank turned in solid Domestic P&C/Wealth results. Good volume growth, cost control and reported margin improvement delivered some of the best bottom-line growth on the quarter and accounted for over 50% of earnings. Recent minor acquisitions are just starting to feed into the numbers and help the outlook. We see additional potential in Scotia’s interests in CI and Dundee Wealth over time. Credit still manageable. PCLs came in nearly C$145 million ahead of our estimate, but the underlying trends are less ominous; gross formations on over 85% of book were down sequentially. The commercial book in International was the exception and we continue to expect it to get worse over the coming quarters. However, management sees no indication of a looming credit spike and they continue to build reserves (with specific reserves above the group average).

Earning through downturn; good leverage to a recovery. Albeit helped by favorable trading, the bank earned through a large PCL expense. Eventually credit concerns will pass and as the world recovers, we expect the market to become increasingly attracted to the favorable International positioning of the platform in a growth world. This should help the stock sustain/improve its relative multiple.

Conference Call Highlights

Credit outlook. One the whole, the bank suggested that credit conditions have largely begun to stabilize across their Canadian Retail book, Domestic Commercial book and Scotia Capital. International (which has lagged the cycle relative to Canada and the U.S.) will likely see additional credit pressure in the near term with delinquencies either stable or up slightly across all products and regions. However, management does not expect to see another large increase in credit costs for 2010.

Guidance. Management was confident in saying they will likely meet their 2009 target objectives (which included ROE of 16%-20%, EPS growth of 7% to 12% and a productivity ratio of less than 58%) given their performance to date and further expects Q4/09 to post substantially better results than Q4/08. On a reported basis, management’s EPS growth objective implies FD-cash EPS for Q4/09 of approximately C$0.81 to C$0.96.

International. Management expects International growth to see some challenges near term primarily on back of rising credit costs, working through recent acquisitions and the impact of a stronger Canadian dollar. However, the bank has been aggressively reducing expenses in International and is meeting its targets.

Acquisitions. The bank remains watchful and patient for opportunistic acquisitions that are in-line with their current strategy. Management does not believe a large transformational acquisition is a high probability for the bank and likely prefers smaller ad-hoc deals.

Quarterly Highlights (year-on-year unless noted)

Domestic – another solid quarter. Assets +9% and revenues +7% and NI +8%. Margins improved sequentially as the bank continues to work itself out of some of its funding/margin pressures from earlier this year.

International – working through higher PCLs. On an adjusted basis NI was down slightly at -2.9% as PCLs rose +220%. Volume trends still look decent with average residential mortgages +8%, personal loans +12% and business loans & acceptances +14%.

Wholesale – an exceptional performance. Driven by strong trading numbers, NI was up 56%. Outlook. We have made no changes to our estimates or Target Price. Our estimates assume a run rate below the Q3 pace largely on elevated PCLs in 1H10 and lower Trading revenues.

Segments. We expect Domestic P&C to see further progress with continued investment and management focus by the bank (which has done several recent ad-hoc acquisitions in Wealth). Scotia Capital is likely to trend lower as the current level of trading revenues is unlikely sustainable. International will reflect a challenging environment largely on back of credit.

Credit. We expect the bank to face further credit pressure in 1H/10 largely on back of International, with some easing in the back half of the year.

Capital. The bank remains comfortably capitalized with a Tier 1 ratio of 10.4%.

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 17.5%, 4.5% and 10.0% respectively implying a Fair Value P/BVPS multiple on the order of 2.60x.

Key Risks to Target Price

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

Investment Conclusion

In our view, management is being conservative, and credit issues appear fairly concentrated. Wholesale/Trading was a big help, but Domestic continues to impress. International should provide leverage in a recovery scenario. In our view, the stock offers decent upside on one of the best platforms in the group. Reiterate Buy.
Globe and Mail, Tara Perkins, 29 August 2009

Rick Waugh is that rare breed of CEO with no desire to pull off a big deal.

Scoop up a major rival that's in distress and transform Bank of Nova Scotia into a much bigger player, or vault it into new markets? No thanks, not for him.

“I call it discipline,” he told analysts on a conference call yesterday.

It's a strategy that doesn't make the headlines, or a big impact on the bank's year-over-year profit growth, he acknowledged. But acquisitions are like a treadmill, and “I would rather take it a little slower on the treadmill.”

These days, the chief executive officer of Canada's most international bank is doing a lot of his walking at home.

When the subprime mortgage crisis began hammering the value of U.S. financial institutions, Mr. Waugh was one of the first executives to go shopping. He took a close look at Cleveland-based lender National City Corp. in early 2008. But he had trouble coming to terms with the unknowns on U.S. banks' balance sheets, and once the government started injecting equity into the banks, he lost his appetite to do a deal there.

So he focused on his top priority in Canada – building up a substantial wealth-management business. Compared to some other countries Scotiabank is in, where even basic financial products such as consumer loans are relatively new, opportunities for growth in Canada are few and far between. Having conquered the lending business here long ago, banks have been turning their sights to wealth management and insurance in an effort to retain control of baby boomers' retirement savings and cash in on them to the full extent possible.

With that in mind, Scotiabank has made a number of deals in recent years, including the acquisition of TradeFreedom Securities Inc., Dundee Corp.'s bank and a stake in its wealth-management operations, a chunk of CI Financial Corp., and all of E*Trade Canada. While each was notable, none were large enough to radically change the bank.

The acquisition spree petered out this year, and some opportunities went to its rivals. Just this month, Manulife Financial Corp. managed to scoop up AIC Ltd.'s mutual fund business for a song.

Chris Hodgson, the head of Scotiabank's Canadian operations, said it's true that good opportunities are still popping up in the wealth management space. But the bank is now “more than comfortable” that it can boost profits in the next few years with what it has already got.

Indeed, its acquisitions aren't contributing all that much to its earnings growth yet. And it is plowing additional money into people, technology and new products such as a flex-GIC (a guaranteed investment certificate that can be redeemed prior to maturity) to squeeze more growth from the business.

Importantly, it is also putting muscle into building a significant insurance business this year, and is now pitching a full lineup of home, auto and life insurance products. That's a significant new growth avenue for the bank, which lagged a couple of its rivals in this respect.

In the hunt for growth in the basic banking and deposit business – the most profitable and jealously guarded operations of the big banks – Mr. Waugh and Mr. Hodgson are looking to steal customers from the competition in the most Canadian way possible: by tugging on the heart strings of the country's hockey moms and dads. Scotiabank, now the official bank of the NHL, is calling itself “Canada's Hockey Bank,” making its support felt in rinks across the country, and has struck a deal with a hockey equipment chain to offer discounts to its customers.

It appears the bank's domestic strategy is paying off. Scotiabank said yesterday that it earned $500-million in Canada in its latest quarter, a new record, despite socking away $169-million for troubled loans. (In total, Scotia's profit was $931-million, down from $1.01-billion a year ago, on record revenue of $3.8-billion.)

In Canada, Scotiabank held $119.9-billion in mortgages, up from $112.3-billion a year ago. Personal loans rose 21 per cent to $35.8-billion.

Analysts are asking executives at the big banks what they intend to spend their excess capital on.

It's a good question, Mr. Waugh suggested. “The world is into a new norm. Repricing has taken place, so sellers' expectations and buyers' expectations may be starting to narrow in and that may create some opportunities.”

He has looked at some significant ones, and he'll continue to take a look at big deals in the future, he said.

But will he crank up the speed on his treadmill by actually following through on a major acquisition? “Never say never,” he said. “But I would put it at a low probability.”

• Company Performance

Like all the Canadian banks, Bank of Nova Scotia suffered a sharp decline in profits during the financial crisis. But it has rebounded in a big way. Key to its strong third-quarter result was a record quarterly profit of $500-million in its Canadian banking unit. Its international banking division, which includes large operations in Mexico and the Caribbean, hasn’t bounced back as swiftly.

• Stock Performance

After being crushed in the banking meltdown, Scotiabank shares have nearly doubled since late February, and closed at $46.40 yesterday – about $8 short of the all-time high. Some analysts wonder if they’ve gone too far, too fast. BMO Nesbitt Burns analyst Ian de Verteuil, pointing to growing credit problems in Scotiabank’s portfolio of international business loans, wrote: “The issue for investors is whether now is the right time to have exposure to emerging markets.” He has a $42 price target on the stock.

• Banking Sector

Canadian banks’ continue to expand their balance sheets, despite the recession. In fact, their assets are growing partly because of the recession. Competing lenders have disappeared and alternative sources of capital have dried up. One eyebrow-raising figure: Bank of Canada data show personal credit lines by chartered banks have increased 21 per cent in the past year