Scotia Capital, 18 February 2010
Banks Begin Reporting February 25
• Banks begin reporting first quarter earnings with Canadian Imperial Bank of Commerce (CM) and National Bank (NA) on February 25, followed by Bank of Montreal (BMO) on March 2, Royal Bank (RY) and Laurentian Bank (LB) on March 3, Canadian Western (CWB) and Toronto Dominion (TD) on March 4, and Bank of Nova Scotia (BNS) closing out reporting on March 9. Scotia Capital’s earnings estimates are highlighted in Exhibit 1, consensus earnings estimates in Exhibit 3, and conference call information in Exhibit 4.
First Quarter Earnings to Decline 5% YOY
• We expect first quarter operating earnings to decline 5% year over year (YOY) and to decline 1% quarter over quarter (QOQ). Bank operating results are expected to be stable and solid with a 16.3% return on equity and very impressive RRWA of 2.05% while absorbing what we believe are peak LLPs in the 80 bp range.
• We have trimmed our first quarter and fiscal 2010 earnings estimates (Exhibit 2) based on expected weaker trading revenue given the decline in volume and tighter asset spreads.
• Reported earnings are expected to closely parallel operating earnings with mark-to-market losses negligible following the trend in 2009 that saw mark-to-market losses decline throughout the year, reaching a nominal amount in Q4/09. Thus, banks are expected to continue to build capital via acceleration of internally-generated capital and aggressive management of risk-weighted assets, especially market at risk.
• In terms of operating earnings this quarter, we assume stable LLPs in the $2.5 billion range and weaker wholesale earnings partially offset by net interest margin improvement. The two most important factors this quarter are the impact of lower trading volumes and equity underwriting (although fixed income is extremely strong), and the net earnings impact on wholesale earnings and the magnitude of the potentially offsetting improvement in NIM.
• Bank earnings have beaten street expectations for most of fiscal 2009 with a substantial beat in Q4/09. Interestingly, bank share prices did not respond particularly well to the heavy Q4/09 beat.
• Wholesale banking earnings resilience will be tested this quarter especially in light of weak trading revenue from U.S. banks. However, it is important to note that the time period is different, with January being a very strong month versus October, especially from a fixed income underwriting perspective. Therefore, we would expect Canadian banks’ trading revenue/wholesale earnings to perform better in Q1/10 (ended January 31) than the U.S. banks’ in Q4/09 (ended December 31), although we expect lower trading revenue versus much of fiscal 2009. Wealth management earnings recovery is expected to continue to be driven by higher asset levels and positive operating leverage. Retail banking results are expected to remain solid, buoyed by stable-to-improving net interest margin.
• Banks’ earnings this quarter are being supported by continued loan repricing (mainly wholesale), stable interest rates, a steep yield curve, relatively high wholesale interest rate spreads, expected improvement in retail spreads, slight narrowing of bond spreads, higher LCDX Index, and significantly lower net security losses (perhaps security gains).
• The drag this quarter is expected to be the continued high level of loan losses, although they are relatively stable (flat QOQ, up 12% YOY), higher gross impaired loans (although gross impaired formations are expected to decline modestly), and the 2% QOQ, 16% YOY, appreciation in the Canadian dollar to the U.S. dollar (average), which will negatively impact foreign currency earnings. Lower securitization gains (narrower mortgage treasury spread), although not much of a factor in Q3/09 and Q4/09, and of course expected lower trading revenue, are expected to be a drag on earnings as well.
• Trading revenue reached record levels in both Q1/09 and Q3/09 at $3.4 billion, with a Q2/09 figure of $2.8 billion and Q4/09 at $2.9 billion. In terms of trading revenue, we continue to 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. However, trading revenue is expected to decline this quarter (cyclical) due to lower volumes and tighter asset spreads.
• Loan loss provisions in Q1/10 are forecast at $2,475 million or 0.80% of loans, essentially unchanged from the past three quarters. Quarterly loan loss provisions are expected to be flat again this quarter down from a peak quarterly growth rate of 45% in Q1/09. We continue to believe that the bank group loan losses are at or very near peak levels for this cycle, in the $10 billion per annum range or 80 to 85 bp, in line with expectations from our report “The Credit Cycle”.
• Our forecast is for a 6% increase in operating earnings in fiscal 2010 and a 15% increase in 2011. Return on equity is expected to bottom in fiscal 2010 at 17.4%, increasing to 18.2% in 2011 as the banks move into a more favorable stage in the credit cycle and economic growth improves.
• The Canadian banks’ caution on the timing of dividend increases was very evident with the release of Q4/09 results. The uncertainty about bank dividend increases has increased with the release of the Basel consultative documents (see our report published January 27, 2010 entitled “Canada’s Dividend Culture – Caught in the Crossfire – Dividend Reset”).
• We expect Canadian banks will be able to meet any new capital requirements with very little disruption to their operating platforms, but dividend increases are likely on hold in the near term pending clarity from regulators.
• Bank fundamentals, we believe, are strong and are expected to improve over the next several years. We view Canadian banks as having low balance sheet risk, being well capitalized and highly profitable, and expect them to continue to generate superior shareholder returns.
• Long-term outperformance is expected, but in the near term we believe the bank group is in a consolidation phase pending some regulatory certainty. We need regulatory clarity, especially on capital and dividend policy, before bank valuations can expand further, in our opinion, thus our market weight recommendation (downgraded December 11, 2009). We expect dividend increases that are currently on hold will be the catalyst for substantially higher P/E multiples in the future.
• In terms of stock selection, we continue to believe RY to be a standout, given the strong reinvestment, competitive positioning in all its major business lines, the resulting industry high profitability and capital, and absence of a premium valuation. We have 1-Sector Outperform ratings on RY and BMO, with 2-Sector Perform ratings on BNS, LB, CWB, NA, and TD, and a 3-Sector Underperform rating on CM. Our order of preference is RY, BMO, NA, CWB, LB, TD, BNS, and CM.
ABCP Settlements – BNS, CM, NA, and LB
• On December 22, 2009, the Ontario Securities Commission (OSC), the Autorité des marchés financiers (AMF), and the Investment Industry Regulatory Organization of Canada (IIROC) announced that settlements had been reached in connection with investigations into the Canadian ABCP market resulting in $138.8 million in administrative penalties and investigation costs. The settlements are as follows: National Bank Financial (NA), $75 million; Scotia Capital Inc. (BNS), $29.3 million; CIBC World Markets (CM), $22 million; HSBC Bank Canada, $6 million; Laurentian Bank Securities Inc. (LB), $3.2 million; Canaccord Financial Ltd., $3.1 million; and Credential Securities Inc., $0.2 million. ABCP settlement costs are non tax-deductible and will be items of note in first quarter 2010 earnings.
TD – TD Ameritrade Earnings Below Consensus
• On January 19, 2010, TD Ameritrade reported a decline in first quarter earnings of 26% YOY to US$0.23 per share, below consensus of US$0.26 per share. Earnings were negatively impacted YOY by higher expenses, particularly higher employee compensation and benefits and higher advertising spend. TD Bank estimates TD Ameritrade’s contribution from this quarter to be C$43 million or C$0.05 per TD share versus C$0.07 per share in the previous quarter and C$0.09 per share a year earlier.
Banks Begin Reporting February 25
• Banks begin reporting first quarter earnings with Canadian Imperial Bank of Commerce (CM) and National Bank (NA) on February 25, followed by Bank of Montreal (BMO) on March 2, Royal Bank (RY) and Laurentian Bank (LB) on March 3, Canadian Western (CWB) and Toronto Dominion (TD) on March 4, and Bank of Nova Scotia (BNS) closing out reporting on March 9. Scotia Capital’s earnings estimates are highlighted in Exhibit 1, consensus earnings estimates in Exhibit 3, and conference call information in Exhibit 4.
First Quarter Earnings to Decline 5% YOY
• We expect first quarter operating earnings to decline 5% year over year (YOY) and to decline 1% quarter over quarter (QOQ). Bank operating results are expected to be stable and solid with a 16.3% return on equity and very impressive RRWA of 2.05% while absorbing what we believe are peak LLPs in the 80 bp range.
• We have trimmed our first quarter and fiscal 2010 earnings estimates (Exhibit 2) based on expected weaker trading revenue given the decline in volume and tighter asset spreads.
• Reported earnings are expected to closely parallel operating earnings with mark-to-market losses negligible following the trend in 2009 that saw mark-to-market losses decline throughout the year, reaching a nominal amount in Q4/09. Thus, banks are expected to continue to build capital via acceleration of internally-generated capital and aggressive management of risk-weighted assets, especially market at risk.
• In terms of operating earnings this quarter, we assume stable LLPs in the $2.5 billion range and weaker wholesale earnings partially offset by net interest margin improvement. The two most important factors this quarter are the impact of lower trading volumes and equity underwriting (although fixed income is extremely strong), and the net earnings impact on wholesale earnings and the magnitude of the potentially offsetting improvement in NIM.
• Bank earnings have beaten street expectations for most of fiscal 2009 with a substantial beat in Q4/09. Interestingly, bank share prices did not respond particularly well to the heavy Q4/09 beat.
• Wholesale banking earnings resilience will be tested this quarter especially in light of weak trading revenue from U.S. banks. However, it is important to note that the time period is different, with January being a very strong month versus October, especially from a fixed income underwriting perspective. Therefore, we would expect Canadian banks’ trading revenue/wholesale earnings to perform better in Q1/10 (ended January 31) than the U.S. banks’ in Q4/09 (ended December 31), although we expect lower trading revenue versus much of fiscal 2009. Wealth management earnings recovery is expected to continue to be driven by higher asset levels and positive operating leverage. Retail banking results are expected to remain solid, buoyed by stable-to-improving net interest margin.
• Banks’ earnings this quarter are being supported by continued loan repricing (mainly wholesale), stable interest rates, a steep yield curve, relatively high wholesale interest rate spreads, expected improvement in retail spreads, slight narrowing of bond spreads, higher LCDX Index, and significantly lower net security losses (perhaps security gains).
• The drag this quarter is expected to be the continued high level of loan losses, although they are relatively stable (flat QOQ, up 12% YOY), higher gross impaired loans (although gross impaired formations are expected to decline modestly), and the 2% QOQ, 16% YOY, appreciation in the Canadian dollar to the U.S. dollar (average), which will negatively impact foreign currency earnings. Lower securitization gains (narrower mortgage treasury spread), although not much of a factor in Q3/09 and Q4/09, and of course expected lower trading revenue, are expected to be a drag on earnings as well.
• Trading revenue reached record levels in both Q1/09 and Q3/09 at $3.4 billion, with a Q2/09 figure of $2.8 billion and Q4/09 at $2.9 billion. In terms of trading revenue, we continue to 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. However, trading revenue is expected to decline this quarter (cyclical) due to lower volumes and tighter asset spreads.
• Loan loss provisions in Q1/10 are forecast at $2,475 million or 0.80% of loans, essentially unchanged from the past three quarters. Quarterly loan loss provisions are expected to be flat again this quarter down from a peak quarterly growth rate of 45% in Q1/09. We continue to believe that the bank group loan losses are at or very near peak levels for this cycle, in the $10 billion per annum range or 80 to 85 bp, in line with expectations from our report “The Credit Cycle”.
• Our forecast is for a 6% increase in operating earnings in fiscal 2010 and a 15% increase in 2011. Return on equity is expected to bottom in fiscal 2010 at 17.4%, increasing to 18.2% in 2011 as the banks move into a more favorable stage in the credit cycle and economic growth improves.
• The Canadian banks’ caution on the timing of dividend increases was very evident with the release of Q4/09 results. The uncertainty about bank dividend increases has increased with the release of the Basel consultative documents (see our report published January 27, 2010 entitled “Canada’s Dividend Culture – Caught in the Crossfire – Dividend Reset”).
• We expect Canadian banks will be able to meet any new capital requirements with very little disruption to their operating platforms, but dividend increases are likely on hold in the near term pending clarity from regulators.
• Bank fundamentals, we believe, are strong and are expected to improve over the next several years. We view Canadian banks as having low balance sheet risk, being well capitalized and highly profitable, and expect them to continue to generate superior shareholder returns.
• Long-term outperformance is expected, but in the near term we believe the bank group is in a consolidation phase pending some regulatory certainty. We need regulatory clarity, especially on capital and dividend policy, before bank valuations can expand further, in our opinion, thus our market weight recommendation (downgraded December 11, 2009). We expect dividend increases that are currently on hold will be the catalyst for substantially higher P/E multiples in the future.
• In terms of stock selection, we continue to believe RY to be a standout, given the strong reinvestment, competitive positioning in all its major business lines, the resulting industry high profitability and capital, and absence of a premium valuation. We have 1-Sector Outperform ratings on RY and BMO, with 2-Sector Perform ratings on BNS, LB, CWB, NA, and TD, and a 3-Sector Underperform rating on CM. Our order of preference is RY, BMO, NA, CWB, LB, TD, BNS, and CM.
ABCP Settlements – BNS, CM, NA, and LB
• On December 22, 2009, the Ontario Securities Commission (OSC), the Autorité des marchés financiers (AMF), and the Investment Industry Regulatory Organization of Canada (IIROC) announced that settlements had been reached in connection with investigations into the Canadian ABCP market resulting in $138.8 million in administrative penalties and investigation costs. The settlements are as follows: National Bank Financial (NA), $75 million; Scotia Capital Inc. (BNS), $29.3 million; CIBC World Markets (CM), $22 million; HSBC Bank Canada, $6 million; Laurentian Bank Securities Inc. (LB), $3.2 million; Canaccord Financial Ltd., $3.1 million; and Credential Securities Inc., $0.2 million. ABCP settlement costs are non tax-deductible and will be items of note in first quarter 2010 earnings.
TD – TD Ameritrade Earnings Below Consensus
• On January 19, 2010, TD Ameritrade reported a decline in first quarter earnings of 26% YOY to US$0.23 per share, below consensus of US$0.26 per share. Earnings were negatively impacted YOY by higher expenses, particularly higher employee compensation and benefits and higher advertising spend. TD Bank estimates TD Ameritrade’s contribution from this quarter to be C$43 million or C$0.05 per TD share versus C$0.07 per share in the previous quarter and C$0.09 per share a year earlier.
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Financial Post, 17 February 2010
Toronto Dominion Bank’s US operation is facing a jump in “past due” loans in the fourth quarter that could herald a rise in defaults in future quarters, says Brad Smith, an analyst at CI Capital Markets.
Of the major domestic banks, TD has the biggest operation south of the border.
Citing U.S. regulatory filings, Mr. Smith said in a note to clients that TD’s U.S. banking group had a US$326-million or 48% increase in loans that were 30 to 90 days in arrears compared to the previous quarter. Of particular concern, he said, was a 134% hike in past due loans secured by non-residential properties.
The bottom line is that if the trend continues, it will likely translate into “upward pressure on future provisioning levels,” Mr. Smith said.
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Toronto Dominion Bank’s US operation is facing a jump in “past due” loans in the fourth quarter that could herald a rise in defaults in future quarters, says Brad Smith, an analyst at CI Capital Markets.
Of the major domestic banks, TD has the biggest operation south of the border.
Citing U.S. regulatory filings, Mr. Smith said in a note to clients that TD’s U.S. banking group had a US$326-million or 48% increase in loans that were 30 to 90 days in arrears compared to the previous quarter. Of particular concern, he said, was a 134% hike in past due loans secured by non-residential properties.
The bottom line is that if the trend continues, it will likely translate into “upward pressure on future provisioning levels,” Mr. Smith said.
