Scotia Capital, 12 August 2010
Banks Begin Reporting Third Quarter Earnings August 24 - Uninspiring
• Banks begin reporting third quarter earnings with Bank of Montreal (BMO) on August 24, followed by Canadian Imperial Bank of Commerce (CM) on August 25, Royal Bank (RY) and National Bank (NA) on August 26, Bank of Nova Scotia (BNS) on August 31, Canadian Western (CWB) on September 1 (after market close), with Toronto Dominion (TD) and Laurentian Bank (LB) closing out reporting on September 2.
• Our earnings estimates are highlighted in Exhibit 1, consensus earnings estimates in Exhibit 2, and conference call information in Exhibit 3.
Third Quarter Earnings - Momentum Stalls
• We expect third quarter operating earnings to decline 1% year over year (YOY) and be flat from the previous quarter. Bank earnings momentum is expected to stall in the third quarter as improvement in credit costs (loan loss provisions expected to decline 24% YOY) and retail net interest margin improvement is being offset by perhaps a cyclical low in the banks' wholesale business, driven by an expected nearly 50% decline in trading and 20% decline in capital markets revenue, as well as higher short-term wholesale funding costs (BAs up 26 bp YOY) and 9% appreciation YOY in the C$.
• We are trimming our Q3 earnings estimates by $0.04/$0.05 per share for RY, NA, and TD mainly due to lower trading revenue expectations.
• RY and NA are expected to record the weakest earnings momentum of the bank group this quarter with declines of 17% and 16% YOY, respectively, due to tough comps and higher trading revenue reliance. BMO and CM are expected to have the highest earnings momentum of the major banks with growth in earnings of 14% and 10% YOY due to lower bases a year earlier and some recovery in their underlying businesses. CWB earnings are expected to be up 21% YOY due to significant recovery in their net interest margin.
• Bank profitability this quarter is expected to remain solid, although with a lower return on equity at 16.4% (Exhibit 8) due to expected wholesale banking weakness and deleveraging. However on RRWA, profitability is trending at near record levels of 2.14% (Exhibit 9).
• Bank earnings have beaten Street expectations for most of fiscal 2009 and the first quarter of 2010, with Q2/10 earnings the first quarter since the earnings recovery began in which banks did not exceed expectations, as heightened expectations were greeted by softer capital markets, a stalled net interest margin (NIM), and negative earnings impact from a strong C$. Impressive retail and wealth management earnings were the main drivers in the second quarter.
• Third quarter earnings are expected to be uninspiring with no growth, although earnings levels remain respectable, especially given the very difficult quarter expected from wholesale banking. We expect the earnings trend to resume its positive track, perhaps as early as Q4/10 after pausing with a relatively weak Q2 and Q3E negatively impacted by the economic and sovereign debt uncertainty.
• Quarterly earnings variables (Exhibits 4 & 5) remain mixed this quarter with positives such as wider mortgage-treasury spreads, credit trends, higher retail spreads offset by negatives such as flatter yield curve, lower wholesale spreads, higher short-term funding costs, lower trading volume, weak equity and fixed income underwriting, and no growth in mutual fund assets.
• We expect retail bank earnings to remain strong although growth is expected to begin to slow as volume growth moderates from a very strong pace (off cycle) and net interest margin improvement may begin to moderate. Wealth management earnings growth is also expected to moderate due to lack of sustained asset growth. Wholesale earnings could be at a cyclical low this quarter as trading revenue is expected to decline 46% YOY and 23% sequentially (Exhibit 5, row #24), with underwriting and advisory revenue down 20% YOY and 6% sequentially (Exhibit 4, row #33).
• We expect trading revenue to decline to $1.9 billion in the third quarter versus $2.5 billion in the previous quarter and $3.6 billion a year earlier. Loan loss provisions are expected to be $1.9 billion in the third quarter, similar to the previous quarter but down from $2.5 billion a year earlier. Loan loss provisions in the second quarter were 61 bp and are expected to decline to less than 30 bp through the cycle. However, loan loss provisions can be lumpy on the descent.
• The one trend that remains solidly intact is balance sheets continuing to strengthen. We expect capital levels to continue to build based on internally generated capital and management of risk-weighted assets. Balance sheet strength and solid earnings are expected to lead to the resumption of dividend growth.
Basel Rules Less Onerous - Uncertainty on Details to be Resolved by Year-End
• The Basel Committee on Banking Supervision on July 26 reached a broad agreement on the overall design of the capital and liquidity reform package (see July 28, 2010 Daily Edge note titled "Euro Crisis/Partial Reality Check for Basel - Tone Improves - Positive for Canadian Banks"). The agreement in general seems to be more balanced and constructive than the December 2009 document. Capital definitions have been eased and liquidity design softened with transition time frames extended. We estimate that the July agreement increases bank capital by 100 bp versus Basel's December 2009 consultative document. The July agreement is positive and the tone has improved; however, calibration risk and uncertainty will likely persist until the detailed rules are released later this year
Valuations Attractive - High Dividend Yield - Low P/E Multiples - Building Base
• Bank valuations remain very attractive with a dividend yield of 4.0%, which is 135% of the 10-year bond yield and 166% of the TSX dividend yield versus historical means of 59% and 145%, respectively. Bank earnings yield relative to corporate bond yields is 187% versus the historical mean of 131%.
• Bank P/E multiples, we believe, are attractive at 10.7x 2011 earnings estimates and are poised for expansion. Bank P/E multiples, we believe, have formed a base and support at 12x, which we expect to expand to the 15x-16x range, similar to the post-2002 cyclical recovery. The resumption of dividend growth is expected to be the catalyst for higher P/E multiples.
Major Bank Stock Rally Pending - Maintain Overweight
• We continue to recommend an overweight position in bank stocks as they grind out some outperformance with a modest 1% increase versus a 1% decline for the TSX as well as higher return of 1.6% from dividends.
• Bank share price performance has been muted in the past quarter based on sluggish earnings, concerns about the economic recovery, nervousness about sovereign debt, and regulatory uncertainty (slight relief with July Basel agreement).
• We continue to believe that a key catalyst for a sustained rally in bank stocks and higher P/E multiples are dividend increases. The first prospect for a dividend increase is expected to arise with the banks' release of Q4 earnings late November/early December. The timing of dividend increases is dependent on Basel capital ratio details due out later this year and OSFI consent.
• We are hopeful that the overreaction stage fraught with noise and drama from politicians and regulators will subside and banks will increase dividends with the release of fourth quarter earnings, significantly improving investor sentiment. Thus, we believe a major bank stock rally is pending.
• We have 1-Sector Outperform ratings on TD, CWB, BNS, BMO, and 2-Sector Perform ratings on CM, LB, RY and NA. Our order of preference is: TD, CWB, BNS, BMO, CM, LB, RY, and NA.
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Banks Begin Reporting Third Quarter Earnings August 24 - Uninspiring
• Banks begin reporting third quarter earnings with Bank of Montreal (BMO) on August 24, followed by Canadian Imperial Bank of Commerce (CM) on August 25, Royal Bank (RY) and National Bank (NA) on August 26, Bank of Nova Scotia (BNS) on August 31, Canadian Western (CWB) on September 1 (after market close), with Toronto Dominion (TD) and Laurentian Bank (LB) closing out reporting on September 2.
• Our earnings estimates are highlighted in Exhibit 1, consensus earnings estimates in Exhibit 2, and conference call information in Exhibit 3.
Third Quarter Earnings - Momentum Stalls
• We expect third quarter operating earnings to decline 1% year over year (YOY) and be flat from the previous quarter. Bank earnings momentum is expected to stall in the third quarter as improvement in credit costs (loan loss provisions expected to decline 24% YOY) and retail net interest margin improvement is being offset by perhaps a cyclical low in the banks' wholesale business, driven by an expected nearly 50% decline in trading and 20% decline in capital markets revenue, as well as higher short-term wholesale funding costs (BAs up 26 bp YOY) and 9% appreciation YOY in the C$.
• We are trimming our Q3 earnings estimates by $0.04/$0.05 per share for RY, NA, and TD mainly due to lower trading revenue expectations.
• RY and NA are expected to record the weakest earnings momentum of the bank group this quarter with declines of 17% and 16% YOY, respectively, due to tough comps and higher trading revenue reliance. BMO and CM are expected to have the highest earnings momentum of the major banks with growth in earnings of 14% and 10% YOY due to lower bases a year earlier and some recovery in their underlying businesses. CWB earnings are expected to be up 21% YOY due to significant recovery in their net interest margin.
• Bank profitability this quarter is expected to remain solid, although with a lower return on equity at 16.4% (Exhibit 8) due to expected wholesale banking weakness and deleveraging. However on RRWA, profitability is trending at near record levels of 2.14% (Exhibit 9).
• Bank earnings have beaten Street expectations for most of fiscal 2009 and the first quarter of 2010, with Q2/10 earnings the first quarter since the earnings recovery began in which banks did not exceed expectations, as heightened expectations were greeted by softer capital markets, a stalled net interest margin (NIM), and negative earnings impact from a strong C$. Impressive retail and wealth management earnings were the main drivers in the second quarter.
• Third quarter earnings are expected to be uninspiring with no growth, although earnings levels remain respectable, especially given the very difficult quarter expected from wholesale banking. We expect the earnings trend to resume its positive track, perhaps as early as Q4/10 after pausing with a relatively weak Q2 and Q3E negatively impacted by the economic and sovereign debt uncertainty.
• Quarterly earnings variables (Exhibits 4 & 5) remain mixed this quarter with positives such as wider mortgage-treasury spreads, credit trends, higher retail spreads offset by negatives such as flatter yield curve, lower wholesale spreads, higher short-term funding costs, lower trading volume, weak equity and fixed income underwriting, and no growth in mutual fund assets.
• We expect retail bank earnings to remain strong although growth is expected to begin to slow as volume growth moderates from a very strong pace (off cycle) and net interest margin improvement may begin to moderate. Wealth management earnings growth is also expected to moderate due to lack of sustained asset growth. Wholesale earnings could be at a cyclical low this quarter as trading revenue is expected to decline 46% YOY and 23% sequentially (Exhibit 5, row #24), with underwriting and advisory revenue down 20% YOY and 6% sequentially (Exhibit 4, row #33).
• We expect trading revenue to decline to $1.9 billion in the third quarter versus $2.5 billion in the previous quarter and $3.6 billion a year earlier. Loan loss provisions are expected to be $1.9 billion in the third quarter, similar to the previous quarter but down from $2.5 billion a year earlier. Loan loss provisions in the second quarter were 61 bp and are expected to decline to less than 30 bp through the cycle. However, loan loss provisions can be lumpy on the descent.
• The one trend that remains solidly intact is balance sheets continuing to strengthen. We expect capital levels to continue to build based on internally generated capital and management of risk-weighted assets. Balance sheet strength and solid earnings are expected to lead to the resumption of dividend growth.
Basel Rules Less Onerous - Uncertainty on Details to be Resolved by Year-End
• The Basel Committee on Banking Supervision on July 26 reached a broad agreement on the overall design of the capital and liquidity reform package (see July 28, 2010 Daily Edge note titled "Euro Crisis/Partial Reality Check for Basel - Tone Improves - Positive for Canadian Banks"). The agreement in general seems to be more balanced and constructive than the December 2009 document. Capital definitions have been eased and liquidity design softened with transition time frames extended. We estimate that the July agreement increases bank capital by 100 bp versus Basel's December 2009 consultative document. The July agreement is positive and the tone has improved; however, calibration risk and uncertainty will likely persist until the detailed rules are released later this year
Valuations Attractive - High Dividend Yield - Low P/E Multiples - Building Base
• Bank valuations remain very attractive with a dividend yield of 4.0%, which is 135% of the 10-year bond yield and 166% of the TSX dividend yield versus historical means of 59% and 145%, respectively. Bank earnings yield relative to corporate bond yields is 187% versus the historical mean of 131%.
• Bank P/E multiples, we believe, are attractive at 10.7x 2011 earnings estimates and are poised for expansion. Bank P/E multiples, we believe, have formed a base and support at 12x, which we expect to expand to the 15x-16x range, similar to the post-2002 cyclical recovery. The resumption of dividend growth is expected to be the catalyst for higher P/E multiples.
Major Bank Stock Rally Pending - Maintain Overweight
• We continue to recommend an overweight position in bank stocks as they grind out some outperformance with a modest 1% increase versus a 1% decline for the TSX as well as higher return of 1.6% from dividends.
• Bank share price performance has been muted in the past quarter based on sluggish earnings, concerns about the economic recovery, nervousness about sovereign debt, and regulatory uncertainty (slight relief with July Basel agreement).
• We continue to believe that a key catalyst for a sustained rally in bank stocks and higher P/E multiples are dividend increases. The first prospect for a dividend increase is expected to arise with the banks' release of Q4 earnings late November/early December. The timing of dividend increases is dependent on Basel capital ratio details due out later this year and OSFI consent.
• We are hopeful that the overreaction stage fraught with noise and drama from politicians and regulators will subside and banks will increase dividends with the release of fourth quarter earnings, significantly improving investor sentiment. Thus, we believe a major bank stock rally is pending.
• We have 1-Sector Outperform ratings on TD, CWB, BNS, BMO, and 2-Sector Perform ratings on CM, LB, RY and NA. Our order of preference is: TD, CWB, BNS, BMO, CM, LB, RY, and NA.
