18 September 2010

Barron's on TD Ameritrade

Barron's, Sandra Ward, 18 September 2010

Hard to believe amid all the hand-wringing about the direction of the economy and the markets, but day trading is alive and well.

A healthy number of individuals continue to indulge a passion for buying and selling stocks, and options and futures on those stocks, on a daily basis, in spite of the continued exodus from actively managed stock mutual funds and intensified interest in bond investments. For proof of these animal spirits, look no further than TD Ameritrade. A leader in online brokerage services based in Omaha, Nebraska, its clients placed a record 413,000 trades a day in the firm's fiscal third quarter, ended June.

Daily trading volume dropped during the summer months, as is typical for the season. But the seasonal drop was exacerbated this year amid renewed fears of a global slowdown brought into sharp relief by continued high unemployment, European debt troubles and looming financial reforms in the U.S. Nonetheless, the impact was softened by strong net inflows of new assets. TD Ameritrade continued to rake in new assets at a pace exceeding the firm's yearly target range of 7% to 11%. Indeed, the firm collected net new assets of $28 billion in the year through June 30, a 12% annualized rate of growth and up 32% from the first nine months of 2009. It now has a total of $324 billion in client assets.

TD Ameritrade appears to be benefiting as investors migrate from the big investment firms to a more self-directed approach to their portfolios, trading for their own account or enlisting the aid of a financial advisor, many of whom use TD Ameritrade as a platform for client accounts. The firm is also gaining from the "breakaway broker" phenomenon, as more and more brokers are choosing to operate independently as registered investment advisors and using TD Ameritrade for their "back office" needs. A sales force whose compensation is linked to bringing in new assets also has made a big difference.

The company's strong relationship with its 45% stakeholder and triple-A-rated Toronto Dominion Bank has also bolstered its asset-gathering efforts. And its 2009 acquisition of thinkorswim Group, the leader in the profitable and fast-growing options-trading arena (Barron's has named thinkorswim the No. 1 online broker two years in a row, and in four of the past five years), puts more capabilities into the hands of its big base of active traders and provides other customers with important tools for better managing their money. And thinkorswim is just the latest in a long line of acquisitions that TD Ameritrade has successfully integrated into its operations.

TD Ameritrade has taken itself beyond its role as simply a discount broker by offering an expanded line of wealth-management services that appeals to a wider audience, as suggested by the improvement in its ability to boost assets under management.

Reflecting this growth in assets, the company is on track to deliver earnings gains of 19% in fiscal 2011 and nearly 30% in fiscal 2012 based on consensus earnings estimates of $1.21 a share for next year and $1.56 the next. Yet, the company isn't getting a lot of credit for this increase, and that's resulted in a wide gap between its expected growth and its stock price: TD Ameritrade shares sport a P/E multiple of just 12.8 times fiscal 2011 estimates and 9.9 times 2012. Charles Schwab, in contrast, trades at 25 times this year's expected earnings and 15.3 times 2011 consensus estimates.

Asset managers typically trade at a 20% to 40% premium to the market multiple. TD Ameritrade wouldn't command the full premium because of its discount brokerage, but its fans argue a higher multiple is warranted.

Its valuation also overlooks a clean balance sheet, a recently authorized 30-million-share stock buyback program (it expects to purchase 12 million shares between now and the middle of November), the possibility of a dividend payout and the potential for a big earnings impact once interest rates begin to rise. Indeed, a 25-basis-point increase in the fed-funds rate would be the equivalent of a seven-cent rise in annual earnings.

"They have extraordinary leverage to interest rates," says Mac Sykes, a brokerage analyst at Gabelli & Co. He considers the stock attractively priced at current levels based on its normalized earnings growth, operating leverage from economies of scale and positive impact from increases in interest rates—widely seen as occurring by the end of next year. Sykes puts a private market value of $24 on the shares, based on a multiple of nine times his enterprise value to Ebitda estimate of $1.4 billion in 2011. It currently trades at 6.2 times EV/Ebitda.

Morgan Stanley's Celeste Mellet Brown recently reiterated an Overweight rating on TD Ameritrade shares after hosting a dinner meeting with management Sept. 7. She cited outsized growth in net new assets, upside potential from a rise in interest rates, the likelihood of return of capital to shareholders and a stock price at bargain levels. Brown attaches a price target of $25 to the shares, which would represent a 61% gain from the current $15.50.

TD Ameritrade has $63 billion in interest-sensitive assets, of which $42 billion is in higher-yielding insured deposit accounts with Canada's Toronto Dominion Bank. Low interest rates have been a problem for all financial institutions and there's no question they are hurting TD Ameritrade's net interest margin and, in turn, operating margins.

But the firm is less interest-rate-sensitive than most, including the granddaddy of all discount brokers, Charles Schwab. About 52% of TD Ameritrade's revenues came from trading in 2009, compared with 24% for Schwab, which has more customers in interest-bearing accounts. The near zero fed-funds rate has led Schwab to waive fees associated with its money-market funds to keep the funds' yield from slipping into negative territory. Schwab also said last week it will take a charge of $130 million in the third quarter to cover losses in its money-market funds related to a defaulted investment.

Another potential catalyst to move TD Ameritrade shares higher is the option Toronto Dominion Bank has to buy the rest of the shares it doesn't already own under a shareholder agreement inked in 2006, when Toronto Dominion's U.S. brokerage business, TD Waterhouse, merged with Ameritrade. Under the agreement, which runs through January 2016, its ownership is capped at 45% between now and 2016 but allows for the bank to make a tender or merger offer for the remaining shares prior to the agreement's end.

TD Bank hasn't commented on its intentions except to say it is happy with its ownership of TD Ameritrade. But it is instructive to note that it bought a stake in the former BankNorth in 2004 and integrated some operations before eventually buying the rest of the bank in 2007. Yet, TD Bank is important to TD Ameritrade's future in other ways. TD Ameritrade plans to tap into the 1,300 branches the bank operates on the East Coast, making its brokerage services—trading, investing and advising—available to the bank's customers.

A precursor of this plan has been in place on Sixth Avenue in Manhattan, where a TD Bank branch and a TD Ameritrade branch sit cater-cornered to each other and refer clients to each other's products.

Did somebody say animal spirits?
A long string of acquisitions from September 2001 through June 2009 has helped TD Ameritrade bulk up.

13 September 2010

Review of Banks' Q3 2010 Earnings

Scotia Capital, 13 September 2010


• Canadian banks' third quarter operating earnings were disappointing, missing earnings estimates, the first quarterly miss of the earnings recovery cycle. ROE: 15.9%, RRWA: 2.06%, Tier 1: 12.8%.


• The major collapse in trading revenue from record levels a year earlier cut wholesale earnings in half. Trading revenue as a percentage of total revenue declined to the lowest level in over a decade. Strong retail earnings and lower LLPs did not fully offset the wholesale earnings drag, resulting in a 4% YOY decline in earnings. We trimmed our 2011 earnings estimates 4% based on the tighter NIM outlook and expected slower retail loan growth.


• We continue to recommend an overweight position in bank stocks, with attractive valuation, signs of lower regulatory risk, and uncertainty partially offset by concerns about economic growth. The prospect of the resumption of dividend growth is key to a shift in investor sentiment and a catalyst for higher share prices and higher P/E multiples.

• We maintain 1-Sector Outperform ratings on TD, NA, CWB, and BMO, and 2-Sector Perform ratings on CM, BNS, LB, and RY. Our order of preference is: TD, NA, CWB, BMO, CM, BNS, LB, and RY.

Earnings Miss – First of Recovery – Tough Comps

• Canadian banks’ third quarter operating earnings were disappointing, missing earnings estimates, the first quarterly miss of the earnings recovery cycle. The major collapse in trading revenue from record levels a year earlier cut wholesale earnings in half. Trading revenue as a percentage of total revenue declined to the lowest level in over a decade. Strong retail earnings and lower loan losses did not fully offset the wholesale earnings drag, resulting in a 4% year-over-year (YOY) decline in earnings. Probably the biggest disappointment in the quarter was the sequential decline in both the overall net interest margin (NIM) and retail NIM.

• We trimmed our 2011 earnings estimates 4% based on the tighter NIM outlook and expected slower retail loan growth, particularly in mortgages, as concern about the housing market surfaces with lower economic growth. Economic growth estimates for 2011 have declined significantly (Scotia Economics recently reduced its 2011 GDP forecast to 2.3% from 2.6%).

• Our 2011 earnings estimate is for growth of 11% off a weaker 2010 earnings base. The risk to our earnings growth forecast is that capital market activity does not return to a more normalized level or economic growth slows further and the housing market has a sharp correction versus a moderate correction.

• The third quarter earnings decline of 4% YOY comes after three straight quarters of positive (although modest) earnings growth, which were the first since Q4/07. The earnings growth this recovery cycle is weaker than past cycles due to stronger cyclical bottom earnings, counter-cyclically strong wholesale earnings in 2009, weak economic recovery, the out-of sync housing cycle, lower earnings sensitivity to credit, and margin pressure (low level of rates/Basel III).

• The highest earnings growth in the third quarter were from CWB and CM at 26% and 22%, respectively, with CWB enjoying a major recovery in margin and solid loan growth and CM showing improvement in retail and easier comps. RY earnings declined 28%, as it had the most difficult comps of the group and recorded a massive drop in trading revenue due to its strong trading platform in the United Kingdom/Europe. RY seems to have suffered the most from the capital markets fallout from the Sovereign Debt Crisis, particularly in the month of May. NA and TD saw earnings decline a more modest 12% and 3%, respectively. BMO, LB, and BNS managed modest earnings growth of 9%, 5%, and 3%, respectively.

• In terms of beats this quarter, CM and NA led the group with modest beats on strong retail and relatively solid wholesale. TD and BNS were more or less in line, with RY the big miss on trading and BMO also missing on trading.

• Profitability for the bank group in terms of operating return on equity declined to 15.9%, the lowest level since the fourth quarter of 2002, reflecting the weakness in wholesale and the banks’ deleveraging of the past several years. The bank group ROE was led by CM and BNS.

• Return on risk-weighted assets (RRWA) remains near record levels at 2.06%, aided by deleveraging and active management of risk-weighted assets. TD and CM produced the highest RRWA of the group with TD at an impressive 2.65%. This quarter’s earnings level, assuming 30 bp in loan loss provisions, would result in ROE of 16.7% with RRWA of 2.20%.

• The weak earnings this quarter were due primarily to the 51% YOY decline in wholesale banking earnings. The wholesale banking earnings tumble was due to an astounding $2.4 billion decline in trading revenue to $1.2 billion from the record $3.6 billion a year earlier.

Trading revenue declined to 5.6% of total revenue, the lowest level since Q4/98

• In addition to the dreadful wholesale earnings, the net interest margin declined, putting further pressure on results. The net interest margin expansion, after stalling over the past few quarters, actually declined both sequentially and YOY. The margin was negatively impacted by higher liquidity costs, higher BAs, price competition, and perhaps higher costs due to extension of term. The overall net interest margin declined 8 bp YOY and 6 bp quarter over quarter (QOQ). The retail margin declined 4 bp QOQ and was flat YOY.

• The C$/US$ appreciated 9% YOY, negatively impacting earnings, although the impact declined from the 21% YOY appreciation in Q2/10 and is expected to decline further with 3% YOY appreciation expected in Q4/10.

• Domestic Retail and Wealth Management was the star business segment in the quarter, reporting record earnings and a 20% YOY increase. Retail banking loan growth was impressive at 10% and was the major driver in retail earnings.

• Domestic retail and wealth earnings growth was led by CM, NA, TD, and BNS at 45%, 28%, 24%, and 20%, respectively. RY and BMO lagged the bank group with moderate growth of 10% and 12%, respectively, and consequently recorded the weakest overall earnings performance of the bank group.

• RY’s and BMO’s trading revenues, significantly weaker than the bank group’s, were compounded by the lower growth in domestic retail and wealth.

• Credit trends remained positive as loan loss provisions (LLPs) declined $882 million YOY and $250 million QOQ to $1.6 billion or 50 bp of loans. LLPs have declined from the quarterly peak of 84 bp and are expected to trough in the 25 bp to 30 bp range in the next three or four years with our 2011 forecast at a conservative 46 bp.

• Gross Impaired Loan (GIL) levels were stable at $19.3 billion or 1.5% of loans. However, GIL formations were much improved as they moderated to $3.2 billion, the lowest since Q3/08, and nearly half the quarterly peak recorded in Q1/09.

• The bank group continued to build its capital positions with Tier 1 capital ratio improving 21 bp QOQ and 128 bp YOY to 12.8%. TCE as a percentage of RWA also improved 51 bp sequentially to 9.9%. Bank dividends remain frozen pending regulatory clarity or a nod from the regulator. Banks paid out 50% of operating earnings in the form of common dividends this quarter. Banks continue to generate strong earnings and actively manage risk-weighted assets.

• Bank balance sheets remain high quality with an unrealized security surplus, increasing to $3.1 billion versus $2.1 billion in the previous quarter.

Remain Overweight – Regulatory/Capital Clarity Pending – Prospects for Resumption of Dividend Growth

• We continue to recommend an overweight position in bank stocks, with attractive valuation and signs of lower regulatory risk and uncertainty partially offset by concerns about economic growth.

• Basel is expected to release capital ratio calibration shortly, with moderation expected from its original draconian proposals. We expect Canadian banks’ Tier 1 common ratio to comfortably meet requirements with negligible restrictions on dividend distributions. However, dividend increases are likely to be modest and limited in the near term (see Exhibit 14) based on our lower 2011 earnings estimates and current payout ratios versus the target range.

• NA, TD, CWB, and LB have the lowest dividend payout ratio and the most leeway to increase their dividends. We expect NA, CWB, LB, and perhaps TD to increase their common dividends as early as December 2, 2010, when they release their fourth quarter earnings.

• The prospects for the resumption of dividend growth is key to a shift in investor sentiment and a catalyst for higher share prices and higher P/E multiples. Bank P/E multiples at 13.0x trailing and 11.5x 2011E are attractive, in our opinion, and well below the high of 15x reached over the past 10 years.

• Bank dividend yield at 3.9% is 133% of the 10-year government bond yield versus the historical mean of 59%, representing three standard deviations above the mean.

• We maintain 1-Sector Outperform ratings on TD, NA, CWB, and BMO, and 2-Sector Perform ratings on CM, BNS, LB, and RY. Our order of preference is: TD, NA, CWB, BMO, CM, BNS, LB, and RY.

Third Quarter Highlights

• Third quarter operating earnings declined 4% YOY and 2% from the previous quarter. The main trends in the quarter were a continuing decline in loan loss provisions, strong Domestic Banking earnings, and very weak wholesale earnings driven by a collapse in trading revenue.

• CM and NA beat consensus estimates by 8% and 3%, respectively, with TD and BNS more or less in line and RY missing estimates by a wide margin of 15%. Third quarter earnings were led by CM and BMO, with YOY growth of 22% and 9%, respectively, due to strong domestic retail banking earnings and positive credit trends. BNS earnings growth was modest YOY, with TD, NA, and RY declining.

Domestic Banking & Wealth Management – Strong

• Domestic banking earnings, including wealth management, were very strong at $4.0 billion, up 20% YOY and an impressive 10% sequentially. Earnings growth was led by CM, up 45% (although boosted by treasury allocation), followed by NA, TD, and BNS up 28%, 24%, and 20%, respectively. BMO and RY retail earnings lagged the bank group with moderate growth of 12% and 10%, respectively, from a year earlier.

Wholesale Banking Earnings Weak

• Wholesale earnings were $1.0 billion in the third quarter, declining 37% QOQ and 51% from a year earlier. Wholesale bank earnings were weaker due to a collapse in trading revenue.

• Wholesale earnings represented 18% of total operating earnings from operations in the quarter, with NA having the largest portion of its earnings coming from wholesale at 34%, followed by BNS at 24%, BMO at 18%, CM at 17%, RY at 16%, and TD at 12%.

Trading Revenue Collapses

• Trading revenue in the third quarter collapsed to $1.2 billion from $3.6 billion a year earlier and from $2.6 billion in the previous quarter. Trading revenue in the third quarter was 5.6% of total revenue, down from the Q2/10 level of 11.7%, and below the five-year average of 9.6%.

• The trading strength indicator was highest for CM at 117%, followed by BNS at 84%, TD at 70%, NA at 61%, and BMO at 40%, with RY at a bank group low of 15%. This indicator was a factor in earnings underperformance this quarter.

Net Interest Margin Declines QOQ

• The bank group’s NIM declined 6 bp QOQ and 8 bp YOY to 1.84%, reinforcing our view of a moderating net interest margin. The compression in banks’ NIM has been affected by a narrowing of wholesale spreads (Prime, BAs), a flattening yield curve, and an increasingly competitive pricing environment. The retail NIM was flat from a year earlier, but declined 4 bp sequentially.

Credit Losses Decline

• Loan loss provisions this quarter were $1.6 billion or 50 bp of loans, down 35% from $2.5 billion or 81 bp of loans from a year earlier, and down 13% from the previous quarter level of $1.9 billion or 61 bp of loans. LLPs for BMO, RY, and NA declined significantly from a year earlier, by 40%, 39%, and 39%, respectively. BNS, TD, and CM LLPs declined 36%, 31%, and 30%, respectively, from a year earlier. We believe that LLPs have peaked on a quarterly basis and on an annual basis in 2009.

• CM recorded the highest LLP levels this quarter at 64 bp, followed by RY at 58 bp, TD at 51 bp, BMO at 49 bp, BNS at 42 bp, and NA at a bank group low of 18 bp.

• Our 2010 and 2011 LLP forecasts declined to $7,330 million or 58 bp of loans and $6,140 million or 46 bp of loans, respectively, from $7,760 million or 62 bp of loans and $6,780 million or 52 bp of loans, respectively.

Gross Impaired Loan Formations Decline

• Gross impaired loan formations this quarter were $3.2 billion or 0.25% of loans, declining from $5.0 billion or 0.41% of loans a year earlier and from $4.1 billion or 0.33% of loans in the previous quarter. RY, TD, and CM formations declined sequentially by 23%, 2%, and 2%, respectively, while BNS formations increased 4%. BMO gross impaired loan formations declined 34% QOQ, excluding the impact of the FDIC-assisted AMCORE Bank acquisition. Including the impact of the acquisition, GIL formations declined 84% from the previous quarter.

Gross Impaired Loans Stable

• Gross impaired loans for the bank group were stable at $19.3 billion or 1.52% of loans from $19.2 billion in the previous quarter.

Capital Ratios Remain High

• Tier 1 capital ratio for the bank group hit another all-time high of 12.8%, led by CM at 14.2%, followed by BMO at 13.5%, NA at 13.0%, RY at 12.9%, TD at 12.5%, and BNS at 11.7%. Risk-weighted assets continued to decline, down 2.3% YOY, aiding capital ratio increases.


• Canadian bank profitability declined in the third quarter to 15.9% ROE for the group. CM and BNS led the bank group with ROEs of 21.5% and 18.1%, respectively, while TD lags the group with an ROE of 13.6%. However, TD boasts the highest RRWA of 2.65%, followed by CM at 2.39% and NA at 1.97%. BMO lags the bank group at 1.62%.
Dow Jones Newswires, Caroline Van Hasselt, 9 September 2010

Canada's banks topped their global peers as the world's soundest for third straight year, the World Economic Forum said. But, the country slipped in terms of its global competitiveness.

Canada ranked ahead of New Zealand, Australia, Lebanon, Chile and South Africa in bank soundness, the World Economic Forum said in its closely watched annual global competitiveness rankings. Panama was ranked 7th, while the U.S., which had to bail out major banks and Wall Street firms to avert a financial-system collapse, ranked 111th in terms of bank soundness, just ahead of Germany and Iran.

Canada's Finance Minister Jim Flaherty said effective supervision, not regulation, is the key to ensure financial system soundness. None of Canada's banks required bailouts during the 2007-2008 global financial crisis.

"Regulation alone is not necessarily the answer to the problem. Many of the institutions that failed around the world were regulated. The key is effective supervision," he said in a statement. "Today's ranking by the World Economic Forum is further evidence that Canada's model does work and is an example to the world."

But Canada still lags on plenty of other indicators.

In global competitiveness, Canada slipped to 10th from ninth, overtaken by the Netherlands.

With a population of 33.6 million, Canada is twice the size of the Netherlands, but it's far less productive. Canada's gross domestic product per capita is $39,669, compared to the Netherlands' GDP per capita of $48,223, the World Economic Forum said.

Canada could enhance its competitiveness and productivity by improving "the sophistication and innovative potential of the private sector, with greater R&D spending and producing higher on the value chain," the Geneva-based think tank said.

Canada also fell short in other rankings, placing 39th in restriction on capital flows, 22nd in securities-exchange regulations and 24th in terms of ease of access to loans and 14th in terms of affordable financial services.

Switzerland took top billing in global competitiveness for a second year, while the U.S. fell two places to fourth, overtaken by Sweden and Singapore.

World Economic Forum, which sponsors the annual gathering of world leaders in Davos, Switzerland, provides rankings on more than 100 indicators for 139 economies.

03 September 2010

TD Bank Q3 2010 Earnings

Scotia Capital, 3 September 2010


• TD operating EPS declined 2% to $1.43, in line with expectations.


• Earnings were solid, driven by a strong performance at Canadian P&C (TDCT) with earnings up 24% YOY, followed by U.S. P&C up 19%, and Wealth Management up 10%, offset by a 45% decline in Wholesale. The bank viewed the Wholesale, earnings decline as normalization. The major weakness was in Wholesale driven by a decline in trading, although trading was solid in the context of the market. LLPs declined as credit trends improved. Retail margin was flat QOQ with overall margin declining. ROE was 13.6%, RRWA was 2.65%, Tier 1 Capital is 12.5%.

• TDCT continues to be the main driver in earnings with revenue growth of 8% driven by volume as the bank gained market share in both personal & business lending.


• Our 2010E EPS is unchanged at $5.85. We have reduced our 2011E EPS to $6.50 from $6.60 due to lower economic growth outlook and moderating net interest margin as the prospect for higher interest rates is delayed. Our one-year target price is unchanged at $90. We maintain our 1-SO rating based on strong retail franchise and improving earnings in the U.S.

Items of Note

• Reported cash earnings were $1.41 per share including a $9 million after-tax or $0.01 per share gain in fair value of CDS hedging the corporate loan book, $14 million after-tax or $0.02 per share loss in fair value of derivatives hedging the reclassified portfolio, and $5 million after-tax or $0.01 per share restructuring charge relating to U.S. P&C acquisitions.

Canadian P&C Earnings Increase 24%

• Canadian P&C (TDCT) earnings increased 24% to $841 million from $677 million a year earlier, with high revenue growth driven by strong volume, lower loan loss provisions, and controlled expenses.

• Real estate secured lending was strong increasing 12% (incl. securitization), with consumer loan volumes increasing 13% and business loans and acceptances increasing 5%.

• Deposit growth was also strong with personal deposits up 4% and business deposits increasing 14%.

• TDCT had solid revenue growth of 8.1% with expense growth of 4.4% for positive operating leverage of 3.7%.

• Retail net interest margin was flat sequentially and declined 4 bp from a year earlier to 2.92%.

• Card service revenues were solid at $216 million versus $197 million the previous quarter and $197 million a year earlier.

• LLPs declined to $236 million from $256 million in Q2/10 and from $290 million a year earlier.

• Insurance earnings were weaker this quarter with insurance revenue, net of claims, at $239 million versus $287 million in the previous quarter and $253 million a year earlier.

Total Wealth Management Earnings Solid

• Wealth Management earnings, including the bank’s equity share of TD Ameritrade, were solid at $179 million, an increase of 10% YOY.

Canadian Wealth Management Earnings Increase 23%

• Domestic Wealth Management earnings increased 23% YOY to $117 million.

• Operating leverage was positive 4.2%, with revenue increasing 9.6% and expenses increasing 5.4%.

• Mutual fund revenue increased 18% to $216 million from a year earlier.

• Mutual fund assets under management (IFIC, includes PIC assets) increased 11.1% YOY to $62.4 billion.

TD Ameritrade – Earnings Solid

• TD Ameritrade contributed $62 million or $0.07 per share to earnings in the quarter versus $56 million or $0.06 per share in the previous quarter and $68 million or $0.08 per share a year earlier. TD Ameritrade’s contribution represented 4% of total bank earnings.

U.S. P&C Earnings Increase 19% - Reg. E to Reduce EPS (est.) $0.03- 0.04/Quarter

• U.S. P&C earnings increased 19% YOY to $287 million or $0.33 per share from $242 million a year earlier, representing 19% of total bank earnings. Earnings were negatively impacted by $25 million due to a strong Canadian dollar. Earnings also increased 17% sequentially due to strong retail fee growth from new pricing structure post Commerce integration and the Riverside acquisition.

• Loan loss provisions in the U.S. declined to $131 million or 0.80% of loans versus $168 million or 1.10% of loans in the previous quarter and $183 million or 1.06% a year earlier.

• Net interest margin declined 12 bp from the previous quarter primarily due to lower prepayment speed on loans and securities. Spreads on deposits and loans remained stable.

• TD disclosed that Regulation E is expected to reduce revenue beginning in Q4/10 by approximately US$40 million-50 million a quarter after taking into consideration mitigation strategies. This is expected to reduce earnings by US$25 million-$35 million or $0.03-$0.04 per share per quarter. The reduction represents approximately 10% of U.S. P&C segment earnings or 2% of overall bank earnings.

• The amendment of Regulation E, Electronic Fund Transfer Act, prohibits financial institutions from charging fees to consumers for paying automated teller machine and point of sale transactions that result in overdraft.

• The negative impact of Reg. E, net of mitigation strategies is slightly greater than expected but not significantly material overall.

U.S. Platforms Combine to Represent 23% of Earnings

• U.S. P&C and TD Ameritrade contributed $349 million or $0.40 per share in the quarter, representing 23% of total bank earnings from operations in the third quarter, down from a high of 29% in Q4/08.

Wholesale Banking Earnings Weaken

• Wholesale banking earnings were $179 million, down 45% from $327 million a year earlier, although down only 19% from $220 million in the previous quarter. The bank views these wholesale earnings as a more normal level.

Trading Revenue Declines but Doesn't Collapse

• Trading revenue declined to $300 million versus $402 million in the previous quarter and a record $633 million a year earlier.

• Interest rate and credit trading revenue was weak at $107 million versus $440 million a year earlier and $193 million in the previous quarter. Equity and other trading revenue increased to $94 million from $39 million a year earlier but declined from $105 million in the previous quarter. Foreign exchange trading revenue declined to $99 million versus $154 million a year earlier and $104 million in Q2/10.

Capital Markets Revenue Stable

• Capital markets revenue was $318 million versus $368 million in the previous quarter and $342 million a year earlier. Underwriting and advisory included in capital markets revenue was down at $77 million versus $83 million in the previous quarter and $105 million a year earlier.

Security Gains Low - Unrealized Security Surplus Modest

• Security gains were low at $10 million or $0.01 per share versus $47 million or $0.04 per share in the previous quarter and a loss of $90 million or $0.07 per share a year earlier. Unrealized security surplus declined to $269 million from $285 million in the previous quarter.

Securitization Revenue and Economic Impact

• Loan securitization revenue declined to $110 million from $123 million in the previous quarter.

• Securitization economic impact was positive $68 million pre-tax, or an estimated $0.05 per share after-tax, versus $0.07 per share in the previous quarter and $0.04 per share a year earlier. Securitization activity is recorded in the Corporate segment.

Loan Loss Provisions

• Specific loan loss provisions declined to $339 million or 0.51% of loans from $425 million or 0.67% of loans in the previous quarter and from $492 million or 0.76% of loans a year earlier.

• We have reduced our 2010 LLP forecast to $1,650 million or 0.61% of loans from $1,800 million or 0.67% of loans. Also, we have reduced our 2011 LLP forecast to $1,300 million or 0.47% of loans from $1,600 million or 0.56% of loans due to improving credit trends.

Loan Formations Decline

• Gross impaired loan formations before debt securities and FDIC covered loans declined to $835 million versus $852 million in the previous quarter, the lowest it has been since Q4/08. U.S. gross impaired loan formations declined to US$375 million from US$393 million in the previous quarter.

• Gross impaired loan formations were $1,181 million in the quarter, including $346 million in debt securities classified as loans and FDIC covered loans versus $1,273 million including $421 million in debt securities classified as loans in the previous quarter.

• Gross impaired loans increased to $3,337 million (including $1,160 million in debt securities reclassified as loans and FDIC covered loans) or 1.25% of loans from $3,032 million (including $814 million in debt securities) or 1.16% of loans in the previous quarter.

• Debt securities gross impaireds increased in the quarter, however the fair value of this portfolio (Commerce acquisition, March 2008) is greater than the book value or carrying value.

• Net impaired loans increased to $758 million from $430 million the previous quarter due mainly to the debt securities reclassification.

Tier 1 Capital – 12.5%

• Tier 1 ratio increased to 12.5% versus 12.0% in the previous quarter and 11.1% a year earlier. Total capital ratio was 16.0% versus 15.5% in the previous quarter.

• Tangible common equity to risk-weighted assets (TCE/RWA) increased to 11.7% versus 10.3% the previous quarter.

• Book value per share increased 7% from a year earlier to $43.41.

• Risk-weighted assets were flat from a year earlier at $189.2 billion and increased 1% QOQ.

• • • • • • • • •


01 September 2010

Scotiabank Q3 2010 Earnings

TD Securities, 1 September 2010

Investment Thesis. The quarter was largely inline with updated expectations in terms of the bottom-line number and key themes.

Domestic Retail turned in another good quarter despite softer margins on good volumes and improving credit. Overall, credit came on much better than expected. Wholesale was soft, but not materially disappointing relative to reduced expectations. To us, International had a decent quarter and continued to earn through some headwinds reasonably well.

From here, we expect growth in Domestic retail on modest volumes and improved credit, and better Wholesale on a potential bounce back in Trading. International remains the key variable in our view. We believe we have been conservative, but expect to see some improved trends in the coming quarters with the potential for a much stronger earnings contribution.

Scotia remains among the best positioned of any of the Canadian banks to capitalize on a recovery scenario in our view (i.e. superior growth in International, easing credit costs, a return of Business lending). Despite some strong recent performance, on our unchanged Target Price we see good upside. Reiterate Buy.

Reaction to Q3/10 Results. There appeared to be very little to get overly worried or excited about in Scotia’s results this quarter. Investors continue to note the strength of the volume trends in the bank’s Domestic Retail operations, having been among the best in the group for the last 2-3 quarters. However, the notable down tick in margins is somewhat worrisome (more on that below).

There was a fairly muted response in the stock initially, but it closed the day down just over 1% amid a mixed tape for the Canadian banks.

Better than expected credit trends were encouraging, relative to concerns that Scotia’s PCLs might run higher for longer, given the bank’s International and Commercial/Business focus. However, improving credit has really ceased to be much of a catalyst for higher expectations.

The wildcard in our view, and in the view of many clients, continues to be International. Through some noise on the quarter, the bottom-line result seems to have been largely inline with broad expectations (it was better than our number) and it is encouraging that the segment can continue to earn through some headwinds.

However, underlying volume trends (to the extent they can be deciphered) appear to be fairly modest. This is not entirely surprising, and we still hold a fairly constructive outlook, but at this stage it does require some faith/optimism that trends will eventually pick-up; which we find some investors continue to doubt.

Key Issues

Time to worry about Domestic Retail trends? In looking across the Q3 results so far, the incremental news for us has been evidence of some slightly worse than expected pricing and competitive pressure in the domestic market as evidenced by the margin trends.

To us, certainly part of the pressure reflects the rate environment of low absolute rates, the compression in the Prime-BA spread on the quarter and the general strength in the mid-part of the yield curve.

However, against this backdrop, commentary suggests that the big wave of re-pricing has now largely washed through the results. Instead, we are now seeing an incremental increase in competitive activity, particularly in residential housing (both traditional mortgages and HELOC products). Likewise, the banks have stepped up competition in the deposit market.

At this stage, we do not see evidence of irrational behaviour (which tends to correct relatively quickly in any case). Although we had not factored into our numbers, we had previously noted the potential for margins to expand in a world of increasing reference rates. At this point, we are more inclined to say margins will be flat to up (very) slightly, with a lower probability of a notable up-tick from here.


We have made next to no changes to our model. In our outlook for next year, we see earnings running north of C$1.10 per quarter as PCLs decline and International starts to show some modest acceleration (and even further acceleration heading into 2012).

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

The bank basically delivered an in-line quarter consistent with the key Q3 themes to date with good Domestic, strong credit and softer Wholesale results. We see potential upside in International. Reiterate Buy.