17 November 2010

Preview of Banks' Q4 2010 Earnings

Scotia Capital, 17 November 2010

Banks Begin Reporting November 30 – Earnings Sluggish

• Banks begin reporting fourth quarter earnings with National Bank (NA) on November 30 (after market close), followed by Canadian Imperial Bank of Commerce (CM) and Toronto-Dominion (TD) on December 2, Royal Bank (RY) and Bank of Nova Scotia (BNS) on December 3, Bank of Montreal (BMO) and Canadian Western (CWB) on December 7, and Laurentian Bank (LB) closing out reporting on December 8.

• Scotia Capital’s earnings estimates are highlighted in Exhibit 1, consensus earnings estimates in Exhibit 2, and conference call information in Exhibit 3.

Fourth Quarter Earnings – Sluggish – Moderate Growth

• We expect fourth quarter operating earnings to increase 6% year over year (YOY) and 5% sequentially (partial recovery in trading revenue). We expect retail banking earnings growth to begin to slow, with wholesale earnings remaining weak, although partially rebounding from the previous quarter. We also expect wealth management earnings to improve.

• Earnings growth YOY is expected to be led by CWB, BNS, NA, CM, and LB at 26%, 20%, 16%, 16%, and 16%, respectively. On a quarter-over-quarter (QOQ) basis, RY should have the biggest rebound at 14%, but the weakest YOY down 7%, as it is up against tough comps.

• We believe dividend increases are possible this quarter, which would be the first increases in two years. This is the longest dry spell for dividend increases since 1957. The release of Basel III capital requirements and the OSFI advisory removing Capital Conservatism has paved the way for increases – payout ratios permitting.

• In terms of dividend payout ratios, CWB, LB, NA, and to a lesser extent, TD, have an opportunity to increase their dividends. We expect CWB, LB, and NA to announce increases of 18%, 11%, and 10%, respectively (see Exhibit 4). TD could surprise with a 7% increase, but it is unlikely. The other banks, we expect, need some earnings growth and greater clarity on earnings for 2011 and 2012, given their payout ratios are above their target ranges.

• Earnings and payout ratios, we believe, are constraining dividend growth, not capital, as our pro forma Tier 1 common at the end of fiscal 2010 is estimated at 8.9%, and given the transition period, will be far in excess of minimum requirements, including proposed and possible capital buffers. Tier 1 common could reach over 13% by 2018. Also, it is important to note that a 5% dividend increase only consumes 5 bp of capital, and if Canadian banks are generating well over 200 bp per annum or 100 bp even assuming a 50% payout ratio, this capital consumption is a moot point.

• Banks’ fourth quarter earnings are expected to be solid but sluggish compared to past cycle recoveries as the last half of 2010 has been negatively impacted by weak wholesale earnings, especially compared to the record wholesale earnings in fiscal 2009. Also, the recovery in Canadian banks’ net interest margin has stalled in the past few quarters. Retail banking earnings are being driven by volume growth, which is slowing, and operating leverage.

• The banks’ overall net interest margin could be under some renewed pressure with higher BA costs, a flatter yield curve, and increased retail bank price competition. The positive impact of higher short-term interest rates takes time to filter through, and there are offsetting pressures. Volume growth slowing is expected to keep pressure on pricing. The residential mortgage GIC spread (posted) in both the one- and five-year term has declined meaningfully in Q4, even from Q3 levels. This is the biggest breakdown in posted spreads since 1982. The caveat is that drawer rates have become more of a factor in the past 10 years; nevertheless, this may be a signal of more aggressive competition.

• Wholesale banking earnings are expected to remain weak, although we expect a partial recovery in trading revenue to $1.9 billion versus $1.2 billion in the previous quarter, but significantly below the $2.9 billion level a year earlier. We expect sequential partial trading revenue recoveries from BMO and RY. Underwriting and advisory revenue is expected to be down YOY and QOQ.

• Credit trends remain positive, with gross impaired loan formations declining. Loan loss provisions are generally declining but lumpy and are expected to be up slightly sequentially, but down 31% YOY to $1.7 billion and expected to remain in the 50-60 bp range, with further declines expected to begin again in 2011.

• International earnings should begin to improve, as the drag from the high C$ is declining. The C$ has appreciated 4% YOY in Q4 vs. 9% YOY in Q3 and a peak of 21% YOY in Q2. The C$ appreciation QOQ is only 1% and we expect the C$ drag to be de minimis going forward. Notwithstanding the currency, International earnings improvements are expected to be modest.

• Quarterly earnings variables (see Exhibits 5, 6, and 7) remain mixed this quarter, with positives such as lower bond yields, higher prime savings rate spread, higher fixed income underwriting, higher equity trading volume, and higher mutual fund assets, offset by negatives such as flatter yield curve, slightly lower wholesale spreads, substantially lower posted mortgage GIC spreads, higher short-term funding costs (BAs), lower equity underwriting, and weaker M&A activity.

• Bank profitability this quarter is expected to remain solid, although with a lower return on equity at 16.3% due to continued wholesale banking weakness, net interest margin pressure, and deleveraging. However, on RRWA, profitability is expected to hit a new high of 2.20%.

• Bank earnings beat Street expectations for most of fiscal 2009 and the first quarter of 2010. However, Q2/10 earnings marked the first quarter since the earnings recovery began in which banks did not exceed expectations, with Q3/10 being weaker than expected.

• We expect another soft quarter, as we believe earnings estimates are still a little aggressive given the slowdown in capital market (including Euro Crisis hangover), low growth, and increasing retail banking competition. BMO, CM, and NA are back competing strongly in the retail space, and non-traditional players are entering the market.

• We believe that CM and NA (aided by dividend increase) will have the best share price momentum post the quarter and TD should also recover from its weak relative performance since third quarter results. We expect BMO and RY trading revenue to recover somewhat, but we believe earnings estimates are too aggressive and valuations susceptible to some retracement.

• 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 position the bank group for the resumption of dividend growth.

Valuations Attractive – High Dividend Yield

• Bank valuations remain very attractive with a dividend yield of 3.9%, which is 126% of the 10-year bond yield and 172% of the TSX dividend yield versus historical means of 59% and 145%, respectively. The bank earnings yield relative to corporate bond yields is 179% versus the historical mean of 131%.

• Bank P/E multiples, we believe, are attractive at 11.5x 2011 earnings estimates and are poised for expansion. In our opinion, bank P/E multiples have formed a base and support at 12x, which we expect will 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.

Maintain Overweight – Dividend Increases Needed to Fuel Rally

• Bank share price performance has been muted in the past quarter based on sluggish earnings, concerns about the economic recovery, and nervousness about sovereign debt, as well as a hot commodity market. Investor interest in bank stocks have fallen off a cliff, with commodities in vogue, which has coincided with bank stocks not participating in rallies but showing modest but continual weakness in pullbacks. These have not been positive signs for the overall market in the past.

• We believe bank fundamentals are strong and valuations are attractive; however, we continue to believe that the key catalysts for a sustained rally in bank stocks and higher P/E multiples are dividend increases.

• We are hopeful that banks that can increase their dividends this quarter will do so, rather than having a wait-and-see approach (Q1/11 or Q2/11).

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