Review of Banks' Q1 2011 Earnings

Scotia Capital, 9 March 2011

Bank First Quarter Earnings – Recovery Jump Starts – Blow-Out

• Canadian banks produced a blow-out quarter, jump starting the earnings recovery cycle after 18 months of grinding through a credit overhang and a low growth economic recovery. First quarter earnings increased 18% YOY and 23% sequentially, much higher than expected. RY produced the largest beat (see Exhibit 2) followed by TD, CM, NA, BNS, BMO, and CWB.

• RY’s beat was impressive at 26%, followed by TD, CM, and NA at 13%, 12%, and 10%, respectively. BMO and BNS’ beats were very modest at 2% and 3%, respectively.

• The bank group’s profitability was impressive with return on equity of 19.0% and RRWA of 2.53%. ROE was the highest level since Q3/08 on high capital levels with RRWA a record. TD led the group with RRWA of 3.06% followed by CM and RY at 2.89% and 2.79%, respectively.

• Retail banking earnings remained very strong as a stable net interest margin and solid volume growth and controlled expenses continued to drive earnings. Wealth management earnings growth accelerated materially as higher asset levels and market activity provided very positive operating leverage. Wholesale earnings also rebounded due to high level of underwriting and advisory fees with trading revenue a significant rebound from the weak last half of 2010.

• Trading revenue rebounded to $2.5 billion in the first quarter, significantly off lows of $1.2 billion and $2.0 billion in the third and fourth quarter of 2010, respectively, but below the first quarter 2010 level of $2.8 billion, and well below the record of $3.5 billion in Q1/09.

• Credit trends remained positive with lower impaired loan formations and lower loan loss provisions, although banks do not have the same leverage to declining loan loss provisions as in past cycles.

• Loan loss provisions declined to $1.5 billion or 0.46% of loans from $1.6 billion or 0.50% of loans in the previous quarter and $2.1 billion or 0.68% of loans a year earlier.

• TD and BNS both increased their common dividends this quarter 8% and 6%, respectively, thus dividend growth mode has returned. This follows increases by CWB, NA, and LB of 18%, 6.5%, and 8%, respectively, in the previous quarter. We expect RY and perhaps CM to increase their dividend in 2011 with further increases likely from CWB, NA, and LB. The bank group's dividend payout ratio on our 2011 earnings estimate is currently 43% with the bank groups target payout ratio generally in the 40% to 50% range with BMO's high-end 55% and TD's high-end 45%. We now have had two quarters of back-to-back dividend increases after two years of treading water.

• The banks’ capital levels remained strong with a Tier 1 ratio of 13.3% versus 13.1% in the previous quarter and TCE/RWA of 10.2% versus 10.1% in the previous quarter.

Share Price Targets – Valuation – Recommendations

• Our one-year share price targets for BMO, BNS, NA, and CWB were unchanged at $68,$72, $90, and $38, respectively. We did, however, increase our one-year share price target for TD to $105 from $100, CM to $105 from $100, and RY to $75 from $65.

• Bank valuations, we believe, remain attractive with a dividend yield of 3.6%, which is 1.8x standard deviations above its historical mean versus 10-year bond yields and 1.8x standard deviations above the mean versus AA Corporate bond yields.

• Bank P/E multiples are also attractive at 14.1x, 12.1x, and 10.9x trailing, 2011E and 2012E, respectively.

• We expect dividend increases to continue to be a catalyst for bank share price preciation. We believe that bank risk premiums will decline materially below historical levels as the industry returns to some normalcy post Basel III. We expect P/E multiples to expand to the 15x to 16x level. Our 12-month target prices are based on a 14.8x P/E multiple on our 2011 earnings estimates for Total ROR of 26%.

• We reiterate our Overweight Recommendation for the bank group. We reiterate our 1-SO rating on TD, RY, and CM. We maintain our 2-SP rating on BNS, NA, CWB, LB, and BMO.

• We in general prefer banks that are able to generate capital the fastest (i.e., the highest) RRWA, which are TD, CM, and RY.

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Scotiabank Q1 2011 Earnings

The Wall Street Journal, Caroline Van Hasselt, 8 March 2011

Bank of Nova Scotia capped off a solid first-quarter earnings season for Canada's biggest banks by posting a record first-quarter profit after sharply reducing credit-loss provisions in its domestic and international banking units.

Scotiabank, as it is known, also raised its quarterly dividend by 6%, becoming the second of the five big banks to increase its payout since the 2008 global financial crisis.

Net income for the quarter ended Jan. 31 rose to a record C$1.17 billion, or C$1.07 a share, from C$988 million, or 91 Canadian cents, a year earlier, the bank said. Operating earnings of C$1.09 a share surpassed the Thomson Reuters mean estimate of C$1.06 and were up from 93 Canadian cents a year earlier.

Revenue rose 5% to C$4.2 billion, with acquisitions accounting for almost half of the increase.

Canada's big lenders have benefited from the country's robust housing market and consumers' willingness to borrow and spend against a backdrop of continued economic growth, job creation and low interest rates. They have boosted deposits and are benefiting from strong retail franchises.

"All in all, it was a great quarter for the Canadian banks," said John Kinsey, a portfolio manager at Caldwell Securities Ltd. in Toronto, which manages about C$1 billion in assets.

Like its peers, Scotiabank, the country's third-largest bank in assets, benefited from its strong Canadian franchise. Improved credit quality in emerging economies, particularly in the Asia-Pacific and Latin American regions where it is active, enabled the bank to reduce loan-loss provisions. But the bank also benefited from a lower-than-expected tax rate and racked up higher expenses from acquisitions, higher stock-based compensation and pension costs.

"Scotia marches to the beat of a different drummer than the others," Mr. Kinsey said. "They have a lot of international business. So, some of their business is higher risk, but perhaps higher reward. But both the Canadian and international personal banking did very well for them."

Scotiabank's provision for credit losses declined sharply to C$269 million from C$371 million a year earlier, reflecting an improved global economy and higher recoveries from U.S. loans, the bank said. In Canada, provisions fell 10%, while in international, provisions declined 65%, mostly from commercial portfolios in the Caribbean and Peru and lower retail provisions in Mexico from a one-time recovery under the Mexican government's mortgage support program.

Scotiabank has operations in 50 countries, including the Cayman Islands, Jamaica, Chile, Mexico, Peru, Puerto Rico and Thailand. In the quarter, it acquired Royal Bank of Scotland Group's's corporate and commercial banking business in Chile and agreed to buy Nuevo Banco Comercial, Uruguay's fourth-largest private bank in loans and deposits, and Pronto!, the country's third-largest consumer finance company.

In Canada, Scotiabank's earnings rose 14% to C$496 million, primarily from 9% growth in residential mortgages and 2% increase in other consumer loans. Average deposits grew 3%.

In international, earnings rose 35% to C$342 million, reflecting retail and commercial loan growth and the contributions from recent acquisitions in Puerto Rico and Thailand.

The bank's newly created global wealth-management division earned C$216 million, up 18%, on increased sales of mutual funds and financial products.

Net income at Scotia Capital fell 19% to C$308 million, reflecting more normalized market conditions, the bank said. The investment bank garnered higher capital-markets trading revenue but non-trading fee and spread revenues were off marginally, said National Bank Financial analyst Peter Routledge.

Return on equity was 18.7% versus 17.4%.

Scotiabank increased its dividend to 52 Canadian cents a share from 49 Canadian cents, payable on April 27 to holders of shares of record on April 5. The country's second-largest lender, Toronto-Dominion Bank, raised its dividend last week.

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RBC Q1 2011 Earnings

TD Securities, 4 March 2011

Investment Thesis. After a series of muddled quarters, Royal came through with a solid well rounded result. To us, this quarter is a truer reflection of what we believe to be the underlying earnings power of the platform. With better evidence in hand, we increased our operating outlook coming out of the quarter.

We continue to view Royal as a solid banking franchise and we expect the broader sentiment around the stock to improve. We look for earnings power to continue to develop favourably through the year and into 2012. On our revised outlook and Target Price we see reasonable upside from yesterday’s close. However, with the name now up over 12% over the past couple of weeks, the likely returns are not quite as generous. We see roughly 15% Total Return over the coming 12-months. We reiterate our Buy rating.

Reaction to Q1/11 Results. The market responded very positively to a solid report that appears to have comfortably exceeded even raised expectations heading into yesterday. In a strong day for Canadian bank stocks, Royal was up roughly 5.25%.

Investors seemed to be impressed with the surprisingly good strength across much of the bank’s businesses, particularly the Domestic P&C franchise which delivered good volumes, improved margins, lower PCLs and better credit expense control after an up-tick in Q4.

Capital Markets had a very strong quarter, ahead of our estimates and one of the better quarters over the past few years (although off peak levels). This was used to somewhat discount the strength of the quarter, and management did suggest the result was at the high-end of the likely range for the year. We continue to view the Wholesale business as a C$400-C$500 million per quarter (with some growth) contribution.

The biggest surprise came in U.S./International. To us, the C$157 million loss in Q4 represented a material understatement of the earnings power. In our last note, we considered the significant potential for the segment to recover and contribute meaningfully. That happened much more quickly than anticipated as the segment moved to a small profit (adjusting for non-core items) on the quarter. However, we would not sound the all clear at this point, but we have greater comfort that the segment will shift from a material drag to steady contributor by late 2011 and early 2012.

There was some resistance to extrapolating the measure of one quarter. However, we believe the past few quarters were the anomaly and taking what we feel is a reasonably conservative outlook, we remain comfortable with the earnings power of the platform.

In terms of dividends, we continue to expect the bank to raise its dividend in Q3/11. We expect the bank to raise the dividend by C$0.03 per share to C$0.53 (up from our previous estimate of C$0.52) or by 6%, reflecting an expected payout ratio of 43.8% versus the bank’s stated target range of 40-50%.

Valuation. The stock has recovered gradually over the past few months, capped with yesterday’s strong upward move. With what we expect will be a healthy round of upward revisions to estimates, earnings have caught back up with the share price. At these levels, we view valuations as only modestly attractive, with the name trading at 12.1x our revised forward earnings or 2.4x Q1/11 reported book value.

Outlook We had previously assumed that the bank would generate better earnings through the back half of 2011 as the U.S. drag subsided and the businesses enjoyed core growth. The drag reversed more quickly than we anticipated and the core businesses are performing better than we had modeled. As a result, our estimates are up for both 2011 and 2012 to C$4.80 from C$4.25 and to C$5.25 from C$4.75 respectively. Our model still assumes the U.S. sees losses over the balance of the year, and we believe the contribution from Wholesale will be lower. However, the outlook still suggests to us a reasonable run-rate on the order of C$1.25+/- per quarter in H2/11.

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TD Bank Q1 2011 Earnings

Financial Times, Bernard Simon, 3 March 2011

Canada’s two biggest financial institutions, Royal Bank of Canada and Toronto-Dominion, reported stronger-than-expected quarterly profits on Thursday, with TD lifting its dividend for the first time since the onset of the financial crisis.

RBC’s earnings hit a record C$1.84bn (US$1.89bn) in the three months to January 31, up 23 per cent from a year earlier. TD lifted earnings by 19 per cent to C$1.54bn, including record profits at its US and Canadian retail operations.

“It was a great quarter for both banks,” said Peter Routledge, analyst at National Bank Financial. Both benefited from lower loan loss provisions as a result of improved economic conditions.

However, Mr Routledge said that RBC may have felt less confident about lifting its dividend because of its heavier dependence on volatile capital markets business.

RBC lost its Moody’s triple-A credit rating last December because of its growing capital markets exposure.

TD is one of only five banks worldwide that still boasts a triple-A rating. Ed Clark, chief executive, forecast “a very good year” ahead, citing “TD’s strong capital position, ongoing investments in our franchises and the proven strength of our retail-focused strategy.”

The Canadian banks came through the financial crisis in far healthier condition than many of their US and European counterparts thanks to a more conservative lending culture, a resilient housing market and robust regulation.

All maintained their dividends. By contrast, almost every big US bank – Goldman Sachs is one notable exception – slashed its pay-out.

Mr Routledge expects that Bank of Nova Scotia, the number-three bank, will also raise its dividend when it reports next week.

With capital ratios well above regulatory minimums, the Canadian institutions have recently embarked on an acquisition spree.

TD agreed to pay US$6.3bn in cash last December for Chrysler Financial, the US-based vehicle finance group. The deal was part of a drive to expand the services offered through its extensive retail network, now the seventh biggest in the US.

Bank of Montreal signed a deal to buy the Wisconsin-based lender Marshall & Ilsley for $4.1bn, more than doubling its US presence. RBC’s expansion strategy is centred on global capital markets and wealth management.

Gordon Nixon, RBC’s chief executive, told the annual meeting on Thursday that the bank was committed to maintaining a balance between its retail and capital markets business of about 75-25 per cent.

While expressing confidence in the bank’s prospects, Mr Nixon said that “one of the biggest risks we face in Canada is that we push regulation so far ahead of other countries, we end up not only with an uneven playing field but with a real cost to Canadians in the form of compromised ability to grow and compete.”

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Financial Times, Bernard Simon, 3 March 2011

Half-a-dozen intruders recently burst into the TD Bank branch in King of Prussia, Pennsylvania. They were not robbers but a group of bank employees, wearing green hats, waving green balloons and carrying gifts to welcome its new brokerage specialist.

The celebration marked another small step in an ambitious plan by Canada’s Toronto-Dominion Bank to make its mark in US retail banking.

TD Bank in the US is mainly the product of two big acquisitions – Maine-based Banknorth in 2005 and Commerce Bank, based in New Jersey, three years later – that have given the Canadians a presence in every east coast state except Georgia.

TD now operates the seventh-biggest retail bank in the US. With 1,300 branches, it has more outlets south of the border than in Canada.

The Canadians are trying to nudge their US subsidiary in a new direction, which is where the newly arrived brokerage specialist in King of Prussia comes in.

Like many other second-tier US banks, Banknorth and Commerce Bank traditionally focused on gathering cheap deposits through exceptional customer service, then recycling the funds into business loans.

They left other forms of lending mostly to specialised institutions, such as mortgage lenders and carmakers’ captive vehicle-finance companies.

TD wants to shift the emphasis by pushing a wider variety of loans, such as mortgages and car loans, as well as other services such as insurance and portfolio management.

“We are retailers that happen to be in banking,” says Bharat Masrani, head of TD’s US operations.

TD’s US rivals have also tried to move into cross-selling but in many cases with less-than-stellar success. Citigroup, Washington Mutual and Wachovia are among those that strayed from their core retail banking business with disastrous results, particularly amid the subprime mortgage crisis.

Turning branch managers and tellers into hard-nosed salespeople requires a sharp shift in culture, with potentially unpredictable results. As Mr Masrani acknowledges: “Selling is not always an easy conversation. You have to make sure that you win the hearts and minds of your people.”

The Canadians have several advantages. Commerce Bank was known as a maverick even before the acquisition. Using the slogan “America’s Most Convenient Bank”, its “stores” were open longer than most other banks, including Sundays. A Walmart-style greeter stood at the doors.

Toronto-Dominion already has a strong presence in the businesses that it wants its US branches to promote. The new brokerage specialist at the King of Prussia branch works for TD Ameritrade, one of the US’s biggest online brokers, which is 39 per cent owned by Toronto-Dominion.

TD also took a big step into vehicle financing last December, buying Chrysler Financial for $6.3bn.

“They’re sitting on two very powerful franchises on both sides of the border,” says Peter Routledge, analyst at National Bank Financial in Toronto.

The Canadians are confident that they can succeed where others have failed by imbuing TD Bank’s culture with some Canadian politeness, reinforced by rigorous training and a panoply of incentives and rewards.

TD has sought to instil a more sales-oriented culture by building on Commerce Bank’s “WOW!” system, which encourages employees “to surprise and delight” customers and each other. The celebration in King of Prussia was mounted by what the bank calls a WOW Patrol – a group of volunteers who commandeer a WOW van to surprise a colleague.

Mike Carbone, who heads TD’s operations in the Philadelphia area, says: “The more products and services you have with any one client, the less likely they are to leave you.”.

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BMO Q1 2011 Earnings

Scotia Capital, 2 March 2011

• BMO cash operating EPS increased 17% to $1.32, in line. Earnings were driven by very solid results with P&C Canada earnings increasing 10%, Private Client increasing 38% (21% excluding insurance), and BMO Capital Markets increasing 21% with P&C the U.S. earnings weak, declining 15%. Trading revenue was the fourth best quarter ever.

• Underlying earnings were stronger than headlines by an estimated $0.05 per share due mainly to a prior period tax charge in U.S. business segment of BMO Capital Markets.

• Operating ROE: 15.9%, RRWA: 1.81%, Tier 1 Capital: 13.0%.

Implications

• The bank indicated that it anticipates a common equity issue of less than $400 million (20 bp capital) prior to close for M&I, and estimated its Tier 1 Common under Basel III at 6.4%.

• BMO's dividend payout ratio is 53% on 2011E EPS versus the target range of 45%-55%; thus, a dividend increase in 2011 is unlikely.

Recommendation

• Increasing our 2011E and 2012E EPS to $5.30 and $5.90 from $5.20 and $5.75, respectively, due to solid operating results. One-year target is unchanged at $68.

• We maintain our 2-Sector Perform rating.

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