09 March 2011

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.