Scotia Capital, 22 February 2012
Banks Begin Reporting February 28
• Banks begin reporting first quarter earnings with Bank of Montreal (BMO) on February 28, followed by Toronto-Dominion Bank (TD), Royal Bank (RY), and National Bank (NA) on March 1, Bank of Nova Scotia (BNS) on March 6, Canadian Western Bank (CWB) and Laurentian Bank (LB) on March 7, and Canadian Imperial Bank of Commerce (CM) closing out reporting on March 8.
• Scotiabank GBM’s earnings estimates are highlighted in Exhibit 2, consensus earnings estimates in Exhibit 3, and conference call information in Exhibit 4.
IFRS Adoption
• Canadian banks have converted to International Financial Reporting Standards (IFRS) starting fiscal 2012 (effective November 1, 2011), with the first quarter marking the first earnings reported under IFRS. In preparation for the transition, the banks have provided their 2011 financial position and results of operations under IFRS.
• The overall financial impact on 2011 financial statements is modest. In summary, total assets increased on average 6%, with loan balances increasing on average 19%, and common equity declining 9%. Cash operating EPS impact ranged from -4% to +3%. Return on equity increased 2.0%, to 19.5%.
First Quarter Earnings - 3% YOY Decline, Up 8% Sequentially
• The sovereign debt crisis in Europe continued to heighten systemic risk in the first half of the quarter, leading to capital markets strain and negatively impacting economic growth globally, with Canada not immune. The intensity of the crisis, while still elevated, showed signs of easing in the latter half of the quarter as demonstrated by improving LIBOR-OIS spreads and lower sovereign/global banks CDS spreads.
• We expect a sequential improvement in wholesale earnings off the lows, with wealth management to be stable and retail banking earnings resilient, although growth is slowing. Retail banking earnings are dependent on net interest margin performance/pressure as volume growth slows. Our first quarter earnings estimates are 2% above consensus.
• We expect return on equity (IFRS) to increase to 17.9% versus 17.3% in the previous quarter (16.3% under Canadian GAAP). The improvement in ROE is aided by the transition to IFRS and the resulting reduction in common equity (retained earnings). Return on risk-weighted assets (RRWA) remains extremely high at 2.35% versus 2.21% in the previous quarter.
• The two main earnings variables to focus on this quarter, in our view, are trading revenue and the retail net interest margin.
• Trading revenue will likely remain weak, but is expected to improve quarter over quarter. We expect trading revenue to be $1.4 billion, a 33% increase sequentially but 42% lower year over year (YOY). The sequential trading improvement is expected from fixed income, with 10-year Canadian and U.S. government bond yields declining 39 bps and 32 bps, respectively. Also, fixed income underwriting activity increased both domestically and globally. Government bond and corporate bond underwritings increased sequentially by 11% and 127%, respectively, which is expected to translate into higher trading volumes. TSX average trading volumes (equity) were relatively soft, declining 11% quarter over quarter (QOQ), although the S&P/TSX Composite Index increased 2% in the quarter. M&A activity was solid, increasing 19% sequentially. Overall, we expect bank group underwriting and advisory revenue to rebound by 42% sequentially to $965 million from the very low fourth quarter level.
• The other focus variable is the retail net interest margin. We continue to forecast a decline of 2 basis points per quarter out to the end of 2013. Rational pricing is required to mitigate some of the margin pressure.
• Credit trends remain stable with loan loss provisions expected to decline modestly to $1.5 billion or 0.37% of loans.
Dividend Increases Expected in 2012 - Timing Discretionary
• The bank group’s dividend payout ratio is currently 43% of our 2012 earnings estimates versus the bank group target payout ratio range of 40% to 50%, so just slightly below the midpoint of the range. In our view, the strongest candidates for dividend increases in fiscal 2012 based on target payout ranges (see Exhibit 5) are LB, NA, CWB, and TD, followed by BMO, BNS, CM, and RY. We expect dividend growth in 2012 to mirror earnings growth in the 6%-7% range.
• For the quarter, the banks may elect to modestly increase dividends in the 3%-4% range, but may elect to keep dividends unchanged for a 6%-8% increase later in 2012. Timing is extremely discretionary.
Bank Share Performance & Valuations
• Canadian bank share prices substantially outperformed the TSX in 2011 despite systemic risk rising sharply as the European sovereign debt crisis escalated. As systemic risk abates and normalcy returns to the capital markets, we believe bank stocks will be well positioned for another period of strong outperformance.
• The Canadian bank index outperformed the market by 10% in 2011 and is performing in line with the market, up 4% year-to-date as at February 17, 2012. The bank beta trade has been on thus far in 2012, with Bank of America, Citigroup, and JP Morgan up 44%, 25%, and 16%, respectively, versus 4% for Canadian banks.
• The market continues to chase high dividend yielding sectors, creating valuation premiums in Pipes & Utilities and REITs, but not banks because of systemic risk. The negative impact of systemic risk on valuations is evident when you compare bank dividend yields versus Pipes & Utilities (see Exhibit 11) and REITs (see Exhibit 12), where systemic risk is relatively low. Bank dividend yields are now 1.0 standard deviations above the mean versus Pipes & Utilities and 2.4 against REITs.
Maintain Overweight Recommendation
• Our share price targets remain unchanged. Our share price targets are based on 12.6x our 2012 earnings estimates and we believe are extremely conservative in the context of the interest rate environment, dividend levels, and capital generation rates.
• In fact, if Pipes & Utilities can trade at 20x to 22x earnings, we believe a banks stock can trade at 16x to 17x in a period of low systemic risk and perhaps a period where the market recognizes the decline in the risk premiums post the full implementation of Basel III and the global restructuring of the banking industry.
• We maintain 1-Sector Outperform ratings on TD, CM, and RY, 2-Sector Perform ratings on CWB, BNS, and LB, and 3-Sector Underperform ratings on BMO and NA.
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Banks Begin Reporting February 28
• Banks begin reporting first quarter earnings with Bank of Montreal (BMO) on February 28, followed by Toronto-Dominion Bank (TD), Royal Bank (RY), and National Bank (NA) on March 1, Bank of Nova Scotia (BNS) on March 6, Canadian Western Bank (CWB) and Laurentian Bank (LB) on March 7, and Canadian Imperial Bank of Commerce (CM) closing out reporting on March 8.
• Scotiabank GBM’s earnings estimates are highlighted in Exhibit 2, consensus earnings estimates in Exhibit 3, and conference call information in Exhibit 4.
IFRS Adoption
• Canadian banks have converted to International Financial Reporting Standards (IFRS) starting fiscal 2012 (effective November 1, 2011), with the first quarter marking the first earnings reported under IFRS. In preparation for the transition, the banks have provided their 2011 financial position and results of operations under IFRS.
• The overall financial impact on 2011 financial statements is modest. In summary, total assets increased on average 6%, with loan balances increasing on average 19%, and common equity declining 9%. Cash operating EPS impact ranged from -4% to +3%. Return on equity increased 2.0%, to 19.5%.
First Quarter Earnings - 3% YOY Decline, Up 8% Sequentially
• The sovereign debt crisis in Europe continued to heighten systemic risk in the first half of the quarter, leading to capital markets strain and negatively impacting economic growth globally, with Canada not immune. The intensity of the crisis, while still elevated, showed signs of easing in the latter half of the quarter as demonstrated by improving LIBOR-OIS spreads and lower sovereign/global banks CDS spreads.
• We expect a sequential improvement in wholesale earnings off the lows, with wealth management to be stable and retail banking earnings resilient, although growth is slowing. Retail banking earnings are dependent on net interest margin performance/pressure as volume growth slows. Our first quarter earnings estimates are 2% above consensus.
• We expect return on equity (IFRS) to increase to 17.9% versus 17.3% in the previous quarter (16.3% under Canadian GAAP). The improvement in ROE is aided by the transition to IFRS and the resulting reduction in common equity (retained earnings). Return on risk-weighted assets (RRWA) remains extremely high at 2.35% versus 2.21% in the previous quarter.
• The two main earnings variables to focus on this quarter, in our view, are trading revenue and the retail net interest margin.
• Trading revenue will likely remain weak, but is expected to improve quarter over quarter. We expect trading revenue to be $1.4 billion, a 33% increase sequentially but 42% lower year over year (YOY). The sequential trading improvement is expected from fixed income, with 10-year Canadian and U.S. government bond yields declining 39 bps and 32 bps, respectively. Also, fixed income underwriting activity increased both domestically and globally. Government bond and corporate bond underwritings increased sequentially by 11% and 127%, respectively, which is expected to translate into higher trading volumes. TSX average trading volumes (equity) were relatively soft, declining 11% quarter over quarter (QOQ), although the S&P/TSX Composite Index increased 2% in the quarter. M&A activity was solid, increasing 19% sequentially. Overall, we expect bank group underwriting and advisory revenue to rebound by 42% sequentially to $965 million from the very low fourth quarter level.
• The other focus variable is the retail net interest margin. We continue to forecast a decline of 2 basis points per quarter out to the end of 2013. Rational pricing is required to mitigate some of the margin pressure.
• Credit trends remain stable with loan loss provisions expected to decline modestly to $1.5 billion or 0.37% of loans.
Dividend Increases Expected in 2012 - Timing Discretionary
• The bank group’s dividend payout ratio is currently 43% of our 2012 earnings estimates versus the bank group target payout ratio range of 40% to 50%, so just slightly below the midpoint of the range. In our view, the strongest candidates for dividend increases in fiscal 2012 based on target payout ranges (see Exhibit 5) are LB, NA, CWB, and TD, followed by BMO, BNS, CM, and RY. We expect dividend growth in 2012 to mirror earnings growth in the 6%-7% range.
• For the quarter, the banks may elect to modestly increase dividends in the 3%-4% range, but may elect to keep dividends unchanged for a 6%-8% increase later in 2012. Timing is extremely discretionary.
Bank Share Performance & Valuations
• Canadian bank share prices substantially outperformed the TSX in 2011 despite systemic risk rising sharply as the European sovereign debt crisis escalated. As systemic risk abates and normalcy returns to the capital markets, we believe bank stocks will be well positioned for another period of strong outperformance.
• The Canadian bank index outperformed the market by 10% in 2011 and is performing in line with the market, up 4% year-to-date as at February 17, 2012. The bank beta trade has been on thus far in 2012, with Bank of America, Citigroup, and JP Morgan up 44%, 25%, and 16%, respectively, versus 4% for Canadian banks.
• The market continues to chase high dividend yielding sectors, creating valuation premiums in Pipes & Utilities and REITs, but not banks because of systemic risk. The negative impact of systemic risk on valuations is evident when you compare bank dividend yields versus Pipes & Utilities (see Exhibit 11) and REITs (see Exhibit 12), where systemic risk is relatively low. Bank dividend yields are now 1.0 standard deviations above the mean versus Pipes & Utilities and 2.4 against REITs.
Maintain Overweight Recommendation
• Our share price targets remain unchanged. Our share price targets are based on 12.6x our 2012 earnings estimates and we believe are extremely conservative in the context of the interest rate environment, dividend levels, and capital generation rates.
• In fact, if Pipes & Utilities can trade at 20x to 22x earnings, we believe a banks stock can trade at 16x to 17x in a period of low systemic risk and perhaps a period where the market recognizes the decline in the risk premiums post the full implementation of Basel III and the global restructuring of the banking industry.
• We maintain 1-Sector Outperform ratings on TD, CM, and RY, 2-Sector Perform ratings on CWB, BNS, and LB, and 3-Sector Underperform ratings on BMO and NA.
