BMO Capital Markets, 8 November 2006
Highlights
• We expect another excellent performance by Canadian banks when they start releasing their fourth-quarter results on November 28, 2006. Earnings are forecasted to be 5–15% ahead of last year, but marginally lower than the operating results in the third quarter. We again believe that the risk to our forecasts is to the upside (i.e. earnings could be better than we predict).
• The major drivers of earnings growth is domestic retail banking reflecting solid asset growth, minor improvements in spreads and good cost control. Specifically, loan growth remains over 10% per annum and the higher levels of short rates should offset the pressures from a flat yield curve. Given that we don’t foresee any deterioration in loan losses, year-over-year increases of 5–20% seem reasonable.
• Capital markets activity remained strong in the quarter. Underwriting and M&A activity appeared to be good and overall volatility did not appear to be unusual. Trading revenues should be similar to the third quarter (for seasonal reasons), but should be well ahead of a disappointing fourth quarter of last year. We expect to see loan losses rise somewhat as the reduced size of impaired loan balances necessarily reduces the potential for recoveries.
• As we look at some of our short-term metrics, it does appear that Royal Bank could have another blow-out quarter (as it did in the second quarter) on the back of capital markets operations. National Bank, however, seemed to be a bit less active than normal. Outside of this, there is little doubt that Royal and TD continue to outclass their peers on domestic retail operations.
• The big debate this quarter will be on dividends. With the decision to tax trust distributions and with one bank (BMO) having moved aggressively on its payout ratio in the second quarter, there is pressure for all banks to move their dividends meaningfully higher over the next 12 months. If bank boards were to decide to pay out 50% of next year’s earnings, there is potential for material dividend increases in the short term. Outside of this, we would expect three banks to increase dividends this quarter: Bank of Montreal, National Bank and Scotiabank. We would not be surprised if CIBC and Royal also joined in to move to return more money to shareholders.
• Our preference is for shares of CIBC, TD and National (all rated Outperform) at current levels. Interestingly, all three have below average existing payouts on 2007 earnings. In our mind, this translates into higher potential for dividend increases over the next 12 months. The CIBC still remains the most intriguing bank equity in our view. Earnings estimates appear to be low, yet it has remade itself into a relatively low-risk, retail-dominated franchise.
Provisions for Loan Losses – Small Increases off a Low Base
We continue to expect modest increases in loan losses from an unusually low base. One element of the unusually low provisioning level over the past year has been a steady stream of recoveries. This gravy train does have an end, and with gross impaired loans down at very low levels, there is a good probability that net provisioning will rise in the next year (Chart 1).
Specifically, we believe that loan losses this quarter will exceed $650 million across the industry with all banks contributing to the increase (Table 1). CIBC’s loan losses will remain stubbornly high—that’s the bad news. The good news is that the bank should be able to manage down its unsecured retail loan losses over the next 12 months to largely offset any problems in the business loan book. Outside of that, we believe that there will continue to be a concerted (if not sequential) increase in provisioning.
We note that there are still few, if any, signs of deterioration in the corporate loan book. One area of concern is the economic weakness in Central Canada, which would affect the SME and commercial loan books. We believe that National and TD could be most affected by such a trend, given their geographic loan mix.
Trading Revenues – Remaining Robust
We believe that trading revenues will remain robust in the fourth quarter, but below first half levels. The volatility in the quarter should not have created problems for most trading platforms. The story in the quarter was the situation at Amaranth, a hedge fund that ran into problems on natural gas futures. While some have expressed concerns on this front, we doubt that there has been a discernible negative impact on the banks. We believe that in aggregate trading revenues will be somewhat lower than in the first half of the year, but will be well ahead of the very poor result in the same quarter of last year, when TD and Royal had difficult conditions (Chart 2).
As always, it is difficult to generalize trading results across banks. Royal should continue to see some moderation after three blow-out quarters, while Scotiabank, which openly admitted its disappointment with third-quarter performance, should see a more normal result. There is little else to differentiate the banks (Table 2).
Dividends – Going Higher
There will be much debate in bank boardrooms regarding dividends this quarter. Two events have clearly crystallized the issue. The first is the obvious, the decision by the Minister of Finance to tax trusts. The second is less omnipresent, but should be no less compelling—it involves the decision earlier this year by the Bank of Montreal to boost its payout range to 45–55% of earnings. The reality is that both these events will pressure bank executives and boards to be more generous on the dividend front.
The first issue, the taxation of trusts, has clearly provided a boost to bank stocks on the basis of their yield attractiveness. Since that inauspicious day, the bank index is up 3.1% and the S&P/TSX overall is unchanged. We broadly believe that the bulk of the money flow has been due to individual investors shifting to companies with high yields or to companies with growing dividends. One wonders how bank boards can ignore the reality that the “average investor” clearly values dividends very highly, and possibly more highly than share buybacks.
The BMO’s decision to raise its payout rate and dividend meaningfully with the release of its second-quarter results could look quite prescient. Again, the short-term (and less than conclusive) evidence suggests that bank share prices are sensitive to dividends and less so to buybacks. We note that since that increase, BMO shares have outperformed the bank index by 1% (BMO shares are up 15% versus the bank index, which is up 14%).
The argument for a more cautious stance, a road well travelled by most bank board members, is based on the concern that boosting payout ratios in late 2006 could well be coinciding with secularly higher ROEs for Canadian banks. Furthermore, with a minority government and what looks like additional tax changes in the Spring 2007 Federal Budget, one could argue for status quo. Whatever the specific decision this quarter, we are confident that bank dividends will be higher in the next 12 months.
As we show below in Table 3, we expect BMO, BNS and NA to move on dividends this quarter, each by 3–8%. In addition, there is certainly some chance that Scotia, National and TD announce an intention to shift their payout target ranges from their modest 35–45% to a more competitive 40–50%. There is also a possibility that Royal and National, both of which have been more aggressive on returning money to shareholders, will go to 45–55% payouts, in line with the BMO. The CIBC has potential to significantly increase dividends, but has indicated that it is most focused on completing the purchase of Barclay’s stake in First Caribbean before fully considering the joint issues of buyback and dividends.
While we don’t expect a wholesale move by the industry on payout ratios this quarter, it is worth quantifying the potential of dividend increases. As we show in Table 4, an across-the-board 50% payout of 2007 earnings would justify very healthy increases in dividends from CIBC, TD and National. We currently recommend all three equities.
Spreads – Should Continue to Grind Higher
We predicted a turn in bank spreads early in 2006, and while the last couple quarters suggest that we are at an inflection point, the jury is still out on the matter. We do believe, however, that there are ongoing developments reinforcing our view that the situation is no longer deteriorating. As we show in Chart 3, we are expecting a further minor improvement in spreads for the overall bank group this quarter.
Several factors are in play. First, the higher average Prime Rate should help margins, as there has not been offsetting repricing of deposits. Second, Prime-BA spreads (which have been under pressure for four quarters) have widened modestly and should help those banks that are more wholesale-funded. Third, we believe that the less competitive position taken by BMO on pricing mortgages should produce some benefits this quarter. As we show in Chart 4, the increases in pricing by BMO arose late in the third quarter, meaning the impact is likely to manifest itself in the fourth quarter (remember that most consumers lock in rates well before they complete the purchase of their homes).
One of the more difficult factors to evaluate is the level of competition in deposit gathering. We broadly believe the role of ING as a price setter has been usurped by new competitors, including Altamira and Dundee. As ING shows, new competitors have no difficulty in overpaying for deposits—they do, however, have a problem in generating consistent levels of profitability.
Loan Growth – Continued Strength this Quarter, but Likely Slowing into 2007
Underpinning our continued positive stance on bank shares is the fact that loan growth continues to be quite strong in Canada. As we show in Chart 5, year-over-year loan growth to the end of September remains very good at 12%. The strength remains broad based, with residential mortgages, the consumer loan book and business borrowing all contributing to overall growth.
Despite the good news in loan growth in the short term, it is not lost on us that the next few quarters will likely see a slowdown. The last 20-odd years have seen four periods where total loan growth exceeded 12%. All of these were followed by periods of much slower growth. In addition, with the strength of the Canadian dollar clearly beginning to have an impact in Central Canada, we would expect business borrowing (which has historically been more volatile) to slow down materially over the next year. We note, however, that the consumer makes up about three-quarters of the overall loan book, so the largest issue will likely continue to be employment growth in Canada.
Capital Markets – Income Trusts Shouldn’t Cause Any Problems in the Quarter
The fourth quarter looks to have been a very reasonable quarter from a capital markets and investment banking perspective, and should be up 10–20% versus the third quarter (and even more versus the same quarter of last year). After the typical summer slowdown, activity levels were reasonable in equities while some concerns on rising rates seemed to push corporations into debt issuance. M&A activity continued to be good, though not as strong as in the first and second quarters.
As always, there were winners and losers. Most notable was the poor performance of National Bank in capital markets. The bank’s limited involvement in mining and the lack of marquee deals by Quebec issuers resulted in what looks like a very weak quarter. At the other end of the spectrum, Royal had what appears to be a very good quarter with notable success in M&A. TD, which isn’t as large a player as some of its peers, also had a good quarter relative to its historical size. As always, we note that the timing of receipt of fees can cause some swings quarter to quarter.
Other Items of Note in the Quarter
Taxes – We have been surprised (even impressed) with the ability of banks to manage down their tax rates over the past couple of years. As we discussed in our recent report (“Banks Make Progress on Tax: Trust Us,” dated November 1, 2006), a meaningful part of the growth rate of banks over the past decade has been due to better tax management and the reduction in tax rates. We believe that this will be a variable that will continue to help banks in the fourth quarter and into 2007.
Securities Gains – After a robust third quarter (complete with the Mastercard gains and strong merchant banking revenues at CIBC), we believe that gains this quarter will be more subdued. Having said that, the level of unrealized securities gains should remain quite robust at TD, Scotiabank and CIBC. With the tremendous performance of Mastercard shares since the IPO, BMO and NA will also be developing a solid cache of latent future profits.
Individual Company Comments
Bank of Montreal – Continued Focus on Spreads and Domestic Volumes
BMO will lead off the earnings parade on Tuesday, November 28, 2006. We expect the BMO to report Cash EPS of $1.25, down from the $1.40 earned in the third quarter and $1.31 in the fourth quarter of 2005. Excluding one-time items that inflated the comparable quarters, we believe that a more appropriate comparison is $1.25 versus $1.30 in Q3 and $1.22 a year ago (Table 5). We believe that the year-over-year improvement reflects volume growth partially offset by higher loan losses, while the quarter-over-quarter decline reflects a somewhat less impressive loan loss result in the wholesale book.
The domestic retail bank should continue to show improvement after a very weak start to the fiscal year. More reasonable mortgage pricing and less aggressive deposit rates should allow BMO to report somewhat better margins. One area worthy of focus is whether the pricing strategy produces any medium-term effect on volume and share.
We expect Chicagoland P&C to be up year over year, given the ongoing growth of branches. Wealth management should be somewhat higher as well (excluding unusuals). The investment bank looks set to complete what will be a record year. Activity levels remain solid (though not as good as in the third quarter) and we expect trading to be stable, despite some market concerns about the impact of Amaranth.
The corporate segment, which includes a plethora of moving parts (including most importantly the benefit of unusually low loan losses), should swing from a surprisingly large profit to a small loss. We are assuming that loan loss reversals will be less additive than in the unusually benign third-quarter and to be more in line with the second half of 2005 and the first half of 2006. Specifically, this means that there should be a loan loss recovery of only $20 million in the corporate segment.
The market will also focus on whether the BMO continues on its trend to return an increased amount of its earnings to shareholders through dividends. We note that the second-quarter dividend increase was very large (a 17% increase to $0.62), yet there has been some precedence for bi-annual dividend increases. We believe a modest $0.02 increase is likely from $0.62 to $0.64 quarterly. Given the strong stock price performance to date, we don’t expect much in the way of positive response to the results.
National Bank – Another Messy Quarter
National Bank is scheduled to report on Thursday November 30, 2006. We forecast EPS of $1.25 compared to reported earnings of $1.30 in the third quarter and $1.20 in the year-ago quarter. National has no amortization of intangibles, so EPS and CEPS are identical. Excluding the Mastercard gain and the reversal of general, the more appropriate comparison is flat with $1.25 earned in the third quarter and up from the $1.10 earned in the weak fourth quarter of last year (Table 6).
The focus for National will be on the wholesale operation, which is run by newly appointed Bank COO, Louis Vachon. The third quarter produced a less than impressive result. Net earnings of $60 million were within a normal range, but the revenues were heavily skewed to securities gains. With de minimus unrealized gains left across the investment portfolios, the market rightly questioned how National will fare going forward. This situation will not be made any better this quarter by the fact that the bank has had a dismal performance in underwriting and M&A activity versus its peers. It does appear, however, as if this was an anomaly driven by the fact that National is less active in mining, has a focus on Quebec-based institutions, which seemed relatively quiet in the quarter, and has experienced more than its fair share of professional turnover in some of its core operations. Clearly, the onus will be on Vachon to define how NB Financial will deliver in the longer term.
The good news is that we believe the comparisons for National in domestic retail and wealth management seem quite good. This, coupled with some less onerous headwind from securitization (in the Other segment), should allow the bank to make up for a weak wholesale segment. Specifically, we forecast domestic P&C will be up 13% versus the fourth quarter and Wealth management will be well up from last year. We believe that the “Other” Segment will also have a modest profit.
The more interesting decision for National is on its dividend. The bank has been surprisingly inactive on its buyback for an extended period. Tier 1 continues to build, and given its relatively limited growth opportunities, the bank may well move its payout ratio and dividend meaningfully higher. We forecast a dividend increase of about 6%, but there is capacity for a much larger increase if the Board has the inclination to do so.
Royal Bank – In the Sweet Spot
It is clear to us that Royal Bank should have a stellar quarter. Continued strength in wealth management, an excellent capital markets quarter and no hiccups from hurricanes or Enron should allow Royal to show a very clean result. The only headwinds include somewhat higher loan losses and possibly a less successful trading quarter.
We expect Royal to report Cash EPS of $0.88 when it reports on November 30, 2006 (the same day as National Bank). This compares to $0.91 in the third quarter and $0.39 in the same quarter of last year. Excluding unusuals and the impact of discontinued operations, the comparison is with $0.92 in the third quarter and $0.83 in the same quarter of a year ago (Table 7).
The Canadian Personal and Business segment should have close to a record quarter with almost $740 million of after-tax earnings. This is essentially flat with the third quarter and up 10% from last year (if we remove the impact of hurricane charges and the reserve releases). As has been widely reported, the bank continues to have solid mutual fund flows and it appears to be competing well in the basic banking business.
The U.S. and International segment (which includes Centura, Dain, Caribbean Banking and Private Banking) should perform in line with the third quarter and up from year-ago levels (if we remove the accounting adjustment). We believe that Dain will be somewhat lower, Centura seems to be performing well and the Private Banking business is benefiting from the acquisitions of the past year.
The big swing variable will be Global Capital Markets. As we have mentioned, this was an excellent quarter in terms of activity levels for RBC. The blow-out result of the second quarter (when the bank earned over $400 million) is certainly possible but we are assuming a bottom line of $306 million, assuming that after two staggering trading quarters, the bank has slightly lower trading revenues and that loan loss reversals moderate somewhat. We estimate overall loan losses of $150 million compared to either side of $100 million in the previous two comparable quarters.
Royal is another bank that could decide to move either its payout ratio or its dividend. It increased its dividend last quarter (to $0.40 from $0.36 quarterly) but if it intends to maintain its aggressive stance on returning money to shareholders, increases are possible.
CIBC – The Long Road Back
One week after the National and Royal report their earnings, we are expecting another solid quarter from CIBC. Looking at the superficial reported results are probably less important than management’s comments on the outlook for 2007. It is clear that management has become more confident that it can deliver earnings growth—and the extent to which the market believes this should be the driver of analyst earning estimates.
We forecast Cash EPS of $1.59 down from the $1.87 in the third quarter and $2.07 in the same quarter of last year. Removing unusuals, the comparison of $1.59 versus $1.70 in the third quarter and $1.45 last year and is quite similar to that of other banks—down slightly from the third quarter (largely due to loan losses and lower securities gains), but up on last year (Table 8).
Retail Markets should be essentially flat with the third quarter (if we exclude the tax item) but up over the same quarter of last year. The two items to monitor are market share and overall revenue performance. CIBC has grappled with transitioning its non-residential consumer lending book from unsecured to secured and this has impacted both these metrics over the past year. We believe that the card book will show much better metrics, while we expect to see overall revenue growth approach industry averages. We don’t expect to see material loan loss improvements this quarter, but expect that reductions will be meaningful over the next year or two.
CIBC World Markets is unlikely to match the strength of the comparable quarter largely because of more “normal” merchant banking activity. Remember that the fourth quarter of last year saw the bank crystallize gains to rebuild the balance sheet post-Enron, while the third quarter was also somewhat elevated. We also expect a somewhat more moderate performance in trading after two comparably strong quarters. All said, we expect earnings of $122 million—one of the weaker quarters in the past three years, despite what looks like a reasonable result in capital markets.
The dividend and buyback story at CIBC remains quite murky. Management has consistently said that it is focused on increasing the bank’s ownership of First Caribbean in the first fiscal quarter of 2007. Having said that, CIBC has one of the lower payout ratios within the bank group and yet the bank has historically been relatively aggressive on returning money to shareholders. We aren’t forecasting a dividend increase, but it could decide to move on the payout ratio this quarter.
Scotiabank – Continued Good News, Except in Canadian Retail
On Friday, December 8, 2006, Scotiabank will report its fourth-quarter earnings. As we have seen in the past few quarters, the bank should continue to show strong results and trends in its non-Canadian businesses, but struggle with domestic Personal and Commercial Banking and Wealth management. Specifically, we forecast Cash EPS of $0.88 versus $0.93 in the third quarter and $0.80 last year. Exclusive of unusuals (Mexican VAT and a reversal of general), the appropriate comparison is $0.88 versus $0.88 in the third quarter and $0.77 a year ago (Table 9).
Domestic Banking (which includes both banking and wealth management) should be marginally higher than in the third quarter and in the same quarter of a year ago. The most positive piece of news this quarter is Prime-BA spreads, which were wider than in comparable quarters. This is somewhat more relevant for BNS, as the bank is more wholesale funded than its peers. We also believe that there is marginally less competition on the high-interest savings accounts, which could allow for better spreads on deposits. On the other hand, the flat yield curve is not constructive. Scotia continues to struggle on the wealth front. It will be interesting to consider whether the new sponsorships will result in additional expenses.
International Banking can be quite volatile, particularly in the fourth quarter. The Scotiabank Mexico results (which currently make up over 40% of International) were solid year over year, but should be the lowest they have been in the past four quarters. With relatively stable currency, however, we believe that the recent acquisitions and good performance from the stalwarts in Jamaica and Trinidad should ensure continued solid results. We should note that the year-over-year comparison is off a weak fourth quarter last year.
Scotia Capital will face several cross currents this quarter. After an outstanding third quarter in terms of capital markets and investment banking, this quarter looks more moderate. On the other hand, the bank had weak trading in the third quarter and suggested that the results in Q4 should be better. The GMAC deal appears to be performing well. We believe a result either side of $250 million is reasonable.
The Other segment can be quite volatile. A year ago, it included the reversal of general, while the third quarter included some positive marks on derivatives. We expect more moderate earnings this quarter.
Scotiabank still retains a target payout ratio of 35–45%, which is at the lower end of its peer group. While this may be defendable on the basis that BNS has opportunities to deploy capital in its international footprint better than its peers, it cannot be ignored that the bank also has one of the strongest capital positions in the industry. We currently forecast a dividend increase of $0.02 to $0.41 from $0.39. As with other banks, however, we risk being too conservative in our estimate of dividend increase.
TD Bank – TD Canada Trust in the Spotlight
TD also reports on Friday, December 8, 2006. With Ameritrade and Banknorth having already reported, there is a fair degree of visibility for earnings overall. Essentially, the focus will be on the domestic retail banking business, TD Canada Trust. Overall, we expect Cash Operating EPS to be $1.16 compared to $1.21 in the third quarter and $1.06 in the same quarter of a year earlier (Table 10). This is relatively consistent with trends forecasted at other banks.
TD Canada Trust, after an outstanding third quarter, will be hard-pressed to repeat. The addition of VFC and the continued growth in cards, commercial banking and insurance remain the main drivers of top-line growth. One issue this quarter could be the expense impact of the numerous new branch openings. Outside of that, however, the ongoing growth in volumes and better share performance argue for continued overall strength. We forecast a solid year-over-year improvement. Wealth Management, given solid fund flows and good activity levels, should also continue to show strong results. Note: the comparison versus last year is distorted by the AMTD deal.
TD Securities, following a very strong third quarter, complete with good securities gains, should see earnings moderate. Activity levels were reasonable in the fourth quarter (well ahead of third-quarter levels) and trading should be much better than year-ago levels, when the bank was in the throes of exiting some structured product businesses. All in, Wholesale Banking should be back to the $150 million run rate—plus or minus $20 million.
With TD Bank having moved last quarter on dividend, there is little likelihood of any movement when the fourth-quarter results are announced. Having said that, it should not be overlooked by investors that the bank appears to have shifted its policy on buybacks over the past two quarters. The four million share buyback program announced along with the third-quarter results has already been completed. Another five million share buyback was subsequently announced and is slated to start in December. TD, like CIBC and National, has a very low payout ratio based on 2007 earnings.
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Highlights
• We expect another excellent performance by Canadian banks when they start releasing their fourth-quarter results on November 28, 2006. Earnings are forecasted to be 5–15% ahead of last year, but marginally lower than the operating results in the third quarter. We again believe that the risk to our forecasts is to the upside (i.e. earnings could be better than we predict).
• The major drivers of earnings growth is domestic retail banking reflecting solid asset growth, minor improvements in spreads and good cost control. Specifically, loan growth remains over 10% per annum and the higher levels of short rates should offset the pressures from a flat yield curve. Given that we don’t foresee any deterioration in loan losses, year-over-year increases of 5–20% seem reasonable.
• Capital markets activity remained strong in the quarter. Underwriting and M&A activity appeared to be good and overall volatility did not appear to be unusual. Trading revenues should be similar to the third quarter (for seasonal reasons), but should be well ahead of a disappointing fourth quarter of last year. We expect to see loan losses rise somewhat as the reduced size of impaired loan balances necessarily reduces the potential for recoveries.
• As we look at some of our short-term metrics, it does appear that Royal Bank could have another blow-out quarter (as it did in the second quarter) on the back of capital markets operations. National Bank, however, seemed to be a bit less active than normal. Outside of this, there is little doubt that Royal and TD continue to outclass their peers on domestic retail operations.
• The big debate this quarter will be on dividends. With the decision to tax trust distributions and with one bank (BMO) having moved aggressively on its payout ratio in the second quarter, there is pressure for all banks to move their dividends meaningfully higher over the next 12 months. If bank boards were to decide to pay out 50% of next year’s earnings, there is potential for material dividend increases in the short term. Outside of this, we would expect three banks to increase dividends this quarter: Bank of Montreal, National Bank and Scotiabank. We would not be surprised if CIBC and Royal also joined in to move to return more money to shareholders.
• Our preference is for shares of CIBC, TD and National (all rated Outperform) at current levels. Interestingly, all three have below average existing payouts on 2007 earnings. In our mind, this translates into higher potential for dividend increases over the next 12 months. The CIBC still remains the most intriguing bank equity in our view. Earnings estimates appear to be low, yet it has remade itself into a relatively low-risk, retail-dominated franchise.
Provisions for Loan Losses – Small Increases off a Low Base
We continue to expect modest increases in loan losses from an unusually low base. One element of the unusually low provisioning level over the past year has been a steady stream of recoveries. This gravy train does have an end, and with gross impaired loans down at very low levels, there is a good probability that net provisioning will rise in the next year (Chart 1).
Specifically, we believe that loan losses this quarter will exceed $650 million across the industry with all banks contributing to the increase (Table 1). CIBC’s loan losses will remain stubbornly high—that’s the bad news. The good news is that the bank should be able to manage down its unsecured retail loan losses over the next 12 months to largely offset any problems in the business loan book. Outside of that, we believe that there will continue to be a concerted (if not sequential) increase in provisioning.
We note that there are still few, if any, signs of deterioration in the corporate loan book. One area of concern is the economic weakness in Central Canada, which would affect the SME and commercial loan books. We believe that National and TD could be most affected by such a trend, given their geographic loan mix.
Trading Revenues – Remaining Robust
We believe that trading revenues will remain robust in the fourth quarter, but below first half levels. The volatility in the quarter should not have created problems for most trading platforms. The story in the quarter was the situation at Amaranth, a hedge fund that ran into problems on natural gas futures. While some have expressed concerns on this front, we doubt that there has been a discernible negative impact on the banks. We believe that in aggregate trading revenues will be somewhat lower than in the first half of the year, but will be well ahead of the very poor result in the same quarter of last year, when TD and Royal had difficult conditions (Chart 2).
As always, it is difficult to generalize trading results across banks. Royal should continue to see some moderation after three blow-out quarters, while Scotiabank, which openly admitted its disappointment with third-quarter performance, should see a more normal result. There is little else to differentiate the banks (Table 2).
Dividends – Going Higher
There will be much debate in bank boardrooms regarding dividends this quarter. Two events have clearly crystallized the issue. The first is the obvious, the decision by the Minister of Finance to tax trusts. The second is less omnipresent, but should be no less compelling—it involves the decision earlier this year by the Bank of Montreal to boost its payout range to 45–55% of earnings. The reality is that both these events will pressure bank executives and boards to be more generous on the dividend front.
The first issue, the taxation of trusts, has clearly provided a boost to bank stocks on the basis of their yield attractiveness. Since that inauspicious day, the bank index is up 3.1% and the S&P/TSX overall is unchanged. We broadly believe that the bulk of the money flow has been due to individual investors shifting to companies with high yields or to companies with growing dividends. One wonders how bank boards can ignore the reality that the “average investor” clearly values dividends very highly, and possibly more highly than share buybacks.
The BMO’s decision to raise its payout rate and dividend meaningfully with the release of its second-quarter results could look quite prescient. Again, the short-term (and less than conclusive) evidence suggests that bank share prices are sensitive to dividends and less so to buybacks. We note that since that increase, BMO shares have outperformed the bank index by 1% (BMO shares are up 15% versus the bank index, which is up 14%).
The argument for a more cautious stance, a road well travelled by most bank board members, is based on the concern that boosting payout ratios in late 2006 could well be coinciding with secularly higher ROEs for Canadian banks. Furthermore, with a minority government and what looks like additional tax changes in the Spring 2007 Federal Budget, one could argue for status quo. Whatever the specific decision this quarter, we are confident that bank dividends will be higher in the next 12 months.
As we show below in Table 3, we expect BMO, BNS and NA to move on dividends this quarter, each by 3–8%. In addition, there is certainly some chance that Scotia, National and TD announce an intention to shift their payout target ranges from their modest 35–45% to a more competitive 40–50%. There is also a possibility that Royal and National, both of which have been more aggressive on returning money to shareholders, will go to 45–55% payouts, in line with the BMO. The CIBC has potential to significantly increase dividends, but has indicated that it is most focused on completing the purchase of Barclay’s stake in First Caribbean before fully considering the joint issues of buyback and dividends.
While we don’t expect a wholesale move by the industry on payout ratios this quarter, it is worth quantifying the potential of dividend increases. As we show in Table 4, an across-the-board 50% payout of 2007 earnings would justify very healthy increases in dividends from CIBC, TD and National. We currently recommend all three equities.
Spreads – Should Continue to Grind Higher
We predicted a turn in bank spreads early in 2006, and while the last couple quarters suggest that we are at an inflection point, the jury is still out on the matter. We do believe, however, that there are ongoing developments reinforcing our view that the situation is no longer deteriorating. As we show in Chart 3, we are expecting a further minor improvement in spreads for the overall bank group this quarter.
Several factors are in play. First, the higher average Prime Rate should help margins, as there has not been offsetting repricing of deposits. Second, Prime-BA spreads (which have been under pressure for four quarters) have widened modestly and should help those banks that are more wholesale-funded. Third, we believe that the less competitive position taken by BMO on pricing mortgages should produce some benefits this quarter. As we show in Chart 4, the increases in pricing by BMO arose late in the third quarter, meaning the impact is likely to manifest itself in the fourth quarter (remember that most consumers lock in rates well before they complete the purchase of their homes).
One of the more difficult factors to evaluate is the level of competition in deposit gathering. We broadly believe the role of ING as a price setter has been usurped by new competitors, including Altamira and Dundee. As ING shows, new competitors have no difficulty in overpaying for deposits—they do, however, have a problem in generating consistent levels of profitability.
Loan Growth – Continued Strength this Quarter, but Likely Slowing into 2007
Underpinning our continued positive stance on bank shares is the fact that loan growth continues to be quite strong in Canada. As we show in Chart 5, year-over-year loan growth to the end of September remains very good at 12%. The strength remains broad based, with residential mortgages, the consumer loan book and business borrowing all contributing to overall growth.
Despite the good news in loan growth in the short term, it is not lost on us that the next few quarters will likely see a slowdown. The last 20-odd years have seen four periods where total loan growth exceeded 12%. All of these were followed by periods of much slower growth. In addition, with the strength of the Canadian dollar clearly beginning to have an impact in Central Canada, we would expect business borrowing (which has historically been more volatile) to slow down materially over the next year. We note, however, that the consumer makes up about three-quarters of the overall loan book, so the largest issue will likely continue to be employment growth in Canada.
Capital Markets – Income Trusts Shouldn’t Cause Any Problems in the Quarter
The fourth quarter looks to have been a very reasonable quarter from a capital markets and investment banking perspective, and should be up 10–20% versus the third quarter (and even more versus the same quarter of last year). After the typical summer slowdown, activity levels were reasonable in equities while some concerns on rising rates seemed to push corporations into debt issuance. M&A activity continued to be good, though not as strong as in the first and second quarters.
As always, there were winners and losers. Most notable was the poor performance of National Bank in capital markets. The bank’s limited involvement in mining and the lack of marquee deals by Quebec issuers resulted in what looks like a very weak quarter. At the other end of the spectrum, Royal had what appears to be a very good quarter with notable success in M&A. TD, which isn’t as large a player as some of its peers, also had a good quarter relative to its historical size. As always, we note that the timing of receipt of fees can cause some swings quarter to quarter.
Other Items of Note in the Quarter
Taxes – We have been surprised (even impressed) with the ability of banks to manage down their tax rates over the past couple of years. As we discussed in our recent report (“Banks Make Progress on Tax: Trust Us,” dated November 1, 2006), a meaningful part of the growth rate of banks over the past decade has been due to better tax management and the reduction in tax rates. We believe that this will be a variable that will continue to help banks in the fourth quarter and into 2007.
Securities Gains – After a robust third quarter (complete with the Mastercard gains and strong merchant banking revenues at CIBC), we believe that gains this quarter will be more subdued. Having said that, the level of unrealized securities gains should remain quite robust at TD, Scotiabank and CIBC. With the tremendous performance of Mastercard shares since the IPO, BMO and NA will also be developing a solid cache of latent future profits.
Individual Company Comments
Bank of Montreal – Continued Focus on Spreads and Domestic Volumes
BMO will lead off the earnings parade on Tuesday, November 28, 2006. We expect the BMO to report Cash EPS of $1.25, down from the $1.40 earned in the third quarter and $1.31 in the fourth quarter of 2005. Excluding one-time items that inflated the comparable quarters, we believe that a more appropriate comparison is $1.25 versus $1.30 in Q3 and $1.22 a year ago (Table 5). We believe that the year-over-year improvement reflects volume growth partially offset by higher loan losses, while the quarter-over-quarter decline reflects a somewhat less impressive loan loss result in the wholesale book.
The domestic retail bank should continue to show improvement after a very weak start to the fiscal year. More reasonable mortgage pricing and less aggressive deposit rates should allow BMO to report somewhat better margins. One area worthy of focus is whether the pricing strategy produces any medium-term effect on volume and share.
We expect Chicagoland P&C to be up year over year, given the ongoing growth of branches. Wealth management should be somewhat higher as well (excluding unusuals). The investment bank looks set to complete what will be a record year. Activity levels remain solid (though not as good as in the third quarter) and we expect trading to be stable, despite some market concerns about the impact of Amaranth.
The corporate segment, which includes a plethora of moving parts (including most importantly the benefit of unusually low loan losses), should swing from a surprisingly large profit to a small loss. We are assuming that loan loss reversals will be less additive than in the unusually benign third-quarter and to be more in line with the second half of 2005 and the first half of 2006. Specifically, this means that there should be a loan loss recovery of only $20 million in the corporate segment.
The market will also focus on whether the BMO continues on its trend to return an increased amount of its earnings to shareholders through dividends. We note that the second-quarter dividend increase was very large (a 17% increase to $0.62), yet there has been some precedence for bi-annual dividend increases. We believe a modest $0.02 increase is likely from $0.62 to $0.64 quarterly. Given the strong stock price performance to date, we don’t expect much in the way of positive response to the results.
National Bank – Another Messy Quarter
National Bank is scheduled to report on Thursday November 30, 2006. We forecast EPS of $1.25 compared to reported earnings of $1.30 in the third quarter and $1.20 in the year-ago quarter. National has no amortization of intangibles, so EPS and CEPS are identical. Excluding the Mastercard gain and the reversal of general, the more appropriate comparison is flat with $1.25 earned in the third quarter and up from the $1.10 earned in the weak fourth quarter of last year (Table 6).
The focus for National will be on the wholesale operation, which is run by newly appointed Bank COO, Louis Vachon. The third quarter produced a less than impressive result. Net earnings of $60 million were within a normal range, but the revenues were heavily skewed to securities gains. With de minimus unrealized gains left across the investment portfolios, the market rightly questioned how National will fare going forward. This situation will not be made any better this quarter by the fact that the bank has had a dismal performance in underwriting and M&A activity versus its peers. It does appear, however, as if this was an anomaly driven by the fact that National is less active in mining, has a focus on Quebec-based institutions, which seemed relatively quiet in the quarter, and has experienced more than its fair share of professional turnover in some of its core operations. Clearly, the onus will be on Vachon to define how NB Financial will deliver in the longer term.
The good news is that we believe the comparisons for National in domestic retail and wealth management seem quite good. This, coupled with some less onerous headwind from securitization (in the Other segment), should allow the bank to make up for a weak wholesale segment. Specifically, we forecast domestic P&C will be up 13% versus the fourth quarter and Wealth management will be well up from last year. We believe that the “Other” Segment will also have a modest profit.
The more interesting decision for National is on its dividend. The bank has been surprisingly inactive on its buyback for an extended period. Tier 1 continues to build, and given its relatively limited growth opportunities, the bank may well move its payout ratio and dividend meaningfully higher. We forecast a dividend increase of about 6%, but there is capacity for a much larger increase if the Board has the inclination to do so.
Royal Bank – In the Sweet Spot
It is clear to us that Royal Bank should have a stellar quarter. Continued strength in wealth management, an excellent capital markets quarter and no hiccups from hurricanes or Enron should allow Royal to show a very clean result. The only headwinds include somewhat higher loan losses and possibly a less successful trading quarter.
We expect Royal to report Cash EPS of $0.88 when it reports on November 30, 2006 (the same day as National Bank). This compares to $0.91 in the third quarter and $0.39 in the same quarter of last year. Excluding unusuals and the impact of discontinued operations, the comparison is with $0.92 in the third quarter and $0.83 in the same quarter of a year ago (Table 7).
The Canadian Personal and Business segment should have close to a record quarter with almost $740 million of after-tax earnings. This is essentially flat with the third quarter and up 10% from last year (if we remove the impact of hurricane charges and the reserve releases). As has been widely reported, the bank continues to have solid mutual fund flows and it appears to be competing well in the basic banking business.
The U.S. and International segment (which includes Centura, Dain, Caribbean Banking and Private Banking) should perform in line with the third quarter and up from year-ago levels (if we remove the accounting adjustment). We believe that Dain will be somewhat lower, Centura seems to be performing well and the Private Banking business is benefiting from the acquisitions of the past year.
The big swing variable will be Global Capital Markets. As we have mentioned, this was an excellent quarter in terms of activity levels for RBC. The blow-out result of the second quarter (when the bank earned over $400 million) is certainly possible but we are assuming a bottom line of $306 million, assuming that after two staggering trading quarters, the bank has slightly lower trading revenues and that loan loss reversals moderate somewhat. We estimate overall loan losses of $150 million compared to either side of $100 million in the previous two comparable quarters.
Royal is another bank that could decide to move either its payout ratio or its dividend. It increased its dividend last quarter (to $0.40 from $0.36 quarterly) but if it intends to maintain its aggressive stance on returning money to shareholders, increases are possible.
CIBC – The Long Road Back
One week after the National and Royal report their earnings, we are expecting another solid quarter from CIBC. Looking at the superficial reported results are probably less important than management’s comments on the outlook for 2007. It is clear that management has become more confident that it can deliver earnings growth—and the extent to which the market believes this should be the driver of analyst earning estimates.
We forecast Cash EPS of $1.59 down from the $1.87 in the third quarter and $2.07 in the same quarter of last year. Removing unusuals, the comparison of $1.59 versus $1.70 in the third quarter and $1.45 last year and is quite similar to that of other banks—down slightly from the third quarter (largely due to loan losses and lower securities gains), but up on last year (Table 8).
Retail Markets should be essentially flat with the third quarter (if we exclude the tax item) but up over the same quarter of last year. The two items to monitor are market share and overall revenue performance. CIBC has grappled with transitioning its non-residential consumer lending book from unsecured to secured and this has impacted both these metrics over the past year. We believe that the card book will show much better metrics, while we expect to see overall revenue growth approach industry averages. We don’t expect to see material loan loss improvements this quarter, but expect that reductions will be meaningful over the next year or two.
CIBC World Markets is unlikely to match the strength of the comparable quarter largely because of more “normal” merchant banking activity. Remember that the fourth quarter of last year saw the bank crystallize gains to rebuild the balance sheet post-Enron, while the third quarter was also somewhat elevated. We also expect a somewhat more moderate performance in trading after two comparably strong quarters. All said, we expect earnings of $122 million—one of the weaker quarters in the past three years, despite what looks like a reasonable result in capital markets.
The dividend and buyback story at CIBC remains quite murky. Management has consistently said that it is focused on increasing the bank’s ownership of First Caribbean in the first fiscal quarter of 2007. Having said that, CIBC has one of the lower payout ratios within the bank group and yet the bank has historically been relatively aggressive on returning money to shareholders. We aren’t forecasting a dividend increase, but it could decide to move on the payout ratio this quarter.
Scotiabank – Continued Good News, Except in Canadian Retail
On Friday, December 8, 2006, Scotiabank will report its fourth-quarter earnings. As we have seen in the past few quarters, the bank should continue to show strong results and trends in its non-Canadian businesses, but struggle with domestic Personal and Commercial Banking and Wealth management. Specifically, we forecast Cash EPS of $0.88 versus $0.93 in the third quarter and $0.80 last year. Exclusive of unusuals (Mexican VAT and a reversal of general), the appropriate comparison is $0.88 versus $0.88 in the third quarter and $0.77 a year ago (Table 9).
Domestic Banking (which includes both banking and wealth management) should be marginally higher than in the third quarter and in the same quarter of a year ago. The most positive piece of news this quarter is Prime-BA spreads, which were wider than in comparable quarters. This is somewhat more relevant for BNS, as the bank is more wholesale funded than its peers. We also believe that there is marginally less competition on the high-interest savings accounts, which could allow for better spreads on deposits. On the other hand, the flat yield curve is not constructive. Scotia continues to struggle on the wealth front. It will be interesting to consider whether the new sponsorships will result in additional expenses.
International Banking can be quite volatile, particularly in the fourth quarter. The Scotiabank Mexico results (which currently make up over 40% of International) were solid year over year, but should be the lowest they have been in the past four quarters. With relatively stable currency, however, we believe that the recent acquisitions and good performance from the stalwarts in Jamaica and Trinidad should ensure continued solid results. We should note that the year-over-year comparison is off a weak fourth quarter last year.
Scotia Capital will face several cross currents this quarter. After an outstanding third quarter in terms of capital markets and investment banking, this quarter looks more moderate. On the other hand, the bank had weak trading in the third quarter and suggested that the results in Q4 should be better. The GMAC deal appears to be performing well. We believe a result either side of $250 million is reasonable.
The Other segment can be quite volatile. A year ago, it included the reversal of general, while the third quarter included some positive marks on derivatives. We expect more moderate earnings this quarter.
Scotiabank still retains a target payout ratio of 35–45%, which is at the lower end of its peer group. While this may be defendable on the basis that BNS has opportunities to deploy capital in its international footprint better than its peers, it cannot be ignored that the bank also has one of the strongest capital positions in the industry. We currently forecast a dividend increase of $0.02 to $0.41 from $0.39. As with other banks, however, we risk being too conservative in our estimate of dividend increase.
TD Bank – TD Canada Trust in the Spotlight
TD also reports on Friday, December 8, 2006. With Ameritrade and Banknorth having already reported, there is a fair degree of visibility for earnings overall. Essentially, the focus will be on the domestic retail banking business, TD Canada Trust. Overall, we expect Cash Operating EPS to be $1.16 compared to $1.21 in the third quarter and $1.06 in the same quarter of a year earlier (Table 10). This is relatively consistent with trends forecasted at other banks.
TD Canada Trust, after an outstanding third quarter, will be hard-pressed to repeat. The addition of VFC and the continued growth in cards, commercial banking and insurance remain the main drivers of top-line growth. One issue this quarter could be the expense impact of the numerous new branch openings. Outside of that, however, the ongoing growth in volumes and better share performance argue for continued overall strength. We forecast a solid year-over-year improvement. Wealth Management, given solid fund flows and good activity levels, should also continue to show strong results. Note: the comparison versus last year is distorted by the AMTD deal.
TD Securities, following a very strong third quarter, complete with good securities gains, should see earnings moderate. Activity levels were reasonable in the fourth quarter (well ahead of third-quarter levels) and trading should be much better than year-ago levels, when the bank was in the throes of exiting some structured product businesses. All in, Wholesale Banking should be back to the $150 million run rate—plus or minus $20 million.
With TD Bank having moved last quarter on dividend, there is little likelihood of any movement when the fourth-quarter results are announced. Having said that, it should not be overlooked by investors that the bank appears to have shifted its policy on buybacks over the past two quarters. The four million share buyback program announced along with the third-quarter results has already been completed. Another five million share buyback was subsequently announced and is slated to start in December. TD, like CIBC and National, has a very low payout ratio based on 2007 earnings.
