Monday, October 16, 2017

Scotiabank is Most Attractive on P/E Valuation, Adjusting for Excess Capital

  
Canaccord Genuity, 16 October 2017

In this report, we focus on Canadian banks P/E valuation analysis relative to the S&P/TSX Composite, bank stock 1-year return analysis under different P/E (NTM) multiple ranges, and looking at implied P/E taking into consideration each bank’s excess capital. Our main findings below are as follows: (1) group bank P/E (NTM) of 11.7x (vs. historical avg. of 10.9x) represents a 32% discount to the TSX Composite (vs. 30% historical avg.); (2) banks trade at P/E (NTM) between 11-13x over 50% of the time (since 2002) with price return over NTM lowest at 6% on average; (3) banks perform well historically when the group is trading above 13x; and (4) BNS’ relative P/E valuation is most attractive (vs. historical) taking into account their excess capital position (see Fig. 6). At Q3/F17, Scotiabank reported the highest CET 1 ratio at 11.3%.

Investment highlights

• Canadian banks trading slightly above historical average. YTD, banks stocks have outperformed the broad index with NA total returns leading at >15% (Fig. 7). The Canadian bank group (Big-6) average now trades a slight premium to its historical average (see Fig. 1). Currently, the group trades at a P/E (NTM) of 11.7x vs. its historical average of 10.9x (since 2002). During this time frame, group bank P/E’s have ranged from a low of 6.6x (during financial crisis) and high of 13.5x (prior to crisis). We believe the market is likely factoring in excess capital build, continued strong quarterly results (FQ4 upcoming), and potential future 2018 EPS upward revisions concurrent with year end results (i.e. stronger NIM and credit trends). Currently, market consensus calls for Big-6 bank EPS growth of 5% (similar to CG) in 2018E, below the S&P/TSX Composite EPS growth expectations of <10%.

• Relative group P/E valuation still trading at discount vs. broad index. In Fig. 1, we compare group bank P/E (NTM) multiples relative to the TSX Composite Index (NTM). On this basis, we find that bank stocks still look quite attractive. Currently, the forward group bank P/E of 11.7x compares to the TSX Composite of 17.3x. This represents a 32% discount, slightly favourable compared to the historical average of 30%. Based on historical trends, we note that investors should be underweight Bank stocks during crisis. Referring to Fig. 1, the three main periods during which Canadian banks traded at larger-than-average discounts related to the Tech bubble (2001-2002), financial crisis (2008-2009), and Oil price collapse (2015, 2016; WTI oil reached $26 in Feb/16).

• Canadian banks trade at P/E (NTM) between 11-13x more than half the time. Dating back to 2002, we looked at S&P/TSX Bank Index P/E (NTM) multiples that traded within four buckets or ranges. We found that the Index valuations traded within a P/E (NTM) range of 11-13x (see Fig. 3) for 54% of the time. Currently, the banks sit at the lower end of this range (11.7x). The group P/E between 9-11x, and 13-16x occurred 22%, and 21%, respectively. At the low-end (P/E of 6-9x) happened just 3% of the time, which was during the financial crisis.

• Looking at Bank performance during certain P/E trading ranges. After that, we took weekly P/E valuation data points and ran stock price returns over the next twelve months using the TSX Bank Index. Not surprisingly, we found that largest stock gains followed the financial crisis with average 1-year returns of 64%. The second highest return periods have come from when banks trade between 9-11x, compiling an average return of 13%. Using historical data, this suggests that it is best to overweight banks when the group trades below P/E (NTM) of 11x. From the group’s trading sweet spot of 11-13x; 54% of time), stock returns over the next year were lowest, averaging 6%. Interestingly, when Canadian banks trade above 13x, returns continued to be solid, averaging 11%. The historical analysis demonstrates that Canadian banks are momentum stocks and that higher valuations don’t necessarily indicate an underweight signal. By way of context, the TSX Bank Index has generated a ~8% CAGR (price return) since 2002 proving that the latter are solid long-term investments.

• Canadian banks improving capital position. Since the financial crisis, Canadian banks have continued to build excess capital. The group has increased their CET1 ratio (avg.) from 7.1% (2008) to 10.9% (F2017E). As of Q3/F17, Scotiabank enjoyed the strongest relative capital position with a CET 1 ratio of 11.3%, followed closely by NA, and BMO (11.2% each). At the low-end is now CM that accounted for the closing of PrivateBank last quarter. CM’s CET1 ratio dropped sequentially from 12.2% to 10.4%. Generally, we believe excess capital will be used for: (1) increased usage of NCIB (although still modest to overall shares outstanding); (2) dividends (we forecast group dividend growth of 5% in 2018E); (3) acquisitions (expect bolt-on acquisitions as global valuations remain high); and (4) organic growth.

• P/E implied valuation accounting for excess capital. Lastly, we take each Canadian bank's current P/E (2018E) and adjust it for the PV of excess capital. For the latter, we have assumed a CET1 floor of 10.5%, which is consistent with most bank’s comfort level. We note the regulatory minimum ratio is 8.0%. For the purpose of this analysis, we assume incremental capital will be depleted by 2020 (i.e. in 3 years) and we discount the excess capital by 10% (estimated cost of equity) to derive the PV of excess capital. The analysis is shown in Fig. 6. Our implied P/E (F2018E) for Canadian banks (adj. for excess capital) moves down on average 0.7x. This would place the group P/E at ~11x, in line (instead of slight premium) with its historical average. Under this exercise, we estimate Scotiabank's implied P/E valuation (adjusting for excess capital) trades at 10.5x (excess capital of 1.0x), a significant discount to its historical average of 11.5x (Fig. 6). We found that CM also trades at a discount, but more modest at -0.3x, while TD, BMO, NA, and RY adj. implied P/E multiples generally trade in line with their historical averages.
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Bank Stocks Are No Longer Cheap, but They’re Still Worth Owning

  
The Globe and Mail, David Berman, 16 October 2017

The great Canadian bank stock sale is over. But don't worry: There are more gains ahead.

After a five-week rally, bank stocks have jumped more than 8 per cent on average. They have now emerged as clear leaders within the S&P/TSX composite index, after briefly lagging the index earlier this year.

But valuations that were cheap by historical measures near the start of September, before the current rally kicked in, are now in line with the long-term average. While that doesn't mean that bank stocks are overpriced, it does suggest that they're no longer a steal.

If you recall, Canadian banks were going nowhere for the four-month period between May and August (inclusive), marking a curious departure from what looked to be an upbeat operating backdrop at the time.

I wrote about this apparent mismatch on Sept. 5. The Canadian economy was humming, the price of crude oil was moving up and banks had reported strong third-quarter profits that were, on average, 11 per cent higher than last year. Best of all, the Bank of Canada was raising its key interest rate, which generally increases bank profits on their loans.

Add an average dividend yield of 4.1 per cent, and – barring a housing market catastrophe – Canadian bank stocks looked hard to pass up.

Yet, share prices were going nowhere. At their low point, on Sept. 7, stocks were trading at levels seen in early December.

Investors appear to have recognized the big opportunity here and, five weeks later, bank stocks are no longer looking unloved.

The S&P/TSX composite commercial banks index, which consists of the Big Six banks, Laurentian Bank of Canada and Canadian Western Bank, has rallied 8.3 per cent from its September lows. The sector has outpaced the 5.6-per-cent gain in the broader Canadian market – itself an impressive feat – and demonstrated that when things are good for Canada, they're very good for the banks.

Royal Bank of Canada, Toronto-Dominion Bank and National Bank of Canada, in particular, have hit record highs within the past week.

Bank stock valuations are now in line with 10-year historical averages. According to data from RBC Dominion Securities, the Big Six bank stocks trade at 11.6-times estimated 2018 profit, which is above the historical average of 10.9-times estimated profit.

Bank stocks also trade at their average historical price-to-book value of 1.8. And that 4.1-per-cent dividend yield before the rally has retreated to 3.8 per cent, attributable to rising share prices.

A nice buying opportunity has passed, but there is no need to fret: If you're inclined to make bets on individual stocks, rather than own the entire sector (I own units in the BMO Equal Weight Banks exchange-traded fund, which gives me exposure to the Big Six), good deals can still be found.

Among the biggest banks, Canadian Imperial Bank of Commerce stands out with price-to-book and price-to-earnings multiples that are below the peer average. The stock also comes with a sector-leading 4.6-per-cent dividend yield.

CIBC has another thing going for it: The stock lagged the returns of its big bank peers in 2016. As I've pointed out in previous articles, lagging bank stocks have a tendency to close the gap with their peers, meaning that last year's underperformer tends to be this year's outperformer.

So far in 2017, CIBC has bucked this trend with a year-to-date gain of just 2.5 per cent – compared with a group average gain of 6.8 per cent. Perhaps this stock-picking strategy won't work this year. Or perhaps CIBC remains an outstanding buying opportunity.

But there's another reason to stick with bank stocks following the group's impressive rally. While valuations have risen from bargain levels, they're not excessive today. That means there is room for stocks to rise further with profit growth, dividend hikes and interest-rate increases – all of which seem likely.

There are good times to buy Canadian bank stocks; there are not bad times to own them.
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Tuesday, October 10, 2017

Scotiabank’s AT1 Security A Hit; Other Banks Expected to Follow Suit

  
The Globe and Mail, Christina Pellegrini and Niall McGee, 10 October 2017

More Canadian banks and possibly life insurers are expected to follow Bank of Nova Scotia's lead and take advantage of a novel source of funding that has proven to be a hit with investors, bankers and analysts say.

Last week, Scotiabank raised $1.25-billion (U.S.) from institutional investors mostly in the United States, Europe and Asia through the sale of a new hybrid security that has many attributes of preferred shares, but is legally debt. The notes were crafted in such a way that the money raised qualifies as additional tier 1 (AT1) capital, which is part of a cash reserve that Canada's top banking regulator expects banks to hold to maintain a minimum level of financial stability.

The Canadian banks have primarily raised this type of capital by issuing preferred shares into the domestic market, which is heavily dependent on retail demand. But preferred shares have been a tough sell for banks to export beyond Canada because Canada Revenue Agency puts a tax of 25 per cent on any passive income generated by investors who are not residents of Canada.

Scotiabank's hybrid note was well-received partly because it was structured in such a way that avoids this tax on foreigners. It also offers investors a yearly interest rate of 4.65 per cent in the first five years and a floating rate after that. It has no scheduled maturity, and converts into equity during times of distress, satisfying the banking regulator's requirements.

Scotiabank lined up 330 interested institutional buyers and amassed an order book that was about seven times oversubscribed, Vivek Selot, an analyst at RBC Dominion Securities Inc., said this week in a research note. The deal was led by UBS AG and featured Scotia Capital Inc., Merrill Lynch, and Citigroup Global Markets Inc. as joint bookrunners.

Scotiabank declined comment on the offering.

Greg McDonald, the director of debt capital markets at TD Securities Inc., called the AT1 issuance "an important step" in Canadian banks' bid to gain access to additional U.S. dollar funding avenues. "Any time you can open up a new market for either funding or capital … it's definitely a plus," he said.

He expects many of the Canadian banks to consider it as a new potential future source of funding, and weigh it against existing options such as preferred shares.

BMO Nesbitt Burns Inc. analyst Kris Somers called Scotiabank's note a "gamechanger," adding in a report that the new structure has the potential to result in reduced supply of preferred shares sold by financials.

This type of offering is being billed as a solution to a problem that Canada's largest financial institutions have been wrestling with for years: The country's market for preferred shares has become a less reliable and more costly way of sourcing AT1 capital.

In 2015, it became clear that the preferred-share market in Canada was encountering stumbling blocks.

After the financial crisis, banks sold preferred shares with a built-in feature that would see the dividend rates reset after a certain period of time. This was done so that when interest rates eventually rose as the economy recovered, so, too, would the income generated by the shares. Except, by 2015, interest rates were not rising – they were still falling. The dividends were resetting lower and investors were earning a lot less, spurring mass selling and pushing preferred-share prices lower.

Opportunistic institutional investors stepped up to fill the void, demanding hefty dividend yields. Banks had little choice but to pony up and swallow the costs. The episode spurred banks and their lawyers to look for another way of sourcing these funds. Two years later, Scotiabank has done just that.
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Sunday, September 24, 2017

Canadian Banks Make Push to Beef Up Utilities Expertise in the US

  
The Globe and Mail, Christina Pellegrini and Niall McGee, 24 September 2017

When word got out in July that Hydro One Ltd. had retained Moelis & Co. to advise on its $4.4-billion deal for Spokane, Wash.-based utility Avista Corp., the reaction from many on Bay Street was: Hydro One hired who?

The transaction showed just how fierce the competition is for this kind of work and how Canadian investment banks have to do more to stay relevant to companies that are plotting growth outside of Canada. Moelis, a New York-based boutique bank, was well suited for the role "given their depth of M&A experience in the U.S. regulated electricity sector," a Hydro One spokesperson said last week. Canadian banks weren't entirely shut out: Three led Hydro One's equity financing deal to help pay for Avista, leveraging their vast institutional and retail distribution networks to raise money quickly. But Moelis ultimately won the lucrative advisory mandate – earning bragging rights as the top dog – and pocketed a $16-million fee, according to an estimate by Thomson Reuters.

In recent years, deal flow in infrastructure has exploded around the globe. Flush with cash, investment funds are on the hunt for assets with stable cash flow and governments are cashing in by moving to privatize certain public assets at rich valuations. This dynamic has resulted in a boom in dealmaking. Meantime, Canadian power and utilities companies have been keen on doing deals in the United States to diversify their businesses, access growing markets and boost their return on equity, says Mona Nazir, an analyst at Laurentian Bank Securities.

As companies expand into new regions, Canada's biggest investment banks are following suit. Many are bolstering their power and utility teams in the United States, hiring more bankers to work on the ground and boosting their coverage of the sector south of the border to capture more deal activity.

"Our Canadian clients' needs are evolving and are increasingly focused on the U.S.," said Pierre-Olivier Perras, the co-head of the power and energy infrastructure group at BMO Nesbitt Burns Inc. The bank is responding by looking at expanding its U.S. utilities practice, he added. "It's really about having the right relationships and the best ideas at the right time."

TD Securities too has singled out the sector as one of its key focuses over the next few years.

Scotia Capital Inc. began expanding its power and utilities franchise outside Canada years ago, following clients such as Emera Inc. and Fortis Inc. into the U.S. market. And it is still looking to add bankers to its U.S. team. In the next 12 months, the bank expects to have the same number of power and utility bankers on both sides of the border, said Charles Emond, who is co-head of global investment banking.

The bank has also built a presence in Latin America in a bid to advise local power and utilities clients or financial players such as the Canadian pension funds. While still early days in these countries, Mr. Emond estimates that roughly half of Scotia Capital's deal flow in the pipeline in the Pacific Alliance region is in power and utilities.

What matters most to acquirers is the proprietary insight their bank has about the regulatory landscape and a potential target, as well as access to that company's management and main shareholders.

"Those relationships with the target is really what resonates the most with the acquirer," Mr. Emond said. "That relationship, the access, the knowledge about the market is the way to often differentiate yourself and get hired."

But despite efforts by Canadian investment banks, they at times fall short when they compete against large U.S. firms for advisory mandates on cross-border deals.

San Francisco-based Wells Fargo Securities has advised on a number of large-cap utility, power and pipeline deals during the past few years, advising both U.S. and Canadian acquirers. When Wells is able to beat out the Canadian competition, said Eric Fornell, vice-chair of investment banking and capital markets, it's often because of lending relationships with companies that go back decades and deep ties with management.

Last year, when Wells advised TransCanada Corp. on its acquisition of Columbia Pipeline Group Inc., Mr. Fornell's relationships with decision makers on both sides was a major factor in winning the mandate; he'd known the CFO of Columbia for 20 years and the head of M&A at TransCanada since 1999. With that kind of history, bankers can have a very "straightforward, direct conversation" with management teams in a way "that's not threatening to them," he said.

Furthermore, when Algonquin Power & Utilities Corp. was negotiating to buy the Empire District Electric Co. in 2016, not only did Mr. Fornell know Algonquin's management well, he knew the Moelis adviser on the other side, having previously worked with him at another bank.

"He was not going to steer me wrong, and I'm not going to tell him anything that's untrue," he said of his dealings with his ex-colleague.

In terms of other Canadian banks in the United States, Mr. Fornell gives kudos to RBC Dominion Securities Inc., saying they have a solid team of bankers on the ground. "We're seeing RBC a lot," he said. (RBC declined to comment for this story.)

"They're doing business and they're lending money," he added. "It's just that in some cases, Wells Fargo and other U.S. banks have been at it longer."
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Wednesday, September 20, 2017

TD Securities Readies for Prime Time in the US

  
The Globe and Mail, Niall McGee, 20 September 2017

At the main offices of TD Securities Inc. in New York, some 250 people buzz around on its trading floor – a patch of real estate once occupied by German colossus Deutsche Bank AG.

The Canadian bank-owned dealer is bulking up – even as some of its foreign competitors pull back. Over the past three years, TD Securities has increased its hiring in the United States, adding 300 people to bring its head count to roughly 900. Over the same period, it has boosted revenue in its U.S. business at an annual clip of 18 per cent and is targeting more double-digit growth in the years ahead.

But making further gains in a region that is drastically more cutthroat than the Canadian market won't be easy. While TD is already a formidable force in the retail banking market in the United States, it's still not clear whether that strong brand presence can make it a dominant player in capital markets.

"While [the United States] is exceptionally lucrative, it is also very competitive, and you don't have the same history and you don't have the same Rolodex and access to the C Suite as you do in Canada and it becomes a much tougher slog," John Aiken, an analyst with Barclays Capital, said in an interview.

In the United States, TD Securities is a tiny fish in an enormous pond, with only about 2-per-cent market share in capital markets – a minnow compared with U.S. behemoths such as JPMorgan Chase & Co. and still smaller than rival Canadian dealer RBC Dominion Securities Inc., which has the strongest footprint of any Canadian bank in U.S. capital markets.

The United States is orders of magnitude bigger than the home market and represents a novel source of growth for TD in capital markets. Added revenue from investment banking, trading and corporate banking also acts as a buffer against any stumbles in the retail part of the business, which over the past decade has made up the bulk of the Toronto-based bank's profit and revenue.

"Our objective is to grow the wholesale earnings of the bank more significantly," Glenn Gibson, vice-chair and regional head for TD Securities USA, said in an interview this summer. "The best opportunity to do that is in the U.S. market."

TD's wholesale business – corporate lending and capital markets – has historically lingered around 9 per cent to 10 per cent of earnings, much lower than those of bank-owned Canadian competitors such as BMO Nesbitt Burns Inc. and RBC, which are closer to 25 per cent.

However, since becoming chief executive officer in late 2014, Bharat Masrani has signalled a shift in TD's strategy that puts more emphasis on expanding its capital-markets business, particularly in the United States.

It's a strategy that deviates from that of his predecessor, Ed Clark, who chiefly focused on growing the bank's retail business during his almost-12-year run.

"Where TD strategically may be more open to a venture like this stems from the fact that Bharat had spent the bulk of his time before he became CEO in the U.S.," Mr. Aiken said. "It's a very different marketplace, which has benefits as well as idiosyncrasies, which Bharat may feel a lot more comfortable with than Ed."

While TD has serious ground to make up in U.S. capital markets, it's not starting from zero. In a handful of areas it is already competitive, particularly in foreign-exchange trading and certain segments of fixed income and corporate lending. For example, in the telecom sector, TD was the 12th-biggest lender in the United States last year, according to Thomson Reuters, and the ninth-biggest dealer in supranational, subsovereign and agency (SSA) debt.

But TD sees opportunities to make greater inroads.

The dealer wants to grab a piece of prime brokerage space for the hedge-fund industry – a lucrative niche that includes providing margin financing and lending securities for shorting. It also aims to become a contender in mortgage-backed securities trading, a previously maligned but still important and profitable subset of the fixed-income market.

TD is under no illusion about how tough it will be to make it big in the United States. "We don't expect anything to be given to us," Mr. Gibson said. "We earn every piece of business that we attract in the U.S."

TD Securities has a long history in the United States. It became a fully fledged investment bank and broker-dealer in 1989. Through the 1990s it was a niche operation, focused mainly on lending to media and telecom companies and the energy sector, and operated separately from its fledgling Canadian unit.

By the mid-2000s, things started to change. Starting in 2004, TD made a number of major retail acquisitions in the United States, spending billions to buy the likes of Banknorth Group Inc. and Commerce Bancorp Inc. But despite a vast improvement in brand awareness, TD didn't make great strides in capital markets. One reason was the cautious nature of Mr. Clark, who viewed the segment as risky and volatile.

"Clark wasn't interested in competing against Goldman Sachs or other investment banks in the United States. That was pointless," Howard Green wrote in his bestselling 2013 book, Banking on America: How TD rose to the top and took on the U.S.A.

Before the financial crisis, TD had no obvious competitive advantage. With every major global dealer vying for business, TD was "struggling to add value outside Canada," Moti Jungreis, head of global markets with TD Securities, said in an interview.

But after the financial crisis, with no exposure to toxic U.S. subprime debt, TD suddenly had an edge. The Canadian dealer was seen as a reliable counterparty to trade with, and its hefty balance sheet allowed it to lend big to corporate clients when others were pulling back.

Chastened and weakened in the years since, European banks such as Deutsche Bank and Royal Bank of Scotland have become drastically weaker players in the United States, presenting a further opportunity for Canadian banks such as TD to fill the void.

Over the past six years, TD's expansion in the United States has intensified. That has meant beefing up its U.S. fixed-income, derivatives and foreign-exchange operations and broadening its corporate-lending business by getting into areas such as autos, utilities and real estate. In 2014, it became a primary dealer, which means it can trade U.S. treasuries.

While TD has mostly built out its capital markets imprint in the United States by creating its own platform, in September, 2016, it announced the acquisition of Albert Fried & Co. The boutique dealer had been in the midst of building a prime brokerage unit that services hedge funds – one of the most active of all traders in capital markets. TD has spent much of this year completing the buildout of the unit, which it has rebranded as TD Prime Services.

TD has also spent a good chunk of 2017 building a mortgage-backed securities platform, which it is close to launching. While banks' exposure to mortgage-backed securities was a major factor in causing the financial crisis of 2008-09, the sector has rebounded strongly in the past few years, in lockstep with the housing market. According to Thomson Reuters, mortgage-backed securities currently represent about 15 per cent of the fixed-income trading market in the United States.

But despite the expansion in its capital markets footprint, there are still weaknesses in TD's coverage in areas such as structured products and municipal debt.

"We need to widen our product [offerings] in the U.S. so we can be more relevant to more clients," Mr. Jungreis said.

The dealer does little business in cash equities. It has a limited institutional equities distribution and only a small cluster of people trading interlisted shares. With margins razor-thin for all banks in cash equities, TD isn't planning to make major inroads into the sector either.

But perhaps the most glaring omission in TD's playbook is in M&A advice, one of the most profitable of all areas in capital markets. Juicy mandates such as advising Shaw Communications Inc. on its $2.3-billion sale of its U.S. data centre business, Via West, earlier this year, are few and far between. While TD has made inroads in the energy and technology, media and telecom sectors, the dealer is hopeful it can win larger mandates in other burgeoning areas, such as the utilities sector.

Over the past few years, it's not just TD's product offerings that have evolved in the United States, it's the investment bank's entire ethos around the region. Long gone is the island mentality of old. The dealer now speaks in terms of its "U.S. dollar business." What that means is the firm's bankers in New York liaise seamlessly with Canadian clients who want access to U.S. capital markets, and vice versa.

But while all divisions are profitable in the United States, Mr. Gibson said, margins aren't what they are in Canada.

"To get to the same margins in the U.S that you have in Canada, you have to get a size and scale that makes sense. We're getting there."

Over the next three years, TD is targeting 15-per-cent annual revenue growth a year in the United States. One way to hit that mark is getting stronger in the "real money" space, as Mr. Gibson terms it. That means building relationships with, and winning more business with the likes of Blackrock Inc. and State Street Corp., which oversee trillions of dollars for investors, vastly more more than the biggest asset managers in Canada.

Although TD isn't aiming to supplant the likes of a JPMorgan or Goldman Sachs in the United States, Mr. Gibson says it can go head to head with the big guns in certain areas.

"We're not trying to be an aggregate league table player. We're not going to knock off the top five U.S. banks," he said. "But can we be right below that lead group of U.S. broker-dealer universal banks? Absolutely we can. And that's where we should be."
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Friday, September 08, 2017

RBC & City National: How Canada’s Biggest Bank Overhauled Its US Strategy

  
The Globe and Mail, James Bradshaw, 8 September 2017

There's no sign of Michael J. Fox, Helen Mirren, Martin Scorsese or any of the other Hollywood stars who have been clients of City National Bank in CEO Russell Goldsmith's office. The closest hint of celebrity in Mr. Goldsmith's eighth-floor, Beverly Hills suite is an autographed picture that shows him shaking hands with Ben Bernanke, formerly the world's most powerful central banker as chairman of the U.S. Federal Reserve.

There are prints by artists David Hockney and Richard Diebenkorn, whose genius captured California's essence, interspersed with more personal mementos such as a photo with his father Bram, who preceded him as chairman and chief executive officer of the financial institution that's known in the United States as a premiere private banker to Hollywood.

And just behind his desk there is a plain white, faintly rumpled golf cap emblazoned with a blue RBC logo.

The cap is an important nod to City National's future – and to its parent, Royal Bank of Canada, which bought the Los Angeles-based bank for $7.1-billion in 2015. But it's also the only visible token of RBC's ownership in Mr Goldsmith's digs, which is emblematic of the Canadian bank's new, lower-profile approach to winning in the fiercely contested United States banking market.

The deal to acquire City National signalled a complete reboot of the Canadian bank's U.S. strategy and is the signature gambit RBC CEO Dave McKay has undertaken in his three years at the helm. It was RBC's largest acquisition in recent memory and the third-largest purchase by a Canadian bank since 2000.

The acquisition has left him with something to prove. Smaller rivals such as Toronto-Dominion Bank and Bank of Montreal built extensive banking networks south of the border – the former has more than 1,200 branches across the U.S. eastern seaboard, while the latter has been growing BMO Harris Bank in the Midwest since the mid-1980s. But for at least two decades – perhaps even longer – Royal Bank's top executives have wrestled with the question of how and where to find international growth.

In the late 1990s and early 2000s, John Cleghorn took a stab at a number of deals, most of which didn't work out and the most significant of which was for a North Carolina bank called Centura Banks Inc. His successor, Gord Nixon, struggled valiantly to turn it into a meaningful foothold in the southeastern states, only to retreat after absorbing losses for 10 straight quarters in the aftermath of the global financial crisis.

Canadian banks have never won success easily in the crowded, cutthroat U.S. banking market. But with the acquisition of City National, Mr. McKay is trying again, driven by the need for new growth to supplement returns from a relatively saturated Canadian banking market. This time, he's charting a different course. The bank's executives have learned lessons from past missteps, he says, and have developed a more effective strategy to thrive in the United States.

Rather than trying to win the hyper-competitive retail market, RBC is staking a claim to a new niche south of the border: high-net-worth wealth management. Instead of slapping the bank's Canadian name on its new acquisition and "RBC-izing" its operations – costly mistakes it made the last time round – it's aiming to let City National be its own brand and largely preserve its own identity and culture as a high-touch relationship-based private bank to the stars. It even installed an executive on the California bank's board whose job has been, in part, to help ensure City National's independence by controlling the flow of demands coming from RBC in Toronto.

Whether RBC's light-touch approach will succeed is a vital question for the bank's long-term plans and could go a long way toward shaping Mr. McKay's legacy.

A new approach

Mr. McKay's courtship of City National began in the summer of 2013, at the Peninsula Hotel in Beverly Hills. When he first reached out to Mr. Goldsmith via a mutual acquaintance, RBC was a mystery to the U.S. CEO. The two executives spoke for the first time over dinner at the hotel. It was clear, though, that they are cut from different cloth. Mr. Goldsmith is the consummate relationship banker, with a warm smile and gregarious nature well-suited to Hollywood deal-making. Mr. McKay comes off as more conservative, a restless intellectual shaped in the more staid mould of Canada's banking culture. Even so, "we really connected," Mr. McKay said.

There was just one problem: City National wasn't for sale. "We saw a bright path ahead for City National as an independent company," Mr. Goldsmith said.

Mr. McKay, on the other hand, saw a promising future, and the lessons learned from the last time the bank tried to plant its flag on U.S. soil were never far from mind.

He was determined to avoid the mistakes that unfolded after RBC bought Centura Banks Inc. in 2001 for $3.3-billion as the centrepiece of an experiment in personal and commercial banking. Applying a piecemeal approach to the U.S. market, the Canadian bank soon took on another acquisition, Alabama National Bancorp., for nearly $1.8-billion, and assembled a loosely knit collection of more than 400 branches across six southeastern states including Georgia, Virginia and Florida.

But the network of outlets never achieved critical mass. Scattered across a string of disparate, smaller markets and heavily dependent on mortgage and construction lending, it struggled when the U.S. financial crisis struck. RBC had tried to establish a clear brand identity, splashing its name across its U.S. properties and eventually dropping the Centura brand altogether, naming its retail network RBC Bank. It even shelled out to name the arena that is home to the NHL's Carolina Hurricanes the RBC Center in an effort to build its brand in the United States. (The rink has since been renamed PNC Arena).

Yet as the financial crisis deepened, the bank was forced to swallow billions of dollars in losses and writedowns. By 2011, RBC had opted out of the U.S. retail banking market, selling its southeastern operations to Pittsburgh-based PNC Financial Services Group for $3.62-billion.

As it regrouped, RBC began looking at economic trends, assessing different parts of banking's profit pool, and looking at where the bank still had U.S. assets that could be built out – and by the time Mr. McKay reached out to Mr. Goldsmith, the executive team was developing a new vision. "We started by narrowing down to a space," said RBC's head of strategy and corporate development, Mike Dobbins.

The bank didn't want another retail network, particularly at a time when digital disruption and the rise of new fintech players is complicating the consumer market, Mr. McKay said in an interview at his Toronto office. Instead, RBC set its sights on three or four lenders occupying a different niche – high-touch, relationship-based private banking catering to high-net-worth and commercial clients. "But none had the breadth of City National," he said.

So at the restaurant table in Beverly Hills, Mr. McKay told Mr. Goldsmith: "I want to be your first call if you change your mind. That's all I want to hear." Then he flew home, determined to be patient but persistent.

Not long after, Mr. Goldsmith came calling. By 2014, the two banks were talking, and Mr. Goldsmith began to see the logic of his Canadian counterpart's vision. RBC wanted to unlock the potential of its undersized U.S. wealth-management business, headquartered in Minneapolis, and to drive its highly competitive New York-based capital markets arm to new heights. And City National saw the potential to grow much faster with access to RBC's larger balance sheet and sterling credit rating.

Mr. McKay and Mr. Goldsmith also grew closer. "I think we've become friends through the process," Mr. Goldsmith said in an interview in Beverly Hills. "We've, on occasion, played golf together and we enjoy each other's company."

The deal was announced in January of 2015 and closed in November the same year.

It's something of a truism that banks are sold and not bought. But in this case, City National wasn't being offloaded, notes Jared Shaw, an analyst at Wells Fargo Securities LLC. "They had everything going for them, at the time, and I think they still do."

Keeping in mind what went wrong last time, Mr. McKay plans to integrate City National with a lighter touch this time around.

After acquiring Centura, for example, RBC sent its own team of managers south to run the operation, and tried to do a full integration of operations and technology systems, none of which meshed properly. And at a deeper level, RBC acknowledges it never found a good cultural fit.

"The mistake we made with Centura [was that] we tried to RBC-ize a southeastern bank in the United States who has their own process and customers," Mr. McKay said. "We tried to make it too much like RBC, and it ended up neither like them nor like us, and in this very bad place in the middle. We learned from that."

With City National, Mr. Goldsmith and his senior management team remain in charge, with three Canadian directors on the bank's board, including Mr. Dobbins, who acted as a gate-keeper of sorts. From the start, RBC has carefully managed the flow of influence and information from one bank to the other.

Senior bankers from both sides would gather to go through client lists, looking for opportunities to refer business back and forth. Finance and risk systems have also been integrated, and the two banks hold quarterly business reviews.

Mr. Dobbins's routine included speaking weekly with business leaders at RBC to make quick decisions about which of their priorities should be brought to City National's attention. "They'd say: I want to do this. We'd debate whether that was light-touch or not, and we'd talk about, is it critical or is it nice to have? And that's how we made decisions," he said.

RBC wants City National to treat its parent like a store, picking and choosing from the menu of products and resources it needs to accelerate its growth.

"I think every company treats an acquisition as a new shiny toy," Mr. McKay said. "We can't have 75 different executives picking up the phone and asking them to do something or getting involved. They don't need it. They've been extremely successful as a standalone company for 60 years."

Maintaining City National's character and reputation will be critical to future success. Founded in 1954 in Los Angeles, the bank has been led by a Goldsmith for more than 40 years: Russell's father Bram from 1975 to 1995, and Russell ever since. And it has deep roots in the entertainment sector – founder Al Hart was a Columbia Pictures board member.

Its clientele, whose identities are closely guarded by industry norms of privacy and discretion, has been known to include Hollywood superstars, including legendary singer Frank Sinatra. In 1963, when the singer's son was kidnapped, City National opened its vault to put up $240,000 to pay the ransom. More recently, it has built a tidy business financing Broadway from its New York offices.

But it is also a successful commercial banker to less glamorous industries, from legal services and biotech to fast-food franchising and wine making. Add to that a low-cost deposit base, a strong reputation in wealth management and a balance sheet that was poised to benefit from expected interest-rate hikes, and it's no wonder the California-based bank looked like an attractive takeover target.

"City National is kind of a crown jewel, a unique business with a very high-end clientele," said Meny Grauman, an analyst at Cormark Securities Inc. "And so it fits in nicely to what Royal Bank already has in the United States and to what Royal Bank's ambitions are."

Yet no integration of two large companies goes totally smoothly, and it takes time to build trust. It's natural for employees to worry about job changes and harbour suspicions about the the new parent's intentions. "We had actually planned for them to be a little bit unfocused as we closed the acquisition," Mr. McKay said. But "they just rocketed right through the close. They just didn't miss a beat."

One thing that helped, according to Mr. Goldsmith, is that no one was laid off or fired because of the merger – "which I think makes it unique among bank mergers of any consequence in the last 30 or 40 years in the United States," he said. Instead, the bank has hired more than 450 new people, luring teams of bankers away from rivals, and now has about 4,400 staff.

But the threat of homogenization remains a key concern. "When you're a small piece in a larger organization, there's a risk that the larger organization changes the magic formula," said Mr. Grauman of Cormark.

Banking on growth

The first of what Mr. McKay calls "critical moments of truth" came about a month after the two banks formally merged, in December of 2015.

Thanks to Mr. Goldsmith's connections, RBC's capital markets arm had a chance to get involved in a $250-million public stock offering out of California. The shares belonged to Santa Monica-based Kite Pharma Inc., a major player in emerging cancer treatments. The deal was tricky and exceeded RBC's built-in risk controls, so it was kicked up to Mr. McKay and the bank's chief financial officer at the time, Janice Fukakusa, for approval.

"We got it done, we made a quick decision, we got comfortable with it," Mr. McKay said, and RBC took part as joint book-running managers.

The deal may seem comparatively small, but Mr. McKay insists "those are seminal moments" because they compel the two banks to work together on a complex problem. "It builds connective tissue," Mr. McKay said. "We're all in this together. This is not us and them, which is a little bit what happened in the old Centura days."

There have been other deals like it since then, though RBC is reticent to name its clients, and there will need to be many more if the bank is to reach its ambitious targets for the coming years.

City National has been growing fast, and "we've accelerated our growth plans as a result of the merger," Mr. Goldsmith said.

At the time RBC acquired it, the bank had about $36-billion (U.S.) in assets and had delivered uninterrupted quarterly profits for 23 straight years. Its assets have now swelled to $47-billion and it contributed $79-million in profit in RBC's fiscal third quarter – a 26-per-cent increase from a year earlier even after accounting for ongoing integration costs.

Looking ahead to 2020, RBC projected that City National could more than double its 2015 pretax profit to $1-billion (Canadian), which would represent a compound annual growth rate of about 22 per cent.

To make the grade, RBC needed interest rates to rise to help its U.S. arm make better margins, and the Fed has so far delivered with three quarter-point rate hikes since December. Each separate hike was expected to be worth about $50-million in profit for RBC's U.S. wealth management franchise, including $35-million from City National.

Growth is also expected to come from expansion into new markets. With RBC's support, City National has opened a third office in New York, and is eyeing a short list of other major cities such as Boston. It has set up shop in Washington, where there's a robust market for legal services, which is one of City National's existing strengths.

And it has opened its first full-service regional banking centre in Minneapolis, in support of RBC's existing wealth management business, which has nearly 2,000 investment advisors. "We had some great assets, but we couldn't unlock the value there," Mr. McKay said. "So how do you unlock that value? … We want to serve a high-net-worth commercial client."

City national has helped RBC reach that client, but McKay is clear that the expansion plan has limits. "We stay to that footprint. That's it," he said. "There's so much opportunity, we're so small within those markets that the last thing you want to do is spread yourself too thin geographically and not cover a market properly."

Another substantial chunk of City National's growth is expected to come from the two banks joining forces to drum up new business. With access to RBC's balance sheet, City National can lend larger sums and finance more jumbo mortgages. And there is also a pipeline to refer business back and forth with RBC.

The earliest benefits were apparent in RBC's New York-based capital markets division, which the bank has continued to build into a top-10 American investment bank with 3.5-per-cent market share. Within two to three years, RBC hopes to grow to its share to 4.5 per cent and move up the rankings.

"Russell introduced us to a number of clients that were thinking of making acquisitions or raising equity," Mr. McKay said. "That's led to business."

But City National's hallmark, its real competitive edge, remains the white glove service it offers.

Nancy Novokmet runs Need Financial, a Los Angeles-based firm that provides back-end accounting and operations to entertainment companies that shoot and produce TV commercials and films.

Her staff has access to a group of dedicated City National representatives who know her firm. And when a foreign production client needed funds released quickly to begin building a set abroad earlier this year, City National got it done within 48 hours.

"They understand the community. In production, there's this sense of urgency that's required," Ms. Novokmet said in an interview. "City National just responds very quickly, and it's not always the case with some of their competitors."

By forging long-standing connections with customers and keeping to major markets where it can compete, City National has built "a defendable moat," Mr. McKay said. "They didn't try to be everybody to everyone. They win on service, they win on speed of turnaround, they win on customization."

But the City National need for speed could still test RBC's appetite for risk.

While Royal of Canada does business in many states across the U.S., the markets it considers a priority for future growth have changed. It once sought to build a network of retail branches for day-to-day banking across a strip of the southeastern U.S. But now it plans to grow its presence in key cities with a concentration of high-net-worth and commercial clients.



Wild cards

Mr. McKay was tapping out an e-mail to Mr. Goldsmith as a reporter entered his office this summer. The two CEOs were debriefing after a television interview Mr. Goldsmith had just given on business network CNBC, in which he suggested it was "time to take a fresh look at Dodd-Frank."

He was referring, of course, to the massive legislative response to Wall Street's 2008 meltdown, which sought to substantially de-risk the shuddering financial system. Like many bankers who feel handcuffed by its strictures, Mr. Goldsmith was arguing for leniency: "For seven years we've piled on a lot of rules and regulations, and it needs to be re-examined," he told the program's viewers.

Back in Toronto, Mr. McKay tuned in from his corner office above Bay Street. Navigating a maze of regulations – and the cost that comes with it – is the thing that worries him most, he said. As a standalone bank, City National used to enjoy the lighter regulatory burden of a mid-sized institution. But combined with RBC and its much larger balance sheet through a holding company, City National gets the large, complex bank treatment, which comes with greater scrutiny from Washington.

That has generated mountains of new work. The combined bank has roughly 300 people involved with just one regulation: The stress-testing exercises known as the Comprehensive Capital Analysis and Review, or CCAR.

"That regulatory change has been difficult for a small bank, and us even, to handle," Mr. McKay said.

At the same time, private banking and wealth management are being reshaped by new regulations and shifting demographics. As the sector "has witnessed a regulatory avalanche over the last few years," banks looking to expand have to navigate a slew of reputational and regulatory risks, according to a 2016 report from Deloitte & Touche LLP.

RBC hasn't been immune to such pressures. The bank has largely pulled out of wealth management in the Caribbean and Latin America, due partly to concerns about anti-money laundering controls. Last year, RBC faced pointed questions about its relationship with the law firm behind the leaked Panama Papers, Mossack Fonseca, through which RBC allegedly registered hundreds of shell companies.

But the regulatory regime in the U.S. is considerably stricter, and City National does its private banking onshore. Mr. Goldsmith notes that City National has succeeded "because our experienced banking colleagues take the time, and dedicate the resources – including the use of state of the art technology – to ensure that we know our clients well."

The other thing that keeps Mr. McKay up at night is "geopolitical instability," and "what could be the contagion effect back to the U.S. economy." Since RBC closed its purchase of City National in late 2015, the world has gone through a series of convulsions, from Brexit and the U.S. election to NAFTA rate hikes and the beginning of a long march back from ultralow interest rates.

The Fed rate hikes are helping ease a prolonged squeeze on banks' profit margins. But the Trump administration's economic agenda, which once produced a surge of confidence among American businesses, is now clouded with uncertainty. Promises of deregulation and tax reform have moved slowly through a chaotic administration, while negotiations to redraw the North American free trade agreement are jarred by periodic threats from the President to withdraw from the pact altogether.

Mr. Goldsmith sees encouraging signs in the U.S. economy, from a surging stock market to strength in housing, industrials and trade. And some of the potential reforms on the table – whether to overhaul Dodd-Frank, or to lower corporate taxes – could provide City National with a major tailwind.

"Even a 5- or 10-per-cent drop in our [corporate tax rate] would be enormously significant, but that's not built into anybody's projections," he said.

But he also knows there are good reasons to be wary. Uncertainty has a habit of making businesses to hold back on investments, which would be bad news for a commercially focused bank with ambitious plans for growth.

"Do I have concerns as to what the policies in Washington may or may not do? Yeah, and we follow it closely," Mr. Goldsmith said. "And I'm obviously particularly concerned to see what happens with any potential renegotiation of NAFTA."

RBC's challenge through it all is to fight the same tendency toward short-term thinking that may afflict some of the businesses it serves, and to continue investing in new business lines and digital capabilities.

And it means not shying away from further, smaller U.S. acquisitions if the price is right. RBC has been putting together a playbook to evaluate potential targets that could accelerate its growth in one of the priority markets. But with U.S. bank valuations at elevated levels, RBC is biding its time, and insists it doesn't need an acquisition in the near term.

"At the end of the day I would say we did this deal and we have a strategy for the next 20 years, which is five [U.S. presidential] administrations," Mr. McKay said. "Honestly, we did not even remotely think about political cycles when we did the deal. Nor should you, right?"
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