Thursday, September 18, 2008

RBC CM: Pair Trade Idea • Long TD Bank, Short BMO

  
RBC Capital Markets, 18September 2008

Pair Trade Rationale:

We prefer TD Bank's stock to Bank of Montreal's. TD is currently trading at the same P/B multiple as BMO, and at a 0.5x premium on a forward P/E basis. However, we believe TD's premium should be higher due to: (1) a more valuable business mix; (2) less credit concerns in the near term; (3) a stronger and faster growing domestic franchise, and; (4) fewer headline exposures related to capital markets. These more than offset a lower capital position than BMO.

We think this pairs trade idea could add value to investors in both a rising and declining market environment and is an opportuunity to add value in an uncertain environment for short term direction in bank share prices.

We maintain our Sector Perform rating on TD's shares.

• Near term, TD's retail results should benefit from efficiency gains on revenue growth that remains strong, and exposure to structured finance is small. The size of the U.S. loan book is a negative, but near term trends in the bank's credit book are better than other banks with U.S. exposures.

• U.S. credit risk is the main concern in 2009, but expected expansion in operating leverage in retail banking (and strong revenue growth), synergies from the Commerce Bancorp and lower exposure to Canadian credit risk should offset loan losses that should rise, but remain below U.S. peers.

• Our 12-month target price of $69 is based on a P/BV multiple of 1.7x, versus the current 1.5x multiple, and it implies a P/E on NTM EPS of 10.5x, whereas where the stock currently trades at 9.5x.

We maintain our Underperform rating on Bank of Montreal's shares.

• We believe that BMO's share price is likely to lag its peers' given: (1) Our outlook for greater deterioration in credit quality near term, based on the bank's U.S. exposures; (2) Domestic retail results that are likely to continue lagging those of the leading banks on a combination of revenue and bottom-line growth; (3) Greater concerns over the sustainability of wholesale earnings than most peers as the bank will likely reassess risk appetite; and (4) Continued overhang from off-balance sheet exposures, particularly as recent market events have led to widening spreads which we believe will put more pressure on structured finance asset valuations.

• Our 12-month target price of $44 is based on a P/BV multiple of 1.35x, versus the current 1.5x multiple, and it implies a P/E on NTM EPS of 8.0x, whereas where the stock currently trades at 9.0x.
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