Friday, December 05, 2008

National Bank Q4 2008 Earnings

TD Securities, 5 December 2008


National Bank reported its full Q4/08 operating results yesterday consistent with the Core Cash FD-EPS of C$1.36 they pre-announced on November 26, 2008.

Slightly Positive. Relative to expectations based on the pre-announced results, the operating details provided some relief around the underlying operating momentum. Credit trends are slipping, but appear manageable and the bank has a middle of the pack capital position at 9.44% Tier 1. The stock appears to be attractively valued on an operating basis, although the yet to be completed restructuring of the ABCP market remains a risk/overhang. On the view that the restructuring is ultimately successful, we see good upside on the name even on slightly lower earnings and reduced Target Price.


Getting to an earnings run rate. In its pre-announcement, the bank reported an adjusted number of C$1.36 inclusive of approximately C$0.25 in gains related to AMF. Ex the gain, the number was below expectations (C$1.11) and suggested a below consensus run rate for 2009. However, the full release offered additional details that indicate the bank also incurred trading related losses on the order of C$61 million after-tax that could be considered one time in nature and an offset to the gain. All in, the trend looks closer to C$1.40+/-; more consistent with the otherwise decent operating trends.

Reasonable underlying operating trends. The quarter suggests continued modest progress here, consistent with our expectations with decent volume growth in P&C and good cost control delivering low single digit growth while Wealth was surprisingly strong at +17.5%. We continue to hold modest expectations for 2009, but management does seem to be moving forward against its initiatives.

ABCP remains THE risk. The proposed restructuring of the 3rd Party ABCP market in Canada remain a key risk around the stock. Efforts have been underway for over a year now, and several difficult hurdles have been cleared (i.e. legal challenges etc). However, the final paper work has yet to be completed. Management, and other proponents of the deal, suggest that progress is being made and they are confident that it will be completed (National is explicitly giving it a 95% probability), suggesting the latest delays are merely housekeeping issues. Our visibility is limited, but the turbulent market conditions and the challenges across a number of counter-parties involved suggest continued risks in our view.

The failure of the restructuring process would be a significant negative development for the stock in our view in terms of its likely impact on capital. We consider the sensitivities around the potential outcomes in Exhibit 1.

Q4/08 Segment Highlights

P&C Banking. The segment continues to make progress along the lines of our modest expectations. Net income growth of 4.4% came on the back of decent volume growth and well controlled expenses (NIX +0.3%). Credit costs are trending higher, coming in ahead of expectations on cards/personal loans. We continue to expect modest progress going forward as management implements its strategic initiatives to drive revenue in the context of a challenging operating environment.

Wealth Management. A surprisingly strong quarter with net income +17.5%, helped in part by the contribution from recent acquisitions in the mutual fund operations. The quarter was also helped by very good cost control. The segment will remain highly market sensitive, but structural changes (cost cutting, acquisitions etc) should provide some help over the coming year.

Financial Markets. The reported numbers indicate the segment was down -20.5% to C$70 million of net income. However, taking out C$45 million after-tax gain on AMF and adding back investment losses of C$61 million (including C$23 million in write-offs for exposure to Lehman Brothers, AIG and Washington Mutual) would result in C$86 million in net income; flat with last year.

Justification of Target Price

Reflecting lower earnings and a lower book value, as well as compressed valuation multiple, we have reduced our Target Price from C$62 to C$55.

Our Target Price reflects a discount to our estimate of equity fair value 12 months forward (based on our views regarding sustainable ROE, growth and cost of equity), implying a P/BV of 1.7x (down from 2.0x).

Key Risks to Target Price

1) Substantial ABCP losses, 2) weakening economic conditions in Quebec, 3) the inability to compete on scale and flexibility, 4) adverse changes in the credit markets, interest rates, economic growth or the competitive landscape.

Investment Conclusion

On the view that the ABCP restructuring plan is ultimately successful, we see good upside on the name even on slightly lower earnings/Target Price.