Wednesday, June 17, 2009

Review of Banks' Q2 2009 Earnings

Scotia Capital, 17 June 2009

Bank Earnings Near Cyclical Bottom

• Canadian banks reported strong second quarter earnings, handily beating consensus estimates. Earnings were driven by robust wholesale banking earnings, loan repricing, and securitization revenue that offset higher credit costs. Mark-to-market writedowns declined and show signs of abating further.

• Operating return on equity was 17.1% despite 83 basis points (bp) in loan losses and some dilution from common equity issues. Bank reported return on equity on a fully loaded basis remained in double digits at 10.6%.

• Second quarter operating earnings declined 7% year over year (YOY) and 10% sequentially, representing the sixth straight decline in quarterly earnings on a YOY basis. We expect the third quarter of 2009 earnings to be the low of the cycle, with quarterly earnings momentum starting to turn positive in Q4/09 and Q1/10.

• Bank second quarter earnings provide some basis for optimism that earnings are near the cyclical bottom based on an improved outlook for the net interest margin, credit cost absorption, and the expected sequential improvement in wealth management earnings based on the major market rebound.

• We believe that BMO reported the strongest results this quarter, followed by NA, BNS, RY, and TD, with CM the weakest. In terms of domestic banking earnings including wealth management, BNS and NA were the most resilient, declining 1.2% and 2.6%, followed by BMO, TD, and RY declining 3.7%, 4.3%, and 6.9%, respectively, with CM the major outlier, down 25%.

Wholesale Earnings Robust

• Wholesale earnings remained extremely robust, driven by strong trading revenue. Trading revenue this quarter at $2.8 billion was down from the all-time record $3.4 billion level in Q1/09 but remained very high, reflecting the Canadian banks’ preferred counterparty status, OTC spreads, and structural expansion in their trading books and platforms. The trend of growing earnings power from wholesale banking is very much intact. The reduction in capacity in wholesale and the major dislocation in this market has created significant opportunities that continue to be more and more evident. There is a structural shift, not just cyclical.

Net Interest Margin Resurgence

• The resurgence in the banks’ net interest margin (NIM) may represent a significant inflection point for the bank group. The banks’ net NIM received some relief in the second quarter, driven by historically high wholesale spreads, aggressive loan repricing (liquidity/risk premium), and steeper yield curve.

• The retail NIM declined 10 bp YOY, with mixed results among the individual banks sequentially. Retail NIMs were positively impacted by securitization, variable rate loan repricing, and attractive transfer pricing, which helped offset the negative impact from the low level of interest rates. BMO, TD, and BNS retail NIMs improved sequentially by 17, 12, and 6 bp, respectively. Conversely, NA, RY, and CM NIM declined 6, 3, and 3 bp, respectively. It appears that the retail NIM has bottomed for some banks and is bottoming for others, after declining for the past eight years. Further margin expansion is likely, aided by the continued repricing of the loan book. The improved outlook for both the overall NIM and retail NIM should be very supportive to earnings going forward.

Higher Capital – Lower Mark-to-Market

• Tier 1 capital ratio for the bank group was an all-time record of 10.7%, driven by internally generated capital, modest capital raises, and some RWA relief via the higher Canadian dollar. TCE to RWA increased to 7.6%. We also expect book value gains as a result of a reduction in the unrealized AFS losses in OCI in the third quarter based on the significant improvement in corporate bond spreads.

• Mark-to-market writedowns were $1.2 billion after tax in the second quarter, down from the $2 billion level in the two previous quarters. We expect mark-to-market losses to continue to decline given the rally in the LCDX Index, tighter CDS spreads, and the significant improvement in corporate bond spreads.

Credit Losses Peaking

• Loan loss provisions (LLPs) this quarter increased to $2.5 billion or 83 bp of loans, 7% higher than our forecast. LLPs are 2.2x higher than a year earlier and reflect the sharp deterioration in the economy and credit quality. Bank LLPs typically peak one year after the economy bottoms. However, with the sharp economic decline in Q1/09 and the havoc that the capital markets debacle had on the real economy, it seems that peak loan losses in this credit cycle are happening sooner. If gross loan formations continue their modest decline experienced in Q2/09 over the next several quarters, this bodes well for credit losses.

• LLPs were mixed among the banks, with NA provisioning remaining low and BMO LLPs actually declining (may have peaked in Q3/08) and BNS, CM, RY, and TD all up sequentially. We believe BMO’s loss ratio may have peaked, with RY, TD, and CM nearing their peak and BNS likely to increase moderately.

• LLPs in the second quarter increased 18% sequentially to $2,470 million or 83 bp. The loss ratio varies, with RY and TD at highs of 107 and 93 bp followed by BMO and CM at 85 and 83 bp, with BNS at 60 bp and NA a continued outlier at 30 bp.

• The highest loss ratios were in the International business segment with BNS Mexico loss ratio of 434 bp, RY U.S. at 308 bp, and TD U.S. at 127 bp. Loan losses in these businesses for BNS, RY, and TD represented 21%, 38%, and 37%, respectively, of the total quarterly loan loss provisions.

• In terms of domestic banking, the lowest loss ratios are being recorded by BMO, BNS, and NA in the 33 to 38 bp range. CM has the highest loss ratio at 73 bp due to heavy weighting in credit cards, with RY and TD at 59 and 52 bp, respectively.

• In terms of wholesale loan loss provisioning as a percentage of total provisioning, for BMO, BNS, CM, NA, RY, and TD they comprise 12%, 25%, 5%, 17%, 19%, and 11%, respectively.

• Gross impaired loans increased 17% sequentially to $14.3 billion, but remain at a relatively low level compared to past cycles at only 1.2% of loans. This ratio is expected to increase further, but to remain significantly below past historical peaks (see our report titled The Credit Cycle, May 2009). Gross impaired loan formations remained high at $5.2 billion but were lower than in the previous quarter. If gross impaired formations continue this trend, it will be positive for the outlook for loan losses.

• We have increased our 2009 loan loss provision forecast to $9.7 billion from $8.5 billion based on the acceleration of provisioning due to the sharpness of the economic decline. However, our 2010 loan loss provision forecast is essentially unchanged at $10.6 billion or 0.78% of loans.

Earnings Power – Dividend Increases

• In summary, we believe second quarter earnings are reflective of bank earnings power and their ability to absorb credit losses and mark-to-market writedowns. The outlook for earnings, with the possibility of net interest margin resurgence, disappearing mark-to-market writedowns, and eventually lower credit costs, is quite powerful. Canadian banks are well positioned to take advantage of the fallout from the global banking crisis. They have significant operating leverage going forward, with revenue growth opportunities as a consequence of banking capacity reduction at the same time they are able to take advantage on the costs side by reducing operating and labour costs. In addition to strong operating leverage, bank capital is worth more, and banks are starting to get paid a major liquidity/risk premium (repricing of loan book) that is higher than in previous cycles. Thus, strong underlying earnings and high capital positions should be conducive to future dividend increases that could occur as early as the fourth quarter of 2009 for select banks.

• The market’s hysteria about the need to raise or preserve capital and the possibility of dividend cuts has reversed itself dramatically. The capital conundrum going forward is likely to be: what are the banks going to do with all that capital? We believe banks have the ability to easily run their Tier 1 capital ratios up to the 12% to 14% range.

• We are a major proponent of bank leadership signalling confidence in their business models to the market by rewarding shareholders with modest dividend increases early. A 5% dividend increase in Q4/09 would consume an insignificant amount of capital but provide a strong signal that would serve to further differentiate Canadian banks from their global peers. Canadian banks have a stellar record of increasing dividends over the past 50 years, with both BNS and TD actually increasing their dividends in fiscal 2008. Banks that are able to increase their dividends through a global crisis would be a powerful statement, but it does require conviction.

P/E Multiple Recovery

• Bank P/E multiples have recovered from valuation contagion that was aided by aggressive selling and the agents of fear. Bank P/E multiples have rebounded to 10.5x from the 6.0x low reached in late February. The current P/E multiple is now more in line with recent past cycle lows. We estimate the valuation contagion overshoot was three to four multiple points. We believe fundamentals support significantly higher valuation, and the market seems to be refocusing on fundamentals. We believe the market is starting to look at earnings power and P/E multiples for valuation versus market to tangible book.

• We continue to expect bank P/E multiples to expand through 2012, similar to that experienced post the 2002 cycle. We expect bank P/E multiples to expand back to 14x in the next few years and eventually reach 16x. Thus with P/E multiple expansion and bank earnings bottoming, this bodes well for continued strong share price gains over the next several years.

Bank Rally – Positive Outlook

• The major bank rally in Canadian bank stocks has happened at breathtaking speed, with the bank group increasing 72% in three months off their February lows. Bank stocks are now significantly outperforming the market with gains of 28% year-to-date versus the market being up 19%.

• It is natural or reasonable to expect a bank share pullback based on the strength of the rally or at least some retracement on a technical basis. However, if we look at the underlying earnings power and valuation, which remains compelling despite the rally, we remain overweight the bank group.

• Bank dividend yields, although down from their lofty heights, are very high at 4.8% and remain in a strong buy range against government bonds or the equity markets. Bank dividend yield relative to 10-year Canada bonds is 3.6 standard deviations above the mean.

• In conclusion, Canadian banks are well capitalized with high-quality balance sheets, a diversified revenue mix, a solid long-term earnings growth outlook, low exposure to high risk assets, and compelling valuation on both a yield and P/E multiple basis. Remain overweight the bank group.

• We have a 1-Sector Outperform rating on Royal Bank, with 2-Sector Performs ratings on NA, BMO, BNS, LB, and CWB and 3-Sector Underperform on TD and CM. Our order of preference continues to be biased towards strong wholesale banks with wealth management earnings momentum expected to pick up. Our order of preference is RY, NA, BMO, BNS, CWB, LB, TD, and CM.
BMO Capital Markets, 2 June 2009

Operating earnings for the bank sector fell 6%, slightly more than the 5% we estimated. Reported earnings for the banks were much weaker than expected, due to another round of asset writedowns and restructuring charges. In response to weak results and price appreciation, we have trimmed our bank weight by 1%.

Ian de Verteuil downgraded CIBC to Underperform. Q1 earnings were weaker than expected, due to larger than expected charges, and the mix of operating earnings was skewed toward low multiple wholesale earnings. Investors will likely remain on the sidelines until there is a cleaner record of profitability or closure on the structured credit front. We have shifted most of our CIBC holdings into larger positions in Royal Bank and National Bank, both of which exceeded our expections on Q1 earnings.
TD Securities, 1 June 2009

Our Views Largely Unchanged Post Quarter - Market-Weight

• Comfortable with Market-Weighting - we see fair returns from here. Following some volatility, the group ended earnings season largely unchanged. We shifted to Market-Weight down from Over-weight on May 8 and remain comfortable with that stance. We see 10-15% average total returns across the group on 12-months.

• Key themes as expected. Trading/Capital Markets revenues were generally strong across the group and in a number of cases masked continued moderation in key operating trends (i.e. volume growth/revenue) and further credit deterioration. Margins were mixed across the names, but commentary suggests that asset repricing and improved funding situation should begin to help restore NIMs.

• Credit deteriorating, but not exploding. Credit conditions and PCLs deteriorated only slightly worse than our expectations while a number of banks made efforts to stay ahead of the curve by building general/sectoral reserves. Credit headwinds should intensify through 2H09 (peaking in 1H10), but we remain comfortable with our standing view that the cycle will ultimately prove manageable.

• Minor changes to our outlook. We made a handful of changes to our estimates. However, on balance we continue to expect a fairly modest 2H09 with easing revenue trends and rising PCLs. We see room for slight growth/recovery in 2010 as PCLs peak, volumes recover and margins firm.

• We moved to the sidelines on CIBC. We downgraded CIBC to HOLD from Buy on Friday, May 29. We still believe progress is being made improving the fundamental business model. However, consistent retail delivery remains a near-term challenge just as rising credit costs loom. At these price valuations/levels we need to be sensitive to these concerns.

• Scotia and TD delivered and hold good outlooks. Both banks delivered decent quarters (broadly inline with our expected themes) and maintain, in our view, solid medium-term prospects.

• More to follow. We will publish our complete Quarterly Key Trends report in the coming days.
Financial Post, 2 June 2009

Scotia Capital took its turn at bat Friday, analyzing second-quarter results from National Bank, CIBC and TD Bank.

Here's a collection of Scotia Capital analyst Kevin Choquette's findings, released Monday.

For CIBC, Mr. Choquette found retail market earnings to be "disappointing" after dropping 21% from the same time last year.

Loan loss provisions and impaired loan formations both increased in the quarter as well.

However, CIBC World Markets earnings rose to $203-million from $80-million a year earlier as the brokerage firm recently took over top trader spot from TD Securities.

TD had held top spot every month since 2003.

Mr. Choquette's 2009 and 2010 earnings estimates remain the same at $6 and $6.30 per share each, and he is keeping CIBC at Sector Underperform while maintaining a 12-month share price target of $68.

The picture at National Bank and TD Bank appears to be rosier as both are considered "wholesale strong" by Scotia.

A 9% increase in operating earnings to $1.53 per share at National Bank is above Mr. Choquette's estimated $1.30 per share, driven by "extremely strong" trading revenue from fixed income.

And TD Bank's overall results and securitization revenue helped offset a spike in U.S. loan losses, as reported a better-than-expected 7% dip in operating earnings.

National Bank also picked up $100-million of securitization revenue in the quarter, up from $58-million the previous year, a 17-cent per share gain.

Mr. Choquette is keeping National Bank's Sector Perform rating, noting "relatively low credit risk" and solid relative retail momentum.

He has also upped TD's 2009 and 2010 earnings estimates to $5 and $5.40 per share from $4.85 and $5.10 per share, but Scotia's share price target of $60 remains static and TD will keep its Sector Underperform.