Tuesday, August 18, 2009

Preview of Banks' Q3 2009 Earnings

Scotia Capital, 18 August 2009

Banks Begin Reporting August 25

• Banks begin reporting third quarter earnings with Bank of Montreal (BMO) on August 25, followed by Canadian Imperial Bank of Commerce (CM) on August 26, National Bank (NA), Toronto Dominion (TD), and Royal Bank (RY) on August 27, Bank of Nova Scotia (BNS) on August 28, and Laurentian Bank (LB) and Canadian Western (CWB) closing out reporting on September 3. Scotia Capital’s earnings estimates are highlighted in Exhibit 1, consensus earnings estimates in Exhibit 2, and conference call information in Exhibit 3.

Earnings Nearing Cyclical Bottom?

• We expect third quarter operating earnings to decline 14% year over year and 2% sequentially. The year-over-year decline in earnings is due mainly to an 81% increase in loan loss provisions and a decline in net-interest margin, partially offset by strong wholesale banking earnings. The sequential decline in earnings is mainly due to lower expected trading and securitization revenue.

• Interestingly, bank operating earnings have handily beaten consensus estimates over the past several quarters; however, these beats have been generally discounted due to continued noise with respect to mark-to-market writedowns and the fact that trading and securitization revenue have been the main drivers in positive earnings surprises. There has also been a lot of uncertainty about what sustainable trading revenue levels are. At the same time, earnings have absorbed high loan losses and a fall-off in wealth management earnings. In terms of trading revenue, we believe that there is both a cyclical and structural component to the high level of trading revenue, with the split very difficult to ascertain with any degree of accuracy. We suspect the market is attributing most of the trading gains as cyclical, with very little structural consideration. However, from a directional perspective, we see a structural expansion in trading revenue due to the expansion of bank trading platforms and activity, less market capacity and competition, and favourable market conditions that may persist for some time (it may take years to fully revert to the mean), which are all expected to lead to higher structural or sustainable trading revenue.

• We expect third quarter bank index operating earnings to be 410, which we believe is at or near the cyclical bottom, with bank operating earnings having retraced back to Q2/06 levels. We expect a modest pickup sequentially in earnings for Q4/09 to 432, which would be flat YOY; thus, Q3/09 would mark the bottom in bank operating earnings.

• We believe that post the spectacular bank stock rally, the market is now discounting that both loan loss provisions and mark-to-market writedowns are manageable. However, we do not believe the market is discounting the possibility that we may be nearing the peak in loan losses this cycle, or that mark-to-market losses could drop precipitously, or the potential positive impact of net-interest margin expansion.

• Operating return on equity is expected to be 16.5% for the third quarter, down slightly from 17.1% in Q2/09 and down more materially from 20.0% a year earlier.

• Loan loss provisions in Q3 are expected to increase to $2.6 billion or 0.83% of loans, slightly higher than the Q2 level of $2.5 billion or 0.83% of loans, but significantly higher than $1.4 billion or 47 basis points (bp) a year earlier. The growth rate in quarterly loan loss provisions is expected to be 4.6% in Q3/09, down from the peak growth in Q1/09 of 36%. We believe that the bank group is nearing peak sequential loan loss levels.

• We expect a substantial reduction in mark-to-market writedowns this quarter and actual gains in the AFS OCI account (although FX translation will be negative for OCI), due to a number of factors. The corporate bond spreads have improved dramatically to 248 bp from 429 bp in the previous quarter, with the LCDX Index (Corporate Debt/LBO Proxy) increasing 17% from the Q2 levels and the ABX-BBB flat at 3.0. In addition, CDS spreads have improved remarkably in the past quarter, narrowing by 50% to 60% for Citigroup, JP Morgan, Barclays, and Goldman Sachs. In terms of the two main monoline insurers, CDS spreads were somewhat stable, with MBIA narrowing (improving) by 3% and Ambac widening by 28% (there is not a linear relationship with respect to probability of default). The magnitude of potential mark-to-market writedowns has declined in general to a guesstimate of $100 to $300 million per bank, if any (except NA with negligible writedown potential).

• The banks’ overall net-interest margin has the potential to positively surprise due to the steep positive yield curve, loan repricing, deposit surge from money market funds, continuing wide wholesale margin, and easing of liquidity pressures. Personal deposits funded 96% of retail loans in Q2/09, up from the historical low of 81% in 2007 and 88% in 2008. The yield curve steepened 32 bp in Q3 to 322 bp (91-day vs. 10-year) and contracted slightly by 7 bp (2-year vs. 10-year), although it remained attractive at 204 bp.

• Bank prime rate averaged 2.25% in the third fiscal quarter versus 2.64% in Q2/09, potentially squeezing the margin; however, the banks have aggressively repriced their loan book to mitigate this pressure. The absolute low level of interest rates continues to be a major concern in terms of bank profitability. Thus, any signal that there will be no further rate reductions and there may perhaps be moderate, orderly incremental increases in interest rates would be viewed very favourably for bank profitability.

• We continue to forecast a 7% earnings decline in 2009 and a 9% increase in 2010. Return on equity is expected to be 17.0% in 2009 and 17.3% in 2010.

• The fear concerning whether Canadian bank dividends are safe has subsided, and the market is now more balanced in looking at underlying fundamentals, earnings power, and P/E multiples. However, the recent Manulife dividend cut did cause some slight extrapolation to Canadian banks and questioning of the safety of Canadian bank dividends, which we believe has no basis. We not only continue to believe that Canadian bank dividends are safe, but also believe that dividend increases are on the horizon. Canadian banks have a significant opportunity to elevate their status and receive a premium from the equity markets for the soundness of their operating platforms and business models.

• We believe that there is a major scarcity of reliable attractive yield in the marketplace. A number of global banks are no longer paying meaningful dividends. Canada’s largest insurance company cut its dividend by 50%; the high yield income trust market is drawing to a close in Canada, thus Canadian banks’ dividend track record stands out (see report titled “Four Decades of Dividend Growth,” March 2002). Further rewarding shareholders for holding their stock via early dividend increases would, we believe, drive this point home with investors and be supportive to higher (premium) valuations.

• Bank stocks have increased 44% year-to-date 2009, substantially outperforming the TSX, which has increased 21%. Despite the share price performance, we believe valuation remains attractive at 11.2x 2010 earnings estimates, especially if earnings are near their cyclical bottom. We continue to expect bank P/E multiple expansion 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.

• Bank dividend yields also remain very attractive at 4.3% or 124% relative to the 10-year government bond yield, which is 3.0 standard deviations above the mean. Bank dividend yields are also attractive against equities at 0.8x the TSX Equity Index versus a 1.4x historical mean and a 1.1x level recorded from 1956 to 1978.

• The sustainability of bank dividends, scarcity of reliable yield, and the resumption of superior dividend growth are expected to be the catalysts for significantly higher bank share prices.

• We quoted Peter L. Bernstein and Robert D. Arnott’s research in our report titled, “Four Decades of Dividend Growth” (March 2002); they conclude that dividends have been the most significant contributor to total equity returns (dividends represented 63% of total equity returns from 1802 to 2001).

• 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 valuations on both a yield and P/E multiple basis. We remain overweight the bank group.

• We have a 1-Sector Outperform rating on RY and BMO, with 2-Sector Perform ratings on BNS, CM, LB, and CWB, and 3-Sector Underperform ratings on NA and TD. Our order of preference is RY, BMO, BNS, CM, CWB, LB, TD, and NA.

BNS – Scotiabank Mexico Contribution Improves Modestly QOQ

• Scotiabank Mexico reported Q2/09 consolidated net income of $32 million (P$372 million), a 60% decline from a year earlier and a 26% decline from the previous quarter. Earnings declined YOY due to higher loan loss provisions, a P$371 million before-tax loss on sale of a P$860 million credit card portfolio, and a gain on sale on the Mexican Stock Exchange IPO a year earlier. This was somewhat offset by a decline in the effective tax rate to 13% from 31% a year earlier and 38% in the previous quarter, due to lower earnings in the quarter and favourable timing differences.

• Scotiabank Mexico’s contribution to BNS, after adjustments for Canadian GAAP, is $61 million or $0.06 per share, versus $54 million or $0.05 per share in the previous quarter, and $104 million or $0.10 per share a year earlier. The adjustment to Canadian GAAP includes a reversal of the loss on partial sale of credit card portfolio, as the loss was recognized in the previous quarter.

TD – TD Ameritrade Earnings Improve Sequentially

• TD Ameritrade (AMTD) reported a 12% decline in earnings to US$0.30 per share from US$0.34 per share a year earlier due to the weak net interest margin and higher expenses, but increased 30% sequentially. Earnings were slightly above consensus. TD Bank estimates TD Ameritrade’s contribution this quarter to be $68 million or $0.08 per TD share versus $0.06 per share in the previous quarter and $0.09 per share a year earlier.

TD Pre-Announced an FDIC Special Assessment Charge for Q3/09

• On May 28, 2009, TD pre-announced a US$50 million FDIC special assessment charge based on 5 bp of total assets less Tier 1 Capital as at June 30, 2009. This charge translates into C$0.04 per share. We estimate that similar charges for BMO and RY would be approximately US$20 million (C$0.04 per share) and US$15 million (C$0.01 per share), respectively.
Financial Post, Eric Lam, 18 August 2009

With Canadian banks reporting their results next week, analyst forecasts continue to roll in. Next up is James Bantis of Credit Suisse, who warns that the pendulum of investor sentiment has swung from too bearish in February to too bullish now.

"Earnings quality in the first half of 2009 was poor, relying on unusually high trading revenue to offset credit challenges," he said in a note to clients. "Looking ahead, credit provisions are expected to accelerate well into the first half of 2010 whereas trading revenue levels may be close to peaking."

Mr. Bantis expects operating earnings to be down 16% on average from the third quarter of 2008, with a considerable downside risk gross impaired loans are forecasted to rise by 10% to 15%.

Credit Suisse has also compiled a brief summary of what to expect from each bank:

•Bank of Montreal: Underperform, EPS 93 cents (in line with consensus), Target Price $36
•Bank of Nova Scotia: Neutral, EPS 84 cents (3 cents above consensus), Target Price $34
•CIBC: Underperform, EPS $1.35 (3 cents below consensus), Target Price $48
•National Bank: Neutral, EPS $1.32 (2 cents below consensus), Target Price $48
•Royal Bank: Neutral, EPS 93 cents (2 cents above consensus), Target Price $37
•TD Bank: Neutral, EPS $1.20 (1 cent below consensus), Target Price $44
Financial Post, Eric Lam, 17 August 2009

With the Bank of Montreal set to announce its third quarter results next week, Blackmont takes a quick look at what to expect for the latest earnings season for Canada's Big Six.

Overall, Brad Smith, analyst, forecasts per share profits will be about 15% below 2008 levels, close to the median consensus forecast of 16%.

"As has been the case for much of the past 12-18 months, credit provisioning decisions will have a meaningful impact on reported profits," Mr. Smith said in a note Monday. "Moreover, it remains to be seen if the banks see fit to increase loss allowances relating to their domestic loan books that have migrated to a more consumer focus in recent years."

Consumer lending has always shown great resilience, but recent pressure on employment and income levels has seen a steep climb in consumer bankruptcies, he said.

Other than earnings, credit loss development and capital positioning are important factors to consider for investors, Mr. Smith said.

As for individual banks, the Bank of Nova Scotia has the best chance of posting a "positive surprise" given its stable credit profile in Mexico, while the Bank of Montreal's weak performance in its U.S. personal and commercial segment and lower-than-expected securitization revenue are likely to depress results.
TD Securities, 13 August 2009

Canadian Banks: A Closer Look - Personal Loan Market

• Defining the credit risks. The third in a series of in-depth reports, we look at the Personal Loan books of the Canadian banks and the outlook for credit losses. We continue to expect credit costs to climb materially in 2009 and 2010, but we maintain our view that expenses will be manageable.

• Personal Loans - a significant driver of credit expense. Our outlook reflects some C$5.3 billion in PCLs relating to Personal Loans in 2010 out of our total estimate of C$9.8 billion for the Large-Cap Canadian banks. This is against our estimate of pre-tax, pre-provision profit of roughly C$35 billion.

• HELOCs - unlikely to be a source of credit stress. The Canadian HELOC exposures are of relatively high quality and should see minimal losses. U.S. exposures are higher risk but represent relatively small portfolios.

• Credit Cards - likely to see relatively intense losses. On a managed basis, trends have been deteriorating across the board with losses running 5-6%. We continue to expect loss rates to ultimately reach high single digits.

• Other Personal Loans - a mixed bag. Sub-prime auto loans and unsecured Lines of Credit, for example, should see elevated losses, but they are a smaller portion of the book. Overall, we expect low single digit losses here.

• CIBC dealing with cards; BMO looks thinly reserved. With the largest Cards book, CIBC is seeing significant credit deterioration, but the bank is well reserved and appears to be managing the downturn. Overall, BMO stands out as having relatively thin reserves. We do not see the Personal Loan portfolio as overly problematic, but it does have some pockets of lower quality U.S. exposures.

Executive Summary

The Personal Loan books of the Canadian banks have deteriorated, and are likely to continue to be a source of relatively intense credit losses. This should drive an estimated C$5.3 billion in PCLs in 2010. However, trends remain reasonably well controlled and the expected material uptick should be manageable.

In this, the third in a series of in-depth reports on the outlook for credit, we detail the industry’s credit exposure to the Personal Loan market (which we define as personal lending excluding traditional residential mortgages which we covered in a previous report - “A Closer Look – Canadian Residential Mortgage Market,” dated April 23, 2009).

Included in this portfolio are Home Equity Lines of Credit (HELOCs), Credit Cards and Other Personal Loans (i.e. unsecured loans/Lines of Credit, investment loans, auto loans etc). Importantly, we consider loan and credit exposure on a managed basis; that is including, where possible, direct securitization exposure. Overall, personal lending represents just below 25% of the managed loan books of the Large-Cap Canadian banks on average.

• HELOCs. A fairly significant portfolio for some banks of total managed loans (TD has a reported exposure of nearly 25%). The Canadian exposures are of relatively high quality, in our view, (helped by the existence of a robust mortgage insurance framework in Canada) and recent performance data continues to suggest minimal losses. Some select U.S. based exposures are likely to see elevated losses, but they are relatively small. Conditions are likely to continue to slip from current levels, but HELOCs are unlikely to be a material source of credit stress for the Canadian banks in our view.

• Credit Cards. Card exposure varies materially across the banks, but peaks at approximately 7% of managed loans at CIBC. Credit cards are likely to see some of the most intense loss rates of any portfolio and we have already seen significant deterioration. We expect losses to continue to track unemployment higher toward a high single digit pace. This will move the industry to levels at or slightly above historical peaks.

• Other Personal Loans. This segment represents a fairly large catch-all ranging from low risk personal investment loans to higher-risk sub-prime auto loans. Trends have been relatively muted to date, but losses are likely to continue to climb driven by higher risk categories. Historical data is particularly sparse for this segment, but we assume PCL rates will reach upwards of 250-300bp.

Overall, we see PCL rates relating to Personal Loans running on the order of 200bp over the coming year, driving some C$5.3 billion in PCL expense in 2010 out of our total estimate of C$9.8 billion for the Large-Cap Canadian Banks. This is against our roughly C$35 billion in pre-tax, pre-provision profits. In this context, we maintain that the current cycle will be manageable. We continue to expect to see losses peak in 1H10.

Looking across each of the names, while all should manage the downturn, there are a range of specific issues for each bank;

Our Take on the Names:

BMO. Overall, the bank is relatively thinly reserved (a function of a high quality book and aggressive charge-offs according to management). In our view, there are no grave issues in the Personal Loan book at BMO, but they do have a small book of lower quality U.S. HELOC loans which should continue to deteriorate.

Scotiabank. The key concern remains the bank’s international portfolio of credit card and consumer finance loans primarily in Mexico and Latin America respectively. Although credit costs have increased, trends have begun to show some signs of moderation over recent quarters.

CIBC. The key exposure at CIBC is clearly the bank’s outsized credit card portfolio. Conditions here have deteriorated in recent quarters and we expect them to get worse. However, the bank has been tightening underwriting standards, managing collection efforts, and increasing credit reserves in anticipation of higher losses. Furthermore, the most recent data points from the bank’s securitization trust suggests trends are moderating with delinquency and credit loss rates improving month over month in June 2009 (echoing similar comments from management in their Q2/09 conference call).

National Bank. In our view, National will likely continue to see above average credit performance with limited areas of concern. The Personal Loan portfolio benefits from an entirely domestic and largely Quebec focus as well as among the smallest concentrations of credit card lending.

Royal Bank. We do not believe the bank has material areas of concern within their Personal Loan book. Although Royal has a sizeable credit card portfolio, it is still relatively small at just 4% of the bank’s managed portfolio and the performance trends to date have been relatively good (although it is unclear how aggressive/conservative the bank has been in building reserves against future card losses).
Financial Post, David Pett, 14 August 2009

With third quarter earnings results looming, BMO Capital Markets analyst Ian de Vertueil fine-tuned a couple of his Canadian bank recommendations this week, putting Bank Of Nova Scotia and Bank of Montreal back on the same playing field.

To start, the analyst upgraded Scotiabank from Underperform to Market Perform while increasing his 2009 cash earnings per share estimate for the bank from $2.90 to $3 and his 2010 cash EPS estimate from $2.55 to $2.65. Mr. Verteuil's price target on the stock climbs from $41 to $42.

"Since we downgraded Scotiabank six months ago, the shares have underperformed the bank group by 8%," he said in a note to clients. "We continue to believe the bank will feel more credit headwinds in the short term from its corporate loan book both in North America and internationally, but the underperformance highlights that much of this is reflected in the share price."

Mr. de Vertueil now also has a Market Perform rating on Bank Of Montreal shares, after downgrading the stock from Outperform and lowering his price target from $56 to $53. He noted that BMO is relatively expensive on earnings but still trades at a discount to the overall group on price to book.

"Since our upgrade a year ago, the shares have outperformed the group, up 9% versus the bank index, which is essentially flat," he said.

"At the time of our upgrade, we thought the concerns on the bank’s off-balance sheet exposure were overdone. We don’t expect any material surprises in the quarter, but we think that most of the sentiment shift on the stock has now occurred. Given the bank’s limited leverage to a more stable credit environment, we believe that a downgrade is warranted."

Overall, Mr. de Verteuil expects Canadian banks to report solid third quarter earnings.

"On a reported basis, we believe that results will be well up from a year earlier, but this entirely reflects the fact that CIBC is comparing with a very weak quarter of a year earlier. Exclusive of CIBC, the group’s reported earnings will be down about 4% versus a year earlier," he wrote.
Financial Post, John Greenwood, 14 August 2009

The impact of rising loan losses at the Canadian banks will be cushioned by stronger trading and underwriting revenues in the third quarter, according to RBC Capital Markets analyst Andre-Philippe Hardy.

Over the past year the banks have been hammered by the credit crunch but as conditions start to stabilize and net interest margins move up the banks will feel the benefit when they post their results starting on August 25.

“We are positive on Canadian bank shares given that indicators of futureprofitability are trending in the right direction, and the banks have enough revenue and capital in our view to handle the impact of challenging economic conditions on loan losses over the next 6 - 12 months,” Mr. Hardy said.

He pointed to National Bank as the player facing the fewest headwinds since it has almost no exposure to the United States and limited operations in the hard-hit province of Ontario.

Meanwhile a report from Desjardins Securities analyst Michael Goldberg warns of a below normal quarter at the banks with continued credit issues.

“US banks have finished reporting their second quarter results, and we believe that the highlights are likely to be mirrored in Canadian third-quarter earnings on a much smaller scale,” Mr. Goldberg said.

Despite the gloomy economy, global financial markets have shown significant improvement since the dark days of March, with rising equity markets helping to buoy bank profits.

Mr. Goldberg said he expects stronger equity markets and narrowing credit spreads to drive higher trading revenue but at the same time warned of underlying concerns over credit quality both in the US and Canada.

“Although we do not believe that the problems in Canada will get near as bad as in the US, we believe that credit quality for the Canadian banks will get worse before it gets better,” he said.