Tuesday, September 15, 2009

Review of Banks' Q3 2009 Earnings

Scotia Capital, 15 September 2009

Earnings Stellar – Inflection Point – Outlook Improving

• Canadian banks reported stellar third quarter earnings, substantially better than Street estimates. This was the third straight quarter of beating estimates, but it was by far the largest beat. Based on the strength of third quarter earnings it appears that Q2/09 was the bottom for the cycle on an operating earnings basis, with Q1/08 the bottom of the cycle on a reported earnings basis, including all writedowns. The banks’ previous quarterly results (Q2) provided some optimism that earnings were near the cyclical bottom based on an improved outlook for the net interest margin, credit cost absorption, and sequential improvement in wealth management, which were all fully delivered in the third quarter with added strength from the continued high level of trading revenue.

• Thus, it appears the Canadian banks have weathered the banking siege in a strong fashion. The quarterly bottom in reported return on equity would be 10.5% in Q1/08 and 17.1% in Q2/09 on an operating basis. This reinforces the strength of the Canadian banking system and the banks’ business models.

• The most significant development this quarter, we believe, was the improvement in the net interest margin, which reversed an eight-year descent. The positive impacts of loan repricing, a steep yield curve, lower funding costs, and lowering of liquidity costs were instrumental in improving the banks’ NIM. This represents an important inflection point and bodes well for bank earnings going forward. The potential beginning of a trend of expanding bank net interest margins is not expected to be meaningfully interrupted in the event interest rates begin to rise, especially if they rise in a controlled and orderly fashion.

• Another potential positive inflection point this quarter was on credit, as gross impaired loan formations declined for the second consecutive quarter and loan loss provisions were flat with the previous quarter, suggesting loan losses may be peaking at the $10 billion annualized rate. Thus, we believe loan loss provisions should start to decline by the last half of 2010.

• The banks’ main earnings driver in the third quarter continued to be wholesale banking, with record results due mainly to the continued high level of trading revenue supported by very modest loan losses. Retail banking results were also solid in the quarter, although muted by relatively high retail loan losses, particularly in credit cards. Wealth management earnings rebounded sequentially and are expected to show strong momentum off the bottom.

• The banks reported a fully loaded return on equity after all writedowns and adjustments of 16.3%, with operating return on equity of 18.6% despite what we believe are near-peak loan losses.

• The market, we believe, has discounted bank earnings strength in the first two quarters of 2009, citing low quality due to high trading and securitization revenue. However, if we balance this out somewhat with the probability that a portion of the very strong trading revenue has a structural component and is not all cyclical, and that banks are arguably absorbing peak loan losses, weak wealth management earnings, and generally booking security losses in their available-for-sale securities portfolio, we conclude that earnings quality is only marginally lower. Also, we believe the actual income statement/net income impact of trading and securitization revenue (exhibits 15 and 16) is much lower than the market is generally factoring in. Thus, we conclude third quarter earnings were stellar with reasonable quality and that bank earnings are poised to rise.


• Bank stocks have increased 50% year-to-date 2009, substantially outperforming the TSX, which has increased 24%. Despite the share price performance, we believe valuations remain attractive on both a dividend yield and a P/E multiple basis.

• Dividend yields of 4.1% are compelling, especially with the prospects of dividend increases as early as the next several quarters and the particularly low yield on government bonds. 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.

• Bank P/E multiples have rebounded to 12.3x trailing from the 6.0x low reached in late February. We estimate the valuation contagion overshoot was three to four multiple points. We believe fundamentals support higher valuation as the market refocuses on fundamentals and earnings power.

• We continue to expect bank P/E multiple expansion similar to that experienced post the 2002 cycle. We expect bank P/E multiples to expand to 14x trailing over the next 12 months and eventually reach 15x to 16x. Thus, with P/E multiple expansion and bank earnings bottoming, we believe this bodes well for continued strong share price gains over the next several years.

• In summary, we believe the positive earnings outlook that is unfolding and the continued high profitability will lead to dividend increases, complemented by low yields on treasuries, and will be supportive to continued expansion or recovery in bank P/E multiples. We do not expect meaningful share price resistance and consolidation until the bank P/E recovers to the 14x range, allowing for a further 28% ROR from the bank group.

• We continue to recommend an overweight position in bank stocks based on strong fundamentals and attractive valuation. In terms of stock selection, RY continues to be a standout given the strong reinvestment, competitive positioning in all its major business lines, and resulting industry-high profitability and capital.

• We have 1-Sector Outperform ratings on RY and BMO, with 2-Sector Perform ratings on BNS, CWB, LB, TD, and NA, and a 3-Sector Underperform rating on CM. Our order of preference is RY, BMO, BNS, CWB, LB, TD, NA, and CM.
Financial Post, David Pett, 11 September 2009

Investors anxious for Canadian banks to start raising their dividends should not hold their breath, says Desjardins Securities analyst Michael Goldberg.

"The impact on operating profit of unsustainably high trading revenue and sustained pressure on loan loss provisions, we do not believe that earnings quality or quantity are yet sufficient to support dividend increases," he said in a note to clients.

Mr. Goldberg added that future dividend increases are dependent on the direction of capital regulation.

"If we assume that OSFI maintains its current minimum standards of 7% Tier 1 and 10% total capital and that the banks will want to maintain a comfortable margin of safety above that level (because the consequences of falling below it are so draconian), then this is another reason for banks not to increase their dividends and it may not even justify issuiing more common equity to strengthen that margin of safety," he wrote.
TD Securities, 8 September 2009

• Q3/09 well through expectation. Exceptional trading results helped drive bottom-line numbers that were 21% better than expected on average. We are most encouraged by the credit trends which were broadly better than feared. Domestic P&C banking segments were also solid.

• Hard to see outsized returns. Outsized returns come on the back of outsized earnings growth or upward revaluation. We see limited prospects for either from current levels with the group seemingly already pricing in what we expect will be a relatively shallow earnings trough in 1H10.

• Introducing 2011 estimates. Our visibility is pretty limited that far out, particularly given what we view as heightened uncertainty around the macro outlook. Nonetheless, we are comfortable that credit costs will decline materially and that offers potentially significant bottom-line leverage for the group.

• Credit largely on pace. In most cases, the pace of deterioration appears to be easing and the outlooks are generally steady. We still expect conditions to deteriorate further (particularly on the commercial side), with losses ultimately peaking in 1H10. We still see credit topping out comfortably below the peaks of prior downturns.

• Staying with leverage to the recovery. We think Scotia and TD continue to offer the best leverage to a positive turn in economic growth. Both are trading at reasonable valuation in our view, but we see more potential for upward revaluation in TD (as ROE improves over time).

Executive Summary

Q3/09 results were largely better than expected, helped by exceptionally strong Trading/Wholesale results. These trends are likely to ease, but credit and core domestic P&C banking were also generally good. The stocks rebounded through results season, outperforming slightly. We are comfortable with how the fundamental story is unfolding. From here we still see valuation as the biggest constraint to outsized returns. We remain market weight.

Q3/09 results were largely better than expected with four out of the six Large-Cap Canadian Banks beating consensus estimate by an average of more than 21%. Through earnings week, the stocks were up roughly 4%, slightly outperforming the local index.

We made relatively minor changes on the quarter with no rating changes. We raised our estimates and Target Prices across Royal, National Bank and TD Bank. We reduced our estimates slightly at CIBC (target unchanged). Consensus estimates continue to rebound.

The composition of the results was still a bit questionable again this quarter, with strong trading results accounting for a large portion of the out-performance. Most management teams referred to the pace of trading results as unsustainable, noting that they are already seeing some softening.

Credit was also very encouraging. Most names reported inline or better than expected PCLs and most were still running below our assumed run rate for 2010 (we only increased our PCL estimates meaningfully in the case of CIBC). Furthermore, the underlying trends were generally encouraging with the pace of deterioration starting to slow. We also note that most banks appear to be well reserved.

We were also encouraged by the solid momentum evident in most P&C banking platforms, with particularly good volume growth which suggests good revenue momentum heading into 2010.

Overall we are comfortable with how the core fundamental story is unfolding. Domestic banking is enjoying a bit more momentum than we had expected, but we suspect some of the volume growth reflects the effect of lower rates and pent-up demand driving a bit of bounce in the housing/mortgage market. We expect trends to moderate in the coming quarters. Credit should also continue to deteriorate (particularly in commercial portfolios). However, the situation seems well in hand based on the underlying trends and management outlook. We expect credit costs to peak in 1H10, slightly above current run rates, and comfortably below prior peaks.

With this report we are rolling out our first look at 2011 estimates. It is still a ways off, but we have focused on what we expect will be the biggest single driver of what we believe will be an earnings recovery, and that is declining credit costs. As a result, we see 2011 EPS up in the order of 25-30% across the group. We remain market weight on the group. The biggest constraint to outsized returns in our view is valuations. The group is currently trading at 2.1x book value which is above the 15-year average of 1.8x book. In our view, a move toward peak valuations would require a more favorable environment than we currently expect (i.e. stronger economic growth and fewer risks). We see average returns on the order of 5-20%, including an average dividend yield of 4.4%.

In terms of stocks, our stance remains the same. We want to remain positioned with the best operating leverage to a recovering global economy. In our view Scotia and TD are the best ideas in this approach. Scotia suffered from some credit disappointment on the quarter with an uptick in GILs in the International commercial loan book. However, the issues appear to be quite concentrated (the rest of the book actually improved) and the related costs are likely manageable (the Q3/09 PCL run rate was still below our standing assumptions for 2010). Ultimately we believe Scotia will manage the credit downturn (likely better than feared) and will be well served by its favorable International positioning and corporate/commercial lending business.

TD saw a strong quarter with positive trading results helping to offset higher credit costs (but came in below expectations) and we see good upside in a recovery scenario. Credit trends remain well controlled and although we believe the bank will face greater pressure in the coming quarters, they will likely remain manageable in the context of the banks largely stable and sizeable Domestic Retail earnings base. In our view, the bank’s U.S. strategy will be key to the outlook of the stock and the integration of the U.S. platform is nearly complete. We believe TD will be able to generate greater value from its U.S. Retail franchise and offer potentially higher ROEs (and valuation multiple) in a recovery scenario.

CIBC remains the most interesting name to watch in our view. The quarter offered a new source of disappointment with surprising credit losses coming out of its leveraged loan book and deterioration in its U.S. commercial real estate business. However, the bank is exceptionally well capitalized with potential sizeable recoveries over the coming years with a large retail platform, although it is underperforming expectations under very tight risk management.