2 Sector Performs ratingScotia Capital, 17 June 2009
Bank Earnings Near Cyclical Bottom
•Canadian banks reported strong second quarter earnings, handily beatingconsensus estimates. Earnings were driven by robust wholesale bankingearnings, loan repricing, and securitization revenue that offset highercredit costs. Mark-to-market writedowns declined and show signs ofabating further.
• Operating return on equity was 17.1% despite83 basis points (bp) in loan losses and some dilution from commonequity issues. Bank reported return on equity on a fully loaded basisremained in double digits at 10.6%.
• Second quarter operatingearnings declined 7% year over year (YOY) and 10% sequentially,representing the sixth straight decline in quarterly earnings on a YOYbasis. We expect the third quarter of 2009 earnings to be the low ofthe cycle, with quarterly earnings momentum starting to turn positivein Q4/09 and Q1/10.
• Bank second quarter earnings provide somebasis for optimism that earnings are near the cyclical bottom based onan improved outlook for the net interest margin, credit costabsorption, and the expected sequential improvement in wealthmanagement earnings based on the major market rebound.
• Webelieve that BMO reported the strongest results this quarter, followedby NA, BNS, RY, and TD, with CM the weakest. In terms of domesticbanking earnings including wealth management, BNS and NA were the mostresilient, declining 1.2% and 2.6%, followed by BMO, TD, and RYdeclining 3.7%, 4.3%, and 6.9%, respectively, with CM the majoroutlier, down 25%.
Wholesale Earnings Robust
•Wholesale earnings remained extremely robust, driven by strong tradingrevenue. Trading revenue this quarter at $2.8 billion was down from theall-time record $3.4 billion level in Q1/09 but remained very high,reflecting the Canadian banks’ preferred counterparty status, OTCspreads, and structural expansion in their trading books and platforms.The trend of growing earnings power from wholesale banking is very muchintact. The reduction in capacity in wholesale and the majordislocation in this market has created significant opportunities thatcontinue to be more and more evident. There is a structural shift, notjust cyclical.
Net Interest Margin Resurgence
•The resurgence in the banks’ net interest margin (NIM) may represent asignificant inflection point for the bank group. The banks’ net NIMreceived some relief in the second quarter, driven by historically highwholesale 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 NIMswere positively impacted by securitization, variable rate loanrepricing, and attractive transfer pricing, which helped offset thenegative impact from the low level of interest rates. BMO, TD, and BNSretail 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 isbottoming for others, after declining for the past eight years. Furthermargin expansion is likely, aided by the continued repricing of theloan book. The improved outlook for both the overall NIM and retail NIMshould 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 of10.7%, driven by internally generated capital, modest capital raises,and some RWA relief via the higher Canadian dollar. TCE to RWAincreased to 7.6%. We also expect book value gains as a result of areduction in the unrealized AFS losses in OCI in the third quarterbased on the significant improvement in corporate bond spreads.
•Mark-to-market writedowns were $1.2 billion after tax in the secondquarter, down from the $2 billion level in the two previous quarters.We expect mark-to-market losses to continue to decline given the rallyin the LCDX Index, tighter CDS spreads, and the significant improvementin corporate bond spreads.
Credit Losses Peaking
•Loan loss provisions (LLPs) this quarter increased to $2.5 billion or83 bp of loans, 7% higher than our forecast. LLPs are 2.2x higher thana year earlier and reflect the sharp deterioration in the economy andcredit quality. Bank LLPs typically peak one year after the economybottoms. However, with the sharp economic decline in Q1/09 and thehavoc that the capital markets debacle had on the real economy, itseems that peak loan losses in this credit cycle are happening sooner.If gross loan formations continue their modest decline experienced inQ2/09 over the next several quarters, this bodes well for credit losses.
•LLPs were mixed among the banks, with NA provisioning remaining low andBMO 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 havepeaked, with RY, TD, and CM nearing their peak and BNS likely toincrease moderately.
• LLPs in the second quarter increased 18%sequentially to $2,470 million or 83 bp. The loss ratio varies, with RYand TD at highs of 107 and 93 bp followed by BMO and CM at 85 and 83bp, with BNS at 60 bp and NA a continued outlier at 30 bp.
• Thehighest loss ratios were in the International
business segment with BNSMexico 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 recordedby BMO, BNS, and NA in the 33 to 38 bp range. CM has the highest lossratio at 73 bp due to heavy weighting in credit cards, with RY and TDat 59 and 52 bp, respectively.
• In terms of wholesale loan lossprovisioning 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% sequentiallyto $14.3 billion, but remain at a relatively low level compared to pastcycles at only 1.2% of loans. This ratio is expected to increasefurther, but to remain significantly below past historical peaks (seeour report titled The Credit Cycle, May 2009). Gross impaired loanformations remained high at $5.2 billion but were lower than in theprevious quarter. If gross impaired formations continue this trend, itwill be positive for the outlook for loan losses.
• We haveincreased our 2009 loan loss provision forecast to $9.7 billion from$8.5 billion based on the acceleration of provisioning due to thesharpness of the economic decline. However, our 2010 loan lossprovision forecast is essentially unchanged at $10.6 billion or 0.78%of loans.
Earnings Power – Dividend Increases
• Insummary, we believe second quarter earnings are reflective of bankearnings power and their ability to absorb credit losses andmark-to-market writedowns. The outlook for earnings, with thepossibility of net interest margin resurgence, disappearingmark-to-market writedowns, and eventually lower credit costs, is quitepowerful. Canadian banks are well positioned to take advantage of thefallout from the global banking crisis. They have significant operatingleverage going forward, with revenue growth opportunities as aconsequence of banking capacity reduction at the same time they areable to take advantage on the costs side by reducing operating andlabour costs. In addition to strong operating leverage, bank capital isworth more, and banks are starting to get paid a major liquidity/riskpremium (repricing of loan book) that is higher than in previouscycles. Thus, strong underlying earnings and high capital positionsshould be conducive to future dividend increases that could occur asearly as the fourth quarter of 2009 for select banks.
• Themarket’s hysteria about the need to raise or preserve capital and thepossibility of dividend cuts has reversed itself dramatically. Thecapital conundrum going forward is likely to be: what are the banksgoing to do with all that capital? We believe banks have the ability toeasily run their Tier 1 capital ratios up to the 12% to 14% range.
•We are a major proponent of bank leadership signalling confidence intheir business models to the market by rewarding shareholders withmodest dividend increases early. A 5% dividend increase in Q4/09 wouldconsume an insignificant amount of capital but provide a strong signalthat would serve to further differentiate Canadian banks from theirglobal peers. Canadian banks have a stellar record of increasingdividends over the past 50 years, with both BNS and TD actuallyincreasing their dividends in fiscal 2008. Banks that are able toincrease their dividends through a global crisis would be a powerfulstatement, but it does require conviction.
P/E Multiple Recovery
•Bank P/E multiples have recovered from valuation contagion that wasaided by aggressive selling and the agents of fear. Bank P/E multipleshave rebounded to 10.5x from the 6.0x low reached in late February. Thecurrent P/E multiple is now more in line with recent past cycle lows.We estimate the valuation contagion overshoot was three to fourmultiple points. We believe fundamentals support significantly highervaluation, and the market seems to be refocusing on fundamentals. Webelieve the market is starting to look at earnings power and P/Emultiples for valuation versus market to tangible book.
• Wecontinue to expect bank P/E multiples to expand through 2012, similarto that experienced post the 2002 cycle. We expect bank P/E multiplesto expand back to 14x in the next few years and eventually reach 16x.Thus with P/E multiple expansion and bank earnings bottoming, thisbodes well for continued strong share price gains over the next severalyears.
Bank Rally – Positive Outlook
• The majorbank rally in Canadian bank stocks has happened at breathtaking speed,with the bank group increasing 72% in three months off their Februarylows. Bank stocks are now significantly outperforming the market withgains of 28% year-to-date versus the market being up 19%.
• Itis natural or reasonable to expect a bank share pullback based on thestrength of the rally or at least some retracement on a technicalbasis. However, if we look at the underlying earnings power andvaluation, which remains compelling despite the rally, we remainoverweight the bank group.
• Bank dividend yields, although downfrom their lofty heights, are very high at 4.8% and remain in a strongbuy range against government bonds or the equity markets. Bank dividendyield relative to 10-year Canada bonds is 3.6 standard deviations abovethe mean.
• In conclusion, Canadian banks are well capitalizedwith high-quality balance sheets, a diversified revenue mix, a solidlong-term earnings growth outlook, low exposure to high risk assets,and compelling valuation on both a yield and P/E multiple basis. Remainoverweight the bank group.
• We have a 1-Sector Outperformrating 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 ofpreference continues to be biased towards strong wholesale banks withwealth management earnings momentum expected to pick up. Our order ofpreference is RY, NA, BMO, BNS, CWB, LB, TD, and CM.