Thursday, August 29, 2013

Review Canadian Banks after Q3 Earnings

Please note I use stock symbols to refer to the banks. BMO and TD are self explanatory. RY refers to RBC, BNS refers to Scotiabank, and CM refers to CIBC. The financial data were all taken from the company's respective websites. I cannot guarantee 100% accuracy but all numbers should be correct. 

I have provided a glossary of key banking terms at the end of the article 
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I will provide a quick overview of the Q3 earnings and then I will explain why I believe TD and BNS will outperform vs. their peers in the next 6-12 months.  

General Overview: 


Q3 Canadian bank earnings were definitely better than street consensus. Analysts were modeling for a softer quarter as they assumed that slower housing activities in Canada and lower Canadian GDP growth affected the banks' Canadian divisions. Nonetheless, the big five banks showed exceptional operational excellence by dealing with the difficult operating environment. Share price reactions, after the announcements, were limited with the exception of TD and CM, which saw gains of 2% after reporting earnings that blew past analysts' estimates. 

Some general trend in the Q3 reports:
  • Canadian banking (P&C) is still the main driver of overall earnings. The average contribution from the Canadian banking segment for the big five is 52.4% and that segment experienced a 10.0% year-over-year (Y/Y) increase in earnings, in-line with the average Y/Y increase of 10.2% in overall earnings for the big five banks
  • The higher interest rate environment will limit declines in net interest margin or NIM (a key profit ratio). Most banks expect their NIMs to remain relatively flat, which is good news considering many banks have guided investors in the past that NIMs will steadily decline. Table 3 shows that despite NIMs being down 4 bps (-0.04%) on average Y/Y, they are up 2 bps (+0.02%) Q/Q  
  • The credit environment is definitely improving. PCL ratios are slightly lower than historical averages for each bank respectively.  
  • The banks' capital levels are strong even on a Basel III basis. Tier 1 common equity ratio averaged 9.1% among the big five banks.  That is significantly higher than the Basel Committee's 7% proposal. Higher capital levels provide a safety cushion and allow banks the flexibility to return excessive capital back to shareholders or re-invest them back into their businesses. Most banks have Normal Course Issuer Bids (NCIB) to repurchase shares. CM announced a new NCIB program in their Q3 results
  • BNS, TD and RY increased dividends this quarter to align their payout ratios near the targeted 40-50%. 

Table 1: Quarterly comparison of adjusted EPS (adjusted EPS excluding one-time items and amortization of intangibles): 
Bank
Q3/2012
Q2/2013
Q3/2013
Y/Y Change**
Q/Q Change***
BMO
$1.49
$1.46
$1.68
12.8%
15.1%
BNS
$1.16
$1.27
$1.24
6.9%
-2.4%
CM
$2.12
$2.06
$2.29
8.0%
11.2%
RY
$1.29
$1.29
$1.46
13.2%
13.2%
TD*
$1.91
$1.90
$2.10
9.9%
10.5%



Average:
10.2%
9.5%
*TD exclude an after-tax charge of $418 million  ($0.45/share) relating to severe weather
** Y/Y change is percentage year-over-year change in earnings 
*** Q/Q change is percentage quarter-over-quarter change in earnings  




RY and BMO experienced a stellar quarter with double digit Y/Y and Q/Q percentage increases while BNS experienced  the lowest growth due to challenges in its emerging market businesses. Looking ahead, BNS's poor performance is likely to reverse since emerging market volatility has decreased since July. BMO's growth is likely to slow in Q4 because its Q3 earnings were driven by some one-time factors such as recoveries on impaired loans. Overall, the earnings trend looks favourable for TD and RY. Nevertheless, the reversal of BNS's poor Q3 performance may also imply a positive earnings outlook for BNS as well. 


Table 2: General comparison of key ratios of the big five banks

BMO
BNS
CM
RY
TD
Avg.
Tier 1 Common Ratio (Basel III)
9.6%
8.6%
9.3%
9.2%
8.9%
9.1%
ROE (to common)
15.6%
16.2%
21.6%
20.0%
13.0%
17.3%
Total efficiency ratio
62.8%
53.3%
55.6%
55.4%
62.5%
57.9%


Canadian P&C Banking Results:

Table 3: Canadian banking results among the big five 

$ in millions
BMO
BNS
CM
RY
TD
Avg.
Canadian P&C earnings
$500
$590
$654
$1163
$973
N/A
    As % of total earnings
44.0%
33.0%
69.2%
52.5%
63.2%
52.4%
    Y/Y % change in earnings 
8.2%
13.5%
9.7%
7.0%
12.0%
10.0%
Loan growth Y/Y
10.0%
6.6%
7.0%
5.0%
4.4%
6.6%
Loan growth Q/Q
3.0%
0.7%
1.2%
1.0%
1.3%
1.4%
Deposit growth Y/Y
8.0%
3.1%
1.9%
7.0%
4.2%
4.8%
Deposit growth Q/Q
3.0%
1.1%
0.6%
1.0%
1.4%
1.4%
∆ NIM Y/Y
-18 bps
-4 bps
+6 bps
-2 bps
-3 bps
-4 bps
∆ NIM Q/Q
- 1bps
+3 bps
-1 bps
+6 bps
+3 bps
+2 bps
Efficiency ratio
50.6%
49.6%
48.9%
44.2%
44.5%
47.6%


Canadian banking divisions of the big 5 are still showing strong growth despite a tough operating environment. Earnings growth of 10% Y/Y is very impressive, partly due to higher volume growth ( + 6.6% Y/Y in loan growth) and lower efficiency ratios obtained through positive operating leverage. RY and TD's efficiency ratios reached record lows due to cost cutting initiatives. Bank executives acknowledged on the conference calls that high earnings growth will be difficult to achieve for the next few quarters. Thus, investors may have to lower their earnings growth expectations from the current 10% run-rate, although earnings will not fall off a cliff as some suggested. With lower earnings growth in the Canadian P&C divisions, investors should favour banks with the highest operating leverage and lowest efficiency ratio like TD or RY. Also, the trend for NIMs are more favourable for TD and RY than the other three banks.  The success of this division is key to potential share price appreciation.



Credit Analysis:

Table 4: Provision for Credit Losses (PCL) of big 5 banks:

$ in millions
BMO
BNS
CM
RY
TD
Avg.
PCL
$77
$314
$320
$267
$477
N/A
   PCL Ratio (%)
0.11
0.31
0.45
0.26
0.43
0.31


Overall credit remains strong at the big five banks. BMO's PCL of $77 million looks low relatively to its historical $150 million run-rate averaged in the past few quarters. The low number was due to a huge recovery on M&I's  (a U.S. bank BMO acquired in 2011) impaired loan portfolios. 





Capital Markets and Wealth Management:

Table 5: Capital market earnings of big five banks: 
$ in millions
BMO
BNS
CM
RY
TD
Avg.
Capital Market Earnings
281
$361
$175
$388
$147
N/A
    As % of total Earnings
24.7%
20.0%
18.6%
21.0%
9.3%
18.7%


Capital market divisions of the big five performed well in light of the market volatility sparked by the Fed's tapering announcement. Bank executives stated that fixed income trading remains challenging as spreads widened and long term rates rose. Earnings from capital markets divisions can fluctuate significantly quarter-over-quarter and large earnings growth in this segment does not necessarily translate into solid long term earnings growth. The increased volatility in fixed income and equity markets in August may lower trading revenues in the 4th quarter. Given that capital market conditions appear less favourable in the next quarter, investors should favour a bank like TD, which has the lowest contribution from its capital market business. 

Wealth management remains a bright spot for most banks. As fee-based accounts increase, fee income  from this division will provide stable earnings and can offset potential profit decline in capital market divisions. BNS and RY are best positioned for growth in the wealth management space. Both spent billions growing their wealth businesses via large acquisitions in the past two years. Canadian banks are grabbing market share from independent fund companies at a rapid pace because smaller dealers are unable to compete with the big five's large distribution channels and economies of scale. 

Dividends:



Table 6: Dividend data of big five banks: 

BMO
BNS
CM
RY
TD
Avg.
TTM earnings
$6.30
$5.04
$8.60
$5.36
$7.38
N/A
Targeted payout ratio
40-50%
40-50%
40-50%
40-50%
40-50%
40-50%
2013 dividends  
$2.94
$2.39
$3.82
$2.53
$3.24
N/A
   Implied payout ratio
46.6%
47.4%
44.4%
47.2%
43.9%
45.9%
*TTM = Trailing Twelve Months


Most banks are near the mid-range of their targeted 40-50% payout ratio. TD is the furthest away from the middle of that range. Dividend investors should prefer TD since it has the best potential to increase its dividend. Given the pattern of dividend hikes every 2 quarters from TD, RY and BNS, expect a dividend hike in Q1/2014 from those three banks.  BMO and CM are not regular dividend hikers but prefer to return more capital via buybacks.


Current Valuation Levels of Canadian Banks:

Table 7: Market and Valuation Data 

As of Aug.29
BMO
BNS
CM
RY
TD
Avg.
Price
$66.88
$58.33
$82.66
$65.24
$89.93
N/A
Dividend Recent Quarterly Annualized
$2.96
$2.48
$3.84
$2.68
$3.40
N/A
Dividend Yield
4.4%
4.3%
4.6%
4.1%
3.8%
4.2%
Earnings (TTM)
$6.30
$5.04
$8.60
$5.36
$7.38
N/A
P/E (TTM)
10.6X
11.6X
9.6X
12.2X
12.2X
11.2X
Book Value
$42.38
$32.51
$40.11
$29.59
$50.04
N/A
P/BV
1.6X
1.8X
2.1X
2.2X
1.8X
1.9X
Tangible Book
$34.08
$23.71
$34.00
$21.96
$33.06
N/A
P/TBV
2.0X
2.5X
2.4X
3.0X
2.7X
2.5X

 ATTACHED is a link graphs of historical Price-to-Book Ratios . Please click the link on the left to view a PDF document of the charts. Canadian banks are still trading at reasonable multiples compared to the past 12 years. Also, the graphs show that BNS is trading below the peer average, compared to its past history of trading at a premium compared to the peer average. BNS also has the highest differential between its current book multiple and its 12-year average multiple compared to the other 4 banks. 


As table 7 illustrates, Canadian banks are trading at 11.2X trailing earnings and 1.9X book. Compared to the big 4 American banks (BAC, C, WFC, JPM), which trade at 16.4X trailing earnings and 1.1X book, Canadian banks look slightly more expensive but the valuation gap has definitely narrowed after U.S. bank stocks gained over 20% YTD. On an earnings basis, Canadian banks are slightly cheaper especially looking at the average 10.8X forward P/E ratio. Accounting for the 4.2% average dividend yield, total annual share returns for the banks should be around the 10% level. 

A Sample Price-to-Book Multiple Analysis:

The table 8 provides a sample valuation based on 3-year average price-to-book ratios. I chose 3-year  (August 2010-August 2013) because it represents the average of the post financial crisis era. This valuation method is crude but it does provide a rough guideline on which bank have the potential to outperform relatively vs. its peers because banks exhibit a strong pattern of mean reversion. The analysis below shows that BNS and CM provide good potential to outperform vs. their peers although this analysis does not take into account multiple expansions or contractions due to fundamental factors. The table below is purely a mechanical exercise and serves as a rough guide  to see which banks look relatively undervalued vs. peers.

Table 8: Sample Book Value Valuation 


BMO
BNS
CM
RY
TD
Book value
$42.38
$32.51
$40.11
$29.59
$50.04
3-year average multiple
1.63X
2.16X
2.26X
2.22X
1.75X
Price forecast average book multiple (A)
$69.08
$68.27
$90.64
$65.69
$87.57

Tangible book
$34.08
$23.71
$34.00
$21.96
$33.06
3-year average multiple
2.0X
3.05X
2.75X
3.05X
2.82X
Price forecast average tangible book (B)
$68.16
$72.32
$93.50
$66.98
$93.23

Average (A) & (B)
$66.46
$70.30
$92.07
$66.34
$90.40
Implied % gain from current market price
-0.6%
+20.5%
+11.4%
+1.7%
+0.5%


Conclusion: Which Bank is a Better Investment?



At the start of the year, I liked RY and TD with BNS ranking 3rd, CM ranking 4th and BMO ranking 5th. I liked RY because of its strategic positioning in its capital markets businesses, which benefited from QE3. RY's rapid growth in wealth management and excellent efficiency in Canadian banking were also positives. I liked TD because of its attractive U.S. growth profile and solid Canadian banking operations. Now with recent changes in share prices and business developments, I like BNS now and still like TD with CM ranking 3rd, RY ranking 4th and BMO ranking 5th. 

The recent decline in BNS's share price from its February highs is hard to ignore. Given it is trading below the average price-to-book of 1.9X, it is undervalued.  BNS rarely traded below the peer average for the last 5 years. BNS investors caught the taper tantrum as emerging markets experienced significant volatility in the past two months after the Fed hinted at tapering QE. Although the volatility may continue, BNS's share price already reflects this risk and higher prices are on the horizon in the next 6-12 month. The price-to-book of 1.75 is very low for a bank that provided consistent earnings growth in the past 5 years and BNS possess an excellent business mix. Retail banking, wholesale banking (capital markets) and wealth management each contribute 1/3 to earnings , providing a very balanced business mix for the bank. BNS's price-to-book averaged near 2 excluding recent months. Therefore, a multiple expansion to 2X book imply that its shares should trade near $65, up 11% from today's price. 

Despite the outperformance of TD in the most recent 6 months, it will continue to perform well in the next few quarters. The average price-to-book for TD was significantly above 2 prior to 2008 crisis. Now with a growing U.S. P&C division. which was acquired after the financial crisis, TD should trade at a multiple of at least 2X book. Thus, implying a share price of ~$100 in the next 6-12 months. The $100 target implies a 11% gain from today's price. Also, investors should not forget that TD has the best potential to increase dividends down the road, one of the most important factor to consider as bank investors. 

As for CM, there is an potential for share price appreciation once the discussion with Aimia regarding the Aeroplan credit card is finished. Since talks are still ongoing, CM shares may still lag in the short term but the potential for gains is there. Its shares underpeformed its peers in the past few months due to the uncertainty regarding the Aimia discussions, pushing CM's valuation to the lowest since 2009. Thus, a reversal of the recent price decline is possible in the months ahead. 

RY's multiples, both on book and earnings basis, are trading significantly higher than the peer average and fully justify the better underlying fundamentals of the company. RY is trading at 2.2X book vs. the peer average of 1.9X and 12.1X earnings vs. the peer average of 10.5X. I expect RY's share price to be flat or slightly higher over the 6-12 month. 

BMO is still facing headwinds despite a good quarter in Q3. BMO's poor track record at lowering the efficiency ratio and failure to attain a sizable positive operating leverage will cause its share price to lag peers, although probably not significantly given Canadian bank stocks usually trend in the same direction. 

All in all, TD and BNS will outperform their peer group while RY and BMO are likely to underperform. BNS's international franchise is currently undervalued because of short term volatility in emerging markets. This is temporary in nature and its emerging market exposure will be beneficial for long term earnings growth. As for TD, it can leverage its U.S. franchise to deliver additional earnings growth by benefiting from a recovering U.S. economy and increasing its economies of scale in its U.S. business. For dividend investors, TD also provides the highest 10-year dividend growth rate with compounded annual growth rate of 10% and the best potential to increase dividends down the road due to its low payout ratio. 

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Glossary:
This glossary intents to provide a short list of brief explanations of banking terminology for those readers that want a better understanding of these key terms

Adjusted or Cash EPS: An EPS measure commonly cited by sell-side bank analysts when analyzing Canadian bank results. The cash EPS exclude amortization of intangibles,  other non-cash items and one time items 

Book Value: Book value is an important measure when analyzing banks. Because banks hold securities that are mostly marked to market, most investors analyze banks by applying a simple price-to-book ratio calculated as by dividing the share price by the most recent book value per share. Book value per share for banks is calculated as equity to common shareholders divided by shares outstanding at end of period. Note that equity for common shareholders exclude non-controlling interests and preferred shares.

Efficiency Ratio: An expense ratio for banks which is calculated as non-interest expenses divided by total revenue. Non-interest expenses are all the fixed expenses of running the bank, which exclude interest expenses.  A lower efficiency ratio shows that the bank is better at controlling expenses 

NIM: Abbreviation for Net interest margin. Net interest margin is net interest income divided by average earning assets. Net interest income is the difference between interest income (received from bank's borrowers) and interest expense (paid to bank's lenders). Total earning assets are sum of all the asset that can generate interest income.


Operating Leverage: Operating leverage, for banks, is the difference between growth rate of revenue and growth rate of non-interests expense. For example, if a bank grew revenue by 5% while non-interest expense grew only 3%, the operating leverage is 2%. Bank investors want the bank with best operating leverage as higher growth rate in sales vs. expenses will lead to better bottom line results.


PCL: Abbreviation for Provision for Credit Losses. This is the amount set aside every reporting period as reserve to cover potential loan losses or losses on impaired loans. This is like a bad debt expense learned in an accounting 101 class. PCL can be expressed as a ratio which compares the dollar PCL amount to the average of loans and acceptances number.


Tangible Book Value:  Adjusted book value to exclude goodwill and other intangibles

Tier 1 Common Equity Ratio: This is the main capital ratio under the new Basel III rules which Canadian banks are already forced to comply by OSFI (Canada's banking regulator). It compares Tier 1 common equity to a bank's Risk Weighted Assets (RWA). Tier 1 common equity includes common stock and retained earnings, which are the most reliable form of capital for the bank. RWA is an subjective figure calculating by adjusting various bank assets to reflect the risks. For example, a $100 million  government bond may only be $10 million under the RWA measure while a more risker $100 million corporate bond may be $80 million under RWA. Also, RWA includes some off-balance exposures as well. 


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