BlackBerry's Q2 Press Release: No Surprises But There Are More Data Points

After BlackBerry's terrible pre-announcement last Friday, the earnings release today is almost a non-event. The main financial drivers were in-line with the pre-announcement so there were no real surprises to shareholders and analysts, although the media is still using the bad financials to create fancy headlines such as "BlackBerry loses $1 billion". 

Key Results:

• Revenue was $1,573 million, slight below the guided $1.6 billion in the pre-announcement
• Adjusted gross margin of 36.2%, slight above the mid-range of guided 35-37% in the pre-announcement. Adjusted gross margin adds back the $10 million restructuring charge and $934 million non-cash inventory/supplier commitment charge. Both were included in the Cost of Sales line on the Income Statement 
• GAAP loss of $965 million (guided $950-995 million) or $0.47/share (guided $0.47-0.51)
• Ending cash (plus investments) balance of $2,569 million at Q2/2014 vs. $3,071 million at Q1/2014

The figures did not surprise anyone but the press release today provided the latest financial statements. There are some interesting conclusion one can make based on them.

Q2 Income Statement:

The pre-announcement already warned everyone about terrible loss number for Q2. Nevertheless, there are some slight positive points about this bad quarter. I believe Prem Watsa understand these points as well when made his $9 offer.  

• The 50% quarter-over-quarter (q/q) decrease in revenue is surprising. However, BB10 device sales are not recognized until they are sold to end-customers (the sell-through model vs. BlackBerry's old sell-in model). Deferred revenue had a big jump of $500 million  q/q on the balance sheet. If one assumes (this is a big assumption) that the $500 million reflected potential BB10 sales, then the  revenue decline would have been 33% q/q vs. the 50%. BB10 sales could have been greater than $500 million but I am using the $500 million jump in deferred revenue as a rough guide
• Adjusted gross margin of 36.2% was 2.3% higher than last quarter's 33.9%, despite most of sales came from older BB7 devices. This implies that management was heavily discounting BB7 in previous quarter to drive BB10 sales. Now with BB10 sales slowing, removing those heavy BB7 discounts actually resulted in higher gross margin. Most corporations still order BB7 devices because BES 10 (the company's mobile device management service) lacks full backward integration to support BB7 devices. Removing BB7 discounts was actually a good idea
• The Cost of Sales line contained a $934 million inventory charge. An inventory charge also reduces the carrying cost of inventory. If BlackBerry can sell those worthless inventory in the future, it will help boost revenue and cash flow. Taking a big bath this quarter is shifting future expenses up-front
• The most interesting point I saw was if we adjust the one-time items and apply the guided 50% cut in operating expenses going forward, the company can money. i.e. take earnings before tax of -$1,438 million, add the $934 million inventory charge, add the $72 million restructuring charge and add the $450 million potential reduction in operating expense. The adjusted earnings before tax becomes $18 million. Therefore, BlackBerry can make money in the future if it downsizes significantly and become a niche player. The 13% reduction in operating expenses did little to offset the 50% decline in revenue this quarter. 

Given BlackBerry's financial performance, the company's ability to generate future earnings is questionable. Therefore, looking at the balance sheet is important because the valuation of the company is heavily dependent on what resources it owns. 

Q2 Balance Sheet:

• Despite the $934 million charge, the ending inventory is $941 million, which is higher than last quarter's! Thus, most of the $934 million charge was related to the $5.3 billion off-balance sheet supply commitment. BlackBerry may have to take additional inventory charge in future quarters 
• The increase in income tax receivable to $462 million from $33 million is positive given this will be a future cash-inflow once collected
• Working capital management appears poor with cash conversion cycle at 94 days (highest in the past 8 quarters), but this number is likely to decrease based historical trend. The company's working capital position improved after it booked a $400 million charge relating to its PlayBook tablet
• Book Value reduced to $16.06 and Tangible Book reduced to $9.38. Looks like Prem's offer is just slightly below Tangible Book

The current value of BlackBerry is balance sheet dependent. The balance sheet contains cash at $2,569 million, PP&E booked at $2,119 million and intangible assets (patents) at  $3,505 million. The market value of patents, a key valuation input for BlackBerry,  is quoted from $1-3 billion. 

As I stated in my prior post, I valued BlackBerry at $11.50 based on the Q1 balance sheet and gave no consideration for future earnings power (the ability to generate future earnings). After seeing the updated Q2 balance sheet, I will revised the figure down to ~$11. However, this valuation does not matter if no one wants to pay for it. Shareholders only have one offer at $9 on the table and it may be the best offer. 

Prem Watsa's $9 Conditional Offer:

The shares are trading almost $1 below the $9 offer price, implying the market is betting the deal may not go through. A 12.5% risk-arb spread looks too good to be true. Nonetheless, there was a 30% risk-arb spread on the Progress Energy deal and a 20% risk-arb spread on the Nexen deal because of uncertainty regarding government approval. Investors should remember that both deals were completed and risk arbitrageurs got their double digit returns.

Some analysts predict Prem may lower his $9 offer to squeeze existing shareholders. That could definitely happen, but there are some negative implications for him as well. If he does lower his offer, his reputation and credibility will be damaged. Prem and Fairfax need that good reputation and credibility for future deal making so trading a good reputation for money is foolish. As Buffett famously said: "Lose money, I'll be understanding. Lose a shred of reputation, I will be ruthless." I think Prem understand what Buffett meant  and put his reputation on the line when he announced that the takeover would be led by Fairfax (his firm).  

Therefore,I think the $9 is creditable despite the uncertainty. Looking at the balance sheet, it is less healthier than I expected so a higher offer is unlikely at this point, although a higher bid could emerge.


Source: BlackBerry 6-K filing 

BlackBerry's Deal with Fairfax Financial

One has to wonder why BlackBerry pre-announced its fiscal Q2 results last Friday when its scheduled quarterly announcement is less than a week away. Shareholders got an answer in today's press release when BlackBerry signed a letter of intent with a consortium led by Fairfax Financial. The letter of intent contemplates a transaction in which BlackBerry shareholders would receive US$9.00 in cash for shares not owned by Fairfax (Fairfax owns 10% of the company). This transaction would value the company at US$4.7 billion, a fraction of the value the market gave it back in 2008 when it was worth US$80 billion. 

The parties will try to reach a definitive transaction agreement by end of November 4,2013. BlackBerry is allowed to enter into "alternative transactions" with another party during the due diligence period (now till November 4,2013). 

My Opinion:

It shouldn't be surprising that Fairfax, being the buyer, would offer a low price of US$9. Being a shareholder, I believe this undervalues the company, but I acknowledge the company is facing more headwinds than I anticipated. The low offer price for BlackBerry almost reminds me of Bear Stearns  when it was first offered $2 per share on March 14, 2008. Jamie Dimon stated that "buying a house and buying a house on fire is not the same". Ultimately, Dimon had to concede to shareholders by offering $10 per share. In case of BlackBerry, I don't expect the final transaction price to be significantly higher than the current pre-announced US$9 offer price. Nonetheless, it is more likely than not that the final transaction price will be higher than the current US$9. Therefore, I am holding my shares for now especially given the shares are trading below US$9 (BBRY) preliminary offer price. The final transaction may be slightly higher at $9.50-$10.50.  The announcement today does buy time for the company to find another buyer as it temporarily puts a floor to the stock price and will limit additional negative rumors on the company. The key point is that Fairfax has provided confidence to BlackBerry 's customers that the company will survive. 

Because of today's announcement, the stock has become a special situation and a pure risk arbitrage play. Taking the playbook from Buffett's 1988 annual letter on how to evaluate this situation:

To evaluate arbitrage situations you must answer the four questions: 

(1) How likely is it that the promised event will indeed occur? (2) How long will your money be tied up?  (3) What chance is there that something still better will transpire - a  competing takeover bid, for example? (4) What will happen if  the event does not take place because of anti-trust action, financing glitches, etc.?

The probability of (1) happening is high given Prem's track record of closing deals. Looking at criteria (2), the timing on this arbitrage trade appears to be 6 weeks. As for criteria (3), there is a chance of a better offer from another bidder or another a group of buyers teaming up to buy BlackBerry and carve out the operations. I think there is definitely a chance for a higher offer price than $9.50-10.50 but investors should keep their expectation low for now. Getting a better outcome than expected is never a bad thing! Finally, I think the chances for criteria (4) is less likely given I feel BlackBerry's management has already took the big bath in order to help Prem Watsa. A possible glitch is the financing because the Fairfax group has not finalized the financing yet.  Nonetheless, chances are low that Prem cannot find the necessary financing for a $2.1 billion ($4.7 billion less $2.6 cash) bid. 

With cash of $2.6 billion, patent value estimated at roughly $2 billion (could be high as $3-4 billion), and value of services/other infrastructure at $1.5 billion, BlackBerry should be worth ~$11.60 conservatively valued. Of course, Fairfax, being the buyer, will not pay that price even if the $11.60/share is a conservative value. However, Fairfax may raise the price slightly to $9.50 or $10 to appease shareholders just like JP Morgan did in its deal with Bear Stearns. There is still value in the company even if they flop the hardware side. The delay in its global BBM launch was disappointing but BBM will still ultimately attract millions of users, which the company can monetize through advertising etc.

The next 6 weeks will be interesting. The earnings report on Friday September 26 will offer more colour on the financial health and future of BlackBerry. 

Source:http://finance.yahoo.com/news/blackberry-enters-letter-intent-consortium-173000552.html

No Tapering...For Now

Market participants were quite surprised at the FOMC's decision to not taper its asset purchase program today. The consensus among many analysts and economists was for the FOMC to taper or reduce the size of its asset purchase program in the range of $10-$15 billion. The reaction to the announcement was quite volatile. The S&P500 rallied to an all time high of 1725, the 10-year treasury yield decrease 15 basis points (bps) to 2.70%,  precious metals rallied and the U.S. Dollar depreciated against the majors. 

Why Not Taper?

During Bernanke's press conference, there was a question phased as "Why not taper now given that the Fed has already signaled to the market that it will taper in September?". The Fed Chairman's answer was simple: the reduction of QE is heavily data dependent and financial conditions have tighten considerably to pose a risk to the economic recovery. Bernanke reiterated his stance that there is no "pre-set course" on ending the asset purchase program (QE3) and market participants were wrong to bet on a September taper. The Fed will consider reducing QE in the "coming meetings" depending on incoming data. Nonetheless, Bernanke's tone in the press conference was more cautious and suggest that the Fed may wait longer before tapering QE; the following statement from the FOMC illustrates this point: "...the Committee decided to await more evidence that progress will be sustained before adjusting the pace of its purchases"

Bernanke clearly explained that the labour market must improve "substantially" and the outlook for the labour market must be equally solid to justify a reduction of QE. The labour market improved since last September, but the improvement was not  "substantial".

• The 6 month average non-farm payrolls did improve from 140K last August to the 155K currently. Many FOMC members stated in their public speeches that a run-rate of 200K or above defines a solid labour market. Because the rolling 6-month average payroll number is still below the 200K level, a September taper does make sense especially due to the Fed's mandate of maximum employment
• The unemployment rate decreased from 8.1% in August 2012 to 7.3% currently. Although the 0.8% reduction in unemployment rate is encouraging, part of the decrease is attributable to the 0.3% decrease in the labour participation rate during the same period, which is definitely not positive. As Bernanke stated in the press conference, the 0.8% decrease should be partially discounted because it ignores decline in the participation rate 

There are also other reasons, as outlined below, that explain why the Fed did not taper:

• The recent spike in interest rates was a major concern as outlined in today's FOMC statement "the tightening of financial conditions observed in recent months, if sustained, could slow the pace of improvement in the economy and labor market". It was obvious that FOMC members realize that market participants perceived tapering as tightening. Given that interest rates have increased significantly since June, FOMC members wanted to let interest rates fall slightly in order to stimulate economic activity, especially in the housing sector. i.e. recent weekly mortgage applications have been decreasing at double digit percentage rates. This is attributable to the 120 bps rise in the 30-year mortgage rate from 3.5% to 4.7% in less than 3 months
• The recent run-up in rates has partially alleviated the Fed's concern about financial stability. Higher interest rates and speculation regarding a September taper helped to reduce the excessive levered positions taken by speculators. With less concerns regarding financial stability, the Fed decided to continue QE as risks to the recovery still remains
• Fiscal problems, such as the potential debt ceiling debate later this month and a possibility of a government shutdown, may slow the recovery. A repeat of 2011 would be disastrous for the financial markets and the Fed is just being cautious ahead of the negotiations 

In the final analysis, all of the points above explain why the Fed decided to keep the size of its asset purchase program at $85 billion and did not taper QE. Also, it is interesting to note that FOMC members lowered their GDP forecast for 2013 to 2.0-2.3% from 2.3%-2.6%. 

When Will the Fed Taper?

Don't count on the 7.0% and 6.5% thresholds:

Many analysts thought Bernanke was giving specific guidance when he indicated that the QE program will end by the time the unemployment rate hit 7.0% and a first hike will occur when the unemployment rate hit 6.5%. Because the Fed chairman uses words like "depends", "subject to", and "data dependent" when explaining Fed policy, investors should rely less on the numbers provided and more on the chairman's qualitative descriptions. He made it clear in today's press conference that the numbers provided were used as illustrations to describe potential exit strategies. Also, the 7.0% and 6.5% are used as thresholds, not as triggers. QE does not necessarily end when the unemployment rate drops below 7.0%. By the same token, a rate hike is not automatically considered if the unemployment rate drops below 6.5%. Investors must remember that the Fed has a dual mandate of maximum employment and price stability. Whether QE is a good policy tool or not is debatable, but FOMC members are simply doing their job by promoting maximum employment when they decided to not taper today. 

The Fed will taper when the labour market has improved "substantially":

As discussed above, the Fed will taper QE when the labour market improve substantially. A substantial improvement can be defined when all the conditions below are satisfied:

• When the 6 month average payrolls number is near or above the 200K level 
• Unemployment is below 7% AND the labour participation rate shows some improvement from current levels
• Wage growth is at or above the current 2% level
• Improvement in other labour market statistics: lower longer term unemployment, lower number of discouraged workers and higher private payrolls

The actual timing is difficult to ascertain but the Fed will eventually taper: 

In my opinion, predicting when the Fed will taper is a pure gamble. Because the FOMC hinted at the possibility of tapering in the "coming meetings" in today's statement, investors should expect a taper announcement either in the October or December meeting depending on the incoming economic data. Investors are making a mistake if they think the Fed will continue its easy monetary policy. Generally, the economy is on a better footing compared to last year, so less monetary stimulus is justified. The Fed needs to communicate clearly to the market on how it will reduce QE over time when it begins to taper QE. Overreactions in the financial markets, such as the rate shock in June, can spill over to the real economy and damage the underlying recovery. 

Implication for Investments:

Today's Fed announcement did not change my long term investment outlook. Investors are facing a rising interest rate environment in the long run and chasing after yields is a bad strategy. Short to intermediate term bonds are better choices than long term bonds, although the long-end of the curve may outperform in the short term. As for equities, valuations are no longer attractive and caution is warranted given that lower interest rate (the driver of lower discount rates) won't be around forever. However, equities are not terribly overpriced either, so betting against stocks is also not a good strategy. I am maintaining all my long equity positions, although I may sell into large rallies in the upcoming months. 

The energy and materials sectors will benefit from today's Fed announcement and will outperform in the short term. Because these two sectors were the laggard this year, investors may benefit from overweight energy and materials stocks relatively to other sectors. Nonetheless, individual stock selection is important given that not all stocks in the energy or materials sectors are attractive.  

There will always be opportunities to take advantage of one-sided expectations. As described in my prior posts, the 10-year treasury with a 3% yield is too high because higher rates will eventually cripple the recovery. After today's rate announcement, the yield decreased to 2.7%. If the yield drops below 2.3% in the upcoming month, a short rates trade may look attractive. The 2.3% was the yield before Bernanke laid out the framework for tapering QE in the June 19th FOMC press conference. The Fed will taper eventually so any large drop in rates, especially within a short time period, provides a good opportunity to short rates.

All in all, investors should remember this: financial assets (stocks or rates) don't grow to the sky, nor do they fall to the floor. 

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Appendix: FOMC policy statement [1], bolded sentences are important.

Information received since the Federal Open Market Committee met in July suggests that economic activity has been expanding at a moderate pace. Some indicators of labor market conditions have shown further improvement in recent months, but the unemployment rate remains elevated. Household spending and business fixed investment advanced, and the housing sector has been strengthening, but mortgage rates have risen further and fiscal policy is restraining economic growth. Apart from fluctuations due to changes in energy prices, inflation has been running below the Committee's longer-run objective, but longer-term inflation expectations have remained stable.

Consistent with its statutory mandate, the Committee seeks to foster maximum employment and price stability. The Committee expects that, with appropriate policy accommodation, economic growth will pick up from its recent pace and the unemployment rate will gradually decline toward levels the Committee judges consistent with its dual mandate. The Committee sees the downside risks to the outlook for the economy and the labor market as having diminished, on net, since last fall, but the tightening of financial conditions observed in recent months, if sustained, could slow the pace of improvement in the economy and labor market. The Committee recognizes that inflation persistently below its 2 percent objective could pose risks to economic performance, but it anticipates that inflation will move back toward its objective over the medium term.

Taking into account the extent of federal fiscal retrenchment, the Committee sees the improvement in economic activity and labor market conditions since it began its asset purchase program a year ago as consistent with growing underlying strength in the broader economy. However, the Committee decided to await more evidence that progress will be sustained before adjusting the pace of its purchases. Accordingly, the Committee decided to continue purchasing additional agency mortgage-backed securities at a pace of $40 billion per month and longer-term Treasury securities at a pace of $45 billion per month. The Committee is maintaining its existing policy of reinvesting principal payments from its holdings of agency debt and agency mortgage-backed securities in agency mortgage-backed securities and of rolling over maturing Treasury securities at auction. Taken together, these actions should maintain downward pressure on longer-term interest rates, support mortgage markets, and help to make broader financial conditions more accommodative, which in turn should promote a stronger economic recovery and help to ensure that inflation, over time, is at the rate most consistent with the Committee's dual mandate.

The Committee will closely monitor incoming information on economic and financial developments in coming months and will continue its purchases of Treasury and agency mortgage-backed securities, and employ its other policy tools as appropriate, until the outlook for the labor market has improved substantially in a context of price stability. In judging when to moderate the pace of asset purchases, the Committee will, at its coming meetings, assess whether incoming information continues to support the Committee's expectation of ongoing improvement in labor market conditions and inflation moving back toward its longer-run objective. Asset purchases are not on a preset course, and the Committee's decisions about their pace will remain contingent on the Committee's economic outlook as well as its assessment of the likely efficacy and costs of such purchases.

To support continued progress toward maximum employment and price stability, the Committee today reaffirmed its view that a highly accommodative stance of monetary policy will remain appropriate for a considerable time after the asset purchase program ends and the economic recovery strengthens. In particular, the Committee decided to keep the target range for the federal funds rate at 0 to 1/4 percent and currently anticipates that this exceptionally low range for the federal funds rate will be appropriate at least as long as the unemployment rate remains above 6-1/2 percent, inflation between one and two years ahead is projected to be no more than a half percentage point above the Committee's 2 percent longer-run goal, and longer-term inflation expectations continue to be well anchored. In determining how long to maintain a highly accommodative stance of monetary policy, the Committee will also consider other information, including additional measures of labor market conditions, indicators of inflation pressures and inflation expectations, and readings on financial developments. When the Committee decides to begin to remove policy accommodation, it will take a balanced approach consistent with its longer-run goals of maximum employment and inflation of 2 percent.

Voting for the FOMC monetary policy action were: Ben S. Bernanke, Chairman; William C. Dudley, Vice Chairman; James Bullard; Charles L. Evans; Jerome H. Powell; Eric S. Rosengren; Jeremy C. Stein; Daniel K. Tarullo; and Janet L. Yellen. Voting against the action was Esther L. George, who was concerned that the continued high level of monetary accommodation increased the risks of future economic and financial imbalances and, over time, could cause an increase in long-term inflation expectations

Source:
[1] FOMC Statement http://www.federalreserve.gov/newsevents/press/monetary/20130918a.htm
[2] FOMC Projects http://www.federalreserve.gov/monetarypolicy/files/fomcprojtabl20130918.pdf
[3] FOMC Press Conference http://www.ustream.tv/federalreserve

A Big Change in the Dow Jones Industrial Average

For passive investors who invests in diamonds, cubes and spiders (see footnote if you don't get this) , the announcement today made by S&P Dow Jones indices should have caught your attention. The index provider has announced that Goldman Sachs (GS), Nike (NKE) and Visa (V)  will replace Hewlett Packard (HPQ), Alcoa (AA), and Bank of America (BAC) in the Dow Jones Industrial Average after the close of September 20th. This is a major component change for the Dow Jones index since 2011. 

Just a brief history on the index, the Dow Jones Industrial Average was created in 1896 when Charles Dow compiled the prices of 12 leading industrial stocks to create a barometer for general business conditions. The index's components increased to 30 by the end of 1928 and numerous revisions were made to the index on a periodic basis. Companies are removed if they no longer considered a leading blue chip company and S&P Dow Jones indices has several methodologies on deciding which company should be added or removed. Out of the 12 original Dow components, GE is the only one that remains.  

What is noticeable about today's change is the addition of two high priced stocks, namely Goldman and Visa. These high priced stock may have a significant influence on how future performance of the Dow Jones Index is calculated given it is a price-weighted index. I have provided a discussion below on price-weighted vs. market-weighted (sometimes called value weighted) indices.

The difference between a price weighted index and market-weighted index:


Price Weighted Example:

A price weighted index is calculated by adding the share price of all the stocks in the index and dividing the sum by the number of components as shown below: 

	Stock Price Time t=0	Stock Price Time t=1	Return
Stock A	10	15	+50%
Stock B	20	10	-50%
Index	15 (average A&B price)	12.5	-16.7%

Despite the average return of the two stocks is 0%, the price weighted index suffered a remarkable 16.7% decline because stock B, the more heavily weighted one, dropped 50%. The weakness of a price-weighted index is that the performance of higher priced stocks can have a huge impact on the overall index performance. 

Market-Weighted Example (price assume same at t=0 and t=1 as last table):

	Shares Outstanding	Market Cap  t=0 (shares x price)	Market Cap Time t=1	Return
Stock A	10	100	150	+50%
Stock B	5	100	50	-50%
Index		200 (sum A+B)	200 (sum A+B)	0%

With a market-weighted index, the result is completely different than the price-weighted index. The index returned 0%, which is the average return of stock A and B (given they have same market-cap).  In a market-weighted index, the individual weights for any stock depends on its market capitalization (share price times shares outstanding) rather than its absolute share price. 

The examples above show the weakness of price-weighted indices. The performance of those indices is highly dependent on the returns of the higher priced stocks. For example, the Dow Jones's highest priced stock is IBM (current at $200), but many Dow components' share price are below $100. Adding higher priced stocks like Goldman Sachs (at $165) and Visa (at $184) to the Dow Jones will skew the index's performance as more weight is given to these new components. The problem with large stock prices is the main reason why blue chip giants Apple (currently priced at $500) and Google (current priced at $900) are not added to the Dow Jones index despite they clearly represent leading blue chip companies. 

Not many major world market indices are price-weighted. For those who are curious, the only other major stock index that is priced weighted is Japan's Nikkei 225 index. The S&P500 and the TSX Composite are all market-weighted indices. 

Implications for the Dow Jones Index going forward:

In the long run, the effect of this change is minor but this change is significant. Goldman and Visa together will represent 15% the Dow's returns, which could distort future price returns of the overall index. Passive investors investing in ETFs such as DIA, should realize that their investment is now more concentrated in the financial sector given that 2 financial companies are added and only one was removed. Also, given the extraordinary high share prices of Goldman and Visa, passive investors are over-weighting financials due to the price-weighted nature of the Dow Index. This is something to keep in mind for passive investors when constructing a portfolio or re-balance their current ones. In addition, for traders using the Dow Theory to predict future prices, the components change will likely alter price patterns of the index and traders need to make the necessary adjustments to minimize price fluctuations due to this components change. 

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Source: http://press.djindexes.com/index.php/goldman-sachs-visa-nike-set-to-join-the-dow-jones-industrial-average/

Footnote: Diamonds, cubes and spiders refer to the classes of Exchange Traded Funds (ETFs) that track the three biggest indices. Diamonds refers to the DIA which tracks the Dow Jones Industrial Average. Cubes refers to the QQQ which tracks the NASDAQ 100. Spiders refers to SPY which tracks the S&P500. ETFs are exchanged traded instruments that is designed to track an underlying index like the Dow Jones or S&P500. ETFs are often lower cost investment products compared to a traditional mutual funds. 

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.