Contributing editor Tom Slee is with us this week, having recently returned from a European holiday during which he was able to experience the angst of the current economic turmoil first-hand. His focus today is on the trials and tribulations of the banking sector and the effect it is having on the share prices of Canadian banks. Here is his report.
Tom Slee writes:
Here comes more trouble. Having successfully shorted British and American financial stocks, the international hedge funds are attacking Canadian banks. These well-heeled predators are a serious threat; as a matter of fact they have been banned in four European countries. This time however, I think that they are going to be sadly disappointed. Trading at a traditional 11.5 earnings multiples, our bank stocks are certainly not overpriced or vulnerable. Supported by 4%+ yields, excess capital, and solid earnings growth, they are some of the most defensive issues on the board.
Now I am not for a moment suggesting that our banks are going to be unaffected by a major market downturn. In 2008 they headed south with everything else. My point is that their fundamentals are sound. Here is what the short sellers are up against.
Despite a slowing economy, Canadian banks turned in a very good third quarter. Industry earnings of $6.1 billion were up a 16% year-over-year and 2% better than the preceding quarter. Overall return on equity was an impressive 17.2%. Perhaps most encouraging, the growth was powered by old-fashioned banking business. Retail and commercial lending was surprisingly strong while loan losses declined. That more than offset weak trading results.
Looking ahead, the industry is expected to generate earnings growth of about 8% to 10% in fiscal 2012, although the going may be tougher. The European debt crisis (which has not been resolved despite the euphoria that followed last week's meeting) and floundering U.S. recovery are bound to take their toll. Nevertheless, our banks are well equipped to ride the storm.
Recent acquisitions such as Toronto Dominion's new Chrysler Finance Division are going to start contributing. Moreover the industry's core domestic business remains healthy. Most important, there is good news regarding two serious concerns that attracted the short sellers in the first place: the ballooning Canadian consumer debt load and foreign debt contagion.
A new report from the Bank of Canada shows that consumer debt growth declined for five straight months. Canadians are paying down their credit cards and auto loans, albeit slowly. In fact, consumer credit growth is now below 5% per annum for the first time since 1988. Initially this is going to stunt bank earnings but bad loan experience should gradually improve and more than compensate. The important thing is that the chances of a bubble are receding.
European debt exposure also seems to be manageable. This is more difficult to quantify because it's constantly changing and a lot of the risk is indirect. For instance, Canadian banks have substantial inter-company balances with the French banks that now hold US$60 billion of suspect Greek debt. However, European governments and the IMF are taking measures to prevent any serious ripple effect. The good news is that Canadian banks have relatively little direct exposure to the most vulnerable nations. According to a recent Scotia McLeod survey, BMO had a total of about $400 million in loans to the weakest European countries at the end of the second quarter. Royal Bank had $250 million of exposure, Scotiabank approximately $400 million, and CIBC about $300 million. These are negligible amounts (in banking terms) and Toronto Dominion and National were not exposed at all. The potential for contagion is limited and the Bank of Canada is making sure that it stays that way.
Fourth-quarter bank numbers, therefore, are likely to be respectable and the stocks should continue to perform relatively well in a very difficult market. Solid, high yielding investments, they fit our present defensive strategy.
Here are updates on my specific bank picks.
TD Bank (TSX, NYSE: TD)
Originally recommended on Feb. 12/07 (IWB #2706) at C$69.85, US$59.59. Closed Friday at C$75.99, US$76.48.
TD Bank reported third-quarter operating earnings of $1.69 a share, well ahead of a $1.62 consensus estimate. It was an impressive effort, up 21% year-over-year and 8% better than the previous quarter. Management celebrated by raising the dividend by 3% to $2.72 annually, the second increase this year.
Canadian operations were particularly strong, generating cash earnings of $945 million, a 13% improvement over 2010, as loans grew 8%. U.S. results were ahead of expectations although credit loss provisions jumped as Chrysler Financial was absorbed. As with the other Canadian banks, however, TD's market and currency trading revenues were down as clients moved into cash positions.
TD's capital ratios are excellent and the bank should have no difficulty meeting the new Basel requirements next year. Corporate expenses remain low. As a result, everything points to earnings of about $6.50 a share this year and $7.25 in 2012, even if the economy continues to weaken.
Action now: TD Bank is a Buy with a slightly reduced target of $90 mainly because earnings multiples are likely to shrink as investors become discouraged by the roller coaster markets.
Scotiabank (TSX, NYSE: BNS)
Originally recommended on Jan. 17/11 (IWB #21102) at C$56.83, US$57.34. Closed Friday at C$53.03, US$53.40.
Scotiabank also had a good third quarter, racking up earnings of $1.14 a share compared to $0.99 a year ago, despite a drop in fixed-income trading profits. Analysts were expecting $1.12.
Wealth Management numbers were a little disappointing and expenses jumped 6% as a result of higher pension and operational costs. On the plus side though, International Banking, Scotiabank's long suit, reported a profit of $338 million, up 21% year-over-year. Canadian Banking was also strong. Everything points to earnings of approximately $4.75 a share in 2011 and close to $5 next year.
Action now: Scotiabank is a Buy with a target of $62. I will revisit the stock if it dips to $45.
National Bank (TSX: NA, OTC: NTIOF)
Originally recommended on April 11/11 (IWB #21114) at C$76.69, US$80.22. Closed Friday at C$72.43, US$73.
Rounding out our selections, National Bank met expectations by reporting third-quarter earnings of $1.84 a share, an 18% improvement over 2010. Surprisingly, given the poor markets, the bank's trading profit of $102 million was up 18%. Loan growth came in at 11% while credit losses were less than expected.
One of the most encouraging things about National is its continuing concern for the shareholders. Management repurchased $228 million worth of stock in the third quarter and there is now a good chance that we will see a dividend increase of as much as 8% in the fourth quarter. Earnings of about $6.75 a share are likely this year with an increase to the $7.25 range in 2012.
Action now: National Bank is a Buy with a target of $85. I have set a $65 revisit level.
Tom Slee writes:
Here comes more trouble. Having successfully shorted British and American financial stocks, the international hedge funds are attacking Canadian banks. These well-heeled predators are a serious threat; as a matter of fact they have been banned in four European countries. This time however, I think that they are going to be sadly disappointed. Trading at a traditional 11.5 earnings multiples, our bank stocks are certainly not overpriced or vulnerable. Supported by 4%+ yields, excess capital, and solid earnings growth, they are some of the most defensive issues on the board.
Now I am not for a moment suggesting that our banks are going to be unaffected by a major market downturn. In 2008 they headed south with everything else. My point is that their fundamentals are sound. Here is what the short sellers are up against.
Despite a slowing economy, Canadian banks turned in a very good third quarter. Industry earnings of $6.1 billion were up a 16% year-over-year and 2% better than the preceding quarter. Overall return on equity was an impressive 17.2%. Perhaps most encouraging, the growth was powered by old-fashioned banking business. Retail and commercial lending was surprisingly strong while loan losses declined. That more than offset weak trading results.
Looking ahead, the industry is expected to generate earnings growth of about 8% to 10% in fiscal 2012, although the going may be tougher. The European debt crisis (which has not been resolved despite the euphoria that followed last week's meeting) and floundering U.S. recovery are bound to take their toll. Nevertheless, our banks are well equipped to ride the storm.
Recent acquisitions such as Toronto Dominion's new Chrysler Finance Division are going to start contributing. Moreover the industry's core domestic business remains healthy. Most important, there is good news regarding two serious concerns that attracted the short sellers in the first place: the ballooning Canadian consumer debt load and foreign debt contagion.
A new report from the Bank of Canada shows that consumer debt growth declined for five straight months. Canadians are paying down their credit cards and auto loans, albeit slowly. In fact, consumer credit growth is now below 5% per annum for the first time since 1988. Initially this is going to stunt bank earnings but bad loan experience should gradually improve and more than compensate. The important thing is that the chances of a bubble are receding.
European debt exposure also seems to be manageable. This is more difficult to quantify because it's constantly changing and a lot of the risk is indirect. For instance, Canadian banks have substantial inter-company balances with the French banks that now hold US$60 billion of suspect Greek debt. However, European governments and the IMF are taking measures to prevent any serious ripple effect. The good news is that Canadian banks have relatively little direct exposure to the most vulnerable nations. According to a recent Scotia McLeod survey, BMO had a total of about $400 million in loans to the weakest European countries at the end of the second quarter. Royal Bank had $250 million of exposure, Scotiabank approximately $400 million, and CIBC about $300 million. These are negligible amounts (in banking terms) and Toronto Dominion and National were not exposed at all. The potential for contagion is limited and the Bank of Canada is making sure that it stays that way.
Fourth-quarter bank numbers, therefore, are likely to be respectable and the stocks should continue to perform relatively well in a very difficult market. Solid, high yielding investments, they fit our present defensive strategy.
Here are updates on my specific bank picks.
TD Bank (TSX, NYSE: TD)
Originally recommended on Feb. 12/07 (IWB #2706) at C$69.85, US$59.59. Closed Friday at C$75.99, US$76.48.
TD Bank reported third-quarter operating earnings of $1.69 a share, well ahead of a $1.62 consensus estimate. It was an impressive effort, up 21% year-over-year and 8% better than the previous quarter. Management celebrated by raising the dividend by 3% to $2.72 annually, the second increase this year.
Canadian operations were particularly strong, generating cash earnings of $945 million, a 13% improvement over 2010, as loans grew 8%. U.S. results were ahead of expectations although credit loss provisions jumped as Chrysler Financial was absorbed. As with the other Canadian banks, however, TD's market and currency trading revenues were down as clients moved into cash positions.
TD's capital ratios are excellent and the bank should have no difficulty meeting the new Basel requirements next year. Corporate expenses remain low. As a result, everything points to earnings of about $6.50 a share this year and $7.25 in 2012, even if the economy continues to weaken.
Action now: TD Bank is a Buy with a slightly reduced target of $90 mainly because earnings multiples are likely to shrink as investors become discouraged by the roller coaster markets.
Scotiabank (TSX, NYSE: BNS)
Originally recommended on Jan. 17/11 (IWB #21102) at C$56.83, US$57.34. Closed Friday at C$53.03, US$53.40.
Scotiabank also had a good third quarter, racking up earnings of $1.14 a share compared to $0.99 a year ago, despite a drop in fixed-income trading profits. Analysts were expecting $1.12.
Wealth Management numbers were a little disappointing and expenses jumped 6% as a result of higher pension and operational costs. On the plus side though, International Banking, Scotiabank's long suit, reported a profit of $338 million, up 21% year-over-year. Canadian Banking was also strong. Everything points to earnings of approximately $4.75 a share in 2011 and close to $5 next year.
Action now: Scotiabank is a Buy with a target of $62. I will revisit the stock if it dips to $45.
National Bank (TSX: NA, OTC: NTIOF)
Originally recommended on April 11/11 (IWB #21114) at C$76.69, US$80.22. Closed Friday at C$72.43, US$73.
Rounding out our selections, National Bank met expectations by reporting third-quarter earnings of $1.84 a share, an 18% improvement over 2010. Surprisingly, given the poor markets, the bank's trading profit of $102 million was up 18%. Loan growth came in at 11% while credit losses were less than expected.
One of the most encouraging things about National is its continuing concern for the shareholders. Management repurchased $228 million worth of stock in the third quarter and there is now a good chance that we will see a dividend increase of as much as 8% in the fourth quarter. Earnings of about $6.75 a share are likely this year with an increase to the $7.25 range in 2012.
Action now: National Bank is a Buy with a target of $85. I have set a $65 revisit level.
