Contributing editor Tom Slee is here this week with a look at the latest financial results from the big banks. They all did better than expected, but you'd never know it from the stock performance, as he explains. Tom managed millions of dollars in pension money during his career and is an expert in fixed-income securities. Here is his report.
Tom Slee writes:
This has been a lacklustre year for Canadian bank stocks, even though the news has generally been pretty good. Earnings exceeded expectations and at long last we have seen some dividend increases. The industry's fundamentals are sound. As a matter of fact Bloomberg rates four of our banks amongst the ten strongest banks in the world.
Yet investors remain unimpressed mainly because the banks' CEOs are down in the dumps. They are worried about new regulations, consumer debt, slowing growth, low interest rates; you name it. Bank of Canada Governor Mark Carney has urged them to be more positive. A little optimism would certainly help.
Take the recent third-quarter results, for example. Banking industry spokespersons went to a lot of trouble preparing us for the worst. We were told to brace ourselves. National Bank warned that demand for consumer credit had plummeted to 2.5% from over 10% in early 2010. A worried BMO executive felt that industry cash operating profits would fall 2% compared to the previous quarter. It seemed that wholesale and domestic results were likely to slip. So we were ready for some bad numbers. What happened was something else entirely.
Canadian banks reported third-quarter average cash operating earnings of $1.49 a share, easily beating the forecasted $1.40 and well ahead of $1.43 for the second quarter. The industry racked up an impressive 18% return on equity (ROE) and all of the big five banks raised their dividends. It was an impressive performance: so much for the dire predictions. Yet the stocks hardly moved as bank presidents issued dismal guidance along with the good results.
Instead of trumpeting a record third-quarter profit of $2.2 billion, Royal Bank CEO Gordon Nixon said: "Demand for credit is very low. People argue whether we are going into a double-dip recession. I take a different perspective: did we ever leave the first recession?"
At CIBC, president Gerry McCaughey announced a profit of $2.06 a share compared to a consensus forecast of $1.95, a 4% dividend increase, and an eight million share buyback program. He then spoiled the effect by saying that he is very worried about new regulations. It seemed as though there was a concerted effort to talk down the strong earnings.
Of course, we all have to remain cautious in these difficult times but there is no need for the banking industry to be pessimistic. My feeling is that fourth-quarter results are likely to be weaker but that is to some extent because banks already have a good year under their belts. They can afford to write off some extraordinary items, perhaps bolster bad debt provisions. That should clear the decks going into next year. As a matter of fact, the prospects for 2013 are already encouraging.
Low interest rates will continue to squeeze profit margins but the banks have costs under control. Loan losses remain manageable and the major players have reduced their European exposure to $79 billion of which $75 billion relates to the stronger nations: France, Germany, the U.K., and the Netherlands. The big question mark is the Canadian real estate market, which is still losing strength.
Housing, or rather mortgage, demand is a significant part of Canadian banking business. According to some analysts, residential mortgages account for approximately 65% of the total domestic loan book. During the recent real estate boom mortgages were almost 80% of loan growth. So a sharp downturn in the housing market poses two threats: diminished loan growth and bad debts, especially amongst condo developers. At present, Canadian banks have $36 billion worth of uninsured exposure to condos across the country.
How deep is the housing downturn likely to be? Some experts are looking for a 15% decline in sales and construction. It's possible. But Finance Minister Flaherty has already pricked the bubble with his new mortgage regulations. So I think the chances are that sales and construction will drop about 10% over the next two years. That will hamper loan growth but not kill it. Banks can compensate by focusing on acquisitions and other business. Industry earnings should continue to grow at about 7% in 2013 thanks in large part to improved controls.
There are a couple of things to keep in mind. Our housing market is high profile and we are going to see a stream of alarming headlines that will probably hurt bank stocks. That may provide some excellent buying opportunities. Another problem that may generate a lot of bad press is a growing realization that the new capital requirements are much more demanding than originally thought. Canadian banks are well equipped to meet these rules but they may have to hoard profits. Therefore dividend increases are likely to be smaller going forward.
Turning to the specific banks, our three recommendations all turned in good third-quarter results. My updates follow.
Insurance companies
Elsewhere, the Canadian Life and Health sector is a mixed bag as companies struggle with three major problems. First, prolonged low interest rates have squeezed margins to the extent that many traditional products are now unprofitable. Moreover, intense competition precludes necessary premium increases.
Second, while the major Canadian insurers are well capitalized they are constantly under pressure to build additional reserves. This has forced Sun Life and Manulife to exit certain business lines in the U.S.
Third, new accounting rules, primarily mark to market, have created huge quarterly adjustments on the balance sheets. These fluctuations hamper long-term planning and generate volatile results.
In short, the days when life insurance was a stable, predictable industry are long gone. Companies are assuming more risk as they shuffle their product mix to meet the new market conditions and improve short-term performance. Standard & Poor's has downgraded 159 North American life insurers since the late 1990s compared to 46 upgrades. I am not suggesting that this is now a high-risk sector. However, the stocks are less defensive. We have to tread carefully on a stock-by-stock basis.
On the other hand the Property and Casualty industry is in relatively good shape. Market fundamentals are improving and commercial premium rate increases are sticking. In September, giant insurer Travelers announced a 7.7% jump in some rates. At the same time, reinsurance markets continue to strengthen and Canadian underwriting numbers are looking better, especially in Ontario. With auto claim frequencies declining, the industry auto loss ratio was 83% in the first half of this year, down from almost 100% in early 2011, although auto insurance fraud remains a concern.
TD Bank (TD, Financial)
Originally recommended on Feb. 12/07 (#2706) at C$69.85, US$59.59. Closed Friday at C$81.17, US$81.32.
TD Bank continues to power ahead and reported third-quarter cash operating earnings of $1.91 a share, easily beating the $1.84 consensus forecast. To celebrate, TD boosted its dividend by 7% and also announced that the payout ratio range has been increased to 40%-50% from 35%-45%. As a result, we should see an accelerated dividend growth although still below historic norms.
The most encouraging thing about TD's results was that all of the divisions performed well. Canadian banking profit came in at $889 million compared to the $850 million that most analysts were expecting. American operations earned $361 million mainly due to organic loan growth, a very healthy sign. The Wealth Management and the Insurance businesses made solid contributions.
With an impressive 16.5% cash return on equity, the bank now seems set to report earnings of at least $7 a share this year followed by $7.90 or more in 2013. Obviously there are some headwinds and the recovery continues to splutter. Nevertheless I think that the stock has upside potential.
Action now: TD Bank remains a Buy with a target of $93. I have set a $73 revisit level.
National Bank (NTIOF, Financial)
Originally recommended on April 11/11 (#21114) at C$69.85, US$59.59. Closed Friday at C$76.87, US$76.83.
National Bank also delivered another good quarter and reported operating earnings of $2.14 a share or $1.98 excluding unusual items. This is up from $1.86 in 2011 and better than the $1.90 analysts were looking for. Personal and commercial banking and wealth management results were strong.
All systems are go at NA and I continue to like this bank. Earnings of close to $9.20 a share are possible this year and the return on equity is nearly 20%. The only problem, and it's a serious one, is that the Quebec election results have cast a cloud over the stock. National has always been regarded as a Quebec institution and that is where the bulk of its business is transacted. Consequently now that the Parti Quebecois has regained power and there is talk of separation once more, major investors are likely to shy away from NA for a while. After all, they have five other highly profitable banks to choose from.
My feeling, therefore, is that National Bank should become a Hold until the political uncertainty in Quebec is resolved. More aggressive investors may want to sell their positions and switch to Scotiabank or TD.
Action now: National Bank is a Hold.
Scotiabank (BNS, Financial)
Originally recommended on Jan. 17/11 (#21102) at C$56.83, US$57.34. Closed Friday at C$53.76, US$53.84.
Scotiabank, on the other hand, is upgraded to a strong Buy. It becomes my first choice amongst the Canadian banks because of its ING Bank of Canada acquisition. This is a game changer if Scotia can retain and cross-sell products to ING's customers.
To recap briefly, on Aug. 29, BNS bought ING Canada for $3.1 billion. It was the largest purchase of Canadian bank assets for a decade and the biggest deal in Scotiabank's 180-year history. With ING's $30 billion in assets, BNS becomes Canada's third-largest bank. Most important, the acquisition entrenches Scotia, which has been viewed as an international operator, as Canada's third-largest domestic retail banker with 14.3% of total consumer deposits.
There are other benefits. Only 20% of ING's 1.8 million customers are existing BNS customers. This provides substantial room for cross-selling especially as ING's clients are on average 40% wealthier than typical Canadian bank customers. At the same time, a large and more profitable Canadian base will allow BNS to expand faster into foreign markets.
The acquisition will not contribute a great deal to the bottom line until 2014 but the potential should lead to Scotiabank's stock trading at a higher multiple. BNS is expected to make about $5.35 a share this year. Trading at $53.76, the shares may mark time for a while as the market absorbs a 29 million common share issue at $52 to fund the ING purchase. Longer term the shares are attractive for growth and income from the $2.28 dividend. At the current price, the yield is 4.24%
Action now: Scotiabank is a Buy at $53.76 with a target of $65. I will revisit the stock if it dips to $47.
Manulife Financial (MFC, Financial)
Originally recommended on Feb. 26/12 (#21105) at C$12.34, US$12.42. Closed Friday at C$12.30, US$12.35.
Manulife Financial continues to struggle but there are signs that the company has turned the corner. Cutting through all the necessary non-recurring adjustments and charges, core second-quarter earnings came in at $0.35 a share, beating the $0.33 consensus forecast. Here again, though, we ran into some gloomy guidance. Management warned that actuarial assumptions could hurt third-quarter results by as much as $0.55 a share. No wonder the stock continues to tread water. It now looks as though MFC will make about $0.75 a share in 2012 and as much $1.50 next year.
The most encouraging thing is that the product repositioning and asset-liability adjustments are starting to pay off. This will partially compensate for the low interest rates that are likely to persist for a while. Insurance sales remain strong, especially in the Asian division where double-digit growth continues. One caveat: analysts remain concerned about MFC's largely unhedged equity market exposure.
Action now: Manulife remains a Buy with a slightly lower $16 target. I have set a $9.50 revisit level.
Intact Financial (IFCZF, Financial)
Originally recommended on Feb. 6/12 (#21205) at C$59.60. Closed Friday at C$60.65, US$59.85 (Sept. 5).
At Intact Financial, second-quarter numbers were slightly disappointing due to a string of above-average storm claims in Thunder Bay and Montreal that inflicted a charge of $0.18 a share. Final earnings came in at $1.35 a share versus the $1.39 analysts were looking for. On the plus side, direct premiums written of $1.98 billion were 4% better than expected and Intact's underwriting profitability continues to improve. The company's operating return on equity is now running at 17.3% compared to an industry average of 11%.
In September Intact completed its $530 million acquisition of Jevco Insurance Company. This addition broadens IFC's exposure to brokers and strengthens its commercial and specialty lines.
The company is on track to earn $5.65 a share this year with an increase to the $6.50 range in 2013. The stock has been weak following news of the storm losses but I regard this as a buying opportunity.
Action now: Intact Financial is a Buy with a target of $70. I will revisit the stock if it dips to $52.
- end Tom Slee
Tom Slee writes:
This has been a lacklustre year for Canadian bank stocks, even though the news has generally been pretty good. Earnings exceeded expectations and at long last we have seen some dividend increases. The industry's fundamentals are sound. As a matter of fact Bloomberg rates four of our banks amongst the ten strongest banks in the world.
Yet investors remain unimpressed mainly because the banks' CEOs are down in the dumps. They are worried about new regulations, consumer debt, slowing growth, low interest rates; you name it. Bank of Canada Governor Mark Carney has urged them to be more positive. A little optimism would certainly help.
Take the recent third-quarter results, for example. Banking industry spokespersons went to a lot of trouble preparing us for the worst. We were told to brace ourselves. National Bank warned that demand for consumer credit had plummeted to 2.5% from over 10% in early 2010. A worried BMO executive felt that industry cash operating profits would fall 2% compared to the previous quarter. It seemed that wholesale and domestic results were likely to slip. So we were ready for some bad numbers. What happened was something else entirely.
Canadian banks reported third-quarter average cash operating earnings of $1.49 a share, easily beating the forecasted $1.40 and well ahead of $1.43 for the second quarter. The industry racked up an impressive 18% return on equity (ROE) and all of the big five banks raised their dividends. It was an impressive performance: so much for the dire predictions. Yet the stocks hardly moved as bank presidents issued dismal guidance along with the good results.
Instead of trumpeting a record third-quarter profit of $2.2 billion, Royal Bank CEO Gordon Nixon said: "Demand for credit is very low. People argue whether we are going into a double-dip recession. I take a different perspective: did we ever leave the first recession?"
At CIBC, president Gerry McCaughey announced a profit of $2.06 a share compared to a consensus forecast of $1.95, a 4% dividend increase, and an eight million share buyback program. He then spoiled the effect by saying that he is very worried about new regulations. It seemed as though there was a concerted effort to talk down the strong earnings.
Of course, we all have to remain cautious in these difficult times but there is no need for the banking industry to be pessimistic. My feeling is that fourth-quarter results are likely to be weaker but that is to some extent because banks already have a good year under their belts. They can afford to write off some extraordinary items, perhaps bolster bad debt provisions. That should clear the decks going into next year. As a matter of fact, the prospects for 2013 are already encouraging.
Low interest rates will continue to squeeze profit margins but the banks have costs under control. Loan losses remain manageable and the major players have reduced their European exposure to $79 billion of which $75 billion relates to the stronger nations: France, Germany, the U.K., and the Netherlands. The big question mark is the Canadian real estate market, which is still losing strength.
Housing, or rather mortgage, demand is a significant part of Canadian banking business. According to some analysts, residential mortgages account for approximately 65% of the total domestic loan book. During the recent real estate boom mortgages were almost 80% of loan growth. So a sharp downturn in the housing market poses two threats: diminished loan growth and bad debts, especially amongst condo developers. At present, Canadian banks have $36 billion worth of uninsured exposure to condos across the country.
How deep is the housing downturn likely to be? Some experts are looking for a 15% decline in sales and construction. It's possible. But Finance Minister Flaherty has already pricked the bubble with his new mortgage regulations. So I think the chances are that sales and construction will drop about 10% over the next two years. That will hamper loan growth but not kill it. Banks can compensate by focusing on acquisitions and other business. Industry earnings should continue to grow at about 7% in 2013 thanks in large part to improved controls.
There are a couple of things to keep in mind. Our housing market is high profile and we are going to see a stream of alarming headlines that will probably hurt bank stocks. That may provide some excellent buying opportunities. Another problem that may generate a lot of bad press is a growing realization that the new capital requirements are much more demanding than originally thought. Canadian banks are well equipped to meet these rules but they may have to hoard profits. Therefore dividend increases are likely to be smaller going forward.
Turning to the specific banks, our three recommendations all turned in good third-quarter results. My updates follow.
Insurance companies
Elsewhere, the Canadian Life and Health sector is a mixed bag as companies struggle with three major problems. First, prolonged low interest rates have squeezed margins to the extent that many traditional products are now unprofitable. Moreover, intense competition precludes necessary premium increases.
Second, while the major Canadian insurers are well capitalized they are constantly under pressure to build additional reserves. This has forced Sun Life and Manulife to exit certain business lines in the U.S.
Third, new accounting rules, primarily mark to market, have created huge quarterly adjustments on the balance sheets. These fluctuations hamper long-term planning and generate volatile results.
In short, the days when life insurance was a stable, predictable industry are long gone. Companies are assuming more risk as they shuffle their product mix to meet the new market conditions and improve short-term performance. Standard & Poor's has downgraded 159 North American life insurers since the late 1990s compared to 46 upgrades. I am not suggesting that this is now a high-risk sector. However, the stocks are less defensive. We have to tread carefully on a stock-by-stock basis.
On the other hand the Property and Casualty industry is in relatively good shape. Market fundamentals are improving and commercial premium rate increases are sticking. In September, giant insurer Travelers announced a 7.7% jump in some rates. At the same time, reinsurance markets continue to strengthen and Canadian underwriting numbers are looking better, especially in Ontario. With auto claim frequencies declining, the industry auto loss ratio was 83% in the first half of this year, down from almost 100% in early 2011, although auto insurance fraud remains a concern.
TD Bank (TD, Financial)
Originally recommended on Feb. 12/07 (#2706) at C$69.85, US$59.59. Closed Friday at C$81.17, US$81.32.
TD Bank continues to power ahead and reported third-quarter cash operating earnings of $1.91 a share, easily beating the $1.84 consensus forecast. To celebrate, TD boosted its dividend by 7% and also announced that the payout ratio range has been increased to 40%-50% from 35%-45%. As a result, we should see an accelerated dividend growth although still below historic norms.
The most encouraging thing about TD's results was that all of the divisions performed well. Canadian banking profit came in at $889 million compared to the $850 million that most analysts were expecting. American operations earned $361 million mainly due to organic loan growth, a very healthy sign. The Wealth Management and the Insurance businesses made solid contributions.
With an impressive 16.5% cash return on equity, the bank now seems set to report earnings of at least $7 a share this year followed by $7.90 or more in 2013. Obviously there are some headwinds and the recovery continues to splutter. Nevertheless I think that the stock has upside potential.
Action now: TD Bank remains a Buy with a target of $93. I have set a $73 revisit level.
National Bank (NTIOF, Financial)
Originally recommended on April 11/11 (#21114) at C$69.85, US$59.59. Closed Friday at C$76.87, US$76.83.
National Bank also delivered another good quarter and reported operating earnings of $2.14 a share or $1.98 excluding unusual items. This is up from $1.86 in 2011 and better than the $1.90 analysts were looking for. Personal and commercial banking and wealth management results were strong.
All systems are go at NA and I continue to like this bank. Earnings of close to $9.20 a share are possible this year and the return on equity is nearly 20%. The only problem, and it's a serious one, is that the Quebec election results have cast a cloud over the stock. National has always been regarded as a Quebec institution and that is where the bulk of its business is transacted. Consequently now that the Parti Quebecois has regained power and there is talk of separation once more, major investors are likely to shy away from NA for a while. After all, they have five other highly profitable banks to choose from.
My feeling, therefore, is that National Bank should become a Hold until the political uncertainty in Quebec is resolved. More aggressive investors may want to sell their positions and switch to Scotiabank or TD.
Action now: National Bank is a Hold.
Scotiabank (BNS, Financial)
Originally recommended on Jan. 17/11 (#21102) at C$56.83, US$57.34. Closed Friday at C$53.76, US$53.84.
Scotiabank, on the other hand, is upgraded to a strong Buy. It becomes my first choice amongst the Canadian banks because of its ING Bank of Canada acquisition. This is a game changer if Scotia can retain and cross-sell products to ING's customers.
To recap briefly, on Aug. 29, BNS bought ING Canada for $3.1 billion. It was the largest purchase of Canadian bank assets for a decade and the biggest deal in Scotiabank's 180-year history. With ING's $30 billion in assets, BNS becomes Canada's third-largest bank. Most important, the acquisition entrenches Scotia, which has been viewed as an international operator, as Canada's third-largest domestic retail banker with 14.3% of total consumer deposits.
There are other benefits. Only 20% of ING's 1.8 million customers are existing BNS customers. This provides substantial room for cross-selling especially as ING's clients are on average 40% wealthier than typical Canadian bank customers. At the same time, a large and more profitable Canadian base will allow BNS to expand faster into foreign markets.
The acquisition will not contribute a great deal to the bottom line until 2014 but the potential should lead to Scotiabank's stock trading at a higher multiple. BNS is expected to make about $5.35 a share this year. Trading at $53.76, the shares may mark time for a while as the market absorbs a 29 million common share issue at $52 to fund the ING purchase. Longer term the shares are attractive for growth and income from the $2.28 dividend. At the current price, the yield is 4.24%
Action now: Scotiabank is a Buy at $53.76 with a target of $65. I will revisit the stock if it dips to $47.
Manulife Financial (MFC, Financial)
Originally recommended on Feb. 26/12 (#21105) at C$12.34, US$12.42. Closed Friday at C$12.30, US$12.35.
Manulife Financial continues to struggle but there are signs that the company has turned the corner. Cutting through all the necessary non-recurring adjustments and charges, core second-quarter earnings came in at $0.35 a share, beating the $0.33 consensus forecast. Here again, though, we ran into some gloomy guidance. Management warned that actuarial assumptions could hurt third-quarter results by as much as $0.55 a share. No wonder the stock continues to tread water. It now looks as though MFC will make about $0.75 a share in 2012 and as much $1.50 next year.
The most encouraging thing is that the product repositioning and asset-liability adjustments are starting to pay off. This will partially compensate for the low interest rates that are likely to persist for a while. Insurance sales remain strong, especially in the Asian division where double-digit growth continues. One caveat: analysts remain concerned about MFC's largely unhedged equity market exposure.
Action now: Manulife remains a Buy with a slightly lower $16 target. I have set a $9.50 revisit level.
Intact Financial (IFCZF, Financial)
Originally recommended on Feb. 6/12 (#21205) at C$59.60. Closed Friday at C$60.65, US$59.85 (Sept. 5).
At Intact Financial, second-quarter numbers were slightly disappointing due to a string of above-average storm claims in Thunder Bay and Montreal that inflicted a charge of $0.18 a share. Final earnings came in at $1.35 a share versus the $1.39 analysts were looking for. On the plus side, direct premiums written of $1.98 billion were 4% better than expected and Intact's underwriting profitability continues to improve. The company's operating return on equity is now running at 17.3% compared to an industry average of 11%.
In September Intact completed its $530 million acquisition of Jevco Insurance Company. This addition broadens IFC's exposure to brokers and strengthens its commercial and specialty lines.
The company is on track to earn $5.65 a share this year with an increase to the $6.50 range in 2013. The stock has been weak following news of the storm losses but I regard this as a buying opportunity.
Action now: Intact Financial is a Buy with a target of $70. I will revisit the stock if it dips to $52.
- end Tom Slee
