Tom Slee writes:
This is shaping up as a banner year for Canadian banks. The recent federal budget was surprisingly kind to them. Prime Minister Harper, an unlikely ally, is vigorously defending them against demands for stricter regulations. And their first-quarter results were exceptional. Even the most optimistic analysts were surprised and for once the numbers were solid. All of the banks performed well thanks to lower loan losses and impressive retail profits. Overall, the industry beat street estimates by a startling 10% and at the same time increased its crucial Tier 1 capital ratio to 12.1%. No wonder banking executives are upbeat about their prospects.
The impressive earnings are good news for several reasons. For starters, this is the first broad-based proof that the Canadian recovery is well underway. Until now we have been comforted by GDP projections and other arcane economic indicators but in the final analysis only earnings count, especially bank earnings. They reflect business conditions, life in the trenches as it were.
Equally encouraging was the fact that the Canadian banks have obviously steered clear of the U.S. financial mess by building on their domestic operations. As recently as February, forecasters were suggesting that last year's gloomy results from major American financial institutions were bound to cloud Canadian credit and revenue growth. CI Capital Markets felt that there was "limited scope for positive surprises when Canadian banks begin reporting their first-quarter results." CI Capital was in good company. As we know, however, our banks came through in style.
The results were also important because our major banks are the Canadian commercial platform and account for more than 20% of the S&P/TSX Composite Index. They set the tone for the entire market. It's hard to imagine other sectors performing well in 2010 if the banks had turned in a dismal performance. Moreover, the results have attracted attention south of the border. Analyst Craig Fehr at Edward Jones in St. Louis said "the first quarter (results) set the table for 2010...and allow the banks to focus on growth rather than navigate around potholes created by the crisis." Comments like that should attract buying from American investors unhappy with their own financial institutions.
Another plus is that the bankers themselves are more confident. They are no longer hunkered down. Senior executives, such as Scotiabank CEO Rick Waugh, are speaking openly about acquisitions and new markets. Bank of Montreal CEO Bill Downe said: "I think we've been out of the woods for six months". Royal Bank stated that it is taking full advantage of opportunities. This is heady stuff coming from senior managers who a few months ago were still in the bunker, reluctant to call the bottom.
As to the first-quarter numbers themselves, total cash earnings were $5.2 billion, up 68% from a year ago and 15% better than the previous quarter. At the same time, there was a significant improvement in asset quality. Loan loss provisions of $2.1 billion were down 15% from the final quarter in 2009, as a result of strong risk management. There was an improvement in loan mix. As a matter of fact, there was little weakness and profit margins are likely to improve as interest rates rise. The consensus is that Canadian bank earnings are likely to grow as much as 40% year-over-year in 2010, followed by a further 20% in 2011. We could see dividend increases late this year or even earlier if the second- and third-quarter results live up to expectations.
The federal budget on March 4 was especially good news for the banks. It removed a large cloud hanging over the industry. Nearly all of the experts were expecting Mr. Flaherty to help reduce his large deficits with a new banking tax. After all, this sector is racking up relatively large profits and Canada is under pressure to join other G20 countries in imposing a global levy on banks. The Finance Minister could have killed two birds with one stone. Instead, he followed through on a previous commitment to reduce the federal corporate tax rate to 15% by 2012. That should add about $1 billion, or 5%, to the banks' bottom lines two years from now. It's also going to give us a competitive international edge.
I am encouraged too by the Finance Minister's praise for the way Canadian banks conducted themselves during the crisis and his efforts to build on this by turning us into a major financial centre. Over the years there have often been sharp differences of opinion between Ottawa and the major banks but right now they are on the same wavelength. Mr. Flaherty is actually defending them against U.S. and European efforts to enact a whole raft of new banking rules. He thinks that we have got the right mix of regulations and guidance. As Julie Dickson, Superintendent of Financial Institutions, said in New York on March 16: "Good regulation comes from nuts and bolts supervision...stricter rules create a false sense of security". As someone who wrestles with the burgeoning Income Tax Act, I was stunned to hear a government official actually say that!
For the moment, therefore, the Canadian banks have a tailwind and are likely to outperform the market in 2010. TD Bank in particular should continue to do well. See my updates for more comments on it and Bank of Montreal.
Toronto Dominion Bank (TSX, NYSE: TD)
Originally recommended on Feb. 12/07 (IWB #2706) at C$69.85, US$59.59. Closed Friday at C$74.14, US$73.88.
TD Bank reported cash earnings of $1.36 billion, or $1.57 a share, for the first quarter, beating consensus forecasts of $1.33 by an impressive 18%. Keep in mind that the analysts are usually able to accurately predict the highly regulated bank results or at least come very close. An 18% margin is extraordinary and in this case extremely encouraging. The stock took off.
The fact is that TD's Canadian divisions surprised everybody with record earnings while the U.S. retail operations, exposed to a very uncertain market, also performed reasonably well, although management continues to make substantial U.S. loan loss provisions. At the same time, the bank's Wealth Management results jumped as trading volumes and assets under management grew.
In short, there was strength across the board. The all-important return on equity (ROE) was 16.7% compared to 13.8% a year ago. TD's Tier 1 capital ratio increased to 11.5%, up from 10.1% in 2009. So given these numbers and the promising outlook, TD Bank should earn about $5.80 a share this year and $6.50 or more in 2011.
Action now: TD Bank remains a Buy with a target of $82. I have set a $65 revisit level.
Bank of Montreal (TSX, NYSE: BMO)
Originally recommended on July 27/09 (IWB #2928) at C$51.67, US$47.71. Closed Friday at C$61.25, US$60.95.
Bank of Montreal posted a first-quarter profit of $644 million, a convincing $454 million improvement over the previous year. Adjusted cash earnings were $1.13 a share, well above the $1.03 analysts were expecting. Canadian personal and commercial banking results were particularly strong. Overall, credit experience was better than anticipated and BMO reduced its loan loss provisions.
U.S. profits, the big concern, were down slightly quarter-over-quarter but respectable given the difficult business conditions south of the border. It's obvious now that wholly-owned Chicago-based Harris Bank lacks bulk and to counter this BMO is shifting $6 to $7 billion of its commercial loans to the subsidiary. This will provide economies of scale and allow management to improve the efficiency ratios. Elsewhere the numbers were excellent. The bank's Capital Markets division racked up $273 million of revenues, well above analyst forecasts of $150 million, as a result of tight underwriting and an active mergers and acquisitions market.
BMO's return on equity is now 14.6% and management is shooting for a much more ambitious 17% to 20%. Tier 1 Capital grew to 12.5% in the quarter. In fact, all systems are Go, with Harris the only slight question mark.
My concern, however, is that most of this good news is already in the stock price. I expect to see earnings of about $4.50 a share this year and $5.35 in 2011. With the shares trading at $61.25, well through our target, the p/e multiple is close to 14. So after a good run the shares may pause for a while.
Investors who are inclined to trade should think about reducing their positions and pocket some of the profits. For those with a long-term strategy, the stock still looks attractive, especially with its now safe 4.6% yield, equal to about 6.5% from a bond after adjustment for the dividend tax credit.
Action now: BMO remain a Buy for investors seeking long-term growth and income. I have set a new $65 target and will revisit the stock if it dips to $53.
Shoppers Drug Mart (TSX: SC, OTC: SHDMF)
Originally recommended on June 15/09 (IWB #2922) at C$47.64, US$42.46. Closed Friday at C$38.25, US$38.07.
Shares in Shoppers fell sharply after the Ontario government announced that prices for generic prescription drugs provided under the provincial Drug Benefit Program would be cut to 25% of the equivalent brand name price, from 50% currently. The province also said that reductions in the prices of generic prescription drugs would be extended to the private sector over time.
The move is expected to hit the profits of retail pharmacies like Shoppers. The share price, which had closed at $43.17 on April 7, fell 11.4% over the next two days to finish the week at C$38.25, US$38.07. That was the lowest closing price for the stock in more than five years. Volume was extremely high, with 14.6 million shares changing hands on Thursday. Normal daily volume is less than one million shares.
The company issued a press release saying it is "strongly opposed to the changes and believes that they will have a direct negative impact on pharmacy services and patient care" in the province. It said it is reviewing the changes to assess the impact on sales and profitability. Media reports speculated Shoppers would soon announce lay-offs and reduced operating hours.
Several analysts immediately downgraded the stock, with some recommending it be sold outright. RBC Capital Markets, which follows the stock closely, was more muted in its analysis, noting that the growth rate for prescription dispensing is expected to be 6% to 8% annually for the foreseeable future. The brokerage firm cut its target price to $48 from $52 but maintained its "Outperform" rating.
My feeling is that Shoppers is already busy devoting more and more space to cosmetics. In a lot of outlets the pharmacy is now tucked away in a corner and is hard to find. I suspect that the company will raise an uproar and then take this setback in its stride.
The sell-off could prove to be an overreaction and aggressive investors may wish to take advantage by adding to positions. More conservative investors should hold. I do not advise selling into this negative news.
I will monitor developments going forward and provide another update soon.
Action now: Hold.