Contributing editor Tom Slee joins us this week with some insights into what proposed new international banking regulations might mean to us. Surprisingly, he thinks Canadian banks may turn out to be big beneficiaries. Tom managed pension money in the insurance industry during his career and is also an expert on taxation. Here is his report.
Tom Slee writes:
Pity the poor politicians. They have just discovered that reforming banks is easier said than done. The finance ministers cannot agree on a bank tax, let alone a ban on hedge funds or ways to clean toxic assets. This is an incredibly complex sector and has to be carefully handled. If the new rules are too weak it's going to be business as usual; too tough and credit dries up. To make matters worse, a lot of economists are alarmed by the European debt crisis and think banks should have more freedom, not less. That's why the G20 kicked the problem down the road. Talk about uncertainty. Yet in an odd way Canadian banks stand to benefit.
One thing is certain. There are going to be some significant changes in the way Canadian banks do business. Sure, they weathered the worldwide collapse much better than their foreign counterparts but they are not going to escape unscathed. Superintendent of Financial Institutions Julie Dickson has already stated: "...the nation's banks will not be immune to international changes in capital and leverage ratios." That sounds harmless enough but the changes are going to have a ripple effect all the way down to how banks extend personal loans and mortgages. Consumers may feel the pinch. On the other hand, our banks are going to be even stronger and more resilient in the future.
We do have one thing going for us. Canadian banks are already in excellent shape and carefully regulated. So it's unlikely that they are going be hamstrung by a lot of the new punitive measures or additional layers of bureaucracy. For instance, there is not going to be a Canadian financial tsar policing the sale of financial products. Moreover, our senior bankers will be exempt from international measures to limit their bonuses. A senior official at the Department of Finance quashed that idea by saying: "Canada already has prudent compensation practices."
Most important, Finance Minister Jim Flaherty remains strongly opposed to a bank tax. Keep in mind, though, that our banks are going to be liable for new taxes on their foreign operations. For example, the recent British budget imposed a balance sheet levy on subsidiaries of overseas lenders.
We are also going to be spared Mr. Flaherty's contingent capital scheme. This involves bank debentures that convert into common stock during an emergency. The plan never got off the drawing board because investors were uninterested. It's easy to see why. No sane money manager is going to buy securities designed to downgrade just when the issuer is in trouble.
Finally, Ottawa shows no interest in passing legislation to deal with the thorny problem of moral hazards. This is a serious concern on Wall Street where banks have encouraged and compensated their traders to speculate and take ever-increasing risks. The Superintendent of Financial Institutions feels that she has that danger under control.
So there you have the non-starters. I have listed them because they are still being debated and cast a shadow over the bank stocks. As often happens, however, the pending changes that really matter have been largely ignored by the media, probably because they are complex and boring. The proposals that count are contained in consultative documents issued by the Bank for International Settlements (BIS) in Switzerland. Officials are generally agreed that these will govern international banking in the future. So Bay Street analysts are burning the midnight oil, agonizing over the small print, trying to gauge the implications.
The first document deals with new global banking capital requirements and it is much more severe than expected. Even the Canadian banks with their huge surpluses are going to feel the impact. The actual calculations are complicated but they boil down to all banks being required to have a lot more really permanent capital, such as common stock, in place. The semi-permanent capital that we have become accustomed to, such as the popular reset preferred shares, will no longer qualify as Tier 1 capital. At first glance, this means Canadian bank industry Tier 1 could shrink almost 200 basis points to about 9%. According to analysts at BMO Nesbitt Burns, the least affected would be Bank of Montreal (50 basis points) and most affected Royal Bank (300 basis points).
What does it mean? Well, stricter capital requirements will slow bank earnings growth, in this case by as much as 5% per annum. The good news is that while Canadian banks could live with these onerous changes, other global banks are going to find them unacceptable. International credit would shrink just when more economic stimulus is needed. So the feeling is that the new capital requirements are bound to be modified.
The second document relates to liquidity and according to many experts is more demanding than the capital requirements. As BIS quite rightly points out, many banks were sound during the financial crisis but ran into trouble because they lacked liquidity. In other words, they were unable to raise cash quickly enough. So in future the entire system is going to be more resilient. Banks will keep a higher percentage of their assets in liquid but inevitably lower-yielding investments such as cash and government bonds. That is going to reduce bank earnings. In fact, it has been estimated the requirements would reduce the Canadian banks' return on equity (ROE) by as much as 150 basis points. We would be left with six major, extremely safe but less profitable financial fortresses. Incidentally, the requirements would also disrupt fixed-income markets as banks start to hoard short term, top quality securities.
CEOs Rick Waugh at Scotiabank and Royal Bank's Gordon Nixon have already issued warnings about the BIS proposals. And so they should. The Institute of Financial Finance (IFF) thinks that in their present form the regulations would knock one percentage point off world economic growth. Other experts think that it could be nearer 3%. The betting, therefore, is that both the capital and liquidity requirements are going to be substantially modified. There is even talk of an elastic phase-in extending to 2012 and beyond.
In an odd way, however, I think that the new rules are going to be a plus for Canadian bank stocks. Our banks are better equipped to cope with the proposed changes and able to implement them fairly quickly. As a result, their earnings are going to be impacted briefly and then grow relatively quickly again. That should spur investor confidence and lift the stocks, which are likely to trade with higher p/e multiples. A rapid adjustment to the new rules will also allow reinstatement of the annual dividend increases, a move that could come as early as late this year or early in 2011. Meanwhile, other international banks, especially those in the U. S., will have a hard time struggling to upgrade. Their profits will continue to suffer as the changes are phased in gradually. Some of them could run into difficulties. That is going to make Canadian bank stocks even more attractive.
Turning to the banks themselves, I still like Bank of Montreal (TSX, NYSE: BMO), trading at $59.92 (US$57.83) and expected to earn about $5 a share this year with an increase to $5.50 in 2011. With a 12 p/e multiple, the shares are cheap and pay a $2.80 dividend to yield 4.67%. Consequently you earn a well above average return even if the economy splutters and capital gains are delayed. I have a $65 target, slightly less than the $67 consensus forecast.
I also continue to like TD Bank (TSX, NYSE: TD) priced at $71.68 (US$69.15) with a conservative target of $82. Some analysts were disappointed with the second-quarter numbers but when you scratched the surface they were solid. Loan losses were far less than expected. We could see earnings of $5.90 a share in 2010 and an increase to the $7 range next year. Both BMO and TD remain as Buys.
Incidentally, so that there is no misunderstanding, I also like National Bank (TSX: NA) and Bank of Nova Scotia (TSX, NYSE: BNS). Accident-prone CIBC is the only question mark in this sector.
Canadian Financials & Utilities Split Corp. Preferreds (TSX: CFS.PR.A)
Originally recommended on Jan. 15/07 (IWB #2702) at $10. Closed Friday at $10.25.
Canadian Financials & Utilities Split Corp. continues to recover slowly and its preferred shares are now quoted at $10.25. Paying a dividend of $0.425 per annum they yield 2.2% to Jan. 31, 2012 when they will be redeemed at a price of $10 a share. Dominion Bond Rating Services (DBRS) continues to rate them Pfd-1, the highest quality.
As I previously reported, the company was forced to liquidate a substantial part of its investments in 2008 because of the market collapse in order to protect the preferred shareholders. Even now the portfolio consists of 64% cash and equivalent and 36% equities of which 67% are banks and utilities. As a result, the preferred dividends and repayment in 2012 are safe.
My only concern is that the Class A shareholders who were badly hurt by the 2008 liquidation may petition the company to reorganize and postpone the 2012 redemption date. There has been no suggestion of this but other split share companies have amended their charters because of the unusual markets.
Given this slight uncertainty, investors who bought the preferred shares on our original recommendation at $10 should give some thought to selling and pocketing the small profit. The stock is now essentially 18-month blue chip commercial paper yielding 4.25% based on the original $10. Similar paper in the market pays about 2.25%. But of for any reason the redemption date is deferred, we are looking at a straight preferred and the yield is unattractive.
Action now: Canadian Financials & Utilities Split Corp. Preferred Shares are a Sell at $10.25. Keep in mind that the market is very thin. Place a limit on your order and be prepared to wait.
PepsiCo. Inc. (NYSE: PEP)
Originally recommended on Dec. 18/06 (IWB #2644) at $62.89. Closed Friday at $63.50. (All figures in U.S. dollars.)
PepsiCo has been turning in some good numbers but so far this year investors have been unimpressed. For example, first-quarter earnings were 76c a share compared to the 75c analysts were expecting. However, the stock dropped $1.29. Of course, these are difficult markets but even so the response was disappointing.
My feeling is that PEP is suffering from a widespread concern about U.S. consumer spending. For example, Standard & Poor's has a neutral rating on the soft drinks sub-industry in the middle of the hot (thirsty) season. S&P's analyst thinks that volume growth is going to be restrained this year. Certainly Pepsi ran into a price war during the first quarter and saw its sales slump.
Longer term, however, this is an attractive company. In February it acquired the remaining shares of Pepsi Bottling and Pepsi Americas. Absorbing the two bottlers should lead to pre-tax synergies of about $400 million annually by 2012. During the first quarter, the directors approved a 7% dividend increase to $1.92 and authorized a $15 billion stock repurchase program through June 2013. At the same time, operating margins are expected to improve and Pepsi's switch to non-carbonated soft drinks, such as Lipton teas, is producing good results.
Based on company guidance we should see earnings of about $4.20 a share this year, up from $3.71 in 2009. A further increase to the $4.60 range is expected next year. As a result, the stock at $63.50 is trading at a 13.8 forward p/e multiple and remains relatively cheap.
Action now: PepsiCo is a Buy with a target of $69. I have set a $56 revisit level.
Emera Inc. (TSX: EMA, OTC: EMRAF)
Originally recommended on Jan. 12/09 (IWB #2902) at C$22.47. Closed Friday at C$26.06, US$25.24.
Emera had an excellent first quarter, reporting earnings of 72c a share, well above the 59c analysts were expecting. Subsidiary Nova Scotia Power came through in style and corporate expenses were less than anticipated.
Many money managers regard Emera as a safe income stock and certainly a dividend increase to $1.15 is in the cards next year. My feeling, though, is that the market is still not recognizing the company's growth potential. With energy and energy-related assets already exceeding $5.4 billion, EMA is on the acquisition trail. In May it purchased a 38% stake in Light & Power Holdings of Barbados, a move that should add at least 6c a share to Emera's annual earnings. The proposed acquisition of a 50% interest in Sierra Pacific Power in Nevada and California is likely to close later this year. All of this adds up to an unusual situation: a utility-based company on the move.
Earnings of $1.45 a share are expected in 2010 and $1.50 or more next year. One caveat: there is a possibility that the company will issue $200 million of common equity. This could temporarily depress the stock. In that case, I would regard it as a buying opportunity.
Action now: Emera is now trading through our $25 target and remains a Buy for income and some growth. I have set a new target of $28 and will revisit the stock if it dips to $22.
Canadian Tire (TSX: CTC.A)
Originally recommended on Sept. 27/99 (IWB #9935) at $34.10. Closed Friday at $55.33.
Canadian Tire continues to struggle. First-quarter earnings of 61c a share were essentially flat year-over-year and a major disappointment. Of even more concern, there seems to be little light at the end of the tunnel. Ontario's blue collar market continues to suffer and this in turn hurts retail sales at Tire and Mark's Work Warehouse. The company's return on invested capital actually declined last year to 7.4% from 8.9% in 2008. Tire remains a first class company but has an uphill battle in this environment. At $55.33 the stock is fully valued at the moment. We have had it on Hold for some time but I now think that the money can be better used elsewhere, although I am sure that we will reinstate Tire at some time in the future.
Action now: Canadian Tire is a Sell at $55.33.
Tom Slee writes:
Pity the poor politicians. They have just discovered that reforming banks is easier said than done. The finance ministers cannot agree on a bank tax, let alone a ban on hedge funds or ways to clean toxic assets. This is an incredibly complex sector and has to be carefully handled. If the new rules are too weak it's going to be business as usual; too tough and credit dries up. To make matters worse, a lot of economists are alarmed by the European debt crisis and think banks should have more freedom, not less. That's why the G20 kicked the problem down the road. Talk about uncertainty. Yet in an odd way Canadian banks stand to benefit.
One thing is certain. There are going to be some significant changes in the way Canadian banks do business. Sure, they weathered the worldwide collapse much better than their foreign counterparts but they are not going to escape unscathed. Superintendent of Financial Institutions Julie Dickson has already stated: "...the nation's banks will not be immune to international changes in capital and leverage ratios." That sounds harmless enough but the changes are going to have a ripple effect all the way down to how banks extend personal loans and mortgages. Consumers may feel the pinch. On the other hand, our banks are going to be even stronger and more resilient in the future.
We do have one thing going for us. Canadian banks are already in excellent shape and carefully regulated. So it's unlikely that they are going be hamstrung by a lot of the new punitive measures or additional layers of bureaucracy. For instance, there is not going to be a Canadian financial tsar policing the sale of financial products. Moreover, our senior bankers will be exempt from international measures to limit their bonuses. A senior official at the Department of Finance quashed that idea by saying: "Canada already has prudent compensation practices."
Most important, Finance Minister Jim Flaherty remains strongly opposed to a bank tax. Keep in mind, though, that our banks are going to be liable for new taxes on their foreign operations. For example, the recent British budget imposed a balance sheet levy on subsidiaries of overseas lenders.
We are also going to be spared Mr. Flaherty's contingent capital scheme. This involves bank debentures that convert into common stock during an emergency. The plan never got off the drawing board because investors were uninterested. It's easy to see why. No sane money manager is going to buy securities designed to downgrade just when the issuer is in trouble.
Finally, Ottawa shows no interest in passing legislation to deal with the thorny problem of moral hazards. This is a serious concern on Wall Street where banks have encouraged and compensated their traders to speculate and take ever-increasing risks. The Superintendent of Financial Institutions feels that she has that danger under control.
So there you have the non-starters. I have listed them because they are still being debated and cast a shadow over the bank stocks. As often happens, however, the pending changes that really matter have been largely ignored by the media, probably because they are complex and boring. The proposals that count are contained in consultative documents issued by the Bank for International Settlements (BIS) in Switzerland. Officials are generally agreed that these will govern international banking in the future. So Bay Street analysts are burning the midnight oil, agonizing over the small print, trying to gauge the implications.
The first document deals with new global banking capital requirements and it is much more severe than expected. Even the Canadian banks with their huge surpluses are going to feel the impact. The actual calculations are complicated but they boil down to all banks being required to have a lot more really permanent capital, such as common stock, in place. The semi-permanent capital that we have become accustomed to, such as the popular reset preferred shares, will no longer qualify as Tier 1 capital. At first glance, this means Canadian bank industry Tier 1 could shrink almost 200 basis points to about 9%. According to analysts at BMO Nesbitt Burns, the least affected would be Bank of Montreal (50 basis points) and most affected Royal Bank (300 basis points).
What does it mean? Well, stricter capital requirements will slow bank earnings growth, in this case by as much as 5% per annum. The good news is that while Canadian banks could live with these onerous changes, other global banks are going to find them unacceptable. International credit would shrink just when more economic stimulus is needed. So the feeling is that the new capital requirements are bound to be modified.
The second document relates to liquidity and according to many experts is more demanding than the capital requirements. As BIS quite rightly points out, many banks were sound during the financial crisis but ran into trouble because they lacked liquidity. In other words, they were unable to raise cash quickly enough. So in future the entire system is going to be more resilient. Banks will keep a higher percentage of their assets in liquid but inevitably lower-yielding investments such as cash and government bonds. That is going to reduce bank earnings. In fact, it has been estimated the requirements would reduce the Canadian banks' return on equity (ROE) by as much as 150 basis points. We would be left with six major, extremely safe but less profitable financial fortresses. Incidentally, the requirements would also disrupt fixed-income markets as banks start to hoard short term, top quality securities.
CEOs Rick Waugh at Scotiabank and Royal Bank's Gordon Nixon have already issued warnings about the BIS proposals. And so they should. The Institute of Financial Finance (IFF) thinks that in their present form the regulations would knock one percentage point off world economic growth. Other experts think that it could be nearer 3%. The betting, therefore, is that both the capital and liquidity requirements are going to be substantially modified. There is even talk of an elastic phase-in extending to 2012 and beyond.
In an odd way, however, I think that the new rules are going to be a plus for Canadian bank stocks. Our banks are better equipped to cope with the proposed changes and able to implement them fairly quickly. As a result, their earnings are going to be impacted briefly and then grow relatively quickly again. That should spur investor confidence and lift the stocks, which are likely to trade with higher p/e multiples. A rapid adjustment to the new rules will also allow reinstatement of the annual dividend increases, a move that could come as early as late this year or early in 2011. Meanwhile, other international banks, especially those in the U. S., will have a hard time struggling to upgrade. Their profits will continue to suffer as the changes are phased in gradually. Some of them could run into difficulties. That is going to make Canadian bank stocks even more attractive.
Turning to the banks themselves, I still like Bank of Montreal (TSX, NYSE: BMO), trading at $59.92 (US$57.83) and expected to earn about $5 a share this year with an increase to $5.50 in 2011. With a 12 p/e multiple, the shares are cheap and pay a $2.80 dividend to yield 4.67%. Consequently you earn a well above average return even if the economy splutters and capital gains are delayed. I have a $65 target, slightly less than the $67 consensus forecast.
I also continue to like TD Bank (TSX, NYSE: TD) priced at $71.68 (US$69.15) with a conservative target of $82. Some analysts were disappointed with the second-quarter numbers but when you scratched the surface they were solid. Loan losses were far less than expected. We could see earnings of $5.90 a share in 2010 and an increase to the $7 range next year. Both BMO and TD remain as Buys.
Incidentally, so that there is no misunderstanding, I also like National Bank (TSX: NA) and Bank of Nova Scotia (TSX, NYSE: BNS). Accident-prone CIBC is the only question mark in this sector.
Canadian Financials & Utilities Split Corp. Preferreds (TSX: CFS.PR.A)
Originally recommended on Jan. 15/07 (IWB #2702) at $10. Closed Friday at $10.25.
Canadian Financials & Utilities Split Corp. continues to recover slowly and its preferred shares are now quoted at $10.25. Paying a dividend of $0.425 per annum they yield 2.2% to Jan. 31, 2012 when they will be redeemed at a price of $10 a share. Dominion Bond Rating Services (DBRS) continues to rate them Pfd-1, the highest quality.
As I previously reported, the company was forced to liquidate a substantial part of its investments in 2008 because of the market collapse in order to protect the preferred shareholders. Even now the portfolio consists of 64% cash and equivalent and 36% equities of which 67% are banks and utilities. As a result, the preferred dividends and repayment in 2012 are safe.
My only concern is that the Class A shareholders who were badly hurt by the 2008 liquidation may petition the company to reorganize and postpone the 2012 redemption date. There has been no suggestion of this but other split share companies have amended their charters because of the unusual markets.
Given this slight uncertainty, investors who bought the preferred shares on our original recommendation at $10 should give some thought to selling and pocketing the small profit. The stock is now essentially 18-month blue chip commercial paper yielding 4.25% based on the original $10. Similar paper in the market pays about 2.25%. But of for any reason the redemption date is deferred, we are looking at a straight preferred and the yield is unattractive.
Action now: Canadian Financials & Utilities Split Corp. Preferred Shares are a Sell at $10.25. Keep in mind that the market is very thin. Place a limit on your order and be prepared to wait.
PepsiCo. Inc. (NYSE: PEP)
Originally recommended on Dec. 18/06 (IWB #2644) at $62.89. Closed Friday at $63.50. (All figures in U.S. dollars.)
PepsiCo has been turning in some good numbers but so far this year investors have been unimpressed. For example, first-quarter earnings were 76c a share compared to the 75c analysts were expecting. However, the stock dropped $1.29. Of course, these are difficult markets but even so the response was disappointing.
My feeling is that PEP is suffering from a widespread concern about U.S. consumer spending. For example, Standard & Poor's has a neutral rating on the soft drinks sub-industry in the middle of the hot (thirsty) season. S&P's analyst thinks that volume growth is going to be restrained this year. Certainly Pepsi ran into a price war during the first quarter and saw its sales slump.
Longer term, however, this is an attractive company. In February it acquired the remaining shares of Pepsi Bottling and Pepsi Americas. Absorbing the two bottlers should lead to pre-tax synergies of about $400 million annually by 2012. During the first quarter, the directors approved a 7% dividend increase to $1.92 and authorized a $15 billion stock repurchase program through June 2013. At the same time, operating margins are expected to improve and Pepsi's switch to non-carbonated soft drinks, such as Lipton teas, is producing good results.
Based on company guidance we should see earnings of about $4.20 a share this year, up from $3.71 in 2009. A further increase to the $4.60 range is expected next year. As a result, the stock at $63.50 is trading at a 13.8 forward p/e multiple and remains relatively cheap.
Action now: PepsiCo is a Buy with a target of $69. I have set a $56 revisit level.
Emera Inc. (TSX: EMA, OTC: EMRAF)
Originally recommended on Jan. 12/09 (IWB #2902) at C$22.47. Closed Friday at C$26.06, US$25.24.
Emera had an excellent first quarter, reporting earnings of 72c a share, well above the 59c analysts were expecting. Subsidiary Nova Scotia Power came through in style and corporate expenses were less than anticipated.
Many money managers regard Emera as a safe income stock and certainly a dividend increase to $1.15 is in the cards next year. My feeling, though, is that the market is still not recognizing the company's growth potential. With energy and energy-related assets already exceeding $5.4 billion, EMA is on the acquisition trail. In May it purchased a 38% stake in Light & Power Holdings of Barbados, a move that should add at least 6c a share to Emera's annual earnings. The proposed acquisition of a 50% interest in Sierra Pacific Power in Nevada and California is likely to close later this year. All of this adds up to an unusual situation: a utility-based company on the move.
Earnings of $1.45 a share are expected in 2010 and $1.50 or more next year. One caveat: there is a possibility that the company will issue $200 million of common equity. This could temporarily depress the stock. In that case, I would regard it as a buying opportunity.
Action now: Emera is now trading through our $25 target and remains a Buy for income and some growth. I have set a new target of $28 and will revisit the stock if it dips to $22.
Canadian Tire (TSX: CTC.A)
Originally recommended on Sept. 27/99 (IWB #9935) at $34.10. Closed Friday at $55.33.
Canadian Tire continues to struggle. First-quarter earnings of 61c a share were essentially flat year-over-year and a major disappointment. Of even more concern, there seems to be little light at the end of the tunnel. Ontario's blue collar market continues to suffer and this in turn hurts retail sales at Tire and Mark's Work Warehouse. The company's return on invested capital actually declined last year to 7.4% from 8.9% in 2008. Tire remains a first class company but has an uphill battle in this environment. At $55.33 the stock is fully valued at the moment. We have had it on Hold for some time but I now think that the money can be better used elsewhere, although I am sure that we will reinstate Tire at some time in the future.
Action now: Canadian Tire is a Sell at $55.33.
