Show Transcript
Canada’s big banks reported quarterly results that mostly beat expectations. Mario Mendonca, Managing Director with TD Cowen, speaks with MoneyTalk’s Kim Parlee about the results and the outlook for the lenders going forward.
Print Transcript
[AUDIO LOGO]
* Canada's big banks have reported their quarterly results with most beating expectations. Here to break down the numbers is Mario Mendonca. He is managing director with TD Cowen. And we should say for full disclosure of companies covered by TD Cowen, a division of TD Securities, please see the link to the TD Securities website at the end of this video.
* Mario, it's good to see you. I want to start off before we get into the overall bank performance, the individual banks themselves, but maybe your take on your expectations coming into this quarter. What did you see? And what things are you looking at?
* Let's go back maybe a year, a little more than a year ago, I expressed some caution around the banks around operating leverage around how abruptly expenses were rising, weaker capital markets-related revenue, weaker capital ratios, and uncertainty around capital, slower balance sheet growth. These are all the big reasons why I downgraded the group back in December '22 to market weight from overweight.
* What I'm finding through Q1 '24 results and looking into Q2 is that many of those factors that would lead me to be somewhat careful in the banks are starting to abate. Capital ratios look solid. Operating leverage is probably going to be positive across the group in Q2 '24. Capital markets-related revenue has improved. And if in fact, interest rates are coming down in the second half. That could support balance sheet growth.
* So at least insofar as pre-tax pre-provision profits are concerned, the environment is improving. I expect better results at our Canadian banks. And as you said in your opener, Canadian banks aren't missing earnings the way they did somewhat in 2023. In fact, in Q1 '24, all the banks met or beat numbers other than BMO. Now, that's the pre-tax pre-provision profit story. Credit might be deteriorating, which we can certainly get into.
* Yeah, and I would like to get into. You do highlight, though, in your report at the very top-- you talk about, this is the seventh consecutive quarter of declining earnings per share. So I guess the question is, is it troughing? And do we maybe start to see things moving in the other direction? Tell me some of the big things you're watching. Let's talk about credit cycle. What are you seeing in terms of just hints of what might be coming?
* Sure. So it's important to highlight that the pre-tax pre-provision profit is growing. And that's a positive part of the story. The negative is that the credit is deteriorating. And the conditions that you see that support that, it's really in personal loans. So think credit cards, auto loans, lines of credit, installment loans. It accounts for about 10% of the loan balance in Canada. We are clearly seeing delinquency ratios increase, gross impaired loans increase. And it's consistent with the increase in insolvencies across the consumer.
* Now, that is now having an effect on credit losses. It's clear that credit losses are rising. And what's really relevant about that is, as credit losses rise, that's fine. We all expected that. The question is, are they rising faster than we expected? Are they rising faster than the banks expected? If in fact credit deteriorates at a pace higher than what the banks are guiding or higher than what the average analyst is forecasting, that has a negative effect on earnings and could have a negative effect on sentiment.
* And you can make an argument that credit in fact is deteriorating at a pace that's faster than what the banks expected or what certainly what I expected.
* A lot of this, it seems as well, too, is just the expectation on rates. I mean, if you-- I don't know-- looked at rate expectations six months ago, everybody was expecting cuts now-- not happening, looking as though they could materialize in June or later. But tell me just about the sensitivity of how that's going to affect what you're talking about right now.
* Rates have a pervasive impact on banks. As rates come down, the pressure on consumers abates somewhat, particularly on their fixed-rate mortgages as they mature, their variable-rate mortgages. So lower rates have a beneficial impact on the credit picture. Now, it doesn't happen instantaneously. There's a lag here. Just as credit didn't deteriorate as rates were rising-- it took time-- the same is true on the way down. As rates fall with a lag effect, you'll see better credit conditions.
* The other thing that's important is that lower rates could help fuel loan demand again. And that's really relevant to me because there's been a problem with loan demand and loan supply. The banks' capital have been somewhat constrained, which constrained supply. Higher rates constrained demand. Now that capital ratios are solid, lower interest rates might marry the two. You might, in fact, have higher loan demand at the same time that the banks feel the capacity to make those loans. So lower rates could have a rather beneficial impact to the balance sheet growth and loan growth in late this year.
* And I guess that's what you're waiting to see. You mentioned here that you think it's not wise to upgrade the group at this point. You need to see a few more things happen.
* Well, the most important thing is, to me, the pre-tax pre-provision profit is growing. That I can say with a lot of confidence, that the underlying fundamentals for our banks, like operating leverage, pre-tax pre-provision profit growth, capital ratios, all of that looks like it's improving and it's solid. The reason why I'm being a little careful here and not upgrading the group yet is I want the credit shoe to fall. And the credit shoe doesn't mean that mortgages blow up and that the Canadian banks struggle with weak capital ratios. That's not what I'm talking about.
* I'm saying that the earnings effect of higher credit losses on personal loans, that needs to make its way into bank earnings, into the investor sentiment. That, I think, would give me the confidence that I could upgrade the banks. But that's possibly much later this year.
* All right. Let's get into some individual names. Let's start with CIBC, who benefited from an upgrade from you based on the performance in the quarter. You upgraded them to a buy from a hold. What did you see with CIBC?
* The main thing is CIBC had the lowest forward P/E multiple in the group. But what was interesting about that is the reasons for the low P/E multiple in the group have started to abate. I'll give you an example. They had higher credit losses in their US commercial real estate. Coming out of the quarter, they're telling us that those losses are now moving lower, that they've reached the peak of those losses. That's important to me, that losses in US commercial real estate are going down.
* The bank had a low capital ratio. And that was affecting their ability to grow their balance sheet. They now have a 13% capital ratio, which is among the highest in the group. On top of that, the bank had pretty strong operating leverage, improving pre-tax pre-provision profit. The reason why people are negative on CIBC is all these factors which are now turning in their favor. So it felt very reasonable for me in the context of that low valuation to express a more optimistic outlook on CIBC.
* All right, let's go to BMO, which probably is the other end of performance in the quarter. I think it was the only bank that did not hit expectations. What's happening there?
* Right. Well, I think a lot of that really emanates from the environment in Q4 '23. A quarter ago, there was a lot of optimistic chatter around BMO, the benefit of expense savings, the benefit of the acquisition. And I think that got estimates a little high, including my own. The quarter was a weak quarter. We saw it in their corporate segment, where margins were weaker, fee income was weaker, capital markets revenue was weaker, negative operating leverage. All of that played a role in hurting BMO's results, including credit losses, the performance credit losses.
I think we're going to look back at Q1 '24 as an inflection point for BMO. I think what the bank said on their call, that revenue would be a low point in Q1 '24 and expenses would be a high point, that really points to solid operating leverage in Q2 and beyond. So we're going to look back at Q1 as the turning point for BMO's performance, I think.
* All right. Bank of Nova Scotia did come in one of the banks that beat expectations. But just tell me what you're seeing here because you make an interesting-- in your conclusion on your note, you say that "their lower earnings power is now abundantly clear." Just tell me a bit about what you mean by that.
* That's really important because banks beat estimates for two reasons. It could either be that the results are really good or that the expectations got kind of down. No bank saw their estimates for 2024 decline more during 2023 than Scotia. What I mean by that is the analysts have significantly reduced earnings expectations for Scotia. It's going to be easier to beat. So it's not necessarily that the results are so much better. It's that the expectations are so low. And that's a good thing.
* That makes it easier for investors to buy Scotia knowing that we're not going to have a surprise miss. The challenge Scotia has is that there's still a lot to fix. There's a lot they need to do to shrink their brokered mortgage book in Canada, grow deposits in Canada, perhaps shrink their footprint in Latin America. These are all big messy things that need to do over the next couple of years.
* I would like to take the view that I'd rather not be there for the bank, like have a buy rating on the bank, while they're going through all these changes. They need to convince me that they've made the changes successfully, that they've executed before I'll get on board. So I'm not there right now-- certainly not with a buy rating.
* OK. And, again, we'll see how that performs the next few quarters. Royal, the last one-- and you note as well too that this particular bank has always traded at a premium 6% to 8% to the group. Is that still warranted right now? What are you seeing?
* I think so. I look at Royal's business mix very strong in Canada-- a good insurance business, very large in capital markets, among the largest in wealth management in the country. That diversified business model does give me confidence that Royal is a good one to own. Now, there are two things that are troublesome. One is that their US business, City National, it's been messy. It's been messy now for a year.
* The bank is doing a lot to improve it, but you can't sugarcoat these things. When a bank stock you like with a great valuation delivers bad results in a segment, you've got to be clear with that. And I think they're cleaning up the situation at City National, but no doubt that was a failure. The other thing that's important about Royal Bank is that they're acquiring HSBC Canada, a very large transaction. When you buy an institution that large and you combine them, you tend to have messy quarters in the early going.
* So no doubt, I think Royal is a great stock. We'll rate it a buy. Look for a little bit of sloppiness in the near term as they integrate HSBC. Longer term, it will lead to excellent cost savings, cross-sell, and it'll be a solid acquisition. I think it will be. But sure, it's going to be choppy in the near term, my guess.
[AUDIO LOGO]
[MUSIC PLAYING]
* Canada's big banks have reported their quarterly results with most beating expectations. Here to break down the numbers is Mario Mendonca. He is managing director with TD Cowen. And we should say for full disclosure of companies covered by TD Cowen, a division of TD Securities, please see the link to the TD Securities website at the end of this video.
* Mario, it's good to see you. I want to start off before we get into the overall bank performance, the individual banks themselves, but maybe your take on your expectations coming into this quarter. What did you see? And what things are you looking at?
* Let's go back maybe a year, a little more than a year ago, I expressed some caution around the banks around operating leverage around how abruptly expenses were rising, weaker capital markets-related revenue, weaker capital ratios, and uncertainty around capital, slower balance sheet growth. These are all the big reasons why I downgraded the group back in December '22 to market weight from overweight.
* What I'm finding through Q1 '24 results and looking into Q2 is that many of those factors that would lead me to be somewhat careful in the banks are starting to abate. Capital ratios look solid. Operating leverage is probably going to be positive across the group in Q2 '24. Capital markets-related revenue has improved. And if in fact, interest rates are coming down in the second half. That could support balance sheet growth.
* So at least insofar as pre-tax pre-provision profits are concerned, the environment is improving. I expect better results at our Canadian banks. And as you said in your opener, Canadian banks aren't missing earnings the way they did somewhat in 2023. In fact, in Q1 '24, all the banks met or beat numbers other than BMO. Now, that's the pre-tax pre-provision profit story. Credit might be deteriorating, which we can certainly get into.
* Yeah, and I would like to get into. You do highlight, though, in your report at the very top-- you talk about, this is the seventh consecutive quarter of declining earnings per share. So I guess the question is, is it troughing? And do we maybe start to see things moving in the other direction? Tell me some of the big things you're watching. Let's talk about credit cycle. What are you seeing in terms of just hints of what might be coming?
* Sure. So it's important to highlight that the pre-tax pre-provision profit is growing. And that's a positive part of the story. The negative is that the credit is deteriorating. And the conditions that you see that support that, it's really in personal loans. So think credit cards, auto loans, lines of credit, installment loans. It accounts for about 10% of the loan balance in Canada. We are clearly seeing delinquency ratios increase, gross impaired loans increase. And it's consistent with the increase in insolvencies across the consumer.
* Now, that is now having an effect on credit losses. It's clear that credit losses are rising. And what's really relevant about that is, as credit losses rise, that's fine. We all expected that. The question is, are they rising faster than we expected? Are they rising faster than the banks expected? If in fact credit deteriorates at a pace higher than what the banks are guiding or higher than what the average analyst is forecasting, that has a negative effect on earnings and could have a negative effect on sentiment.
* And you can make an argument that credit in fact is deteriorating at a pace that's faster than what the banks expected or what certainly what I expected.
* A lot of this, it seems as well, too, is just the expectation on rates. I mean, if you-- I don't know-- looked at rate expectations six months ago, everybody was expecting cuts now-- not happening, looking as though they could materialize in June or later. But tell me just about the sensitivity of how that's going to affect what you're talking about right now.
* Rates have a pervasive impact on banks. As rates come down, the pressure on consumers abates somewhat, particularly on their fixed-rate mortgages as they mature, their variable-rate mortgages. So lower rates have a beneficial impact on the credit picture. Now, it doesn't happen instantaneously. There's a lag here. Just as credit didn't deteriorate as rates were rising-- it took time-- the same is true on the way down. As rates fall with a lag effect, you'll see better credit conditions.
* The other thing that's important is that lower rates could help fuel loan demand again. And that's really relevant to me because there's been a problem with loan demand and loan supply. The banks' capital have been somewhat constrained, which constrained supply. Higher rates constrained demand. Now that capital ratios are solid, lower interest rates might marry the two. You might, in fact, have higher loan demand at the same time that the banks feel the capacity to make those loans. So lower rates could have a rather beneficial impact to the balance sheet growth and loan growth in late this year.
* And I guess that's what you're waiting to see. You mentioned here that you think it's not wise to upgrade the group at this point. You need to see a few more things happen.
* Well, the most important thing is, to me, the pre-tax pre-provision profit is growing. That I can say with a lot of confidence, that the underlying fundamentals for our banks, like operating leverage, pre-tax pre-provision profit growth, capital ratios, all of that looks like it's improving and it's solid. The reason why I'm being a little careful here and not upgrading the group yet is I want the credit shoe to fall. And the credit shoe doesn't mean that mortgages blow up and that the Canadian banks struggle with weak capital ratios. That's not what I'm talking about.
* I'm saying that the earnings effect of higher credit losses on personal loans, that needs to make its way into bank earnings, into the investor sentiment. That, I think, would give me the confidence that I could upgrade the banks. But that's possibly much later this year.
* All right. Let's get into some individual names. Let's start with CIBC, who benefited from an upgrade from you based on the performance in the quarter. You upgraded them to a buy from a hold. What did you see with CIBC?
* The main thing is CIBC had the lowest forward P/E multiple in the group. But what was interesting about that is the reasons for the low P/E multiple in the group have started to abate. I'll give you an example. They had higher credit losses in their US commercial real estate. Coming out of the quarter, they're telling us that those losses are now moving lower, that they've reached the peak of those losses. That's important to me, that losses in US commercial real estate are going down.
* The bank had a low capital ratio. And that was affecting their ability to grow their balance sheet. They now have a 13% capital ratio, which is among the highest in the group. On top of that, the bank had pretty strong operating leverage, improving pre-tax pre-provision profit. The reason why people are negative on CIBC is all these factors which are now turning in their favor. So it felt very reasonable for me in the context of that low valuation to express a more optimistic outlook on CIBC.
* All right, let's go to BMO, which probably is the other end of performance in the quarter. I think it was the only bank that did not hit expectations. What's happening there?
* Right. Well, I think a lot of that really emanates from the environment in Q4 '23. A quarter ago, there was a lot of optimistic chatter around BMO, the benefit of expense savings, the benefit of the acquisition. And I think that got estimates a little high, including my own. The quarter was a weak quarter. We saw it in their corporate segment, where margins were weaker, fee income was weaker, capital markets revenue was weaker, negative operating leverage. All of that played a role in hurting BMO's results, including credit losses, the performance credit losses.
I think we're going to look back at Q1 '24 as an inflection point for BMO. I think what the bank said on their call, that revenue would be a low point in Q1 '24 and expenses would be a high point, that really points to solid operating leverage in Q2 and beyond. So we're going to look back at Q1 as the turning point for BMO's performance, I think.
* All right. Bank of Nova Scotia did come in one of the banks that beat expectations. But just tell me what you're seeing here because you make an interesting-- in your conclusion on your note, you say that "their lower earnings power is now abundantly clear." Just tell me a bit about what you mean by that.
* That's really important because banks beat estimates for two reasons. It could either be that the results are really good or that the expectations got kind of down. No bank saw their estimates for 2024 decline more during 2023 than Scotia. What I mean by that is the analysts have significantly reduced earnings expectations for Scotia. It's going to be easier to beat. So it's not necessarily that the results are so much better. It's that the expectations are so low. And that's a good thing.
* That makes it easier for investors to buy Scotia knowing that we're not going to have a surprise miss. The challenge Scotia has is that there's still a lot to fix. There's a lot they need to do to shrink their brokered mortgage book in Canada, grow deposits in Canada, perhaps shrink their footprint in Latin America. These are all big messy things that need to do over the next couple of years.
* I would like to take the view that I'd rather not be there for the bank, like have a buy rating on the bank, while they're going through all these changes. They need to convince me that they've made the changes successfully, that they've executed before I'll get on board. So I'm not there right now-- certainly not with a buy rating.
* OK. And, again, we'll see how that performs the next few quarters. Royal, the last one-- and you note as well too that this particular bank has always traded at a premium 6% to 8% to the group. Is that still warranted right now? What are you seeing?
* I think so. I look at Royal's business mix very strong in Canada-- a good insurance business, very large in capital markets, among the largest in wealth management in the country. That diversified business model does give me confidence that Royal is a good one to own. Now, there are two things that are troublesome. One is that their US business, City National, it's been messy. It's been messy now for a year.
* The bank is doing a lot to improve it, but you can't sugarcoat these things. When a bank stock you like with a great valuation delivers bad results in a segment, you've got to be clear with that. And I think they're cleaning up the situation at City National, but no doubt that was a failure. The other thing that's important about Royal Bank is that they're acquiring HSBC Canada, a very large transaction. When you buy an institution that large and you combine them, you tend to have messy quarters in the early going.
* So no doubt, I think Royal is a great stock. We'll rate it a buy. Look for a little bit of sloppiness in the near term as they integrate HSBC. Longer term, it will lead to excellent cost savings, cross-sell, and it'll be a solid acquisition. I think it will be. But sure, it's going to be choppy in the near term, my guess.
[AUDIO LOGO]
[MUSIC PLAYING]
