Canadian banks put in a mixed showing in their latest quarterly results, amid concerns about mortgage maturities and slowing growth. Kim Parlee discusses the potential headwinds and tailwinds for the sector with Mario Mendonca, Managing Director at TD Cowen.
Originally published December 21, 2023
* While the earnings results are in for Canada's big banks and while it appears to some that the concerns about the impact of mortgage maturities amid high rates may have been overdone, challenges do remain for some lenders. These latest results mark the sixth consecutive quarter of declining earnings per share. Earlier, I spoke with Mario Mendonca. He's Managing Director at TD Cowen. And I asked him about his overall take on the results.
* Earnings have been deteriorating for a little while-- as I said, six consecutive quarters. And it's being driven by a lot of factors. One in particular is that credit losses are normalizing. And by normalizing, I want to be clear. Normalizing is different from deteriorating.
* We came through a period post-pandemic or during the pandemic when credit losses were incredibly low. Think 15, 16 basis points. What we're doing is gradually migrating back to normal. Normal might be something like 35 to 40 basis points. As you return to normal, it has a meaningful impact on your EPS growth. I think credit losses were up over 80% year over year in Q4.
* That's not the only factor that's causing EPS to come under a little bit of pressure. What we often refer to as pre-tax, pre-provision profits-- this is excluding taxes, excluding credit losses-- that, too, has been under some pressure. Earnings growth there has been very modest. I think this quarter might have been 2%.
* And the reason for that is that we're not seeing the loan growth we've seen in the past. Loan growth has really tapered off, perhaps with the exception of credit cards, where growth is still pretty strong. Margins aren't expanding anymore because rates have stopped rising. Expenses are somewhat elevated.
* When you combine weaker pre-tax, pre-provision profit growth with this normalization in credit, you're going to get weak EPS growth. And probably the best way to look at it is operating leverage, which is your year-over-year growth in revenue minus your year-over-year growth in expenses, that number has been negative for seven consecutive quarters, meaning expense growth has been greater than revenue growth. And that's really all you need to know about why EPS growth has been soft for our group.
* I want to dig into when you think that might reverse, not yet. But I do want to ask you. You make note, though, that a lot of people concerned about mortgage meltdowns. As people start to renew, we start to see that cycle. And you say in your note that that might be overstated. I'm paraphrasing. You tell me what you see.
* Yeah. What I wrote in a note-- the title was somewhat glib. I wrote, "Canadian banks don't get hit by slow-moving trains." And what I meant by that is when the Canadian banks and the regulators and the department of finance and consumers and borrowers-- when we all see this crisis coming at us for miles away, years from now-- let's say a year, maybe year plus-- where these significant mortgage renewals occur, resulting in significantly higher payments-- when you can see the trouble coming from this far away, you don't sit there in the middle of the tracks and get mowed down.
* My experience with these banks over 20-plus years is that they're awfully good at adjusting to problems. Now, what does that mean, adjusting to problems?
* Well, the first thing you do is you make sure that your borrowers are well aware that these payments are coming, this renewal is coming. And you encourage them to make larger down payments. You encourage them to increase their payments ahead of time. That's the first thing you do. And that's like the price of admission. And all of our banks are doing that.
* From a regulatory perspective, one thing you do-- and this is exactly what OSFI did just last week some time-- they didn't raise the domestic stability buffer. So they're not putting further pressure on these banks to hold more capital. We've got the Bank of Canada now talking about not raising rates and potentially guiding to lowering rates sometime in 2024. That, too, helps to cushion the blow of these significant mortgage renewals.
* So I often sit back, and I read a lot of the press. I read what other analysts and investors say about the mortgage market. And it reminds me of that one thing that I learned many years ago. Our Canadian banks don't get hit by slow-moving trains. You adjust.
* OK. I want to come back to that in terms of longer-term outlook in just a moment. But I wouldn't mind talking about some names. You mentioned two stocks that you have buy rated. Royal and BMO gave confidence that the direction they're moving in is going to help maintain that rating. But tell me a bit more about what you saw with those ones.
* Yeah, sure. In BMO's case, they're particularly well positioned. You've got a bank stock that trades at a multiple that's not all that different from where Scotia and CIBC are. But you've got a lot of promising things playing out in 2024.
* For example, they've taken material restructuring charges that'll have a meaningful effect on their expense growth in 2024. They've done this transaction for Bank of the West. The integration synergies on that transaction will also lead to cost savings. So by Q2, you could very well see-- this is Q2 '24-- you can very well see BMO report solid positive operating leverage simply from those integrations or the restructuring and the integration.
* On top of that, you've got a bank that has a meaningful US capital markets exposure. And that means a lot to me because, going into 2024, I think US capital markets might be the more important driver of revenue growth. And that really suits BMO.
* But really, pulling it all together, you've got these positives emerging for the company in 2024. And at the same time, you've got a valuation that's discount. It reminds me-- it's very similar to where Scotia and CIBC are.
* Now, Royal is a little different. Royal doesn't have the really low valuation that BMO does. But they do have a lot of things that I like going into 2024-- meaningful restructuring initiatives. Hopefully, at some point, we'll hear about the closing of the HSBC Canada transaction, which will also support Royal's performance in 2024, but also the fact that the bank is very big in US capital markets. And that's an area that I think will drive revenue growth in 2024. So those two fit in really well for me going into 2024.
* Let's go to the ones where I believe you have a hold on CIBC and National. So what did you see or not see that has you feeling the way you do with those two?
* Well, CIBC had a good quarter. CIBC delivered another quarter of good expense growth, as in modest expense growth. And the title of my report was something to the effect of, CIBC's become one of the leaders in expense management. And I truly believe that to be the case. And I think the bank was clear, management was clear, going into 2024, that they can manage that expense growth lower if the revenue environment doesn't cooperate.
* The challenge I have with CIBC is the story has become too much about expense growth and not enough about top line. And my feeling with CIBC is, because of some capital constraints that the bank is facing, a lack of loan growth-- my feeling with CIBC is that they're going to have a lot-- it's going to be difficult for them to grow their top line. And I don't like a story that's entirely leveraged on being able to cut expenses. And that's why CIBC, although a good discount and the stock's performed well recently, doesn't fit in well for 2024.
* National is a little different. National's business model, in my view, appears somewhat vulnerable. They have grown significantly in Cambodia. They're now, I think, the largest lending bank in Cambodia. Cambodia, we're starting to see gross impaired loans start to rise there. I don't think they're going to experience a lot of losses in Cambodia. But as the gross impaired loans start to rise, I think you'll see the bank pull back on loan growth there.
* In their capital markets business, there are some of those businesses look leveraged to changes in tax regulation, changes-- particularly taxes. We're now going to tax dividends received by Canadian companies. That could affect their equity structured products business in Canada. I'm not going to get into the details too much, but the bank acknowledged that that could be an issue for 2024. National doesn't trade at a discount. And that's another reason why I put that on-- I rate that on a hold.
* I want to finish up with Scotia, and your words, not mine. Just when we thought all the bad news was out, they missed by 24%. Of course, they were first, so they certainly set the tone for the rest coming in after. What's happening with Scotia?
* Well, Scotia missed by a significant amount in Q4. It was expense driven. It was credit loss driven. I do think it's fair to say that that performance out of Scotia in Q4 is probably not indicative of Scotia's earnings power. I suspect their earnings power is better than what we saw in Q4. But that was a very big miss. And in fact, they were the only bank that missed by a margin of that amount.
* So Scotia-- I refer to it as a bit of a fixer upper, this bank. And at their investor day-- I believe that was last week sometime-- yeah, last week. At their investor day, they did a really good job of articulating what they're going to do to grow that business over time.
* And I listened to management carefully. And I have faith in these guys. They sound very legitimate. To me, it sounds like they've got a good plan in place. The problem I can foresee is, in the near term, the bank's not going to grow at the same pace as their peers.
* I can see a few years here where they get lapped by their peers in terms of earnings growth as the bank sort of focuses on client primacy, which is one of their big themes for their investor day. I have a lot of faith in this management team's ability to turn things around. I just don't think it happens in the near term. And in the near term, I expect some of their peers to outgrow them. And that's why they don't rank well for me.
* When you look ahead to next year, I mean, it's interesting, Mario, because every bank has a different starting position in terms of where we'll be coming. F24, you said Scotia must need some time, maybe, to work through what they need to work through. Others, like CIBC, you want to see more growth, not just so much focus on expenses.
* But if you were to characterize what you think we're moving into, it feels like this is a-- you meant like slow-moving trains. This feels like there's a soft landing coming, and the banks are aware of it. And they're going to navigate OK through the next year.
* Yeah. I have a very nuanced view on this for the group. I do not fall into the catastrophe camp, the camp that says mortgages are going to blow up our Canadian bank. I've expressed that routinely. That's not the camp I fall into. In the near term, the market seems bullish on banks again because rates are moving down. There's less risk associated with a hard landing because rates are moving down.
* But here's where the view becomes a little nuanced. You cannot leverage up the Canadian consumer the way we have over the last 20 years without some kind of consequence. Now, the consequence doesn't have to be a major credit blow-up, like on mortgages. But the consequence is still there.
* And in my view, the consequence of leveraging up the Canadian consumer as much as we have over the last couple of decades is it's going to constrain balance sheet growth. You can't continue to add leverage on leverage. At some point, balance sheet growth gets very constrained across the group. And that's already happening now.
* When you layer on top of that that we've got to preserve capital as well, because capital requirements are moving higher, it tells me that the 7% to 8% balance sheet growth we saw across the group over the last few decades will be very difficult to repeat. And if we go through a period of modest balance sheet growth, we're going to go through a period of weak earnings growth, which I think constrains valuation.
* We've got the market right now buying the banks on the basis that lower interest rates will sort of save the day on credit. And I buy that. I understand that. That's consistent with my view. Where I've cautioned investors is that these are not the banks of the past, where 7% to 8% EPS growth every year is going to be easy to do.
* The balance sheets will be constrained. And I think that's going to constrain earnings growth. And ultimately, I think that constrains multiples. It's going to be difficult for these banks to trade through 10 times. The days of trading up to 12 times is being over to me because we can't grow our EPS at that pace anymore.
* That was Mario Mendonca, managing director at TD Cowen. And a reminder, for full disclosure on companies covered by TD Securities, please see the link to TD Securities' website at the end of this video.