In Q4 2017 the Canadian banking industry reported EPS growth that was stronger than expected at 7% year-over-year. Mario Mendonca, Research Analyst, TD Securities, talks to Kim Parlee about how Canadian banks performed, the driving factors, and shares his 2018 outlook on the Canadian banking sector.
It was, yeah. There were so many aspects of this year that were impressive. Throughout the year, I don't think there was a quarter where a bank really missed a result.
Q4 was good. For the most part, the banks met or beat numbers. There were a few results that I thought were maybe slightly below the estimates. But earnings growth was still very good at 7% year over year. Dividend growth was solid. And the banks' guidance for 2018 was especially good.
So was it as good as the first three quarters of the year? Not really. But it was still a very solid quarter.
Let's then build on that in terms of what's happening in 2018 and what you expect to see. I mean, one of the key themes in the past year for Canadian banks was, of course, improving margins on the back of increasing rates. That's going to continue. in '18?
And when I think about the outlook, one of the things that I really focus on is, what are the bank executives saying. What do they say in open forums, as they have recently at conferences? What do they say in investor meetings?
And the outlook from the management teams varies from bullish to very bullish. In fact, recently, they've all--and this was on their conference calls and in subsequent meetings. They've all reaffirmed their medium-term guidance, but applying it to 2018.
There's a point I want to make here. Very often, our banks will say, we believe that over the next three to five years, we can grow our EPS at 7%. They're not saying that now. They're saying they can grow earnings at that level in 2018.
And the factors that are driving it, margins--margin's a key one, because higher rates affect margins. The other thing they're saying is that all of the digitization and technology spending laid down is going to help to reduce expenses in 2018 or at least bend the cost curve in 2018. So they're very bullish.
Now, the one area where they're especially bullish is their US operations. So the banks with large US operations are especially bullish. Part of that is taxes. But there are other factors as well.
Yeah. And bank executives not exactly prone to exaggerations.
Yeah. OK. You also talked about the fact that when you looked into '18, you mentioned momentum in domestic retail. I'm assuming part of that is driven by that technology cost curve you're talking about.
Strong 2018 guidance, which you just talked about, and strong capital levels. And what that leads to is exciting.
Oh, yeah. There's an analogy often used with capital. I say, capital can be a shield, but it can also be a sword. It's a shield in so far as it protects you from the downturns. The banks' capital levels have reached a point now where they're in an excess position. They should use their capital now for things like buybacks or acquisitions. And in fact, there are a few banks that are openly talking about that.
Scotia, for example, recently announced a large deal in Chile. That's the sort of thing I think we'll see more of in 2018, not only your standard dividend increases but actually using the capital more as a sword to grow earnings as opposed to just being a shield.
Interesting. You also, last time you were here, talked a bit about which banks I thought were most attractive. A lot of that was in terms of valuations. And not surprisingly, you liked the laggards at the time.
And that did well.
It did. So the two banks that I was recommending last time as among my top picks were CIBC and BMO. And I did that because the group as a whole--the valuation was becoming attractive. It was approaching 12 times earnings. It's a little bit above that now.
But there were two that had underperformed, CIBC and BMO in particular. CIBC had an amazing Q4 and offered very good guidance. So the stock's really recovered. BMO's making its way back. And in fact, today at a conference, the CEO Darryl White was talking specifically about how optimistic he is about their US business in 2018.
So I still feel good about these laggards. But having said that, they've caught up with their peers.
Yeah. Let's run through them one by one. And let's pick up with Bank of Montreal. You do have $110 price target on this. You guys still have a buy on this, despite the fact that it has appreciated.
It has, not as much as CIBC. But the rationale for this one is it's a very strong commercial player. Commercial's where you want to be, because I think the Canadian consumer, we all know, needs to take a bit of a break here. Mortgage growth will likely slow. I think it'll slow gradually, but it'll slow. A strong commercial business on top of that US business really does support BMO, I think.
CIBC, $135 price target and a buy?
Oh, yeah. And that stock's really moved lately. So I don't have as much upside on CIBC as I've had in the past. It has been a very underappreciated story, not so under appreciated anymore. But the fact is that I still like the fact that it's got a very strong domestic retail franchise, really focusing on cutting costs.
They've done a recent US deal that could add to earnings as that business grows. But we've got to call it the way it is. The stock's really moved in the last little while. So it does not have the upside it did when we last spoke.
Bank of Nova Scotia, $91 buy rating.
You'll notice how many buys there are in here. There's a lot of buys for a reason. I like these banks. It's great covering Canadian banks for that reason.
Scotia has two characteristics that really appeal to me. One is their international business. You can see either commercial loan growth remains very strong. And it's being driven, frankly, just by above average GDP growth in South America. And I would say the countries you really want to focus on there would be Mexico, Chile, Peru, and Colombia. Those are the ones that are really driving it for Scotia.
But the second part of it is, they have one of the most ambitious cost-cutting strategies out to 2019 and beyond of any of the banks. The CEO Brian Porter is really pushing that cost-cutting story.
Royal Bank, $110 and a hold.
An amazing bank, don't get me wrong. The problem is everybody knows it's an amazing bank. And it trades at a pretty significant premium to the group, right now about a 6% premium to the group.
Don't get me wrong. Everything about Royal is great. And in fact, the bank's CEO, this morning when he was speaking at a conference, he offered one of the most bullish outlooks for the bank I've heard in a long time. So there's nothing wrong with Royal. It's just that everybody's already paying for it. And I'm just looking for better value right now.
Now, TD, you're restricted. So we can't talk about that one. My final question to you is just, you are obviously bullish on most of the banks. The CEOs sound bullish on most of the banks. What are the red flags? What are things that could take it off track?
The first thing that we have to be careful of is, everybody is so bullish right now. The market looks very, very bullish. There's people talking about a melt up as opposed to a meltdown. So there's going to come a time when we're going to run out of room in valuation. So that's one thing that I clearly think about.
Another one is, will the Canadian consumer eventually tire to the point where we start to see credit losses. That could happen. So any really consumer-oriented bank--CIBC's one of them--we'll see credit losses move a little higher as the Canadian consumer slows down.
But the one factor that I focus on the most, the factor that's most highly correlated with credit is unemployment. And unemployment statistics are still great. So until I see some evidence of rollover in unemployment, I'm going to assume credit's fine. But that's the risk.
Mario, thank you.