Show Transcript
Canada’s largest banks reported solid third quarter earnings, with most beating estimates. Mario Mendonca, Managing Director at TD Cowen, speaks with MoneyTalk’s Kim Parlee about the results, potential challenges and why he holds a constructive view on the group.
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* The results are in. Canada's big banks have reported their third quarter earnings, with most beating estimates. My next guest has a constructive outlook on Canadian banks but also notes they have underperformed when compared to Canadian life insurance companies or their US bank counterparts.
* Mario Mendonca is managing director at TD Cowen. He joins us now. Mario, it's good to see you.
* Good to see you.
* Let's start off with maybe just your overview on the group for the quarter. What were some of the material things you took away from it?
* Yeah, going into the quarter, or even going into 2024, there was a view-- and I shared it-- that banks were going to continue to underperform the way they have over the last few years, and the underperformance was going to be in the form of weaker pre-tax provision profit growth and accelerating losses, not in the corporate and commercial but more on their unsecured consumer-- so think credit cards, auto lending, that sort of thing.
* And for the most part, that's what's happened. The banks have continued to underperform. They've underperformed the life co's, the US regionals, the US money center banks. And they've underperformed the TSX now for, I'm going to say, about three of the last four years. So it's been a prolonged period of underperformance.
* What was interesting about this quarter is, as you said, most of the banks beat. Five of the six banks beat estimates. BMO was the only one that didn't. I shouldn't say they all beat. They either beat estimates or they were in line with estimates. BMO was the only one that missed in a meaningful way.
* But what was particularly interesting about this quarter is not only did pre-tax, pre-provision profit accelerate, but you also had every bank with a capital ratio over 13%. And then, most importantly, we're getting better indications of the resilience of the unsecured Canadian consumer-- so the resilience in credit card lending, auto lending, lines of credit.
* So the quarter really was positive in a lot of different respects. And it led me to the view that this prolonged period of underperformance probably is near its end. I don't expect our banks to underperform the way they have for the last few years.
* Interesting. I also thought it was interesting you said in your note that-- you talked about group performance, and it wasn't as meaningful to talk about group performance anymore because of the disparity within the banks in terms of what they're doing. Maybe you can talk to us a bit about that as well, too.
* Yeah. Over the many years I've been following banks, you rarely see a scenario where one bank, or, in this case, three banks, are up 22% to 23%. I'm referring to National, Royal, and CIBC. And several banks are down meaningfully-- in this case, BMO down 14% or 15%.
* That spread in performance is so wide that it's made references to average performance less meaningful. And the disparity in performance between, let's say, the banks that have performed really well, 22%, 23%, and the banks that have not performed well, aside from some individual issues facing some of these banks, the biggest differentiator between the banks that have performed well and the banks that have performed poorly is ROE and the change in ROE.
* The banks that are performing well have seen their ROEs climb by 100 to 200 basis points year over year. The banks that are performing poorly have seen their ROEs diminished by 100 to 200 basis points. And this is one of those areas that really deserves a much closer look.
* We need to think a lot about, why are some banks driving their ROEs higher, and others are much lower? And that's something that I think we all have to spend some time thinking about.
* Well, I'd like to dig in on that. I think I might save that for the end, though, because it's meaningful. Let's talk about some of the individual performances on the banks. And I'm just going to go in the order that you have. BMO, which you downgraded to a hold on August 27, that was the one, of course, that caught most people's attention this quarter.
* Yeah. So BMO has missed earnings by a meaningful amount for three consecutive quarters. In the first quarter of 2024, it was more on revenue and expenses. In the last two quarters, it's been on credit losses. Their credit losses have been materially higher than peers.
* And there's no way around it-- BMO, in this credit cycle, if you want to call this a credit cycle, stands out from its peers in a very meaningful way. There's no way to sugarcoat it. I really felt that this quarter was going to be the beginning of the end for BMO-- that this would be an elevated credit loss quarter, but they would guide us to something more moderate going forward.
* In fact, we got the opposite. The bank is guiding to further elevated credit losses, perhaps going on another six or nine months. It's very clear to me that BMO really-- I think BMO stepped out of its lane, probably 2020 to 2022, in their lending practices. It could be things like hold limits being too high-- because normally, banks make these large loans and they syndicate a portion.
* The amount that they held on to was too high. Or maybe they were lending into sectors they shouldn't have. As it turns out, BMO is a very clear standout from a credit perspective. And until credit stabilizes and becomes similar to what their peers are experiencing, BMO's likely to underperform the group.
* Let's move on to the next one, Bank of Nova Scotia. You've got a hold.
* Yeah. Bank of Nova Scotia has been one of those names that I've been bearish on for some time. A hold doesn't mean a sell. A hold is a hold. That's the rating. But it's one of those banks that I've been less optimistic about, because I think Scotia's going through so many meaningful changes, like shrinking their mortgage book, focusing on deposit growth.
* Their balance sheet hasn't shown any growth. They've been capital constrained until recently. They need to exit certain businesses in Latin America. My view on Scotia is one of I'd rather wait to see how the bank navigates through all these changes before I'm going to stick my neck out.
* Let's see how they muddle through, and I don't mean that in a negative way, but how they get through the next year or so making through these changes. I'll revisit my call then. But I do want to highlight one thing about Scotia. After many quarters of no balance sheet growth, we did see some balance sheet growth this quarter.
* We did see growth in mortgages and in their international business. And I think it might be too early to call that an inflection point, but it's clearly positive that Scotia is starting to grow the balance sheet again.
* Interesting. CIBC-- you recently upgraded this to a buy from a hold after the first quarter release of results. What did you see this quarter?
* Yeah, that was back-- I think that was about nine months ago when I made CIBC our top pick. The stock's done extremely well. Now, part of the reason for this is the bank has traded at a discount to its peers for a long time. It was trading at a discount to Scotia, or maybe in line with Scotia.
* It was trading at a discount to Bank of Montreal. It was one of those names where the underlying performance was clearly better than the valuation would suggest. We saw growth in pre-tax pre-provision. Their credit ratio, after getting a little high because of losses in US commercial real estate, has since moderated. Their capital ratio's over 13%.
* So when you've got that kind of solid performance with the discount valuation, it makes sense to upgrade the stock, as I did, I think, about nine months ago. What was special about this quarter is they continued their solid performance, but on top of that, they announced a normal-course issuer bid. They're buying back about 2% of their stock.
* And I think the market really views that positively because I think a lot of investors have lost patience with banks spending a lot of money in US deals. Hearing CIBC say this incremental cash or capital will be spent on buying back stock, I think, certainly relative to Scotia's decision to buy an interest in KeyCorp, the market really values that. And I think that's why CIBC has been so strong.
* Interesting. What about National? You got a hold on National, but you highlight a couple of things that you could be concerned about.
* Well, National has been one of those names that's been really surprising to me. Given the business mix of National, overweight or 10% of their earnings come from Cambodia, which is leveraged to Cambodia commercial real estate, a very big capital markets business, I've been surprised that the stock has done this well.
* But I'll give them credit. Their bet on Cambodia has worked. Cambodia has got very strong margins, strong loan growth, without a lot of credit losses, and a very low efficiency ratio, meaning they're a highly efficient bank. So they've delivered. National has, along with Royal, I'd call it the highest ROE in the group.
* I don't want to make any bets on National right now. The valuation is right up there. It's not far off of where Royal is. And I still don't like that business mix.
* But ultimately, the reason I'm cautious on National is the bet that they've made on Cambodia has worked so far. And my challenge is you've got gross impaired loans-- these are loans that are challenged-- have been rising materially in Cambodia for over a year now. The bank has not taken any material charges against those.
* But when I see those, what we call gross impaired loans, rise as they will, it's a harbinger to me that something could be deteriorating in Cambodia. The market doesn't agree with that. National has a different view. My view is I don't need to bet on National now, certainly not with the increase in gross impaired loans.
* If I could pull the thread a bit on the ROE comment with Royal Bank, you said it's a good story that you've seen from them. And you highlight that the capital markets, I think them being overweight, that helping that. So maybe tell us a bit more about Royal, what you saw. And I think you've got a buy on Royal.
* Yeah, what's happened with Royal, the reason it's been one of these big performers, is the allocation of capital they've made has been to-- certainly, they've done a deal in the US. They allocated $5.4 billion to City National a few years back. But their big allocation of capital was HSBC in Canada. And that transaction has gone extremely well.
* They did what they call a close and convert. The deal closed, and they converted the systems pretty much on the same day. It's resulted in very good operating leverage since the deal closed. But there's more than just HSBC with Royal Bank.
* It's also a very strong capital markets business, strong wealth management, positive operating leverage, buying back stock. There's really nothing to dislike about Royal right now. The only thing you might highlight is that it's being paid for that strong performance.
* It has the highest valuation in the group by a healthy margin. And that's the challenge. The challenge is, do you want to allocate even more capital to Royal, given where that valuation is? The argument I'm making for now is, yes. I expect it to continue to outperform the group, and that's why we rate it a buy.
* I want to finish up, if I could, with a bit of a double-barreled question. I mentioned I wanted to come back to ROE because you said that's what to watch going forward. What's going to change on that front, do you think, for some of the banks? And what else should we be watching?
* Well, the way to really look at that is BMO is at the low end-- the lowest ROE ratio and ROE in the group, and, say, National and Royal at the upper end. So what I've been asking myself is this-- what is it going to take for BMO's ROE to migrate back up to, let's say, 14%? Their long-term target is 15%-- or medium-term target is 15%.
* What's it going to take to get there? It's going to take things like improving their efficiency ratio, reducing credit losses, growing in low capital-intensive businesses. BMO has a pathway to a higher ROE.
* The market will eventually pay for that. The problem is, do you want to buy it now when they're going through this credit problem, where credit losses are going to be elevated for six-, nine-plus months? And my answer is "no."
* But there's going to come a time when we can get comfortable with BMO from a credit perspective, and it could be the bank to own because it's got the most room for improvement in the ROE. And that's part of a longer-term thesis I'm working on, which is to say, let's buy those banks that have the most room to improve their ROE.
* BMO is one of those names. Scotia is one of those names. But now's not the time. And that's what I reflect in my ratings.
* Mario, always a pleasure. Thanks so much for this.
* Thank you.
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* The results are in. Canada's big banks have reported their third quarter earnings, with most beating estimates. My next guest has a constructive outlook on Canadian banks but also notes they have underperformed when compared to Canadian life insurance companies or their US bank counterparts.
* Mario Mendonca is managing director at TD Cowen. He joins us now. Mario, it's good to see you.
* Good to see you.
* Let's start off with maybe just your overview on the group for the quarter. What were some of the material things you took away from it?
* Yeah, going into the quarter, or even going into 2024, there was a view-- and I shared it-- that banks were going to continue to underperform the way they have over the last few years, and the underperformance was going to be in the form of weaker pre-tax provision profit growth and accelerating losses, not in the corporate and commercial but more on their unsecured consumer-- so think credit cards, auto lending, that sort of thing.
* And for the most part, that's what's happened. The banks have continued to underperform. They've underperformed the life co's, the US regionals, the US money center banks. And they've underperformed the TSX now for, I'm going to say, about three of the last four years. So it's been a prolonged period of underperformance.
* What was interesting about this quarter is, as you said, most of the banks beat. Five of the six banks beat estimates. BMO was the only one that didn't. I shouldn't say they all beat. They either beat estimates or they were in line with estimates. BMO was the only one that missed in a meaningful way.
* But what was particularly interesting about this quarter is not only did pre-tax, pre-provision profit accelerate, but you also had every bank with a capital ratio over 13%. And then, most importantly, we're getting better indications of the resilience of the unsecured Canadian consumer-- so the resilience in credit card lending, auto lending, lines of credit.
* So the quarter really was positive in a lot of different respects. And it led me to the view that this prolonged period of underperformance probably is near its end. I don't expect our banks to underperform the way they have for the last few years.
* Interesting. I also thought it was interesting you said in your note that-- you talked about group performance, and it wasn't as meaningful to talk about group performance anymore because of the disparity within the banks in terms of what they're doing. Maybe you can talk to us a bit about that as well, too.
* Yeah. Over the many years I've been following banks, you rarely see a scenario where one bank, or, in this case, three banks, are up 22% to 23%. I'm referring to National, Royal, and CIBC. And several banks are down meaningfully-- in this case, BMO down 14% or 15%.
* That spread in performance is so wide that it's made references to average performance less meaningful. And the disparity in performance between, let's say, the banks that have performed really well, 22%, 23%, and the banks that have not performed well, aside from some individual issues facing some of these banks, the biggest differentiator between the banks that have performed well and the banks that have performed poorly is ROE and the change in ROE.
* The banks that are performing well have seen their ROEs climb by 100 to 200 basis points year over year. The banks that are performing poorly have seen their ROEs diminished by 100 to 200 basis points. And this is one of those areas that really deserves a much closer look.
* We need to think a lot about, why are some banks driving their ROEs higher, and others are much lower? And that's something that I think we all have to spend some time thinking about.
* Well, I'd like to dig in on that. I think I might save that for the end, though, because it's meaningful. Let's talk about some of the individual performances on the banks. And I'm just going to go in the order that you have. BMO, which you downgraded to a hold on August 27, that was the one, of course, that caught most people's attention this quarter.
* Yeah. So BMO has missed earnings by a meaningful amount for three consecutive quarters. In the first quarter of 2024, it was more on revenue and expenses. In the last two quarters, it's been on credit losses. Their credit losses have been materially higher than peers.
* And there's no way around it-- BMO, in this credit cycle, if you want to call this a credit cycle, stands out from its peers in a very meaningful way. There's no way to sugarcoat it. I really felt that this quarter was going to be the beginning of the end for BMO-- that this would be an elevated credit loss quarter, but they would guide us to something more moderate going forward.
* In fact, we got the opposite. The bank is guiding to further elevated credit losses, perhaps going on another six or nine months. It's very clear to me that BMO really-- I think BMO stepped out of its lane, probably 2020 to 2022, in their lending practices. It could be things like hold limits being too high-- because normally, banks make these large loans and they syndicate a portion.
* The amount that they held on to was too high. Or maybe they were lending into sectors they shouldn't have. As it turns out, BMO is a very clear standout from a credit perspective. And until credit stabilizes and becomes similar to what their peers are experiencing, BMO's likely to underperform the group.
* Let's move on to the next one, Bank of Nova Scotia. You've got a hold.
* Yeah. Bank of Nova Scotia has been one of those names that I've been bearish on for some time. A hold doesn't mean a sell. A hold is a hold. That's the rating. But it's one of those banks that I've been less optimistic about, because I think Scotia's going through so many meaningful changes, like shrinking their mortgage book, focusing on deposit growth.
* Their balance sheet hasn't shown any growth. They've been capital constrained until recently. They need to exit certain businesses in Latin America. My view on Scotia is one of I'd rather wait to see how the bank navigates through all these changes before I'm going to stick my neck out.
* Let's see how they muddle through, and I don't mean that in a negative way, but how they get through the next year or so making through these changes. I'll revisit my call then. But I do want to highlight one thing about Scotia. After many quarters of no balance sheet growth, we did see some balance sheet growth this quarter.
* We did see growth in mortgages and in their international business. And I think it might be too early to call that an inflection point, but it's clearly positive that Scotia is starting to grow the balance sheet again.
* Interesting. CIBC-- you recently upgraded this to a buy from a hold after the first quarter release of results. What did you see this quarter?
* Yeah, that was back-- I think that was about nine months ago when I made CIBC our top pick. The stock's done extremely well. Now, part of the reason for this is the bank has traded at a discount to its peers for a long time. It was trading at a discount to Scotia, or maybe in line with Scotia.
* It was trading at a discount to Bank of Montreal. It was one of those names where the underlying performance was clearly better than the valuation would suggest. We saw growth in pre-tax pre-provision. Their credit ratio, after getting a little high because of losses in US commercial real estate, has since moderated. Their capital ratio's over 13%.
* So when you've got that kind of solid performance with the discount valuation, it makes sense to upgrade the stock, as I did, I think, about nine months ago. What was special about this quarter is they continued their solid performance, but on top of that, they announced a normal-course issuer bid. They're buying back about 2% of their stock.
* And I think the market really views that positively because I think a lot of investors have lost patience with banks spending a lot of money in US deals. Hearing CIBC say this incremental cash or capital will be spent on buying back stock, I think, certainly relative to Scotia's decision to buy an interest in KeyCorp, the market really values that. And I think that's why CIBC has been so strong.
* Interesting. What about National? You got a hold on National, but you highlight a couple of things that you could be concerned about.
* Well, National has been one of those names that's been really surprising to me. Given the business mix of National, overweight or 10% of their earnings come from Cambodia, which is leveraged to Cambodia commercial real estate, a very big capital markets business, I've been surprised that the stock has done this well.
* But I'll give them credit. Their bet on Cambodia has worked. Cambodia has got very strong margins, strong loan growth, without a lot of credit losses, and a very low efficiency ratio, meaning they're a highly efficient bank. So they've delivered. National has, along with Royal, I'd call it the highest ROE in the group.
* I don't want to make any bets on National right now. The valuation is right up there. It's not far off of where Royal is. And I still don't like that business mix.
* But ultimately, the reason I'm cautious on National is the bet that they've made on Cambodia has worked so far. And my challenge is you've got gross impaired loans-- these are loans that are challenged-- have been rising materially in Cambodia for over a year now. The bank has not taken any material charges against those.
* But when I see those, what we call gross impaired loans, rise as they will, it's a harbinger to me that something could be deteriorating in Cambodia. The market doesn't agree with that. National has a different view. My view is I don't need to bet on National now, certainly not with the increase in gross impaired loans.
* If I could pull the thread a bit on the ROE comment with Royal Bank, you said it's a good story that you've seen from them. And you highlight that the capital markets, I think them being overweight, that helping that. So maybe tell us a bit more about Royal, what you saw. And I think you've got a buy on Royal.
* Yeah, what's happened with Royal, the reason it's been one of these big performers, is the allocation of capital they've made has been to-- certainly, they've done a deal in the US. They allocated $5.4 billion to City National a few years back. But their big allocation of capital was HSBC in Canada. And that transaction has gone extremely well.
* They did what they call a close and convert. The deal closed, and they converted the systems pretty much on the same day. It's resulted in very good operating leverage since the deal closed. But there's more than just HSBC with Royal Bank.
* It's also a very strong capital markets business, strong wealth management, positive operating leverage, buying back stock. There's really nothing to dislike about Royal right now. The only thing you might highlight is that it's being paid for that strong performance.
* It has the highest valuation in the group by a healthy margin. And that's the challenge. The challenge is, do you want to allocate even more capital to Royal, given where that valuation is? The argument I'm making for now is, yes. I expect it to continue to outperform the group, and that's why we rate it a buy.
* I want to finish up, if I could, with a bit of a double-barreled question. I mentioned I wanted to come back to ROE because you said that's what to watch going forward. What's going to change on that front, do you think, for some of the banks? And what else should we be watching?
* Well, the way to really look at that is BMO is at the low end-- the lowest ROE ratio and ROE in the group, and, say, National and Royal at the upper end. So what I've been asking myself is this-- what is it going to take for BMO's ROE to migrate back up to, let's say, 14%? Their long-term target is 15%-- or medium-term target is 15%.
* What's it going to take to get there? It's going to take things like improving their efficiency ratio, reducing credit losses, growing in low capital-intensive businesses. BMO has a pathway to a higher ROE.
* The market will eventually pay for that. The problem is, do you want to buy it now when they're going through this credit problem, where credit losses are going to be elevated for six-, nine-plus months? And my answer is "no."
* But there's going to come a time when we can get comfortable with BMO from a credit perspective, and it could be the bank to own because it's got the most room for improvement in the ROE. And that's part of a longer-term thesis I'm working on, which is to say, let's buy those banks that have the most room to improve their ROE.
* BMO is one of those names. Scotia is one of those names. But now's not the time. And that's what I reflect in my ratings.
* Mario, always a pleasure. Thanks so much for this.
* Thank you.
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