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National Bank research and analysis

Contributed by eResearch

By Bob Weir

National Bank (NA) reported cash operating EPS (fd) of $1.74. Excluding the negative $0.06 per share impact of the items of note discussed below, adjusted EPS was $1.80, an increase of 10% Y/Y. Adjusted EPS was $0.09 higher than our forecast and $0.13 higher than consensus. Cash adjusted ROE in the quarter was 17.7% versus 17.5% last quarter. The Tier 1 capital ratio (Basel II) declined to 13.6% from 13.9% as at the end of last quarter but NA remains one of the best capitalized banks in Canada.

The quarter was once again driven by solid results in the Wealth Management group, whereby net income was up 18% Y/Y and benefited from higher volumes and the acquisition of Wellington. Personal & Commercial (P&C) group reported another decent quarter in line with expectations and driven by strong volume growth. Financial Market earnings were somewhat better than the prior quarter but 8% below last year. Trading revenue this quarter was about 20% below the 8 quarter average.

For fiscal 2011 as a whole, NA reported adjusted net operating earnings of $1.2 billion or $7.00 per share, up 11% Y/Y versus $6.25 per share last year. P&C adjusted net income increased 9% Y/Y while wealth management’s adjusted net income increased 43% Y/Y. Financial markets adjusted net income was higher by 4% Y/Y and represented 42% of total net income, down marginally from 46% in fiscal 2010. Provision for Credit losses (PCL) was $134 million in fiscal 2011, down 7% Y/Y. Adjusted ROE for 2011 averaged 18.1% vs 17.7% in fiscal 2010.

For fiscal 2012, we have maintained our EPS estimate at $7.55. Our 2012 forecast represents an ROE of about 17.3% which is at the higher end of management’s target range. Our preliminary EPS outlook for fiscal 2013 has been set at $8.30, an implied increase of 9%. The 2012 forecast includes some modest accretion in EPS from the Wellington acquisition and some improvement in capital markets activity. Management is expected to review the dividend over the next several quarters. If there are no unexpected negative surprises, investors could expect a further dividend increase of 5% to 10% as the payout ratio forecast for fiscal 2012 and 2013 is 38% and 34% respectively and well below the lower end of management’s 40% to 50% target range.

We have lowered our 12-month share price target to $81.00 from $83.00 and maintained our BUY recommendation.

Valuation

Our target represents a multiple of about 10.7x our 2012 EPS outlook. Overall, this valuation represents about an 8% discount to the bank average.

Items of Note in Q4/11 – Negative Impact of $0.06 Per Share

NA indicated the following earnings adjustments to Q4/11:

- $8 million after-tax charge related to severance cost from the Wellington acquisition.

- $5 million after-tax provision for litigation issues.

- $4 million after-tax gain from the reversal of provisions for income tax contingencies.

IFRS Impact Update

Management gave an update on the impact of IFRS accounting changes that will impact Q1/12 reporting on both the Bank’s Balance Sheet and Income Statement.

Shareholders’ Equity

- Negative by $0.8 billion comprised largely of employee pensions (cumulative actuarial gains/losses recognized in opening balances). Phase in over 5 quarters offset by expected retained earnings over the period. Balance Sheet

- Increases by $9 billion mainly due to securitized assets included on balance sheet.

Income Statement

- Small 1% positive increase due to lower pension expense in 2011.

Tier 1 Capital (Basel II)

- Reduction of 166 bps on Tier 1 Basel II – to be phased in over 5 quarters.

Basel III Impact

NA is in a very strong capital position with respect to the new Basel III capital requirements. Management estimates that its current Common Equity Tier 1 ratio under Basel III is 7.6% and meets the full implementation of the Basel III program (minimum of 7.0% in 2019). NA’s Basel II Tier 1 capital ratio as at the end of the quarter was 13.6%, down from 13.9% last quarter. The Bank’s tangible common equity ratio stands at 10.1%, down slightly from 10.4% last quarter.

Other Quarterly Highlights

- Total Q4/11 net operating income was $294 million, up 2% Y/Y. Adjusted operating income, excluding the items of note, was reported at $303 million, up 7% Y/Y and 3% sequentially. Total revenue increased 6% Y/Y while non-interest expense increased by 10% for a negative increase in operating leverage of 4%. Expenses excluded severance charges related to the Wellington acquisition.

- The P&C group reported net income in Q4/11 of $156 million, up 6% Y/Y. Sequentially, net income declined by 8%. Overall, a decent quarter and in line with expectations. Revenues increased by 4% Y/Y while operating expenses were up 4% providing no increase in operating leverage. Average loans were up 12% Y/Y. Mortgage loans increased 13% Y/Y. Personal loans and credit card volumes increased by 12% Y/Y and commercial loans increased 10% Y/Y. The volume growth was offset to some degree as interest margins decreased 21 bps Y/Y and 7 bps sequentially driven by competition. PCL was $51 million, flat Y/Y and up almost 16% sequentially.

- Wealth Management reported solid net income of $39 million, up 18% Y/Y and 5% sequentially. Total revenues increased 19% Y/Y and expenses increased by 21% Y/Y generating a negative operating leverage of 2%. The expense ratio improved to 75.8% versus 76.1% in the same period last year if the Wellington acquisition is excluded. The Wellington transaction increased net income by $2 million in the quarter and is expected to increase pre-tax income in 2012 by $15 million. Assets Under Management (AUM) were $56 billion, up 6% Y/Y but declined 2% sequentially. Assets Under Administration (AUA) amounted to $182 billion which was flat Y/Y. Mutual fund revenue was flat Y/Y while brokerage commissions increased 19% Y/Y driven by the Wellington acquisition.

- Financial & Capital Markets reported a steady quarter with net income of $113 million, down 8% Y/Y but higher sequentially by 7%. Total revenues were lower by 4% Y/Y but higher by 6% sequentially. Underwriting and advisory revenues of $71 million increased 9% Y/Y but were lower by 7% sequentially. Trading revenue was higher sequentially at $106 million but well below the $139 million reported last year. Trading revenue this quarter was about 20% below the 8 quarter average. Fixed income trading was 40% lower sequentially. The Financial Markets group represented 37% of net income this quarter versus 34% last quarter.

- Security gains decreased sequentially to $10 million or about $0.05 per share versus a gain of $26 million in the previous quarter and $7 million in the same period last year.

- Securitization revenue was very strong at $118 million versus $74 million last quarter and $86 million in the same quarter last year.

- Unrealized securities surplus increased to $490 million in the quarter from a surplus of $379 million last quarter. Equity surplus was $21 million versus $38 million last quarter.

- Provision for Credit Loss (PCL) was reported at $36 million versus $26 million last quarter and $37 million in the same period last year. As a % of loans, PCL was about 22 bps versus 16 bps last quarter. Overall, a decent performance as losses moved back to the 8 quarter moving average. Commercial PCL doubled sequentially (losses were exceptionally low last quarter due to recoveries) while Personal PCL was 18% higher sequentially.  We have increased our 2012 PCL expectation to $135 million from $125 million and now expect the PCL to remain at the $135 million level in fiscal 2013.

- Gross Impaired Loans (GIL) increased in the quarter to $407 million from $382 million last quarter and were higher by 10% Y/Y. New impaired loan formations were $45 million driven by higher formations in the commercial sector related to one file adding $15 million. The level of GIL this quarter was about 10% higher than expected. We have increased our forecast of GIL to $410 million from $390 million for fiscal 2012 and expect the GIL will stay at the $400 million level in fiscal 2013.

European Risk Exposure

The Bank announced that it had US$12 million in direct credit risk exposure to PIIGS countries as at the end of the quarter. The majority was in Italy. Total exposure including trade finance obligations was US$183 million. Exposure to all of Europe was US$226 million or US$735 million including trade finance obligations.

Proposed Acquisition of HSBC Securities (Canada) Inc. On September 20, 2011, NA announced that it had entered into an agreement to acquire the full service investment advisory business of HSBC Canada and certain assets related to the segregated fund and insurance business of HSBC Insurance Agency (Canada) Inc. No price was disclosed and the transaction is expected to close in January, 2012.

- 80 IAs have signed on with NA.

- NA has a transition service agreement with HSBC for 18 months regarding support services with a price adjustment being made according to revenue retention.

Acquisition of Wellington West Holdings Inc.

On July 15, 2011, NA announced that it had completed the acquisition of all the shares of Wellington West Holdings Inc. (Wellington) for approximately $273 million ($333 million for 100%).

- The consideration consisted of NA common shares and cash. Approximately 2.2 million NA shares issued.

- Increased NA’s level of investment advisors by almost 30%.

- Accretive to earnings in fiscal 2012.

- Increases advisor count by 245 outside of Quebec.

- Created about $276 million of new goodwill.

- In our opinion, NA valued Wellington (excluding cash) at an estimated 1.5 times revenue, 10.5x EBITDA and 2.35% of AUA.