Banks Still Offer Low-risk Growth

Canadian bank stocks have moved down in recent weeks, mainly due to fears that rising interest rates will hurt demand for mortgages and other loans. While that is a possibility, the banks are in a much better position to handle a drop in loan volumes than they were a few years ago.

Tighter credit policies have cut the risk of big loan write-offs. The banks’ entry into new businesses such as insurance and mutual funds has cut their reliance on traditional banking operations. Growing overseas operations also cut their geographic risk.

We still like the long-term prospects of all five of Canada’s big banks, and recommend that every Canadian investor aim to own at least two of them.

ROYAL BANK OF CANADA $47 (Toronto symbol RY; Conservative Growth Portfolio, Finance sector; SI Rating: Above average) is Canada’s largest bank, with assets of $487.9 billion.

In the past few years, Royal has steadily built up its U.S. operations, mainly through acquisitions of regional banks and wealth management firms. Royal prefers to focus on smaller markets like North Carolina where it can quickly build market share. This way, it avoids competing directly with larger U.S. banks.

Thanks to a restructuring, earnings from Royal’s U.S. operations in its first fiscal quarter ended January 31, 2006 rose 3.1%, to $101 million from $98 million a year earlier. If you exclude the impact of the rising Canadian dollar, profit at the U.S. division grew 9%. Royal itself earned $0.89 a share (total $1.17 billion) from continuing operations in the quarter, up 18.7% from $0.75 a share ($977 million) a year earlier (all pershare amounts adjusted for a 2-for-1 stock split in April 2006).

Royal is now looking to expand its U.S. operations, particularly since the higher Canadian dollar cuts the cost of new acquisitions. It will probably focus on small operations that complement its current businesses.

The bank will likely earn $3.36 a share in fiscal 2006, and the stock trades at 14.0 times that amount. The $1.44 dividend yields 3.1%.

Royal Bank is a buy.

TORONTO-DOMINION BANK $62 (Toronto symbol TD; Conservative Growth Portfolio, Finance sector; SI Rating: Above average) is the secondlargest Canadian bank, with $384.4 billion in assets.

Like Royal, TD is aggressively expanding in the U.S., mainly through subsidiary TD Banknorth Inc., which operates 400 branches in northern New England and upstate New York. TD now gets 8% of its revenue from the U.S. operations.

Also like Royal, TD is concentrating on markets close to its current operations. For example, TD Banknorth recently agreed to buy Interchange Financial Services Corp., which has 30 bank branches in northern New Jersey, for $480.6 million U.S. That will make TD Banknorth the ninth-largest bank in New Jersey, with around 130 branches.

TD Bank will help fund this purchase by buying $405.2 million U.S. worth of new TD Banknorth common shares. To put that in context, TD earned $1.15 a share (total $835 million) before unusual items in its first fiscal quarter ended January 31, 2006. The extra shares will increase TD’s stake in TD Banknorth, from 55.8% to 58.6%.

It will probably take a year before the new operations contribute to TD’s profits. In the meantime, strong growth at its Canadian retail banking and wealth management operations should lift TD’s profits in fiscal 2006 to $4.68 a share. The stock now trades at 13.2 times that figure. The $1.76 dividend yields 2.8%.

TD Bank is a buy.

BANK OF NOVA SCOTIA $45 (Toronto symbol BNS; Conservative Growth Portfolio, Finance sector; SI Rating: Above average) is Canada’s third-largest bank, with total assets of $325.0 billion.

The bank has the highest international exposure of the big five Canadian banks, and now gets nearly 30% of its revenue and income from overseas assets. Bank of Nova Scotia prefers to invest in developing areas like the Caribbean and Latin America, where spreading prosperity is fueling demand for banking services. It has few operations in the United States.

For example, Bank of Nova Scotia just agreed to pay an undisclosed sum for Citigroup Inc.’s retail banking business in the Dominican Republic. The purchase will make it that country’s fifth-largest bank, and enhances its credit card and consumer loan operations.

This wide geographic base is paying off. In the three months ended January 31, 2006, earnings grew 9.1%, to a record $0.84 a share (total $852 million) from $0.77 a share ($788 million) a year earlier. That gives it plenty of cash for stock buybacks, or dividend increases; the current annual dividend rate of $1.44 a share yields 3.2%.

Bank of Nova Scotia is still the most efficient of the five banks. Its productivity ratio (non-interest operating expenses divided by revenue — the lower, the better) fell to 55.2% in the most recent quarter from 55.7% a year earlier.

The stock now trades at 13.2 times its likely fiscal 2006 profit of $3.41 a share. That’s low considering the growing profit potential of its international operations.

Bank of Nova Scotia is a buy, and our top choice for new bank investment.

BANK OF MONTREAL $62 (Toronto symbol BMO; Conservative Growth Portfolio, Finance sector; SI Rating: Above average) is Canada’s fourth-largest bank, with assets of $305.8 million.

The bank continues to expand its Chicago operations, where its Harris Bank subsidiary is the area’s second-largest bank in terms of deposits.

In 2005, acquisitions added 21 branches to the Harris network, and expanded its geographic reach to Indiana. Harris now operates close to 200 branches, and supplies 10% of Bank of Montreal’s revenue, and 5% of its profit.

The Chicago banking market is highly fragmented with over 250 different firms. It’s likely that Harris will strengthen its market share with more acquisitions this year.

In its first fiscal quarter ended January 31, 2006, earnings rose 5.2%, to $1.22 a share from $1.16. Higher income from retail banking and wealth management helped offset a 21% jump in loan loss provisions. However, the bank feels that provisions for the entire year will likely fall 19% below its earlier forecasts.

The stock now trades at 12.7 times the $4.90 a share Bank of Montreal should earn in fiscal 2006. The $2.12 dividend yields 3.4%.

Bank of Montreal is a buy.

CANADIAN IMPERIAL BANK OF COMMERCE $83 (Toronto symbol CM; Conservative Growth Portfolio, Finance sector; SI Rating: Above average) is the fifth-largest bank in Canada, with assets of $288.9 billion.

In 2005, CIBC paid $2.8 billion to settle class-action lawsuits over its involvement with U.S. energy trading firm Enron Corp. We felt at the time that CIBC did not intentionally try to deceive investors, and the stock would bounce back. It’s now back to pre-settlement levels.

The bank’s new managers now aim to cut costs by $250 million this year. To put that in context, CIBC earned $1.62 a share (total $580 million) in its first fiscal quarter ended January 31, 2006, down 16.5% from $1.94 a share ($707 million) a year earlier. If you exclude gains on the sale of assets in the year-earlier period, CIBC’s pershare earnings actually grew 11.7%.

Now that CIBC has put its Enron problems behind it, it can take advantage of attractive acquisition opportunities. It recently agreed to double its stake in FirstCaribbean International Bank, from 43.7% to 87.4%, for $1.08 billion U.S.

FirstCaribbean operates 100 branches in 17 countries. Owning a majority interest will make it easier for CIBC to integrate FirstCaribbean’s operations with its own businesses in the region.

The stock now trades at 13.1 times its estimated fiscal 2006 profit of $6.33 a share. The $2.72 dividend yields 3.3%.

CIBC is a buy.