Expectations of Weaker Credit Quality Cause Bank Bearishness at Dundee

 |  Includes: BMO, BNS, CM, LRCDF, RY, TD
by: FP Trading Desk

Both Royal Bank (NYSE:RY) and Toronto-Dominion Bank (NYSE:TD) were downgraded to a “sell” at Dundee Securities on expectations for weaker credit quality, bringing them in line with the firm’s bearish view on the sector as a whole and its recommendations for all of the Big 5 banks.

Despite significant deterioration in its U.S. loan portfolio’s credit quality, Royal’s earnings have held up reasonably well on the back of its domestic retail banking programs, analyst John Aiken told clients. However, since Canada is unlikely to escape the “economic carnage” occurring in the U.S., he said it is only a matter of time before domestic credit quality begins to weaken materially, as credit card exposures have already started to show.

“Consequently, although Royal will likely fare relatively well and should retain a premium to the group, absolute risk still exists,” Mr. Aiken said, cutting his price target on the stock from C$38 per share to C$35. It closed at C$34.04 on Thursday.

His forecast for TD moves from C$51 to C$44 as a result of expectations for a challenged outlook in the coming quarters as a result of additional deterioration in credit quality. It ended the day at C$44.05.

While Mr. Aiken said TD’s operations remain strong and its long-term prospects are solid based on its U.S. growth platform, he thinks 2009 will be the second straight year of declining earnings.

The analyst said:

TD will not be immune and we believe that there is a risk that current expectations for credit losses have a significantly greater chance of being too low rather than too conservative.

Mr. Aiken did upgrade Laurentian Bank from a “sell” to “neutral,” but lowered his price target from C$36 to C$33. The stock closed at C$31.41 on Thursday.

“We believe that Laurentian’s (OTCPK:LRCDF) valuation is much more reasonable at these levels,” he said, adding that while the bank does not have any direct exposure to the U.S., it will still feel pain on the domestic front.

In general, Mr. Aiken feels the impact of underlying economic weakness and credit woes in the U.S., which has produced an earnings drag, increased write-downs and higher loan loss provisions, has also filtered into the Canadian market and will likely linger into the first half of 2009.

He said:

Consequently, we believe that headwinds to the banks’ earnings and concerns of capital adequacy will remain in the forefront as the banks begin the journey into 2009, and with it, the remaining perils from the past year, plus those yet unknown.

As a result, the analyst said now is not the time to change his cautionary stance on the sector. Instead, he said it is time to remain “selective and mindful.”

Mr. Aiken suggested that strong domestic operations should bode well for the retail market leaders TD, Royal and to a lesser extent CIBC (NYSE:CM). He also expects higher provisioning will come from the U.S. exposures of TD, Royal and Bank of Montreal (NYSE:BMO), as well as the ripple effects to Bank of Nova Scotia’s (NYSE:BNS) Latin America assets.

The analyst said:

Overall, valuation outlook will be largely predicated on the depth and breadth of the U.S. economic slowdown. Further credit deterioration will result in higher provisions, while added margin compressions will also depress earnings, offering little justification for any meaningful near term increase in valuations.