Analysts See More Turbulence Ahead for the Canadian Banking Sector

The Canadian banking sector could be facing a new, more far-reaching phase of turbulence in coming quarters, National Bank analyst Rob Sedran said in a note.

The recent turmoil affecting bank stocks can be divided into two phases. While some banks have been able to avoid Phase I, we believe all banks will be affected to some degree by Phase II.

Phase I was when some banks took big writedowns on subprime-related securities that put pressure on the balance sheet. Most notable among the domestic banks was Canadian Imperial Bank of Commerce (CM). But CIBC has recapitalized thanks to a C$2.9-billion new equity issue, and capital concerns across the sector are waning.

Mr. Sedran also notes that Phase I did not have much long term impact on earnings estimates because profit from the affected businesses “is generally not overly material.”

In contrast, in this new phase of the turmoil, “concerns relate mainly to the income statement,” he says.

He added:

The slowing economy, funding pressure, rising provisions for credit losses and weak capital markets related revenues will likely weigh on earnings. All banks are exposed to Phase II – albeit to varying degrees.

National Bank estimates 3% average growth rate for the big banks in 2008. Mr. Sedran’s top pick is Toronto-Dominion Bank (TD), which is rated “outperform” with a C$79 target price.

TD vs CM vs RY vs BNS 1-yr chart:

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The main thrust of a note from Credit Suisse analyst Jim Bantis, is that things are going to get worse before they get better for Canada’s banks. As a result, he is marking down his 2008 earnings per share estimates for the sector by 4%.

Profits will be hit by the weakness in capital markets and rising loan defaults as the deteriorating U.S. economy has a spillover effect on Canada.

“Outside of tighter cost control, we do not see any offsets for these near-term headwinds,” Mr. Bantis says.

Canadian bank stocks are down 16% from 2007 highs, but it’s still too early to call the bottoming out of the decline in banking sector shares, he adds.

Short-term, we would remain on the sidelines until sector valuations become washed out or visibility in the credit markets improves.

Credit Suisse prefers Royal Bank of Canada (RY) and Toronto-Dominion Bank because of their strong domestic retail franchises, and Bank of Nova Scotia (BNS) with its international growth platform. Mr. Bantis’ top pick is RBC, which is rated “outperform” with a C$65 target price.