Canada’s top banks all reported quarterly results within three days during the last week of May. It wasn’t a pretty picture.   

Canada’s six biggest lenders reported the first profit declines in at least nine years and missed most analysts’ estimates because of writedowns and lower capital markets fees.   

Bank of Nova Scotia’s (NYSE: BNS, TSX: BNS, Scotiabank) second quarter (ended April 30, 2008) results were depressed by the continuing down-the-line impact structured products are having on the global financial system. But losses to this point have been modest and easy to absorb.

Scotiabank reported a profit of CAD980 million, down 6 percent from CAD1 billion a year ago. Domestic banking profits were up 15 percent to CAD416 million, driven by strong loan growth. Profits from overseas operations also rose, up 13 percent to CAD335 million, despite the negative effect of foreign currency translation and higher provisions for retail loan losses in Mexico. But Scotia Capital’s profits fell 21 percent to CAD251 million amid a difficult environment for deal-making.

Scotiabank said it’s unlikely to meet its objective of 7 to 12 percent growth in earnings per share for the year, although the second half of the year is likely to be much better than the first. The results were below expectations but were still of decent quality.

Non-Trust recommendation Scotiabank, Canada’s third-largest bank by assets and second largest by market cap, has less exposure to the paper assets providing fuel for the immolation of many financials’ balance sheets. Scotiabank’s comparatively low CAD153 million in credit-loss provisions, decent domestic performance and promising overseas developments helped it stand out. And Scotiabank actually boosted its dividend from 47 cents Canadian per share to 49 cents Canadian per share.

Value Hunters

At least one PR-savvy money manager and several analysts have focused on one particular name that stands apart from Canada’s Big Six banks. Pierre Bernard’s IA Clarington Canadian Leaders Fund made the top 4 percent in its category by loading up on energy; in late May, his focus switched to banks.

Bernard sold more than half the CAD100 million Leaders Fund energy stocks and boosted his bank position by 44 percent; he sold all his Imperial Oil shares and added Scotiabank. Energy shares now make up 10 percent of his fund, down from 25 percent, while banks rose to 23 percent from 16 percent.

RBC Capital Markets analyst Andre-Philippe Hardy downgraded Toronto-Dominion Bank (NYSE: TD, TSX: TD, TD) to “market perform;” the stock is among the best-performing major banks in North America in 2008, with an 8 percent gain compared to a 14 percent loss for the KBW Bank Index in the US. He also downgraded Canadian Imperial Bank of Commerce (NYSE: CM, TSX: CM, CIBC) but boosted Scotiabank because of its domestic retail operations and strong growth overseas.

Bank bullishness is inspired by the hope that the worst is over for financials and the heaviest writedowns have been absorbed. The bear case rests on questions about how the Canadian economy responds to slowing growth in the US and around the globe.

Scotiabank faces an easier road because its risk management program prevented the type of recklessness that’s left some of its Canadian peers, not to mention some of the biggest names in global finance, vulnerable to digestion in the consolidation food chain. And TD has the least exposure to shaky structured products of the Big Six. Not only have they avoided the balance-sheet turmoil most financials have suffered, Scotiabank’s and TD’s future risk is limited.

As for the health of Canada’s economy, GDP slid 0.3 percent during the first quarter (ended March 31, 2008) after expanding at an annualized 0.8 percent during the fourth quarter 2007 and 2.3 percent during the third quarter of 2007. The size of Canada’s resource economy relative to its overall economy, however, provides a clear advantage other developed economies lack.

According to Canada’s official arbiter, “The term recession refers to a significant drop in economic activity, lasting more than a few months, as measured by employment rate and real gross domestic product.”

The most recent data from Statistics Canada indicate that, over the prior 12 months, employment increased by an estimated 348,000, or 2.1 percent, with full time growing twice as fast as part time. The employment rate, the share of the working-age population employed, continued to hover around a record high in April.

Year-over-year growth in average hourly wages was 4.3 percent in April, slightly lower than earlier in the year but well above the most-recent increase in the Consumer Price Index, which was 1.4 percent.

The strength of Canada’s resource economy has led to significant improvement in its terms of trade; real income is now rising at a 3.7 percent year-over-year pace, compared with 1.5 percent for the US. Surging wages in a low-inflation environment are likely to bolster domestic consumption–despite slumping nonenergy US exports–and allow economic expansion to resume.

The Organization for Economic Cooperation and Development (OECD) doesn’t see a recession in Canada’s forecast. The relatively healthy state of the economy as it slowed, the effect of tax cuts and aggressive monetary policy easing will help Canada avoid recession in 2008. The Paris-based OECD forecast in its semiannual outlook that growth in Canada will slow to 1.2 percent this year from 2.7 percent in 2007 and will likely expand 2 percent in 2009.

Scotiabank, a methodical, detail-oriented deal maker, remains focused on growing overseas operations. The bank was tossed around as a potential acquirer of Cleveland-based National City Corp before that struggling regional bank secured USD7 billion in bailout financing through a private equity firm.

But don’t expect Scotiabank to step into US retail banking any time soon. During Scotiabank’s second quarter conference call, CEO Rick Waugh admitted that relatively high multiples on the Canadian bank’s stock, compared to the drubbing administered to many US regional players, make valuations “intriguing,” but a departure from its current growth strategy wasn’t warranted.

“We’ve always been opportunistic. We’ll keep our eyes and ears open, but I feel very comfortable in our strategies.” That means expanding South and Central American operations and building an integrated Canadian bank.
 
Bank of Nova Scotia is a buy up to USD58.

The Rest of the Story

Compared to the losses recorded by many American and European banks, the Canadian financial services sector has weathered the subprime crisis with far less pain. Total writedowns at Canada’s six largest banks stand at approximately USD11 billion, about 5 percent of the total global subprime writedowns to date. Though not an insignificant number, that pales in comparison to the total USD200 billion in combined global bank writedowns since last summer and is far less than UBS’ cumulative USD38 billion in losses alone.

TD has almost escaped without any serious losses since last July. But Canada’s No. 2 bank by assets has considerable exposure to US consumers and may face higher loan losses as the economy slows. TD reported a 3.1 percent profit gain for the second quarter, but investment-banking profit dropped 57 percent because of a decline in advisers’ fees from mergers and stock sales.

TD’s profit dipped for the first time in five quarters, falling 3.1 percent to CAD852 million (CAD1.12 per share) from CAD879 million (CAD1.20 per share) a year ago. CEO Edmund Clark noted in a statement accompanying TD’s earnings release that the bank wasn’t “able to outrun the collateral effects of the issues facing the financial services industry.” Hold Toronto-Dominion Bank.
 
Royal Bank of Canada (NYSE: RY, TSX: RY, RBC), Canada’s largest bank by market capitalization, and CIBC now share the dubious distinction of featuring among the global banking sectors’ top 40 list for the largest writedowns and credit losses since the banking sector started hemorrhaging last fall. And Bank of Montreal (NYSE: BMO, TSX: BMO, BMO) is ranked second only behind CIBC for posting rising losses tied to structured products and other writedowns in Canada.

RBC Capital Markets struck a deal this week to acquire Richardson Barr & Co, a Houston-based energy advisory firm specializing in acquisitions and divestitures (A&D) in the exploration and production sector. A&D firms specialize in assisting public and private companies in the sale of oil and gas properties.

A new entity, to be known as RBC Richardson Barr, will provide A&D support to RBC’s North American energy group. RBC expects sales of oil and gas properties to increase in the next couple years ahead of a potential boost to the US capital gains tax rate by a Democratic president.

That deal-volume story may or may not play out. If commodity prices continue to rise (the operating assumption here is that, based on long-term, rapid growth in Asia and the relative scarcity of and competition for natural resources, the era of cheap energy, in particular, is over), will wealthy families who own parcels of land be more likely to sell, even with a capital gains hike?

RBC’s consumer banking and insurance revenue was up, but subprime-related writedowns led to a 27 percent profit decline to CAD928 million. Overall results were bolstered by a 15 percent increase in consumer banking profit; earnings from insurance, mortgages and deposits in Canada helped offset a 43 percent drop in profit from international consumer banking, which includes Raleigh, N.C.-based RBC Bank. Royal Bank of Canada is a hold.

CIBC booked CAD2.5 billion of writedowns in the quarter, about two-thirds of the total for Canadian banks. It also saw weaker-than-average growth in retail banking revenues and ongoing problems in wholesale banking. CIBC reported a second quarter loss of CAD1.1 billion (CAD3 per share).

Analysts have forecast additional writedown costs of as much as CAD3.6 billion. Sell Canadian Imperial Bank of Commerce.

BMO’s net income fell 4.3 percent to CAD642 million (CAD1.25 per share) from CAD671 million (CAD1.29 per share) a year ago. It set aside CAD151 million for bad loans and expects loss provisions as defaults tied to US real estate increase and the Canadian economy slows. It was the fourth straight quarter of declining profits for BMO.

National Bank of Canada’s net income declined 29 percent to CAD165 million, but the shares may benefit because of its relatively limited exposure to structured finance and the US. Hold Bank of Montreal.

National Bank of Canada’s (TSX: NA, OTC: NTIOF) net income declined 29 percent to CAD165 million. Profit at National Bank’s consumer bank rose 1 percent to CAD113 million. National, the junior member of the Big Six, had CAD73 million in costs for its holdings in asset backed commercial paper. The shares may benefit because of its relatively limited exposure to structured finance and the US, but National Bank of Canada is a hold.