Big Six poised for earnings bonanza as bad-loan fears subside

By Paul Bagnell

Canadian banks are showing a soft period for loan growth: Analyst

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Paul Bagnell

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For Canada’s big banks, the blockbuster earnings beats they reported back in February may be a tough act to follow. But that doesn’t rule out a strong set of fiscal second-quarter results – and another leg up in share prices – when the banks report earnings next week.

In the fiscal first-quarter results, covering the three-month period that ended on Jan. 31, each of the Big Six banks blew past earnings expectations in a big way. An improving credit picture was the story, with banks booking less money than expected in new provisions for credit losses and some banks actually releasing modest sums from previously booked loan-loss reserves.

After the dust settled on the first-quarter results, bank shares began a rally that has continued through to today. All but one of the Big Six bank stocks have vastly outperformed the S&P/TSX Composite Index since Feb. 25, the final day of first-quarter reporting. Shares of Bank of Montreal are up 15 per cent over that period, and the stocks of National Bank of Canada, Canadian Imperial Bank of Commerce, Royal Bank of Canada and Toronto-Dominion Bank are not far behind. The laggard is Bank of Nova Scotia, whose stock is up almost five per cent over the period. The S&P/TSX Composite is up seven per cent during that stretch.

Analysts who cover the banks say the credit recovery story is still very much in place. Some have boosted earnings estimates and price targets on bank stocks, saying they see another post-earnings rally coming.

Let’s back up a bit.

When it became clear the COVID-19 pandemic was going to require much of the Canadian and U.S. economies to shut down, banks began booking huge sums of money in provisions for credit losses – a judgment on their part that a big wave of loan losses was coming in the year ahead. And Canada’s banking regulator, the Office of the Superintendent of Financial Institutions (OSFI), clamped down on dividend hikes and share buybacks. Those bans remain in place.

But since then, actual loan losses have been more modest than feared. Huge amounts of government support to consumers and business is one big reason why. The banks’ dealings with troubled borrowers – extensions on payment-due dates, for instance – is another. So banks have since announced smaller provisions for credit losses and, as noted, have in some cases actually released funds back into net income. It’s that second development – reserve releases – that analysts say will really propel big earnings growth in future quarters. And the upcoming quarterly results should offer evidence of that trend gathering steam.

Meny Grauman, an analyst at Scotia Capital, expects reserve releases “to be a bigger part of the story” in the second-quarter results and predicts earnings growth compared to the second quarter of fiscal 2020 will be significant because banks were setting aside those vast provisions a year earlier. (Every dollar taken in a loan-loss provision is a dollar lost to profit. Every dollar released from a loan loss reserve is a dollar added back to profit.)

Grauman calls the whole sector a buy.

“With the post-pandemic economic outlook remaining extremely favourable for the sector as a whole, we believe that the Canadian banks can trade well above historic average forward multiples,” he wrote in a recent note to clients. He increased the price-to-earnings multiple he thinks the bank stocks can command to 12 times forward earnings – close to the high end of their historic range.

Scott Chan, an analyst at Canaccord Genuity, has hiked his earnings estimate for the group by an aggregate 23 per cent as the second-quarter numbers draw closer. His target prices have gone up by an average of three per cent.

He too sees reserve releases as likely, and points to Toronto-Dominion Bank and Bank of Montreal as the two that could deliver the biggest releases. That’s because both have outsized exposure to the rapidly improving U.S. economy.

Chan said in a report this week he believes “the Big Six bank shares have the ability to grind higher near term.”

The market is also eyeing an eventual move by OSFI to lift its prohibition on dividend increases and share buybacks. Most analysts believe it will come in September. Banks have accumulated large amounts of excess capital – in excess, that is, to regulatory requirements – and once free to do so, will almost certainly boost dividends, increase share buybacks and – perhaps – go on M&A shopping sprees.

Here is when each bank is scheduled to report its fiscal second-quarter earnings: