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More Dividend Cuts?
It seems like the market is expecting either really, really bad quarterly results from the Canadian banks or it is expecting the banks to cut their dividends.
What am I talking about? Let's take a look at the current annual dividend payouts of the top 5 Canadian Banks:
Royal Bank: $2.00
TD Canada Trust: $2.44
Bank of Montreal: $2.80
Ok, now what are the stocks trading at (as of 9:50am February 20, 2009):
Royal Bank: $26.75
TD CanadaTrust: $33.46
Bank of Montreal: $24.96
That gives us yields of:
Royal Bank: 7.48%
TD Canada Trust: 7.29%
Bank of Montreal: 11.21% (!)
Prime is currently at 3% and I think has a fairly good chance of moving to 2.75% on March 3 when the Bank of Canada sets the target for the overnight rate, provided the banks pass a BoC rate cut along to consumers. So currently the spread between the prime rate and the yield on Canadian banks at a minimum of 4.29% and as high as 8.21%.
So the question is does the market have it right and will we see at least one Canadian bank cut their dividend (I'm looking at you BMO) or is the market just totally out to lunch? One way to get a feel for that is to take a look at the payout ratios of the banks and their payout ratio targets. The payout ratio is the percent of income the bank uses to fund the dividend. The Canadian banks vary in their target payout ratios but their target ranges fall in the 35%-55% range. Based on Q1 2009 earnings estimates (as predicted by TD Newcrest) here's what the target payout ratio ranges and the projected Q1 2009 payout ratio will be:
Royal Bank: Target: 40%-50%, Expected Q1 2009: 56% (based on 90 cents/share earnings)
TD Canada Trust: Target: 35%-45% Expected Q1 2009: 47% (based on $1.49/share earnings, which isn't a TD Newcrest estimate because they have a conflict in covering their parent)
Scotiabank: Target: 35%-45% Expected Q1 2009: 54% (based on 90 cents/share earnings)
Bank of Montreal: Target: 45%-55% Expected Q1 2009: 67% (based on $1.05/share earnings)
CIBC: Target: 40%-50% Expected Q1 2009: 58% (based on $1.50/share earnings)
So it looks like all the banks are going to be outside their target payout ratio range with TD Canada Trust being the closest and BMO being the furthest from their range. I would expect that a bank that is within up to 5% of their payout ratio target wouldn't want to move their dividend at all but a bank like BMO that could be almost 12% outside their range (and their range is the highest of all the banks) might want to make some adjustments.
Now the question is what would it take to get their payout ratio back into their target range? Well 55% of $1.05 is 57.75 cents. They are currently paying out $2.80 a year or 70 cents a quarter so a move to 57.75 cents would be a 17.5% reduction. Of course my bet would be that if they did decide to cut the dividend they would give themselves way more room than just hitting the top end of their target range. After all, if you are going to disappoint investors by cutting the dividend at all you might as well give yourself some breathing room and an opportunity to really increase the dividend once earnings start to recover. So if and I really mean if BMO does decide to cut their dividend I would expect to see a 20 or 21 cent per quarter reduction which would be about a 30% drop (21 cents/ 70 cents = 30%). That would put them in the low end of their target payout ratio range (at around 46%) and it would also put their yield down in the 7.85% range (based on the $24.96 price listed above) which isn't too far off the other banks.
So out of all the banks I think that BMO is in the worst shape with respect to dividend payout ratios vs. their target payout ratios and I think that if any bank has a slim chance of cutting their dividend it will be BMO. Even if BMO does cut their dividend I think they will cut it by at most around 30% (which will give them lots of room to increase their dividend when earnings finally start recovering) and the yield of the stock will fall roughly in-line with the other banks at around 7.85% based on a stock price in the high $24 dollar range. I'll take an almost 5% above prime yield from a Canadian Bank after a dividend cut thank you very much.
In short, I don't see too much more downside in Canadian bank stocks based on the lows that they hit this morning. The earnings releases for the big 5 Canadian banks are scheduled to take place of the next couple of weeks ( starting on Wednesday next week and going into the first week of March). We could be in for an interesting ride on the bank stocks.