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20 February

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
Scotiabank: $1.96
Bank of Montreal: $2.80
CIBC: $3.48

Ok, now what are the stocks trading at (as of 9:50am February 20, 2009):
Royal Bank: $26.75
TD CanadaTrust: $33.46
Scotiabank: $25.23
Bank of Montreal: $24.96
CIBC: $39.43

That gives us yields of:
Royal Bank: 7.48%
TD Canada Trust: 7.29%
Scotiabank: 7.74%
Bank of Montreal: 11.21% (!)
CIBC: 8.83%

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.

posted at 10:52:05 on 02/20/09 by 0xCC - Category: Personal Finance

Comments

Mr. Cheap wrote:

Interesting post and I can't fault your reasoning or conclusions. As a BMO shareholder, I wouldn't be HAPPY about a 30% cut, but as you say, it would still be a very juicy yield from a historical perspective.
02/21/09 14:05:24

0xCC wrote:

The main point I was making is that the market thinks that at least BMO is going to cut its dividend and I was trying to lay out what might be the worst-case scenario. I personally don't think that any of the Canadian Banks are going to cut their dividend but even they do the current stock prices are probably a little bit low.

I've been making some bets that the earnings season we are coming into isn't going to be a good one for the banks. However, I suspect that even though from an earnings perspective this past quarter wasn't good that the banks will hold out to see if things stay bad for another quarter or two before contemplating a dividend cut. So if this quarter is bad and next quarter is bad too *and* the quarter after that looks bad *then* we may start to hear about the *possibility* of dividend cuts. Hopefully things don't get that bad.
02/21/09 14:21:03

0xCC wrote:

Oh, and I should mention that our household owns shares in Scotiabank, TD Canada Trust, BMO and Royal Bank. So I wouldn't be happy with a dividend cut either. Although I do think that would set the banks up for the ability to rapidly increase the dividends as their earnings improved on the other side of this current economic slump...
02/21/09 16:09:12

CanadianFinance wrote:

I'm interested in all 5 of these stocks. I hoping that IF they are going to cut their dividends, they do it before I purchase their stocks. If I can get a deal on the price and still make 3% or more yield I won't be complaining.
03/16/09 13:22:44

0xCC wrote:

Well CF, you have about 2 and a half months to make a purchase in that case. I suspect the banks won't announce any changes in their dividend until the next quarterly earnings. It seems like the banks have decided that raising capital by issuing preferred shares rather than holding onto capital by cutting their dividends. I think that the chances of a dividend cut have gone down a lot now (even though it was at a fairly low level in the first place).
03/16/09 13:31:32

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