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Inside the Market’s roundup of some of today’s key analyst actions

Citibank analyst Maria Semikhatova downgraded Canada’s five biggest banks to “neutral” after a lackluster fiscal fourth quarter earnings season that wrapped up earlier this month. Previously, the analyst had “buy” recommendations for Royal Bank of Canada, Toronto-Dominion Bank, Bank of Nova Scotia, Bank of Montreal and Canadian Imperial Bank of Commerce.

The downgrades, based on her expectations that the stocks will deliver returns of less than 15 per cent (including dividends) over the next 12 months relate to a number of headwinds that are buffeting the entire sector: Competitive mortgage pricing in Canada and the impact of lower U.S. interest rates are compressing loan margins (or net interest margins); commercial loan growth is expected to slow on both sides of the border; and rising consumer insolvencies in Canada are leading to rising provisions for credit losses.

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Ms. Semikhatova expects that these headwinds will weigh on bank profits in 2020 and 2021, making the stocks less attractive relative to their expected returns.

“Historically, performance of the Canadian bank shares correlated with 1 year forward EPS [earnings per share] and profitability outlook. Given muted EPS growth expectations (2% in 2020 and 4% in 2021) and further pressure on profitability (ROE at 14.1% in 2020 and 13.8% in 2021) we downgrade the sector to Neutral. The forecast decline in returns is driven by revenue and asset quality headwinds,” she said in a Dec. 16 note.

The analyst also examined each bank specifically. It’s not all gloomy.

Bank of Montreal: Ms. Semikhatova raised her earnings estimates by 2-3 per cent for 2020-2021, based on lower costs, after the bank announced a fourth quarter restructuring. She also raised her target price to $108 form $105 previously. But she believes that the stock is fairly priced, given an expected total return of 8.5 per cent.

“Given a leading market share in Canadian corporate lending, we expect the bank to be affected by expected slowdown in corporate lending in Canada and the US and NIM compression following the rate cuts in the US. Moreover, credit risks are on the rise with steady increases in impaired loans,” she said.

CIBC: She lowered her earnings estimates by 3 per cent for 2020-2021, because of higher expected costs at the bank. She also cut her price target to $113 from $115 previously, and expects a total return of 8.5 per cent.

Royal Bank of Canada: The analyst lowered her earnings estimates by 1-2 per cent for 2020-2021. She maintained a price target of $113, which implies a total return of 13 per cent.

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Scotiabank: She lowered her earnings estimates by 2-4 per cent for 2020-2021, and maintained a price target of $80, implying a total return of 11.9 per cent.

Toronto-Dominion Bank: Ms. Semikhatova lowered her earnings estimates by 4 per cent for 2020, based on higher provisions for credit losses and a revised IDA (insured deposit agreement) with Charles Schwab after the U.S. financial giant struck a deal to buy TD Ameritrade (in which TD has a large stake). She reduced her target to $78 from $82 previously, implying total returns of 10.5 per cent.

“TD is one of the nimblest and fastest-growing players in the Northeast U.S. and one of most customer-centric banks both in Canada and the US. However, we see near-term headwinds for TD from the rate cuts in the U.S., zero commissions introduced by TD Ameritrade and revised IDA agreement,” she said.

Separately, DBRS noted Monday that large Canadian banks have been ramping up their exposure to non-investment grade borrowers at a relatively brisk pace over the past five years, subjecting the banks to greater risk if there is a severe economic downturn.

The credit-rating agency said in a note that non-investment grade loans now represent 50 per cent of the banks’ aggregate loan portfolios, up from 43 per cent in 2014. The numbers are based on an analysis of the large banks’ corporate and commercial loan portfolios through the fourth quarter of 2019.

This remarkable shift follows a period of low interest rates and a benign credit environment, which pushed the banks in search of higher yields.

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“The trends indicate that non-investment-grade loans are growing at a faster pace (11 per cent) than investment-grade loans (7 per cent),” DBRS said in a note.

There are mitigating factors at work here, though. The key one: The banks have been diversifying their loan base from cyclical sectors such as commodity producers toward finance, healthcare and education.

“Although this diversification is a mitigating factor, we believe that the banks’exposure to non-investment-grade loans could pose a risk in the event of a severe economic downturn as these borrowers could face greater challenges in rolling or paying down their debt versus their invest-ment-grade peers,” DBRS said.

DBRS added: “Furthermore, recognizing the risk associated with the growing proportion of non-investment-grade lending and overall growth of these loans, the Office of the Superintendent of Financial Institutions recently increased the Domestic Stability Buffer for domestic systemically important banks citing the growth in corporate indebtedness as one of the key systemic vulnerabilities to the Canadian financial system.”

**

Citibank’s global commodity team is relatively bearish on zinc and iron ore for 2020, but relatively bullish on alumina, copper and coking coal. The outlook means that analysts are optimistic about Canada’s Teck Resources Ltd., a dismal performer in 2019 with a 22 per cent decline in US-dollar terms.

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Citibank analyst Alexander Hacking upgraded Teck to “buy” from “neutral.” He also raised his price target on the stock to $27 from $25.

“We acknowledge that the first quarter of 2020 might be difficult with coal production weighted to the second half of the year and an updated QB2 [Quebrada Blanca Phase 2 project, a copper mining being built in Chile] capex budget, but believe this is well understood by the market,” Mr. Hacking said in a note.

But he sees potential in a number of areas.

One, the price of met coal is 30 per cent below recent averages, despite potential seasonal outages in Australia and Chinese demand growth over the medium term. Two, the analyst likes Teck’s longer-term exposure to copper. Three, the reasons for the positive sentiment that had driven bullish sentiment toward the stock at the start of 2019 are still in place: The sale of copper project could raise value and its Neptune terminals in British Columbia will reduce coal costs.

Yet, the analyst argues that the stock trades at just 0.7-times net asset value (based on on US$140/t met coal, US$3.40 copper and US$1.00 zinc). His upgraded target price implies that the valuation can improve to 0.9-times NAV.

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British American Tobacco’s efforts to shift away from the status quo of a traditional tobacco company and to quicken decision making won the company a rare double upgrade from Bank of America Global Research.

The brokerage raised its rating to “buy” from “underperform” - its first-ever double upgrade for BAT - citing reduced near-term U.S. regulatory risk and a more favourable competitive vaping environment for the Newport and Dunhill cigarette maker.

“The company is taking the right actions, shifting away from the status quo of a traditional tobacco company, recognizing the challenges faced in NGPs (new generation products) and implementing the right strategic decisions to compete more effectively in the new fast-evolving world of tobacco,” analyst Mirco Badocco wrote in the note.

BAT’s shares rose as much as 5% to 3,198 pence in morning trading after BofA also raised its share price objective to 3,400 pence from 2,500 pence.

Badocco also cheered Chief Executive Officer Jack Bowles’ moves to slim down the company, including removing duplicate processes and 20% of its senior managers and consolidating brands within its new generation products (NGP) portfolio of e-cigarettes and heat not burn vaping products.

“If implemented in the right way…all of this has a big potential to make BAT much more agile and faster in decision making, which has been a key drag for the company in the fast-changing world of NGPs,” Badocco said.

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Tobacco companies have made huge bets on e-cigarettes to counter declining sales of traditional cigarettes, but alarm bells have been raised over their safety following a spate of vaping-related lung injuries and deaths in the United States.

However, the health fears have made the competitive environment more favourable for BAT, the brokerage said, as rivals such as Altria-backed Juul, which have held a strong lead over BAT for years, scale down marketing investments.

BAT would also see near-term benefits from the U.S. Food and Drug Administration’s moves to delay its decision to reduce nicotine levels and ban menthol cigarettes for at least the next 12 months as it focuses on curbing the vaping crisis.

A ban on menthol products, especially, would be damaging for BAT as it controls 55% of the U.S. menthol market from which it makes 60% of its U.S. revenue, Badocco said.

The current average analyst rating on the stock is “buy,” with a median analyst price target of 3,600 pence, according to Refinitiv data.

**

Power Corp. of Canada and Power Financial Corp. shares surged on Friday after the companies announced a plan to simplify the ownership and management structure of the complex financial conglomerates. More gains are coming, according to CIBC analyst Paul Holden.

Mr. Holden raised his recommendation on Power Corp. to “neutral” from “underperformer.” He also raised his 12-month target price to $36 from $33. For Power Financial, the analyst maintained a “neutral” recommendation on the stock but raised his price target to $38 from $34 .

The changes follow a remarkable announcement on Friday. The co-chief executive officers of Power Corp., Paul Desmarais Jr. and André Desmarais, will step down. Jeffrey Orr, currently the president and CEO of Power Financial, will become president and CEO of Power Corp. As well, Power Corp. will gain full control of Power Financial (it now has a 64 per cent ownership stake), boost the quarterly dividend by 10 per cent and buy back shares.

“Collapsing the Power Financial holding company structure is a win for both PWF and POW shareholders. It will result in cost efficiencies, with combined corporate expenses expected to come down $50-million and combined financing costs down $15-million. The transaction will also simplify the structure for investors and improve liquidity,” Mr. Holden said.

The key question now: What is the appropriate discount for Power Corp. shares, which have traditionally traded at a large discount to net asset value (NAV) because of the complex structure?

“The trading discount to NAV could narrow over time if POW is able to find additional efficiencies, as it grows management fees from building a third-party AUM [assets under management] business, and value creation from its investments in additional financial services companies,” Mr. Holden said.

For now, Mr. Holden is using a discount of 18.9 per cent, which is based on the five-year discount for Power Financial. The discount could narrow though, which provides an upside scenario for the stock: There have been times when Power Financial’s discount was between 8 per cent and 12 per cent.

The various subsidiaries offer potential value creation, too, especially at Great-West Lifeco Inc., the insurance company.

“We expect GWO to make a number of bolt-on transactions in the U.S. retirement plan administration space. We would view probability of success with such bolt-ons as high, but financial impact as low. The other destination for capital is U.S. asset management. We would view potential financial impact as high, but integration risk is also higher,” Mr. Holden said.

**

Citigroup analyst Keith Horowitz upgraded Goldman Sachs Group to “buy” from “neutral”, believing the investment bank is in a better position than other banks with the Federal Reserve committing to keeping interest rates low.

“We see favourable risk/reward at the brokers given their lack of interest rate and credit risk, and would likely instead see earnings upside if an accommodative Fed spurs capital markets activity,” CNBC quoted Mr. Horowitz as saying in a research note.

He hiked his price target to US$255 a share from $220.

With a file from Reuters

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