Wednesday, November 26, 2008

BMO Q4 2008 Earnings

  
TD Securities, 26 November 2008

Event

Yesterday BMO reported core cash FD-EPS of C$1.00 (including C$0.19 increase in General Allowances) versus TD estimate at C$1.10 and consensus of C$1.07.

Impact

Slightly Positive. BMO delivered a decent bottom-line number (relative to recent fears) with a steady result in its domestic P&C operations, but was helped by lower taxes and strong trading results offsetting a material pick-up in credit costs. The bank remains well capitalized, and maintains a healthy dividend. Going forward the bank continues to face slippage in its credit book/mix and managing down some specific exposures. We see upside across the group, but think there are stronger names than BMO.

Details

Domestic holding in reasonably well. BMO’s domestic P&C operations continue to make progress and delivered a steady quarter amid a challenging environment. We continue to believe the worst is behind us, but building on the progress will be a challenge as the environment slows and competition tightens. In particular, we believe the bank has much work to do in accelerating its residential mortgage business.

No longer the clean credit bank. BMO has historically been viewed as a high quality credit bank. That image appears to be diminishing with continued sizeable growth in impaired loans (largely in the bank's U.S. credit book). Further, despite rising PCLs, the bank’s reserve levels are eroding, setting up the risk of higher costs in the coming quarters. Finally, credit cards, commercial and wholesale loans (typically higher risk credits) are leading the bank's loan book growth, suggesting a potentially higher risk mix going forward.

Ongoing risks/exposures. BMO was forced to take another mark on its Apex/Sitka exposure this quarter and current values seem to suggest the bank is underwater on its loans in support of its SIVs. Management maintains that the risk of realized losses is remote on both fronts. Nonetheless, they remain lingering issues for us in an unsettled market, fixated on capital levels.

Conference Call Highlights

Guidance. On the back of uncertain market conditions, management did not provide an outlook for 2009, but provided medium term guidance of +10% average EPS growth per year, ROE between 17-20%, cash operating leverage of at least 2% and maintaining a strong regulatory capital position.

Dividends. Dividends were unchanged at C$0.70 per share and management indicated future dividend growth near term is unlikely given market conditions and that BMO is currently operating above their dividend payout ratio target of 45-55%

Apex/Sitka. The bank recorded pre-tax losses of C$170 million on two exposures to the restructured conduits on MTM, however management views the chance of actual losses as remote given the performance of the underlying credits and structure/subordination in the structure.

SIVs. In Links, total senior notes outstanding and BMO's liquidity outstanding total US$7.6 billion while underlying asset fair values equal US$6.8 billion implying that at today's prices the protection from capital notes has been eroded. Over the coming 6 months, the bank's exposure is expected to grow to C$6.7 billion (effectively replacing the remaining senior notes). Management maintains that the underlying assets are sufficient to repay their loans at maturity and has not taken any marks or reserves against the bank's exposures.

Q4/08 Segment Highlights

Canadian P&C. A steady quarter with good revenue growth offsetting investment driven expense growth and higher credit costs. Margins were up 8bps year over year driven largely by interest collected on a tax refund. Volume growth was good (AIEA +6% year over year). However, growth is being driven by cards (+14%) and personal loans (+21%) and commercial lines in lieu of residential mortgages where growth was nominal. This is helping a higher margin mix, but should carry higher credit costs. In our view, invigorating the mortgage portfolio remains a key focus for 2009.

Private Client Group (PCG). Ex-items the group was down marginally year over year on softer revenues with total assets down 3% year over year and AUM down 6% with ongoing investment driven expense growth. U.S. P&C. Struggles continue here with modest Net Income of C$25 million. Recent acquisitions are helping to offset margin pressure in driving revenue growth, but NIX rose materially (even ex-items). A small portion of the overall earnings picture, it remains difficult to see how the bank's U.S. retail platform (inclusive of PCG and portions of Capital Markets) can be a meaningful driver.

Capital Markets. Another strong trading quarter (totaling C$496 million versus a Q4/07 loss of C$150 million) helped offset the expected weakness in some core wholesale businesses along with higher NIX and PCLs. We continue to note strong loan growth with balances +17% year over year and almost 9% asset growth (reflecting in part the weaker C$). While potentially profitable given the opportunity for wider margins, it does suggest heightened credit risk given the challenges the bank is facing in its U.S. credit book.

Credit. We are concerned about the deterioration in BMO's credit profile. Impaired loans jumped materially, while reserve builds were relatively modest, driving a decline in coverage ratios. Combined with what we view as a slightly higher risk loan growth mix (cards, personal loans, commercial and corporate) we continue to expect elevated PCLs through the coming year.

Capital. Notwithstanding some hits on the quarter, the bank remains well capitalized in our view at 9.77% at the end of Q4/08 (Exhibit 2) and BMO maintained its healthy dividend payout.

Outlook

We have revised our 2009 estimate down to C$4.25 (from C$4.60) reflecting primarily increased PCL costs and inline operating results from P&C.

Justification of Target Price

Our target price reflects our estimate of equity fair value 12 months forward based on our views regarding sustainable ROE, growth and cost of equity (implying a P/BV of 1.7x).

Key Risks to Target Price

1) Additional losses or write-downs from key risk exposures 2) significant competition in the Chicagoland market and 3) adverse changes in the credit markets, interest rates, economic growth or the competitive landscape.

Investment Conclusion

We see upside across the group, but in our view, we believe there are stronger names than BMO.
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Financial Post, David Pett, 26 November 2008

Bank of Montreal says its dividend is safe for now, but the Street isn't 100% sure that investors can count on the current payout down the road.

"BMO has a higher dividend payout ratio than peers and, if the economic slowdown proves deeper and longer than we expect, BMO has less flexibility, in our view, to maintain its dividend," said RBC Capital Markets analyst Andre-Phillipe Hardy in a note to clients, following Bank of Montreal's fourth quarter results.

In addition to reporting a 24% year-over-year increase in profit during the quarter, the bank reaffirmed to shareholders its 70¢ quarterly dividend, but also said it is unlikely they will see a dividend increase any time soon.

Mr. Hardy noted that Bank of Montreal's capital ratios are high, and it may need to strengthen capital. If it does, the analyst said he believes the bank would prefer to continue raising non-common equity as opposed to cutting the dividend or raising common equity.

"The bank's high dividend payout target of 45% to 55% means that its dividend burden would be higher than other banks if it issued more common shares," he wrote.

"For BMO to cut dividends, we believe that its earnings power would have to be threatened and/or equity capital would be needed to a degree that the increase in shares outstanding would make the quarterly dividend payment too large to support from income."

John Aiken, analyst at Dundee Capital Markets, echoed some of these thoughts, also telling clients in a note that he doesn't anticipate a dividend cut in the coming quarters. That is unless "the domestic economy deteriorates to a significantly greater degree than we forecast."

The Dundee analyst said Bank of Montreal's capital remains strong. While the bank will not likely need to raise additional common equity, he added that a dividend increase is out of the question for now, given the earnings headwinds facing the company.
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Financial Post, Eoin Callan, 25 November 2008

Bank chiefs on Bay Street are urging Ottawa to commit to making a major injection of cash into the economy to help stem a rising tide of bad loans, after internal bank figures showed Canadians were increasingly struggling to make payments on money they've borrowed.

Bill Downe, chief executive of BMO Financial, said strong and timely fiscal stimulus was needed from government, arguing it would be "positive for employment" and facilitate "constructive investment," while reviving growth for banks.

The appeal came as BMO Tuesday provided the first granular picture of Canadians' borrowing habits since the credit crisis developed into a full-blown economic crisis, revealing a sudden spike in credit defaults.

Figures from the bank's own books showed bad loans had already exceeded the peak reached in 2001 after the dot-com crash and were on the way to hitting levels not seen since the last recession almost two decades ago.

BMO said the amount of loans that had become impaired had jumped to $2.4-billion this year from $720-million last year, as it Tuesday jacked up the stash of cash it sets aside to cover credit losses to $1.1-billion.

Mr. Downe said he expected the value of loans sought by Canadians to drop "in the first half of 2009" amid rising borrowing costs, undermining one of the last areas of profit growth for banks buffeted by market turmoil.

While the executive expects the business environment to worsen after Christmas, he said in an interview that the economy, and banks' fortunes, could be turned around by the second half of next year if Ottawa and Washington acted decisively.

The demand for government intervention underlines the extent to which the banking system is counting on policymakers to jump start growth at a time when many financial institutions are being forced to conserve cash and scale back their ambitions.

The success of policymakers in halting an economic decline and staving off an unprecedented increase in consumer and corporate loan defaults is of great financial importance to BMO.

The bank is enmeshed in a complex web of investment vehicles with more than $35-billion in exposure to credit markets that are largely held off-balance sheet.

The investment portfolios are under duress because there is no appetite in the current environment to trade the holdings -- which include corporate bonds and mortgage backed securities -- thereby forcing BMO to commit to providing tens of billions in liquidity.

Executives argued Tuesday that their strategy of keeping the vehicles on life support with bank cash was proving manageable and that they could shield the bank from major losses and recover value for their clients by holding the assets until maturity.

But this strategy depends on repayments of the underlying loans to corporations, credit card holders, and homeowners in the U.S. and Canada holding up at a level roughly in line with other downturns in history.

By taking this approach, BMO has slowing won back a measure of confidence from investors that were initially spooked by the exposures, easing they way for the bank on Tuesday to seek up to $250-million in capital in the form of recallable preferred shares.

The bank sought to raise the funds even after it showed Tuesday it had managed to preserve capital and maintain earnings in the fourth quarter. The bank's pool of reserves dipped only slightly as it delivered a steadier performance than its larger rivals on Bay Street, despite recording a $500-million loss on investments in international credit markets.

"Capital remains strong," said John Aiken, an analyst at Dundee Capital Markets, adding that a 24% rise in quarterly earnings to $560-million was "much stronger than we had anticipated."

BMO's core capital held at a level above TD and Royal Bank of Canada, despite a slip to 9.7% from 9.9%, meaning the bank holds just under $19-billion of reserves to back up about $190-billion of assets judged to face varying degrees of risk.

TD Bank Financial Group on Tuesday finalized an emergency move to top up its reserves, raising an initial $1.2-billion from a mix of institutional and retail investors.

The sale of deeply-discounted shares by TD pulled down its stock price, but will help push its core capital reserves back up to a level of about 9%.
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The Globe and Mail, Tara Perkins, 25 November 2008

Bank of Montreal has stopped setting annual profit goals for the time being because the outlook for the coming year is too uncertain, but executives hope that government spending will lift the economy.

“I think there will be co-ordinated stimulus, and it makes sense. Canada is integrated into the North American economy to a very large extent,” BMO chief executive officer Bill Downe said in an interview Tuesday. “It is very sound economic policy.”

The bank's personal and commercial lending business in Canada is still seeing good numbers, but there is a lag effect, he said. “I think we do have the benefit of a delay in the slowdown, and the slowdown will come I think through the course of 2009 in Canada.”

The level of losses from bad loans will be an issue next year, chief risk officer Tom Flynn said on a conference call.

“Loss performance in the industry and for our bank will depend on how the economy does, what happens to unemployment, what happens to U.S. housing,” he said. “And the environment is a weak one and appears to be getting weaker. We are hopeful that the fiscal stimulus programs that governments are talking about introducing will be introduced and will have some positive impact in mitigating the downward economic trend late next year.”

The U.S. economy is sliding into a deeper recession, and Canada's has fared only modestly better because it has been supported by continued growth in consumer spending, Mr. Downe said.

“It too will face a downturn in coming quarters. Potential for a modest recovery in the second half of 2009 in response to aggressive monetary and fiscal stimulus and some stabilization in the U.S. housing markets could well be delayed until the end of next year,” he said.

BMO met one of its five performance targets for fiscal 2008, obtaining a strong capital ratio. It missed its goals for profit, return on equity, provisions for bad loans, and leverage, as it had cautioned earlier this year that it might.

While some of the bank's rivals have disclosed they will take writedowns in the fourth quarter, BMO was the first to give a full performance picture.

Fourth-quarter profit of $560-million was up 24 per cent from a year ago, and was much stronger than anticipated, said Dundee Securities Corp. analyst John Aiken.

The bank still has risky exposure to areas such as structured investment vehicles, but those have been previously disclosed and did not cause surprises. What was most concerning about the bank's results was a significant increase in its provisions for bad loans, which rose by $314-million from a year ago to $465-million. Less than $200-million of that related to Canada, while $269-million related to the U.S.

“Evidence of credit deterioration is clear,” said RBC Dominion Securities analyst AndrĂ©-Philippe Hardy.

Mr. Downe said the bank is aggressively managing the “watch lists” it keeps on loans that could potentially cause trouble, and is focused on maximizing its recoveries.

Royal Bank of Canada said Monday its provision for credit losses nearly doubled from the previous quarter, to about $620-million, and that its profit had fallen about 15 per cent from a year ago to $1.1-billion.

BMO issued $150-million of preferred shares Tuesday, a move that will help pad its already-strong capital levels.

In an interview Monday, Toronto-Dominion Bank CEO Ed Clark said he thinks the market is too focused on capital levels and it would be better for banks to put some of that money to work by lending.

Mr. Downe appeared to disagree. “In this environment, strong capital ratios give you the ability to be the decision maker about what happens next,” he said.
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