There are a lot of things to like about Bank of Montreal (NYSE:BMO), including its relatively solid credit quality, its strong dividend and its willingness to look outside of Canadian retail and commercial banking for future growth. What's not to like, though, is the relatively stagnant near-term performance, the weakening credit metrics and the weakening margins in both the American and Canadian operations. Although Bank of Montreal looks undervalued on the basis of its likely future returns on equity, investors considering these shares ought to appreciate the relatively bearish sentiment out there and be ready to wait to see value.

Investopedia Broker Guides: Enhance your trading with the tools from today's top online brokers.

Earnings Quality a Little Wobbly
Before diving into BMO's earnings report, it's important to mention that it's commonplace to make adjustments to the reported results, but that no two analysts will necessarily make the same adjustments. While the conclusions should be directionally similar, the actual numbers may vary a bit.

BMO saw what looked like strong year-on-year revenue growth, but that was boosted by the acquisition of Marshall & Ilsley. Sequentially, revenue fell 4% as net interest income dropped almost 10% on a 20 basis point contraction in net interest margin. Expenses were down a bit on a sequential basis, but pre-provision earnings were soft.

What concerns me a little more, are the changes in credit metrics. Gross impaired loans increased about 7% sequentially, with net impaired loans up about 5%. Likewise, charge-offs showed a meaningful sequential increase, particularly in the United States ops. On a more positive note, the bank did see about 11 cents of recoveries from M&I's impaired loan book, and I would expect more of this in the future.

SEE: Analyzing An Acquisition Announcement

Non-Banking Doing Pretty Well
Although about half of BMO's earnings come from Canadian banking, management has been trying to grow its ancillary businesses for some time. That diversification paid off this quarter, as the company's banking operations were actually the drag on total results.

Canadian banking earnings were basically flat on a sequential comparison, while earnings from the U.S. operations declined about 10%. BMO's capital markets, though, saw 14% sequential growth, while the private client business posted about 9% sequential growth.

SEE: Banking: Introduction

A Slower, but More Sustainable, Path?
The differences between the Canadian and U.S. banking systems are pretty remarkable in many respects. While many in the U.S. still work themselves into breathless tizzies over the thought of "too big to fail," about 90% of Canada's retail deposits reside within just six banks. The flip side of this concentration has been a tighter and generally more restrictive lending environment - a lending environment that has largely avoided nationwide bubbles.

Canada's banks never courted oblivion like so many of their American peers and they don't offer the same recovery play or overall growth potential. Likewise, growth for many Canadian banks means expanding beyond Canadian retail banking.

Bank of Nova Scotia (NYSE:BNS), for instance, has built up a pretty impressive Latin American banking business, with a sizable exposure to markets like Mexico. For BMO, it's about the capital markets and expansion in the U.S. Likewise for Toronto Dominion (NYSE:TD), which actually has more branches in the U.S. than in Canada.

Of course, these ventures don't always go to plan - Royal Bank of Canada (NYSE:RY) opted to retreat from the U.S. banking market and sold its operations to PNC (NYSE:PNC) after about a decade of actively building the business.

SEE: Earning Forecasts: A Primer

The Bottom Line
While Canada hasn't seen a nationwide housing crisis like the U.S., there are nevertheless plenty of concerns about the operating environment in Canada. In particular, it seems like the worry d'jour is that the increasing competition for mortgage loans and simultaneous competition for deposits is going to significantly narrow margins and place even greater reliance on those external business ventures for ongoing growth.

With nearly half of the company's profits are still based in Canadian banking, that's not a trivial risk for BMO shareholders. That said, the Big Five banks have usually been relatively smart about not competing away all of their profits. To that end, while I do not believe that BMO is going to see significant improvements in ROE over the next five years, more or less holding the line would suggest that the shares ought to trade in the high $60s or low $70s. Couple that with a solid dividend yield and these aren't bad shares to consider for generally conservative accounts.

Use the Investopedia Stock Simulator to trade the stocks mentioned in this stock analysis, risk free!

At the time of writing, Stephen D. Simpson did not own shares in any of the companies mentioned in this article.

Related Articles
  1. Stock Analysis

    Analyzing Altria's Return on Equity (ROE) (MO)

    Learn about Altria Group's return on equity (ROE) and analyze net profit margin, asset turnover and financial leverage to determine what is causing its high ROE.
  2. Investing News

    Icahn's Bet on Cheniere Energy: Should You Follow?

    Investing legend Carl Icahn continues to lose money on Cheniere Energy, but he's increasing his stake. Should you follow his lead?
  3. Stock Analysis

    Analyzing Google's Return on Equity (ROE) (GOOGL)

    Learn about Alphabet's return on equity. How has its ROE changed over time, how does it compare to its peers and what factors are driving ROE for the company?
  4. Investing News

    Is Buffett's Bet on Oil Right for You? (XOM, PSX)

    Oil stocks are getting trounced, but Warren Buffett still likes one of them. Should you follow the leader?
  5. Stock Analysis

    Tech Stocks Vs. Financial Stocks in 2016

    Consider the arguments for allocating more of your investment portfolio to either the technology sector or the financial sector for 2016.
  6. Stock Analysis

    The Top 5 Financial Penny Stocks for 2016 (CPSS, ASRV)

    Learn about some of the most promising penny stocks in the financial services sector that investors can consider adding to their portfolio for 2016.
  7. Investing News

    Chipotle Served with Criminal Probe

    Chipotle's beat muted expectations and got a clear bill from the CDC, but it now appears that an investigation into its E.coli breakout has expanded.
  8. Stock Analysis

    Analyzing Sprint Corp's Return on Equity (ROE) (S)

    Learn about Sprint's return on equity. Find out why its ROE is negative and how asset turnover and financial leverage impact ROE relative to Sprint's peers.
  9. Stock Analysis

    Why Alphabet is the Best of the 'FANGs' for 2016

    Alphabet just impressed the street, but is it the best FANG stock?
  10. Investing News

    A 2016 Outlook: What January 2009 Can Teach Us

    January 2009 and January 2016 were similar from an investment standpoint, but from a forward-looking perspective, they were very different.
  1. How can insurance companies find out about DUIs and DWIs?

    An insurance company can find out about driving under the influence (DUI) or driving while intoxicated (DWI) charges against ... Read Full Answer >>
  2. How do dividends affect retained earnings?

    When a company issues a cash dividend to its shareholders, the retained earnings listed on the balance sheet are reduced ... Read Full Answer >>
  3. What is the difference between called-up share capital and paid-up share capital?

    The difference between called-up share capital and paid-up share capital is investors have already paid in full for paid-up ... Read Full Answer >>
  4. Why would a corporation issue convertible bonds?

    A convertible bond represents a hybrid security that has bond and equity features; this type of bond allows the conversion ... Read Full Answer >>
  5. How does additional paid in capital affect retained earnings?

    Both additional paid-in capital and retained earnings are entries under the shareholders' equity section of a company's balance ... Read Full Answer >>
  6. What types of capital are not considered share capital?

    The money a business uses to fund operations or growth is called capital, and there are a number of capital sources available. ... Read Full Answer >>
Trading Center