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.

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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.

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