Beneath The Surface, Bank Of Montreal Not So Strong

By Stephen D. Simpson, CFA | December 05, 2012 AAA

Bank earnings are admittedly foggy at the best of times, and it only gets worse when the size of the bank in question increases. That said, Bank Of Montreal (NYSE:BMO) increasingly looks under pressure when it comes to core growth. With Canada potentially facing a housing crunch of its own and BMO's assets in the United States still underperforming, shareholders ought to ask themselves if the discount in BMO's price really compensates them for the risks.

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A Good Fiscal Fourth Quarter ... or Was It?
The BMO certainly delivered pleasing headline numbers for the fiscal fourth quarter. Total revenue rose more than 9%, adjusted revenue rose 7% and adjusted net income rose 25%, as reported earnings trounced expectations by more than 15%.

All of this may not be as good as it seems, however. BMO saw its reported results boosted by lower taxes and accelerated recoveries at M&I (the troubled Wisconsin-based bank that BMO bought in 2011). While BMO was still a few pennies ahead of the sell-side even after those items, there were still some changes in actuarial assumptions and portfolio holdings that helped results. What's more, a big increase in trading (a volatile business) added much to the quarter.

Core Banking Looking Iffy
On the banking side, Canadian banking profits were flat, as higher loan volume and fees were offset by lower net interest margin. While loans did increase 2.4% sequentially, the Canadian net interest margin shrank seven basis points (BPS) sequentially (and 21BPS year over year) to 2.67%. Relative to Royal Bank Of Canada (NYSE:RY) that loan growth was pretty good, but the margin compression is problematic.

U.S. profits fell 16% (15% on an adjusted basis) on weak margins and lower lending activity. Loans were down about 3% sequentially despite an increase in commercial and industrial (C&I) lending. Net interest margin fell 12BPS to 4.26%. While that net interest margin compares well to other regional competitors like U.S. Bancorp (NYSE:USB) and JPMorgan (NYSE:JPM), the loan and deposit growth at BMO's operations is not as impressive, nor is the basic profitability of the operations.

Trading Good, but Mind the Bubble
BMO did see profits from its wholesale banking (trading and other investment bank operations) more than double, and trading was up about 30% sequentially. That's a solid result, but strong trading and i-banking results always have to carry the caveat that these results are erratic at even the best banks.

Looking at BMO's core operations, the retail banking business still concerns me. In Canada, it looks like most investors have moved from denial ("there's no bubble here!") to bargaining ("well, it's just in a few cities, and besides Canada is different!"). Although Canada's regulators have been more aggressive in trying to defuse the situation than the U.S. was, investors shouldn't fully discount the risk that Canada will still need to pass through anger and depression before it's all finished. As the fourth-largest bank, BMO definitely has some risk exposure to this process, though I do believe retail banking in Canada is likely to remain a protected and lucrative business for the long term.

Part of the problem for BMO (and other large Canadian banks) is what they do to supplement their Canadian franchise. Unlike The Bank Of Nova Scotia (NYSE:BNS), which has dived deep into Latin American banking, BMO has built up a franchise of Midwestern banks in the U.S. Unfortunately, while BMO has picked banks with good market share in Illinois and in Wisconsin, these banks have been notable underperformers; Harris Bank has been a long-term underperformer for BMO for a while now. Perhaps some of this is just a timing problem (not many U.S. banks have looked good in recent years), but perhaps competing in the sheltered world of Canadian banking has left BMO's senior management ill-prepared for the mosh pit of American banking.

The Bottom Line
With a stable Canadian franchise and a dividend yield pushing 5%, it's hard for me to really dislike BMO all that much. Yes, I think the company's ventures into the U.S. banking market haven't been some of the wisest picks available, but I believe the price tag involved makes long-term value creation pretty likely. Moreover, while I do so see some risks to Canada's economy from both housing and global commodity trends, I don't think the banking sector is going to replicate the belly flop of its U.S. peers.

With a long-term estimate for return on equity in the mid-teens, I think Bank of Montreal shares could trade up into the high $60s before testing fair value. That's not huge undervaluation, but Canadian banks rarely get all that cheap. BMO isn't my favorite risk-reward idea today, but I don't think BMO shareholders need to jump ship today.

At the time of writing, Stephen D. Simpson owned shares of JPMorgan since 2005.

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