Friday, March 03, 2006

BMO Downgraded at RBC CM & Scotia Capital

RBC Capital Markets, 3 March 2006

We are downgrading our rating on BMO to Underperform from Sector Perform.

Investment Opinion

Vulnerable to Negative EPS Revisions. We are lowering our price target for BMO from $71 to $67, now using a 0.5 point lower target P/E multiple of 13x our revised ’07 cash EPS estimate of $5.15, down from $5.25. We are holding our below-consensus 2006 cash EPS estimate at $4.80, and expect we may see negative EPS revisions as the year progresses. Revenue growth (loan spread in particular) and operating leverage have both deteriorated in Q106, cyclically assisted by trading and loan losses. Our ½ point reduction in target multiple reflects BMO’s lower evident revenue strength, a reduced merger premium likelihood, low relative capital and rising reinvestment risk. BMO confirmed it is actively looking to acquire another small U.S. retail bank.

Q1/06 EPS Beat Consensus But Underlying Earnings Weak. BMO reported $1.24 cash EPS to beat our $1.18 estimate and $1.19 Thomson First Call mean estimate. However, earnings quality was weak. Included was ~ 5¢ from above-normal trading and securities gains as well as a very low loan loss provision. At first glance, sustainable EPS at ~$1.16 was 6¢ below consensus, well below $1.22 expected consensus run–rate for ‘06.

Revenue Growth Slowed to 5%. Overall, core earnings have weakened. BMO generated only 5% revenue growth YoY, compared to BMO’s Q405 at 9% YoY growth. Excluding trading and securities, core revenue grew only 2.5%, now at the low end of the peer group range, well behind the sector leaders. The main culprit was domestic retail spread which dipped 12 bps QoQ (7 bps normalized) and 10 bps YoY to 2.58%, erasing otherwise strong volume (ie. 12% YoY mortgage growth).

Wholesale Trading Drove the Result, Again. Trading revenue at $231MM was up $70MM or 43% QoQ to add an estimated $0.04 on top of the already-strong Q4/05 trading result. Excluding trading revenue, BMO’s Q1 revenue growth was flat YoY and down -8% QoQ, with the weakness driven by loan book spread compression.

Valuation. Our revised $67 price target is set at 13x our $5.15 2007E cash EPS estimate, in line with our sector target P/E multiple. In our view, BMO earnings will reflect solid wealth management, though we are less optimistic about domestic retail banking. Tempering the BMO valuation will be: (i) a rising CAD, and; (ii) potential for a U.S. community bank acquisition and related re-investment and integration concerns. Our price target is indicated at ~2.25x our estimated book value of $29.72 (as at Jan 31/07).
Scotia Capital, 3 March 2006

• We are downgrading Bank of Montreal to 3-Sector Underperform from 2-Sector Perform to reflect the bank's industry low profitability and our continued view that BMO's relative P/E multiple is too high and not sustainable based on the level of profitability, capital, and business mix.

• Our earnings estimates and share price targets are unchanged with BMO having one of the lowest total return expectations of the bank group.

What It Means

• BMO first quarter 2006 earnings produced a return on risk weighted assets (RRWA) of 1.65% (1.51% normalizing trading revenue) the lowest of the major banks versus TD at 2.48%, CM at 1.91%, and NA at 1.81% with RY and BNS expected to beat our expectations of 2.12% and 1.95%, respectively, today.

• Our stock selection in order of preference remains unchanged with TD and RY followed by LB, CWB, NA, BMO and CM. We are restricted on BNS.