Monday, August 21, 2006

TD Newcrest Preview of BMO Q3 2006 Earnings

TD Newcrest, 21 August 2006

Bank of Montreal will be reporting its Q3/06 results on Tuesday, August 22, 2006. We are expecting EPS of $1.20, just below consensus of $1.21, and below $1.24 earned last quarter.


Neutral. ‘Stuck in the Mud’ is how we described BMO’s Q2/06 results. We remain uncertain of BMO’s strategic direction and expect 2007 earnings growth to be modest relative to its Canadian peers.


P&C Canada

Total retail banking results in Q2/06 were weak, with cash earnings of $294 million, versus $308 million in Q1/06 and $303 million in Q2/05. Solid asset growth (average assets increased 9% year over year), was offset by margin compression. Margin compression reflected aggressive loan pricing, particularly in mortgages, as the bank lowered rates to defend declining markets share earlier this year. Although we believe NIM pressure will be limited this quarter (as rationality appears to have returned to the domestic loan-pricing environment), management has indicated that it intends to defend market share vigorously.

P&C Chicagoland results were also weak, with cash net income of US$28 million down 20% sequentially and 7% year over year. The decline was driven by higher expenses to upgrade the branch technology platform. Also, increasing competition in the Midwest and a flattening yield curve environment compressed NIM’s further. We are anticipating this trend to continue in Q3/06 (consistent with what the US mid-west banks have recently reported).

Investment Banking

Investment banking results helped boost earnings in Q2/06. The group reported cash net income of $245 million versus $229 million in Q1/06 and $173 million in Q2/05. Trading was the key driver in the improvement year over year reflecting favorable trading conditions and increased client activity in energy markets. A repeat performance is unlikely in Q3/06 due to a combination of seasonal factors (i.e. summer months) and very difficult market conditions. Also, preliminary estimates indicate that investment banking activity has slowed.

Justification of Target Price

Our $66.00 target price is a product of adding 90% of our fundamental target price to 10% of our acquisition value. Our fundamental target price of $66.00 is calculated by adding 50% of the $63.65 value derived from our 2007 P/E valuation of 12.6 times, to 50% of the $66.60 value derived from our 2007 price-to-book valuation of 1.84 times. Our acquisition model derives a BMO acquisition value of $78.75.

Key Risks to Target Price

We believe that the four key valuation risks specific to BMO that may prevent the stock from attaining our target price are: 1) unfavourable interest rate changes; 2) the competitive environment in the United States constraining Harris Bank’s profitability; 3) the bank making a larger than expected U.S. acquisition at premium valuation multiples; 4) the Conservative government stating they will not permit mergers and 5) a deterioration in the credit environment.

Investment Conclusion

BMO surprised the market in Q2/06 by increasing its payout target ratio to 45-50%, and significantly increasing its dividend 17% to $0.62. While a positive for investors seeking increased yield, we believe this action is more an indication of the bank’s limited growth alternatives, or unwillingness to pursue acquisitions at existing prices.

We believe tangible organic growth opportunities for BMO may be limited, as the bank has completed a cost reduction strategy, and market share losses in its retail bank have cut deep, as management attempted to defend declining market share.

What will perhaps be most interesting will be the conference call. We were somewhat disappointed to see the head of Harris bank be transferred to head the P&C Canada operation, and an individual with seemingly little recent US retail banking experience move to head Harris. A glimpse into their planned strategies would be useful. We reiterate our HOLD recommendation and $66.00 target price.