Thursday, May 24, 2007

BMO Q2 2007 Earnings

Analysts' ratings and target prices for BMO:

• BMO Capital Markets maintains "market perform," 12-month target price has been raised from $70.00 to $72.00

• Blackmont Capital maintains "hold," 12-month target price is $72.00

• CIBC World Markets raised BMO from "sector perform" to "sector outperform." The 12-to-18-month price target is $78.00

• Credit Suisse maintains "underperform", 12-month target price is raised to $73.00

• Desjardins Securities maintains "buy," 12-month target price is $77.00

• National Bank Financial maintains "sector perform", 12-month target price is $76.00

• Scotia Capital maintains "underperform," 12-month target price is $80.00

• TD Securities maintains "hold," 12-month target price has been raised from $71.00 to $75.00

• UBS reiterates its "neutral" rating, while raising its estimates. The target price has been raised from $75.00 to $76.00.

In a research note published this morning, UBS expects BMO to report mid pack results in the upcoming quarters. UBS notes that BMO has achieved healthy capital results, made progress in P&C and faces positive credit trends. The EPS estimates for 2007 and 2008 have been raised from $5.35 to $5.55 and from $5.70 to $5.92, respectively.
BMO Capital Markets, 24 May 2007

Details & Analysis

BMO Financial Group reported second quarter cash earnings of $668 million, or $1.31 per share, compared to $348 million, or $1.15 per share, in the last quarter, and $652 million, or $1.27 per share in the same quarter of last year. It was, as expected, a messy quarter. This quarter included a portion of the pre-announced commodities trading losses which amounted to $90 million, or $0.18 per share. Also in the quarter were several unusual items - an insurance gain, a gain on securities in the retail bank and a large interest recapture which added about $0.10 per share. Last quarter's earnings (after restatement) were also impacted by the commodity trading losses - by $237 million, or $0.46 per share, as well as by a $88 million restructuring charge that took $0.17 off of EPS.

We believe the appropriate operating comparison is $1.49 per share in this quarter, $1.32 in the last quarter, and $1.27 in the same quarter of last year. We had forecast $1.34, so the results were better than we had expected, reflecting the $0.10 of one-time items, very strong performance in underwriting and M&A, and a better result in the domestic bank.

Canadian Personal and Commercial Banking reported earnings of $327 million, up 11% over the quarter and 24% over the year. This quarter included a $23 million after-tax insurance gain and a $9 million after-tax investment security gain. Exclusive of these items, the domestic bank reported a 12% year-over-year gain. It will be interesting to see if this stands up as good performance in the context of its peers.

Chicagoland P&C earnings have been and continue to be weak. Earnings were roughly unchanged from year-ago levels in US$ terms. It is telling that with half the year now over, 2007 looks like this will be the second year in a row of declining contribution from this business. We see little on the horizon that would justify optimism on the operating fundamentals of this unit.

The Private Client group produced earnings of $102 million, up 6% over the quarter, and in line with our expectations. Slightly slower asset growth was offset by higher fee-based revenue. We believe that this level of earnings should remain roughly stable for the remainder of the year. The contribution from the Corporate Segment was normal at $20 million.

Ironically, the results out of the Investment Banking group were, excluding the trading losses, quite strong. The reported profit of $199 million included $90 million for the net effect of the trading losses and various adjustments. Fee revenue appeared to be at the highest level ever. We expect to see quarterly profits in the $200-$250 million range assuming that there are no further trading losses, and that capital markets activity moderates.

From a credit perspective, the bank's results reflect the strong credit environment. Our concern that recoveries and reversals might start to track downwards was unjustified, and gross and net impaired loans fell over the quarter.

Tier 1 declined slightly in the quarter to 9.7%, from 9.9% at the end of the first quarter, and versus the year end. Tier 1 has declined from 10.2% to 9.7% this quarter, with about half of this arising from the trading loss and the rest from rapid growth in risk-weighted assets, partially offset by the issuance of non-cumulative preferred shares.

There was some additional disclosure on the trading loss, though the bank continues to hedge on the ultimate financial impact of the snafu. Apparently, the commodity portfolio was being 'marked-to-market' by traders daily, with independent monthly valuations confirmed by Optionable. The bank now uses a market-based methodology for valuing the portfolio.

Projections and Valuation

We are raising our 2007 and 2008 operating earnings estimates to $5.65 and $5.95, respectively. The 2007 estimate excludes the impacts of the trading losses in both quarters as well as the restructuring charge taken last quarter. With reported earnings of $1.49 ($1.39 excluding a variety of unusual items) in a seasonally weak quarter, our forecasts are not aggressive.

BMO currently trades at the lowest P/E in the bank group reflecting its below-average ROE and as a penalty for the lack of visibility on the trading losses. The second quarter did include some positive news: retail earnings showed double digit growth, the investment bank has momentum and the balance sheet is strong. We believe that other banks will also display strong year-over-year comparisons and that earnings revisions for Canadian bank stocks as a whole will remain to the upside. We continue to prefer CM, TD and RY at current levels.
RBC Capital Markets, 24 May 2007

Investment Opinion

Core cash EPS of $1.42 were ahead of our $1.36 estimate (consensus of $1.31) on higher than expected revenue in investment banking and, to a lesser extent, domestic retail banking. M&A as well as underwriting activity drove the positive variance in investment banking.

We have raised our 2007E and 2008E core cash EPS by $0.15 to $5.55 and $5.90, respectively, to reflect the positive variance in Q2/07 earnings and greater than previously anticipated benefits from the restructuring charge announced in January 2007. We have bumped up our 12-month target price to $71 from $70 as a result.

Trading losses related to commodities came in as pre-announced ($509 million in the restated Q1/07 results, and $171 million in Q2/07 results) and reported Q2/07 cash EPS of $1.31 include an impact of $0.18 net of taxes and adjustments to performance-based compensation.

Credit losses remained low at $59 million and guidance for 2007 losses was lowered from $325 million to $300 million on "favourable Q2 results and more subtle expected deterioration later in the year."

The earnings would suggest strong capital markets results for the industry (NA is most exposed among banks we cover) while continued low loan losses would most benefit NA and BNS among the banks we cover. The 7% increase in core revenue in domestic banking in spite of market share losses should lead to good results from the stronger domestic banks. TD is most exposed among the banks we cover.

Management quantified expected savings of $300 million from the $135 million restructuring charge announced earlier this year - the number is higher than we would have thought and a portion is expected to flow to the bottom line, whereas we had previously believed most of the savings would be reinvested in revenue-generating initiatives.

We maintain our Underperform rating. BMO trades at 12.6x 2007E EPS, compared to an industry median of 13.1x. We feel that a discount is justified given retail banking challenges in both Canada and the U.S., less room for dividend increases and less earnings coming from retail businesses.
Scotia Capital, 24 May 20007

• Earnings were better than expected due to stronger results from BMO Capital Markets and P&C Canada. Underlying operating earnings were $1.44 per share versus our estimate of $1.33 per share.

• Earnings growth in Q2 was led by BMO Capital Markets and P&C Canada. BMO Capital Markets was up 17%, excluding the impact of the commodity trading loss with P&C Canada earnings growth excluding insurance and investment gains up 12%. Private Client earnings increased a modest 4% with P&C U.S. continuing to struggle, down 4%.

• We are increasing our 2007 earnings estimate to $4.90 per share from $4.75 per share due to the stronger earnings recorded in this quarter. Our 2008 earnings estimate remains unchanged at $5.80 per share.

• Maintain 3-Sector Underperform.
Financial Post, Duncan Mavin, 24 May 2007

Bank of Montreal has engaged a top New York law firm to unravel "irregularities" related to two of the bank's former commodity traders and a brokerage firm that are at the centre of the $680-million the bank lost betting on the natural-gas market.

Lawyers at Sullivan and Cromwell LLP have been asked to investigate the losses that were covered up because the bank's book of natural-gas trades was valued wrongly based on data provided by New York-based Optionable Inc.

One result of the investigation could be possible legal action, BMO chief executive Bill Downe said yesterday.

"Our actions will be informed both by the results of our internal review and the legal review by Sullivan and Cromwell to identify irregularities in trading or valuation," said the BMO chief. "The actions that are within our control will be taken promptly," he added.

The bank first revealed the losses almost four weeks ago--initially estimating the shortfall at up to $450-million--and blamed poor luck in the markets.

But after the National Post reported BMO had hired forensic auditors to investigate its commodity trading business in February, a wider story emerged, centred on former star trader David Lee, his boss Bob Moore, and their relationship with Optionable.

Messrs. Lee and Moore had been making huge profits for the bank during early 2006 and had become the single biggest client for Optionable, a fast-growing commodity broker.

At some stage, the BMO men's luck ran out and their profits turned to massive losses. However, the bank's senior management was unaware of the problems because their star trader's book of trades was based on inaccurate information.

Mr. Downe, who only took over at BMO in March, was speaking yesterday on a conference call for analysts following the announcement of the bank's second quarter earnings.

BMO's year-to-date net income was $1-billion, down 19%, or $238-million from a year ago.

The company's stock closed on the TSX yesterday at $70.20, up $1.32 on the day.

Mr. Downe said it will take six to 12 months for the bank to work its way out of the problem trades and reduce its portfolio to a more appropriate level.

However, as the bank focuses on tightening up controls over its trading activities, its investigation into the losses will likely focus on Optionable.

The New York firm has plunged into crisis since BMO announced its losses. Its stock price has plummeted more than 90%; its biggest shareholder, the New York Mercantile Exchange, has threatened the company with legal action; and the chief executive and chairman of Optionable have both resigned.

It has also emerged that former chief executive Kevin Cassidy -- a close friend of the deposed BMO natural-gas trader Mr. Lee -- spent time in jail for tax and payment fraud in the 1990's.

The National Post also reported last week that Mr. Cassidy had offered traders at other firms stock or warrants in Optionable if they pushed their employers' business the way of his company -- a practice considered highly unethical by many in the industry and which legal experts said could be against U.S. federal and state laws.

Optionable has also been named in a number of class-action lawsuits filed on behalf of shareholders. The suits allege Optionable did not properly disclose Mr. Cassidy's criminal past or the full extent of its relationship with the BMO traders.

Meanwhile, BMO said Canada's top banking regulator, the Office of the Superintendent of Financial Institutions, has been kept apprised of the events surrounding the trading problems.

Mr. Downe acknowledged that lapses in the bank's own risk management processes were partly to blame for the losses and said the bonus pool has been reduced by $120-million.

"With the benefit of hindsight we could have done a number of things better with the managing of this business," Mr. Downe said. "Our commodity trading team did not operate according to standard BMO business practices. Leadership oversight of the business was not as disciplined or as rigorous as it could have been."

The natural-gas trading losses add to a difficult start to life in the BMO hot seat for Mr. Downe. In January, the bank announced it will slash 1,000 jobs.
The Globe and Mail, Tara Perkins, 24 May 2007

The Bank of Montreal's chief executive officer, commenting on recent trading losses, says its commodity trading team didn't operate according to standard BMO business practices, and executives accept responsibility for the "isolated lapses."

Bill Downe said the $680-million trading losses, allocated to the first and second quarters, came after the bank's commodity portfolio was incorrectly valued. The wrong valuations "masked the rapid escalation of risk and the real cost of the positions," he said.

The portfolio contained "an unacceptable level of out-of-the-money options, which by their nature are illiquid, at a time when there was a steep decline in the volatility of gas prices," he said in a conference call with analysts.

BMO is continuing to take "every additional step we deem necessary on behalf of our shareholders, including possible legal action, and any further organizational and personnel changes," he said.

The bank's total trading operations lost $362-million in the first six months of the fiscal year, dragged down by commodities, specifically natural gas. Trading brought in $442-million a year earlier.

Now BMO's efforts to tighten risk controls will mean smaller growth in the trading business, and that revenue will be missed, UBS analyst Jason Bilodeau said in a market note.

BMO was the first big bank to announce second-quarter financial results, and it surpassed expectations despite a hit of $171-million from the trading losses. Lower taxes and lower bonuses for employees mean the final hit was only $90-million. The quarter's profit, reported yesterday, came in at $671-million, up $20-million from a year ago.

BMO allocated most of its trading losses to the previous quarter. First-quarter profit was restated yesterday, lowered by $237-million after taxes and bonus reductions.

The trading loss means BMO will struggle to meet its annual financial targets, the bank said. "With the benefit of hindsight, we could have done a number of things better in the management of this business," Mr. Downe said.

To value its portfolio, the bank had been relying on independent market quotes from a New York-area brokerage firm called Optionable Inc.

BMO is now using multiple sources to value its portfolio, and has hired the prominent Wall Street law firm Sullivan and Cromwell to investigate "possible irregularities in trading and valuation" - including a review of the quotes provided by Optionable.

BMO is no longer doing business with Optionable, and two bank employees in New York - natural gas trader David Lee, and his boss, Bob Moore - are no longer employed by BMO.

The bank is confident its portfolio is properly valued as of April 30, Mr. Downe said. "Having already reduced the risk in this portfolio, we're continuing to reduce the risk every day. And, with each passing day our comfort with the total level of risk is increasing. A fire sale is not necessary and it's not on." He expects it will take six months to a year to draw the portfolio down to the appropriate level of risk.

"In the future in this portfolio we will only engage in the amount of market-making activity required to support the hedging needs of our oil and gas producing clients," he said.

"We're satisfied that these losses were restricted to one business, in one location, during one time period."
Bloomberg, Doug Alexander, 23 May 2007

Bank of Montreal said second-quarter profit rose 3 percent as higher fees from mutual funds and stock sales offset the biggest commodities trading loss for a Canadian bank.

Net income for the three months ended April 30 climbed to C$671 million ($619 million), or C$1.29 a share, from C$651 million, or C$1.25 a share, a year earlier, the Toronto-based bank said today. The stock rose after profit beat some analysts' estimates.

Record mutual fund sales and rising demand for loans contributed to a 24 percent increase in consumer banking profit, countering the natural gas losses. The bank said on May 17 it would report a pretax trading loss of C$680 million, with about 75 percent of that reported in the fiscal first quarter.

``I think it was better than expected in light of the commodity trading loss, but a big portion of that has been shifted to the first quarter,'' said Jackee Pratt, who helps manage C$755 million at Mavrix Fund Management in Toronto.

Canada's fourth-biggest bank expanded trading in natural gas options after prices rose following Hurricane Katrina in 2005. The bank relied on one broker to price contracts as the portfolio grew, resulting in an ``inappropriate level'' of options that lost value when there was a decline in the volatility of gas prices, Chief Executive Officer William Downe said today on a conference call.

``The steep level of loss was largely a result of incorrect valuation of the commodity portfolio, which masked the rapid escalation of risk and the real cost of the positions,'' Downe said. ``Our commodity trading team did not operate according to standard BMO business practices. Leadership oversight of the business was not as disciplined or rigorous as it could have been.''

Bank of Montreal hired New York-based law firm Sullivan & Cromwell LLP for an external investigation into possible ``irregularities'' in trading and options valuation, including prices provided by broker Optionable Inc., Downe said. Two New York-based bankers involved in the trades are no longer with the firm, including Bob Moore, the executive managing director of commodities products, and David Lee, who did natural-gas trades for the bank through Valhalla, New York-based Optionable. A message left with Richard Keating, an outside spokesman for Optionable, wasn't immediately returned.

Downe, 55, said the trading losses haven't reduced the bank's risk ``appetite.'' He said the natural gas portfolio is now ``appropriately'' valued, and that the loss was an ``isolated event.''

``I want to make it clear that there has been no change in our appetite for risk, and I'll repeat that: there has been no change in our appetite for risk,'' he said.

The bank reduced the risk in its commodities portfolio since January, and it may take six to 12 months to draw the portfolio down to an appropriate level, he said, adding the bank won't hold a ``fire sale'' to reduce it. The bank will also scale back its so-called ``market making,'' or buying and selling natural gas contracts.

Bank of Montreal shares rose C$1.32, or 1.9 percent, to C$70.20 at 4:10 p.m. trading on the Toronto Stock Exchange, the biggest gain in two months. The stock is up 1.7 percent this year, compared with a 4.8 percent increase for the nine-member Standard & Poor's/TSX Banks Index.

Bank of Montreal said first-quarter profit was C$348 million, or 67 cents a share, according to restated numbers. That compares with net income of C$585 million, or C$1.13 a share, reported March 1. The total impact of the commodities trading loss was C$327 million, or 64 cents a share, for the first half of the fiscal year.

Bank of Montreal said profit was C$1.31 a share excluding one-time items, an increase of 3.1 percent from a year ago. Profit was boosted by a lower tax rate and insurance gains. The median estimate of nine analysts polled by Bloomberg News was C$1.32 a share on that basis. Blackmont Capital analyst Brad Smith, who rates the stock a ``hold'', said the bank earned C$1.42 a share on that basis, beating his estimate by nine cents a share.

The trading losses will make it harder for the bank to meet its profit target for the year, Downe said. Bank of Montreal said per-share earnings were C$2.13 for the first half of fiscal 2007, a 12 percent drop from a year ago. The bank's annual target is earnings growth of between 5 percent and 10 percent.

``We are now unlikely to meet our performance targets for this year,'' Downe said.

Canadian consumer banking profit rose to C$324 million, topping estimates from UBS Canada analyst Jason Bilodeau. The unit had higher revenue from loans, deposits and credit cards, the bank said. Profit from its Chicago-based Harris Bank unit fell 3.7 percent to C$27 million as the Canadian currency surged 6.2 percent in the quarter relative to the U.S. dollar.

Bank of Montreal set aside C$59 million for soured loans, compared with C$66 million a year earlier.

``Their retail banking operations showed some pretty good improvement in the quarter,'' said Tom Kersting, an analyst at Edward Jones & Co. in St. Louis. ``The fact that the retail banking operations did well -- and they have been struggling quite a bit -- you would assume that the other banks did well in the quarter.''

Profit from its private client group, which includes brokerage and mutual funds, rose 5 percent to C$101 million. Mutual fund sales at the bank, including its Guardian Group of Funds unit, rose 17 percent to C$1.08 billion in the quarter, according to preliminary figures from the Investment Funds Institute of Canada.

Investment banking profit fell 19 percent to C$199 million because of the commodities trading loss. Revenue from underwriting and advisory fees rose 41 percent to C$159 million, the bank said. The BMO Capital Markets investment banking unit managed $1.38 billion in equity sales in the quarter, up nearly threefold from $473.9 million a year earlier, according to Bloomberg data.

``If you can bring yourself to ignore the trading losses, BMO's underlying quarter was strong on capital markets-related activities,'' CIBC World Markets analyst Darko Mihelic said today in a note.

Downe said the bank set a cost savings target of C$300 million, and aims to meet half that amount this fiscal year. The company announced January it would cut 1,000 administrative and head office jobs. About a third of those jobs have been cut, with the rest done by January, Chief Financial Officer Karen Maidment said today on the call.

Bank of Montreal, the first lender to report results, may be the laggard among Canada's six biggest banks in the second quarter. Profit before one-time items will rise on average 14 percent, led by fees from investment banking and trading, Genuity Capital Markets analyst Mario Mendonca said in a note. That would be the slowest profit growth in a year.

The six Canadian bank stocks are trading close to record highs, and profits have risen nine straight quarters. Mergers are running ahead of last year's record pace, increasing advisory fees, while a 30-year-low jobless rate boosts demand for consumer loans and mortgages. The booming economy has pushed the Canadian dollar to a 30-year high against the U.S. currency.