Wednesday, November 28, 2007

BMO Q4 2007 Earnings

RBC Capital Markets, 28 November 2007

Investment Opinion

• Q4/07 core cash EPS of $1.38 were between our expectations of $1.40 and consensus estimates of $1.35, and were up 4% versus Q4/06.

• GAAP EPS were $0.50 lower than core EPS primarily because of large items negatively impacting capital markets and corporate results by $251 million after tax. Those items are operating events, in our view, but we exclude them because their magnitude is such that growth in 2008 would be overstated if we included them in core results.

• Management's 2008 GAAP EPS objective translates into approximately $5.85 to $6.10 on a cash EPS basis. Our 2008E EPS of $5.80 is unchanged.

• Capitalization was stronger than we expected, with the Tier 1 ratio at 9.5% as approximately $10 billion in Canadian residential mortgages were removed from the balance sheet during the quarter.

• Credit trends were not as favourable as in recent quarters, as provisions for credit losses and impaired loan formations both rose, and the bank added to its general reserves.

• Domestic retail earnings were not as high as expected due to net interest income margin pressure, offsetting a better quarter from the U.S. division on expense management.

We expect better risk-adjusted returns from peers' stocks

• We maintain our Underperform rating. We expect BMO's stock to continue trading at a discount to its Canadian banking peers on weaker retail banking growth, more exposure to low multiple wholesale earnings, and more exposure to potential calls on liquidity if the financial services system sees more liquidity contraction. The bank's stock currently trades at 10.0x NTM earnings, compared to the bank peer median of 10.7x

• If the economy remains healthy in 2008 and the U.S. financial services system does not go into a crisis, we would expect the Canadian bank stocks (including BMO) to provide attractive upside, but we do not expect the share price appreciation to occur in the near term given the capital markets and credit overhang in U.S. financial markets. The banks' median forward P/E multiple of 10.7x NTM is below the five year median of 12.4x, which we believe reflects the potential for near term negative earnings surprises and slower earnings growth in 2008.
Scotia Capital, 28 November 2007


• Bank of Montreal (BMO) reported an 8% increase in Q4/07 cash operating earnings to $1.44 per share, better than expected due to tax recoveries and security gains. ROE was very solid at 19.9%.

• Reported cash earnings were $0.89 per share including $0.55 per share in charges and write-downs.

What It Means

• Operating earnings growth (before write-downs) was led by BMO Capital Markets and Private Client Group with P&C Canada earnings growth modest at 4% and credit quality deterioration modest.

• The bank provided additional disclosure on SIVs.

• Tier 1 Capital remains strong at 9.5%.

• Our 2008 earnings estimate remains unchanged at $6.00 per share. We are introducing our 2009 earnings estimate at $6.50 per share. We maintain our 3-Sector Underperform rating on BMO based on expected lower earnings growth, low return on equity versus the bank group, earnings mix (too wholesale reliant) and absence of significant growth opportunities.
Financial Post, Jonathan Ratner, 28 November 2007

There’s a new “lightning rod” at Bank of Montreal, says Credit Suisse analyst Jim Bantis.

The natural gas trading scandal that broke earlier this year and which has cost the bank $860-million has more or less run its course. But concerns about the commodities debacle have been replaced by fears over the bank’s exposure to structured investment vehicles (SIVs).

“Given the uncertainty in the credit markets and ongoing concerns surrounding liquidity for SIVs in particular, multiple expansion is limited near term,” Mr. Bantis notes. “BMO’s current valuation discount of 9.7 times our 2008 earnings per share estimate (compared to peers of 10.7 times) is warranted at this time.”

BMO’s losses on SIVs are just $15-million to date. The bank, which reported its fourth quarter results on November 27, has decided to make available up to US$1.6-billion in senior debt to support its SIVs, which are faced with challenges because of the global credit crunch. Management says the SIVs are backed by high quality assets, and recent asset sales from the SIVs did not come at a big discount.

Mr. Bantis also notes problems in BMO’s domestic retail bank. Despite a record set of annual earnings for Canadian operations, the performance of BMO’s domestic retail franchise dipped in the fourth quarter, with market share losses in personal deposits and residential mortgages.

“Canadian retail banking results took a step back reporting their lowest net earnings for the year at $286 million, well below the trailing four quarter run rate of $312 million,” Mr. Bantis said.

Credit Suisse has a neutral rating on the bank and a $68 target price.
Financial Post, Jonathan Ratner, 28 November 2007

Blackmont Capital analyst Brad Smith reiterated his “buy” rating and $72 price target on shares of Bank of Montreal after encouraging fourth quarter results.

Operating cash earnings per share (EPS) came in at $1.36 compared to $1.33 in the same period a year ealier. While this number was below Blackmont’s forecast of $1.40, it beat the Street consensus by 2¢, Mr. Smith told clients in a note.

He also noted that BMO’s guidance range for 2008 EPS at 10% to 15% exceeded his existing target of 8.1%.

While exposure to asset-backed commercial paper (ABCP) and structured investment vehicles (SIVs) continues to pose a risk for BMO and many other global financial institutions, the Canadian bank’s comments on this exposure reinforced Mr. Smith’s opinion that the downside risk has already been priced-in by the market.
The Globe and Mail, Tara Perkins, 27 November 2007

A downturn in capital markets took a big bite out of Bank of Montreal's latest quarterly profit, but the bank beat market expectations by posting a record year in its domestic consumer banking operations.

The bank, whose stock had been most-battered by the recent credit crunch, kicked off the year-end earnings season yesterday by reporting annual profit of $2.1-billion.

The figure was down 20 per cent from the previous year due to a battery of writedowns that collectively sliced profit by $787-million, after taxes, but still managed to beat earnings forecasts.

“Looking back on the challenges of the last nine months, I take great confidence in the resiliency of our businesses,” chief executive officer Bill Downe said on a conference call. “Charges which related to capital markets, commodities, restructuring and an increase in our general allowance clearly weighed heavily on our reported results in 2007, and despite these conditions we earned a return of 14.4 per cent.”

The market reacted by sending BMO's shares up nearly 5 per cent. The bank made a profit of $1.42 a share, beating Thomson First Call analysts' expectation of $1.35.

Canadian bank stocks were up across the board yesterday, a phenomenon that Edward Jones analyst Craig Fehr attributed to the strength in BMO's retail, or consumer, operations. That's “encouraging to me, because one of the things I'm going to be looking at this quarter, and in quarters to come, is how well banks can flip the switch,” he said. “Capital markets revenues have been driving earnings for some time now. My expectation is that capital markets as a source of earnings are going to slow materially going forward,” he said.

“I think that the market is looking now to say ‘who has got the more defensive retail earnings that we can rely on going forward?' So you see that TD and [Bank of Nova] Scotia are up a little bit more than their peers,” he added.

John Aiken, an analyst at Dundee Capital Markets, said the core earnings momentum demonstrated by BMO in the fourth quarter bodes well for 2008.

It wasn't all roses for the bank's domestic banking division, though. RBC Dominion Securities analyst André-Philippe Hardy points out that spreads dropped to 2.96 per cent in the three months ended Oct. 31 from 3.08 per cent in the previous quarter. The bank attributed that to heightened competition and rising funding costs.

BMO is also still struggling to persuade its customers to park more cash in their accounts. The bank has been using the lure of Air Miles and other incentives in an attempt to increase its personal deposits, an effort that it said “continues to prove challenging.”

Despite the hurdles, profit from the domestic banking division rose 4.2 per cent from a year ago to hit $284-million in the quarter. That compares with a 74-per-cent drop in earnings from the capital markets division, which contributed $48-million.

The quarter was challenging for many investment banks as concerns over asset quality affected liquidity, credit spreads and valuations, the bank noted.

“Activity levels were down from the first three quarters of the year in most product areas.”

Mr. Downe said that “the environment in which [BMO Nesbitt Burns] operates will continue to be unsettled at least for the first half of 2008.” He expects the second half of the year to be stronger than the first.

This past quarter's earnings were walloped by a slew of one-time charges, many of which stem from the credit crunch that's been rippling through financial markets since mid-August.

The items, which had been announced ahead of the quarterly report, include a pretax hit of $169-million because of trading, structured credit-related positions and preferred shares; $134-million related to asset-backed commercial paper; and $15-million related to two structured investment vehicles (SIVs), Links Finance Corp. and Parkland Finance Corp.

BMO wrote down its holdings in some bank-sponsored commercial paper conduits (an $80-million charge), and in third-party ABCP (a $54-million charge) by 15 per cent.

The bank said it is in discussions with a number of counterparties about restructuring its bank-sponsored conduit.

As for the SIVs, BMO disclosed earlier this month that it would participate in the senior debt of the two vehicles up to a maximum of about $1.6-billion. Yesterday it said that it has bought about $1.25-billion of senior notes thus far.

BMO also said that it would take a $25-million writedown on its continuing effort to reduce its commodities portfolio, which has been a thorn in its side since the bank revealed this spring that it would record hundreds of millions of dollars in losses, relating mostly to its natural gas trading operations.

While the bank was unable to meet most of its financial targets during fiscal 2007 due to writedowns, it raised its target for share profit growth for next year to between 10 and 15 per cent from 5 to 10 per cent this past year.

“In our view, the biggest positive in BMO's fourth quarter reporting was its guidance for 2008,” Mr. Aiken wrote.

“BMO, typically known as a conservative bank, particularly when it comes to guidance, is providing for targets that are well above current consensus growth estimates for 2008,” he said. “Consequently, we believe that a more positive outlook for the banks may begin to be priced into their valuations in the near term, particularly if we receive similar targets/guidance from the other banks.”
Dow Jones Newswires, Monica Gutschi, 27 November 2007

Bank of Montreal said Tuesday it is unlikely to follow HSBC Holdings PLC's lead and take the assets held in the two structured investment vehicles it sponsors onto its balance sheet.

"We're not at the present time going through the process" of examining such a move, Bank of Montreal's chief executive, Bill Downe, said on a conference call. He noted the two BMO-sponsored SIVs have a "different universe of assets," among other factors.

Downe noted the assets held in BMO's SIVs are of high quality and said the bank's decision to provide liquidity through the purchase of senior notes "will assist the SIVs in restructuring."

As reported, HSBC became the first bank to bail out its SIVs, announcing it plans to gradually shut them down and take $45 billion in mortgage-backed securities and other assets owned by the funds onto its own balance sheet.

Bank of Montreal sponsors two SIVs - Links Finance Corp. and Parkland Finance Corp. - and had agreed to provide up to $1.6 billion in liquidity support to the vehicles.

It noted in its fourth-quarter earnings report that it has purchased $1.3 billion in the senior notes in order to provide liquidity. Other investors have also provided $1.1 billion in liquidity through the purchase of senior notes.

As well, bank executives said a large number of the assets held in the SIVs have been sold into the market at a relatively small discount. Links now has an asset market value of $18.7 billion, down by $4.0 billion, while Parkland has a value of EUR2.5 billion, down by EUR820 million since late August.

Bob McGlashan, BMO's chief risk officer, noted that no securitization has been downgraded by any ratings agency. He said the weighted average rating on the assets is AA. There is minimal exposure to U.S. subprime mortgages in Links and none in Parklands.

SIVs are structured financial products created to provide investment oportunities in customized, diversified debt portfolios. SIVs have been in trouble since the summer, when the markets for short-term debt, on which SIVs depended, all but dried up. After a brief revival, those markets have deteriorated further in recent weeks.

However, Yvan Bourdeau, head of BMO Capital Markets, said each SIV "has to come up with their own plan for a resolution. We feel that our plan is the proper one."

He also said that, if BMO were to take the SIVs onto its balance sheet, there would be minimal implications for the bank's capital.

In the fourth quarter, the bank took a C$15 million charge for its investment in the capital notes in Links and Parkland, reducing the book value of its capital notes to C$53 million.
Financial Post, Jonathan Ratner, 27 November 2007

Shares of Bank of Montreal traded up on Tuesday morning as investors breathed a sigh of relief after the company kicked of earnings season for the Canadian banks. BMO reported a 20% profit decline in 2007 on credit crunch-related charges. Fourth quarter profits fell 35% to $452-million compared to the same period last year, while full year earnings dipped $532-million to $2.1-billion.

Dundee Securities analyst John Aiken said the fourth quarter results look very solid and BMO’s core earnings momentum bodes well for 2008.

“In our view, the biggest positive in BMO’s fourth quarter reporting was its guidance for 2008,” he said in a note to clients, adding that the bank expects earnings per share growth of 10% to 15%. This was higher than Dundee was expecting, forecasting 10% as a high for all of the Big Six banks. Mr. Aiken expects this will provide positive support for BMO shares, but also the entire group.

“BMO, typically known as a conservative bank, particularly when it comes to guidance, is providing for targets that are well above current consensus growth estimates for 2008,” he said. “Consequently, we believe that a more positive outlook for the banks may begin to be priced into their valuations in the near term, particularly if we receive similar targets/guidance from the other banks.”

Mr. Aiken continues to rate BMO at “market outperform” with a $68 price target.
Financial Post, Duncan Mavin, 26 November 2007

The Canadian banking industry will see a slump in earnings growth in 2008, but the impact will not be enough to force a change to stable ratings outlooks, says Lidia Parfeniuk, an analyst at Standard & Poor’s. With plenty of capital, the banks could even step up their M&A activity in the U.S.

“S&P expects the Canadian banks’ well-capitalized positions to remain unchanged for their risks,” Ms. Parfeniuk says. “The more aggressive M&A activity south of the border should continue as the banks take advantage of the strong Canadian dollar and lower bank stock valuations.”

Despite the strong fundamentals though, earnings could suffer in the current tough banking environment. Revenue will be hit by a decline in capital markets activity resulting from the credit crunch, while loan loss provisions could start to climb, Ms. Parfeniuk says.

“For 2008, our baseline assumption is that revenue growth will slow from the high teens in 2007,” she says.

S&P also forecasts the banks will record further marked-to-market writedowns related to structured products linked to the U.S. subprime mortgage market and non-bank sponsored asset-backed commercial paper in Canada.
Financial Post, John Greenwood, 26 November 2007

Among the numerous commentators holding forth on the mess in asset backed commercial paper (ABCP), there are optimists and pessimists. Then there is Citigroup analyst Shannon Cowherd.

On Monday, Ms. Cowherd published a report predicting that Canada’s big banks could be in line for write downs of a whopping $14-billion as a result of potential losses from their own ABCP.

The market for third-party ABCP seized up in early August after investors started fleeing from exposure to the U.S. subprime mortgage crisis, which came mainly in the form of collateralized debt obligations (CDOs).

The larger bank-sponsored market has continued to function, partly because investors believe the quality of the paper is stronger. But Ms. Cowherd says that’s not the case. Bank-sponsored ABCP is headed for a cliff, and the banks will be on the hook for the losses, she warns.

However, before jumping to any conclusions, let’s look at her argument.

Ms. Cowherd assumes that because Canada’s third-party ABCP is made up of more than 76% of CDOs, the bank sponsored notes must contain a similar proportion. Pegging the total value of the bank-sponsored market at about $100-billion, she estimates there is about $63.8-billion of CDO’s in it. That’s a big number, but observers say it’s wrong.

“This doesn’t sound right at all,” said one analyst who asked not to be named. “The Canadian banks were a whole lot more conservative in their attitude to CDOs”

So what is the real level of CDOs in bank-sponsored ABCP? According to the rating agency DBRS, Ms. Cowherd is way off the mark. In a report that came out in August, DBRS calculated that bank-sponsored ABCP contained only about 9% CDOs. Moreover, it’s restricted to a handful of conduits and clearly identified in information provided to investors.

Ms. Cowherd was not available for comment.