Wednesday, August 25, 2010

BMO Q3 2010 Earnings

  
Scotia Capital, 25 August 2010

Event

• BMO cash operating EPS increased 9% to $1.14, below our estimate of $1.20 and consensus of $1.21. Earnings were lower-than-expected due to extremely weak trading revenue and lower security gains, partially offset by lower than expected LLPs. Operating ROE was 13.9%.

Implications

• Positives for the quarter were credit and strong operating results in core businesses: P&C Canada and Wealth Management (excl. insurance).

• P&C Canada earnings were strong at $428M, up 17% YOY with retail NIM increasing 9 bp YOY and 5 bp QOQ. BMO Capital Markets hit a cyclical low due to extremely weak trading revenue. Trading revenue fell to $145M from $410M in Q2/10.

Recommendation

• We have reduced our 2010E and 2011E EPS to $4.75 and $5.20 from $4.85 and $5.60, due to continued low capital market activity, weak trading revenue, lower economic growth outlook, and expected persistence of low interest rates. Our one-year share price target is unchanged at $70.

• We maintain our 1-SO rating based on continued leverage to recovery in Canadian retail franchise and expected improvement in U.S. banking operations.

P&C Canada Earnings Increase 17%

• P&C Canada earnings increased 17% from a year earlier to $428 million, driven by an improvement in the retail net interest margin (NIM), strong operating leverage, and solid loan volume growth.

• Retail net interest margin improved 9 bp from a year earlier and 5 bp sequentially to 2.96%.

• P&C Canada revenue growth was very strong at 9.3%, with expenses increasing 3.8% for strong operating leverage of 5.5%.

• Loan growth was 5.9% with personal loan growth strong at 16% and mortgage loan balances increasing only 1% due to run-off of broker channel loans. Personal deposits were down 1% from a year earlier, with market share declining due to a highly competitive environment. The productivity ratio was 51.1% versus 53.8% a year earlier.

P&C U.S. Net Loss on Actual Loss Experience Basis

• P&C U.S. cash earnings declined 31% YOY to $45 million (using expected loan loss provisions) from $65 million a year earlier. If we use actual loan loss provisions of $103 million versus $31 million expected loan losses, P&C U.S. earnings would have been a loss of $4 million versus a loss of $9 million a year earlier.

• The P&C U.S. retail NIM improved 59 bp YOY and 15 bp sequentially to 3.70%.

Overall Net Interest Margin Flat

• The bank’s overall net interest margin on average earning assets was flat sequentially and up 14 bp YOY to 1.88%.

Private Client Group Earnings Strong Excluding Insurance

• Private Client Group (PCG) earnings in Q3 declined 5% YOY and 8% sequentially to $109 million. PCG earnings included $34 million from insurance versus $67 million a year earlier. Excluding insurance, PCG earnings were $74 million, increasing 61% YOY.

• Mutual fund revenue improved 17% YOY to $139 million. Mutual fund assets under management (as reported by IFIC) increased 8% YOY to $35.1 billion.

BMO Capital Markets Earnings - Cyclical Low

• BMO Capital Markets earnings were very weak, declining 58% YOY and 50% QOQ to $131 million from $310 million a year earlier and $260 million in Q2/10, respectively due to extremely weak trading revenue. Average loans & acceptances declined 26% YOY to $24.3 billion.

Trading Revenue Declines 64%

• Trading revenue declined 64% to $145 million versus $410 million in the previous quarter and $407 million a year earlier, the lowest level since Q2/08 and Q4/06. The major weakness in trading revenue was concentrated in interest rate products which declined to $20 million from $225 million in the previous quarter and $288 million a year earlier. Equity trading revenue declined to $91 million in the quarter from $107 million in Q2/10 but increased from $87 million a year earlier. FX trading revenue declined to $62 million versus $69 million in the previous quarter and $85 million a year earlier. Trading revenue declined to 5.0% of revenue from 13.7% a year earlier.

Capital Markets Revenue Stable

• Capital markets revenue was $349 million versus $358 million in the previous quarter and $341 million a year earlier. Underwriting and advisory fees declined 10% YOY to $91 million, while securities commissions and fees increased 8% to $258 million.

Security Gains Negligible

• Security gains recorded in the quarter were $9 million or $0.01 per share versus $0.07 per share in the previous quarter and a loss of $0.01 per share a year earlier. Unrealized security surplus increased to $767 million from $378 million in the previous quarter and $381 million a year earlier.

Loan Loss Provisions Decline More Than Expected

• Specific loan loss provisions (LLPs) were below expectations at $214 million or 0.49% of loans, declining from $249 million or 0.60% of loans in the previous quarter and from $357 million or 0.82% of loans a year earlier.

• The lower-than-expected loan losses were due to a recovery at BMO Capital Markets and lower commercial LLPs in P&C Canada.

• We are reducing our 2010 and 2011 LLP forecast to $1,040 million or 0.59% of loans and $900 million or 0.48% of loans, from $1,100 million or 0.63% of loans and $1,000 million or 0.53% of loans, respectively, to reflect the improving credit trends.

Impaired Loans Decline

• Gross impaired loan (GIL) formations declined to $242 million from $366 million (excluding acquisitions) in the previous quarter. Including acquisitions, GILs declined to $132 million from $803 million the previous quarter. Net impaired loan (NIL) formations declined slightly to $113 million from $124 million in the previous quarter, excluding the impact of acquisitions.

• GILs declined in the quarter to $3.1 billion or 1.80% of loans. Net impaired loans were $1.2 billion or 0.72% of loans.

• The coverage ratio (Allowance for Credit Losses as a percentage of GILs) improved to 60% versus 55% in the previous quarter, but declined slightly from 62% a year earlier.

Capital Ratios Strong

• Tier 1 Capital increased to 13.5% from 13.3% in the previous quarter due to a 2% sequential decline in risk-weighted assets (RWA) and internal capital build. Tier 1 Capital was 11.7% a year earlier. Tangible common equity to RWA was extremely high at 10.4%.

• RWA declined 9% YOY and 2% quarter over quarter to $156.6 billion. Market-at-risk assets declined 24% YOY to $5.5 billion.

• The total capital ratio was strong at 16.1% at the end of the quarter versus 15.7% in the previous quarter and 14.3% a year earlier.
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