RBC Capital Markets, 15 August 2006
Q3/06 Preview – New Management, New Directions?
Bank of Montreal reports earnings on August 22. Our cash EPS estimate of $1.19 is 2¢ below the Thomson First Call mean estimate of $1.21. Last quarter the bank reported $1.25 cash EPS to beat our $1.17 estimate and $1.21 consensus estimate, but revenue quality was skewed to cyclical items. Relative to our estimate, market-sensitive revenue and a low tax rate added an estimated 14¢ per share.
Our Q306 estimate translates into growth of 10% year over year, and a 5% decline quarter over quarter, whereas consensus estimates peg growth at 12% year over year and –3% compared to Q2/06. Our underlying EPS growth estimate (i.e. excluding the change in securities gains and loan losses) is indicated up 11% from a year ago. We believe the consensus estimates may be looking for a larger contribution from wholesale than we are modeling. Our combined estimates for trading and securities gains is indicated down 10% sequentially after 3 quarters of above-trend results, still 12% higher than a year earlier. With the weakness in equity markets in quarter, even our conservative view may prove too optimistic.
Key Themes:
1. New Leadership in Key Posts. Both the domestic Retail Bank and BMO Harris have new CEO’s this quarter. This may bring a degree of process change while new courses are implemented, particularly for the Domestic Retail Bank.
• Frank Techar Heads Up Canadian P&C Bank. Frank Techar moves back to Canada after four years at the helm of BMO Harris to head up the Canadian Personal & Commercial Bank, in our view, cementing his candidacy as CEO of the bank at some point in the future. We believe the change is to signal a subtle change in management style. The domestic bank appears to have been “spinning its wheels’ in recent years, ‘leaking’ market share in certain high-margin or key product lines (core deposits, small business and/or cards), while accumulating lower-margin market share in commoditized products, particularly mortgages. To turn this around, we believe Mr. Techar will have to address the bank’s decentralized pricing and risk models, long considered a hallmark of the bank. Early signs of such change, already initiated under the previous divisional head, may be evident this quarter. We expect we may see stabilized spread but perhaps some volume erosion.
• Costello Assumes Top Role at Harris Bank. BMO Capital Markets executive Ellen Costello will take Mr. Techar’s position at BMO Harris. Although regarded as an excellent manager, Ms. Costello’s experience has been primarily in wholesale banking, as we understand it. Her new position will require a quick study of two important dynamics, U.S. Retail Banking and M&A consolidation in that segment. In our view, this is a tall order. We do feel her appointment may well be too recent to expect her to offer a view on direction for the U.S. regional banking subsidiary. The key issues around BMO Harris are: (i) declining net interest margin, and (ii) growth through acquisition. It is the latter where we expect Ms. Costello may have more impact.
2. Domestic Spread Erosion. Last quarter, we were concerned by BMO’s eroding spread in its Canadian retail bank, down 12bps quarter over quarter, which held revenue growth to 5% year over year for the division. Management’s plan to better control discretionary pricing in the branch network and in the field (we think aimed at mortgages specifically) has not yet had time to take effect, owing to the 90-day rate guarantees locked in during Q106. BMO’s mortgage volumes were up 14% year over year in Q2/06 and beat the peer average growth rate by 50% or more, perhaps precisely because of these generous rate offers. In our view, with mortgage spreads looking weak amid aggressive competition, this strategy may have limited financial benefit, unless the bank can prove it has best-in-class cross-sell success. Put another way, we think some very smart banks are not as actively engaged in the traditional mortgage market, preferring instead to sell higher-value adjustable rate lines of credit and other higher-margin product. Our model factors relatively stable spreads, down in 2bps in quarter. Last quarter, the domestic personal and commercial bank posted 7% earnings growth YoY, down 2% QoQ.
3. Healthy Outlook for BMO Wealth Management. The long-term outlook for this division remains solid, given BMO’s strength in mutual funds and retail brokerage. Also helpful is that management is no longer distracted by Harrisdirect, disposed of last year. In Q2/06, earnings for the Private Client Group (wealth) were up 11% YoY on strong sales and trading activity, and healthy AUM growth assisted by the strong markets. Excluding Harrisdirect from the prior year, the division posted 8% YoY revenue growth in Q2/06 and 5% growth in assets under management, while expenses were up 4%. Weak equity markets and slowing net sales will likely temper BMO’s otherwise robust wealth division.
4. Expect Trading and Securities Gains to Normalize. Our estimate for trading and securities gains in Q3/06 is $187 million, relative to an 8-quarter average of $183 million and down 10% QoQ. BMO has reported three consecutive quarters of above-run-rate revenue from these sources (including trading-related net interest income). It will also be curious to observe if a decline in securities also has an adverse impact on the tax rate.
5. Low Loan Losses to Persist. Our $70 million loan loss estimate (0.18% of loans) is indicated down 4% YoY and up 6% from Q2/06. This compares to our Q3/06 forecast for the peer average at 0.26% of L&A.
Capital & Dividends
No Dividend Hike This Quarter. We are not factoring any dividend increase at BMO this quarter, as the bank implemented an off-cycle hike in May from $0.53 per share to $0.62 and raised the target payout ratio to a peer high of 45%-55%.
Excess Capital Earmarked for U.S. Acquisitions. We still see this bank earmarking an increasing amount of capital to build out its U.S.-based Harris platform with US$1 billion to US$2 billion community bank acquisitions. With the recent leadership change at BMO Harris, we would not anticipate any large acquisitions in the next year.
Valuation
Our $64 price target is set at 12.5x our $5.15 2007 cash EPS estimate. Our target multiple of 12.5x is ~4% below our sector target P/E multiple. In our view, BMO earnings will continue to reflect solid wealth management, though we are less optimistic about domestic retail banking. Tempering the BMO valuation will be a rising CAD, and potential for a U.S. community bank acquisition and related re-investment and integration concerns. Our price target is indicated at ~2.1x our estimated book value of $30.57 (as at Jul 31/07).
Price Target Impediments
Our price target may be exceeded if domestic mergers become hot again, though we see this risk as very low given the recent election of a minority government with several higher priority items on the agenda. Risks to achieving our EPS estimates or price target include: (i) low leverage to wholesale market-sensitive revenue, (ii) low-in-sector loan spread, (iii) unique exposure to the highly competitive Chicago market and (iv) reinvestment risk on a more aggressive acquisition plan in the United States.
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Q3/06 Preview – New Management, New Directions?
Bank of Montreal reports earnings on August 22. Our cash EPS estimate of $1.19 is 2¢ below the Thomson First Call mean estimate of $1.21. Last quarter the bank reported $1.25 cash EPS to beat our $1.17 estimate and $1.21 consensus estimate, but revenue quality was skewed to cyclical items. Relative to our estimate, market-sensitive revenue and a low tax rate added an estimated 14¢ per share.
Our Q306 estimate translates into growth of 10% year over year, and a 5% decline quarter over quarter, whereas consensus estimates peg growth at 12% year over year and –3% compared to Q2/06. Our underlying EPS growth estimate (i.e. excluding the change in securities gains and loan losses) is indicated up 11% from a year ago. We believe the consensus estimates may be looking for a larger contribution from wholesale than we are modeling. Our combined estimates for trading and securities gains is indicated down 10% sequentially after 3 quarters of above-trend results, still 12% higher than a year earlier. With the weakness in equity markets in quarter, even our conservative view may prove too optimistic.
Key Themes:
1. New Leadership in Key Posts. Both the domestic Retail Bank and BMO Harris have new CEO’s this quarter. This may bring a degree of process change while new courses are implemented, particularly for the Domestic Retail Bank.
• Frank Techar Heads Up Canadian P&C Bank. Frank Techar moves back to Canada after four years at the helm of BMO Harris to head up the Canadian Personal & Commercial Bank, in our view, cementing his candidacy as CEO of the bank at some point in the future. We believe the change is to signal a subtle change in management style. The domestic bank appears to have been “spinning its wheels’ in recent years, ‘leaking’ market share in certain high-margin or key product lines (core deposits, small business and/or cards), while accumulating lower-margin market share in commoditized products, particularly mortgages. To turn this around, we believe Mr. Techar will have to address the bank’s decentralized pricing and risk models, long considered a hallmark of the bank. Early signs of such change, already initiated under the previous divisional head, may be evident this quarter. We expect we may see stabilized spread but perhaps some volume erosion.
• Costello Assumes Top Role at Harris Bank. BMO Capital Markets executive Ellen Costello will take Mr. Techar’s position at BMO Harris. Although regarded as an excellent manager, Ms. Costello’s experience has been primarily in wholesale banking, as we understand it. Her new position will require a quick study of two important dynamics, U.S. Retail Banking and M&A consolidation in that segment. In our view, this is a tall order. We do feel her appointment may well be too recent to expect her to offer a view on direction for the U.S. regional banking subsidiary. The key issues around BMO Harris are: (i) declining net interest margin, and (ii) growth through acquisition. It is the latter where we expect Ms. Costello may have more impact.
2. Domestic Spread Erosion. Last quarter, we were concerned by BMO’s eroding spread in its Canadian retail bank, down 12bps quarter over quarter, which held revenue growth to 5% year over year for the division. Management’s plan to better control discretionary pricing in the branch network and in the field (we think aimed at mortgages specifically) has not yet had time to take effect, owing to the 90-day rate guarantees locked in during Q106. BMO’s mortgage volumes were up 14% year over year in Q2/06 and beat the peer average growth rate by 50% or more, perhaps precisely because of these generous rate offers. In our view, with mortgage spreads looking weak amid aggressive competition, this strategy may have limited financial benefit, unless the bank can prove it has best-in-class cross-sell success. Put another way, we think some very smart banks are not as actively engaged in the traditional mortgage market, preferring instead to sell higher-value adjustable rate lines of credit and other higher-margin product. Our model factors relatively stable spreads, down in 2bps in quarter. Last quarter, the domestic personal and commercial bank posted 7% earnings growth YoY, down 2% QoQ.
3. Healthy Outlook for BMO Wealth Management. The long-term outlook for this division remains solid, given BMO’s strength in mutual funds and retail brokerage. Also helpful is that management is no longer distracted by Harrisdirect, disposed of last year. In Q2/06, earnings for the Private Client Group (wealth) were up 11% YoY on strong sales and trading activity, and healthy AUM growth assisted by the strong markets. Excluding Harrisdirect from the prior year, the division posted 8% YoY revenue growth in Q2/06 and 5% growth in assets under management, while expenses were up 4%. Weak equity markets and slowing net sales will likely temper BMO’s otherwise robust wealth division.
4. Expect Trading and Securities Gains to Normalize. Our estimate for trading and securities gains in Q3/06 is $187 million, relative to an 8-quarter average of $183 million and down 10% QoQ. BMO has reported three consecutive quarters of above-run-rate revenue from these sources (including trading-related net interest income). It will also be curious to observe if a decline in securities also has an adverse impact on the tax rate.
5. Low Loan Losses to Persist. Our $70 million loan loss estimate (0.18% of loans) is indicated down 4% YoY and up 6% from Q2/06. This compares to our Q3/06 forecast for the peer average at 0.26% of L&A.
Capital & Dividends
No Dividend Hike This Quarter. We are not factoring any dividend increase at BMO this quarter, as the bank implemented an off-cycle hike in May from $0.53 per share to $0.62 and raised the target payout ratio to a peer high of 45%-55%.
Excess Capital Earmarked for U.S. Acquisitions. We still see this bank earmarking an increasing amount of capital to build out its U.S.-based Harris platform with US$1 billion to US$2 billion community bank acquisitions. With the recent leadership change at BMO Harris, we would not anticipate any large acquisitions in the next year.
Valuation
Our $64 price target is set at 12.5x our $5.15 2007 cash EPS estimate. Our target multiple of 12.5x is ~4% below our sector target P/E multiple. In our view, BMO earnings will continue to reflect solid wealth management, though we are less optimistic about domestic retail banking. Tempering the BMO valuation will be a rising CAD, and potential for a U.S. community bank acquisition and related re-investment and integration concerns. Our price target is indicated at ~2.1x our estimated book value of $30.57 (as at Jul 31/07).
Price Target Impediments
Our price target may be exceeded if domestic mergers become hot again, though we see this risk as very low given the recent election of a minority government with several higher priority items on the agenda. Risks to achieving our EPS estimates or price target include: (i) low leverage to wholesale market-sensitive revenue, (ii) low-in-sector loan spread, (iii) unique exposure to the highly competitive Chicago market and (iv) reinvestment risk on a more aggressive acquisition plan in the United States.
