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BMO Financial Group research and analysis

Contributed by eResearch

By Bob Weir

BMO Financial Group (BMO) reported cash EPS for Q4/11 of $1.34. Adjusted EPS, which excludes other items noted below, was $1.27, up 1% Y/Y. EPS was impacted by a 13% increase in the average number of common shares outstanding (issued in the Marshall & IIsley Corporation (M&I) acquisition). The quarter was about $0.04 per share lower than we expected and $0.03 per share below consensus. Adjusted ROE declined to 13.5% from 15.6% last quarter due largely to the equity issued for M&I. The Basel II Tier 1 capital increased to 12.0% from 11.5% last quarter.

The quarter benefited from a 17% Y/Y decline in Provisions for Credit Losses (PCL) and a 13% Y/Y earnings increase in Wealth Management. U.S. P&C net income doubled driven by the M&I acquisition and lower than expected PCL. BMO Capital Markets had a weak quarter, declining 30% Y/Y. Both trading revenues and underwriting revenues were weak. Personal & Commercial (P&C) Canada earnings were softer than expected and increased only 1% Y/Y driven by lower interest rate spreads.

For the fiscal year-ended 2011, cash EPS was reported at $5.26, up 10% Y/Y. Adjusted operating EPS (excluding various charges and increases in general loan loss provisions in fiscal 2011) was $5.29, an increase of 10% Y/Y. Canadian Personal & Commercial (P&C) net income increased 10% Y/Y while Capital Markets net income was higher by 13%. The U.S. P&C business reported a 75% increase in net income driven by the acquisition of M&I. Wealth Management net income increased 13% Y/Y. Total PCL in fiscal 2011 was $819 million, down 22% Y/Y. Adjusted ROE was 15.3%, up from 15.0% last year. The dividend of $2.80 per share was unchanged in the 12-month period.

Our fiscal 2012 EPS estimate has been lowered to $5.65 from $5.80. Our 2012 EPS reflects (i) the expected small dilutive impact from the Marshall & IIsley Corporation (M&I) acquisition, (ii) slower loan growth and continued spread pressures, (iii) an increase in Capital Markets activity and, (iv) no further decline in PCL. For fiscal 2013, we have set our preliminary EPS estimate at $6.15. The earnings growth over the two years is expected to average about 8% annually.

We have maintained our target share price at $67.00 and recommend BMO as BUY. In our view, the stock is not a compelling investment given the risks associated with the integration of the M&I acquisition. However, given the pull-back in the banks generally, we believe the expected return justifies the Bank as a Buy.

We believe that the dividend will be maintained at the current level until early 2013. The payout ratios on our 2012 and 2013 EPS estimates are 50% and 46% respectively, the highest of the major banks in Canada. We would also note that based on our estimates, the forecast payout ratios are still around the middle of management’s targeted dividend payout range of 45% to 55%.

Conclusion: BUY – 12-Month Target Maintained at $67.00

Valuation

Our share price target implies a valuation of 11.8x our 2012 EPS forecast which is about 5% below the average of the other five Canadian major banks. We believe this is reasonable given the stable P&C earnings performance in Canada, better overall PCL experience and our caution regarding the M&I acquisition.

Items of Note – Positive $47 Million After-Tax or $0.07 Per share

- Positive $271 million ($167 million after-tax) recognition of a portion of the credit mark on the acquired M&I loan portfolio.

- Negative $53 million ($35 million after-tax) integration charge regarding M&I transaction.

- Negative $34 million ($25 million after-tax) amortization charge related to intangible assets.

- Negative $98 million ($60 million after-tax) increase in general allowance for credit losses and specific provisions on the M&I loan portfolio.

European Exposure – Low Exposure to PIIGS

Management disclosed limited information on its European exposures.

Total Europe is $10.0 billion comprising $203 million to PIIGS:

- Loan exposure of $2.1 billion (Banks $1.2 billion, Corporate $1.0 billion). Of this amount, $127 million was to PIIGS.

- Securities exposure of $7.2 billion (Banks $528 million, Corporate $124 million, Sovereign $6.5 billion). Of this amount, $38 million was to PIIGS.

- Other exposure, including derivatives, was $0.7 billion including $38 million to PIIGS.

IFRS Impact Update

Management gave an update on IFRS accounting changes that will impact Q1/12 reporting on both the Bank’s Shareholders’ Equity, Balance Sheet and Income Statement.

Shareholders’ Equity

- Negative by $1.6 billion comprised largely of $1.2 employee pensions (one time recognition of deferred actuarial gains/losses into retained earnings), $188 million of asset securitization required to recognize on balance sheet loans originated by the bank and sold to securitization programs and $88 million of other. Impact on capital is about 50 bps - to be phased in over 5 quarters offset by expected retained earnings over the period.

Income Statement

- Impact is not expected to be material.

Balance Sheet

- Increases by $25.6 billion (or about 5% of total current balance sheet assets) consisting of $18 billion in mortgages and $4 billion of credit card loans sold to securitization programs that do not qualify for off-balance sheet accounting.

Other Quarterly Highlights

- BMO’s Q4/11 net income was reported at $897 million. Adjusted for the Items of Note above, net income was $850 million, up 14% Y/Y and 1% sequentially. Revenue increased 20% Y/Y while underlying operating expenses increased by 19% which resulted in positive operating leverage of 1%. Revenue and expense increased largely due to the M&I acquisition which included a full quarter of results. Overall, net interest margins (NIM) declined 20 bps Y/Y and 5 bps sequentially. The decline in NIM was driven by lower interest rates on deposit spreads. Lower Canadian NIM was partly offset by higher spreads in the U.S. due to a better mix of higher margin loans.

- P&C Canada net income increased to $424 million, up 1% Y/Y but down 2% sequentially. Loan volumes increased 4% Y/Y and personal loans increased 5% Y/Y. Credit card balances were up 1% Y/Y due to securitizations last quarter. Revenue increased by 1% while expenses increased by 3% Y/Y providing negative operating leverage of 2%. Interest margins declined 11 bps Y/Y and 4 bps sequentially. The lower interest margins have resulted from increased competitive pressures. A credit card securitization during the second quarter resulted in lower fee income. PCL was reported at $138 million versus $137 million last quarter and $132 million in the same period last year.

- P&C U.S. (Harris) reported adjusted net income of $171 million, up 100% Y/Y and 65% sequentially (adjustments exclude goodwill charges). The P&C U.S. Bank represented about 20% of BMO’s overall net income this quarter. This quarter included $111 million of net income from the M&I acquisition. Excluding the M&I acquisition, net income rose 25% Y/Y. Net interest margin improved Y/Y driven by an increase in loan spreads, a more favourable mix of higher margin loans and deposit balance growth. PCL was $69 million, down from $130 million in the same period last year and up from $51 million last quarter.

- Wealth Management Group (Private Client including BMO Life) net income increased 13% Y/Y and 21% sequentially to $144 million. This quarter included net income from BMO Life Assurance of about $41 million, up from $19 million last quarter. Wealth Management net income (excluding the Life group) was very solid and increased 20% Y/Y. This quarter included $6 million of net income from the M&I acquisition. Mutual fund revenue increased by 9% Y/Y and brokerage commissions increased 7% Y/Y. Assets Under Management (AUM) increased to $150 billion, up 44% Y/Y due to acquisitions.

- BMO Capital Markets net income was $149 million, down 30% Y/Y and 47% sequentially. Trading revenue was lower by 13% Y/Y and sequentially. Underwriting and advisory revenue was particularly weak declining about 40% Y/Y and sequentially driven by lower activity in M&A.

- Gross Impaired Loans (GIL) increased in the quarter to $2.7 billion from $2.3 billion last quarter but were slightly lower than the $2.8 billion in the same quarter last year. New formations increased to $543 million in the quarter versus $252 million in the prior quarter. Of the increase in formations, acquisitions accounted for $185 million. New formations in Canada increased 17% and were focused in the residential mortgage portfolio. Overall, the level of GIL this quarter was higher than expected by about 10%. We have increased our forecast for GIL to $2.6 billion from $2.4 billion for both fiscal 2012 and 2013.

- Provision for Credit Losses (PCL) increased in Q4/11 to $210 million from $174 million in the prior quarter but declined 17% Y/Y. We had expected PCL to approximate $200 million. The difference was largely due an increase in PCL in the P&C U.S. portfolio to $69 million from $51 million last quarter. P&C Canada reported losses up 8% Y/Y but flat on a sequential basis. Losses this quarter included $18 million associated with the M&I acquisition. Total PCL in fiscal 2011 was $819 million, down 22% Y/Y. For fiscal 2012 and 2013, we expect PCL to level off at the $850 million level (including the M&I transaction).

- Securitization revenue was increased to $264 million versus $211 million last quarter and $188 million last year.

- Security gains in the quarter were $60 million or $0.08 per share versus $32 million or $0.04 per share last quarter and $0.05 per share last year. Unrealized security surplus as at the end of the quarter was $1,128 million versus $988 million in the prior quarter.

Basel III Tier 1 Common Equity Ratio at 6.9%

Under current Basel II capital rules, BMO’s Tangible Common Equity Ratio is now 9.6% and its Tier 1 Capital Ratio is 12.0%. Both ratios declined from 10.3% and 13.5% respectively in the prior period due to the M&I transaction completed during the prior quarter. Management estimates that its Tier 1 Common Equity Ratio under Basel III (2019 rules) was 6.9% (which includes the M&I acquisition) as at the end of Q4/11. This level is very close to the 7.0% minimum required by 2019.

Update on M&I Acquisition
- Closed on July 5, 2011 for consideration of about 67 million BMO shares or about $4 billion.
- Added $148 million of net income to Q4/11 results and represented 17% of total net income. for a return on invested capital of about 14.0%.
- Increased goodwill by $1.8 billion.
- Added $29 billion of loans after adjustment of future losses.
- More than doubled the number of U.S. branches to 688.
- Added 2 million customers and increased assets under administration by $149 billion to $530 billion.