Bank Of Montreal Faces A Challenging Canadian Environment

| About: Bank of (BMO)
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Summary

While Bank of Montreal and Canada weathered the Financial Crisis well, the poor economic outlook is holding back profits and returns for shareholders of the bank.

Up until the last few months, the bank's stock price had been volatile and delivering poor returns for shareholders.

Returns have improved of late and the bank's performance looks a bit better thanks to a couple of divisions doing well but that's not enough to justify an investment here.

Bank of Montreal (NYSE:BMO), Canada's fourth largest bank, was a pretty good investment immediately after the financial crisis as so many other banks were. Canada had a shallower recession than many other parts of the world, and BMO bounced back from the crisis quite nicely through mid-2010. Since that time though, further gains in the stock have been limited. Going on five years now since the Recession, and with the economic prospects for Canada looking less then sanguine, investors in the company are no doubt a much more diffident lot than they once were. On the outside BMO looks attractive with a nice dividend yield, a substantial ~$600B (NYSEARCA:CAD) pile of assets, a long history of profitability, much less exchange rate and political risk than most foreign banks, and the size to effectively compete in a global marketplace of financial giants.

So with all of these positive factors, why did the stock underperform many peers last year? Perhaps it is because after one scratches the surface, the positive sheen on BMO quickly begins to tarnish. Net revenues actually fell from 2012 to 2013, and while they rose on a YOY basis at the firm's last report, future growth still looks questionable. Profits at the firm are in much the same boat. While profits beat by $0.10 at last report, total revenues missed while growth was weak in my view. Add to this the widespread concerns across the market about over-indebted consumers in BMO's home market, warning signs in Canadian housing market, and an increasingly weak spending environment across much of Canada and it is no surprise that the market has been cool on the BMO story until recently. To be fair of course, BMO is sporting a P/E multiple right now that is considerably below average for the market as a whole, but this is consistent with the discounted multiple that is being applied by the market to all large-cap financial companies. In that sense then, BMO is probably fairly valued where it is, and maybe even a bit overvalued if Canada's economy really does worsen markedly.

Revenue

1Q

2Q

3Q

4Q

Year

2014

4,927

4,672

--

--

--

2013

5,255

4,957

5,039

5,175

20,426

2012

5,353

5,140

5,057

5,420

20,970

2011

4,364

4,190

4,297

4,938

17,789

2010

3,943

3,653

3,607

3,981

15,184

2009

3,892

3,415

3,231

3,499

14,037

EPS

1Q

2Q

3Q

4Q

Year

2014

1.48

1.45

2013

1.53

1.40

1.63

1.56

6.12

2012

1.65

1.52

1.41

1.58

6.16

2011

1.30

1.41

1.33

1.35

5.39

2010

1.05

1.24

1.10

1.22

4.61

2009

0.32

0.51

0.90

1.02

2.75

While BMO was delivering solid revenue growth prior to CY2012, much of this was due to an acquisition spree by the company. Since that time, BMO has seen falling US revenues and continued stagnation in Canadian operations… at least in its basic banking businesses. Wealth management is doing well at the company and BMO's niche Capital Markets business is a stellar performer, but this is not enough to keep the company's boats rising. Instead for real success and earnings growth, BMO needs to see better growth in loans and interest earning assets as well as a widening net interest margin. Of course this is the problem for much of the banking sector, so none of this should be much of a surprise.

The income side of the net interest margin is hard for a bank of BMO's size to control, but there may be some opportunities on the cost side if the bank is willing to truly get aggressive about controlling expenses. BMO's noninterest expenses come in around 63% of net revenues which are substantially higher than Canadian peers which stand at 55%. US peers are lower still, but there are some structural limitations which make that comparison a bit unfair. Still, even if BMO could just come in line with peers and bring down their 63% ratio to 55%, it would still be a tremendous boost to earnings. There are some signs BMO is trying to ameliorate the situation with FY13 noninterest expense growing a slow 0.3%. But slow cost growth is a slow way to bring costs into line with revenues especially since revenue growth is not great right now. Granted making costs cuts is never easy in big organizations where managers often jealously defend their internal budgets, but after four years of slow growth on many metrics, BMO investors are fully justified in asking management to start making some hard choices.

One redeeming factor for BMO is that credit quality at the firm remains strong. This is a positive feature for many banks in the wake of the financial crisis as credit standards on new loans have come way up and been met by improving consumer credit-worthiness thanks to an improvement in the overall economy. Further, while Montreal-based BMO obviously does have a strong Canadian presence (which may face some small credit issues in the next 12-18 months in my view), its Chicago-based US subsidiary operates mainly in the Midwest which is seeing great growth especially in the areas benefiting from the Bakken formation and the Shale Oil boom.

Investors looking at taking a long-position in BMO (in the absence of clear evidence of success in cost-cutting), are essentially betting on three things then - (1) a shallow/short-lived set of problems in Canada, (2) good growth in the US-businesses such as the old Marshall & Illsley (M&I) of Wisconsin which BMO bought out for $4.3B in stock in July 2011, and (3) continued stellar performance in BMO Capital Markets. I think the first of these issues is very questionable, the second is an even money-bet, and the third is fairly safe. Canada's issues are real and don't look like they are going away overnight though I also don't think they will lead to a serious recession there.

On the second point, growth across the US has been and continues to be relatively tepid. US growth will probably improve a bit going into late 2014 and early 2015, but with the rest of the world in such a funk, 4% US growth can hardly be expected. Moreoever, BMO made three major acquisitions in the past four years including M&I and Harris Bank of Chicago. While both organizations were probably good long-term buys given the price that BMO paid, neither was an all-star during the credit crisis and M&I in particular could probably be classified as a bit troubled when it was bought. BMO's acquisition of Diners Club from Citi in 2009 was a nice move as well, but hardly a needle-mover for a company of BMO's size. All of this combined suggests the segment is doing well given its legacy issues, but it's not big enough or going to plausibly grow fast enough to really help shareholders in the parent company.

Finally, BMO capital markets is probably my favorite asset in the overall company right now. Capital Markets groups are always a bit inconsistent in terms of their performance, but BMO is definitely an up and coming player growing into the power vacuums left in the wake of the Crisis. The loss of Bear and Lehman among others really shook things up on Wall St, and the new regulatory scrutiny since then has further hamstrung many of the firms that remain. BMO's capital markets group, with its operations from 30 offices in 17 countries, is well positioned to benefit from this turmoil. Wealth Management in particular is doing very well and will probably post low double-digit revenue growth this year while Capital Markets will probably see ~10% revenue growth. The bank is posting big expense increases in the area at least partially driven by new hiring, but also by higher comp costs across existing employees. Shareholders should not be wild about this latter expense growth, but the former is probably a reasonable investment.

On the whole then, while BMO Capital Markets is a fairly safe candidate to keep growing quickly for the next few years, without the other two pieces of the puzzle, the company and its stock price will probably be stuck in neutral going forward. For income-oriented investors with a long-term perspective, BMO might be interesting at these levels, but for almost everyone else, something needs to change before the company is worth owning.

Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.