Company Profile

Bank of Montreal (TSX: BMO) is a diversified financial services provider and the 8th largest bank (by assets) in North America. With total assets of CAD 987 billion as of April 30, 2020, and a team of diverse and highly engaged employees, BMO provides a broad range of personal and commercial banking, wealth management and investment banking products and services to more than 12 million customers and conducts business through three operating groups: Personal and Commercial Banking, BMO Wealth Management and BMO Capital Markets. The group's majority of revenue comes from Canadian market operations. In the year 2019, the bank's ~31% revenue came from the Canadian Personal & Commercial Banking segment, ~30% from the Wealth Management segment, ~21% from U.S Personal & Commercial Banking segment and rest from Capital Market segment.

Investment Rationale

• Higher provisioning reflects a margin of safety: Due to the challenging macro-economic environment, the bank created provisioning of CAD 1,118 million in the current quarter against CAD 176 million in the previous corresponding period (pcp). The group has opted the safety-first approach during the quarter and made a provision of CAD 705 million on performing loans. Though the higher provisioning has taken a toll on the profitability, it is likely to provide a cushion against the future setbacks if non-performing assets rise.

• Strong Balance Sheet with decent CET1 ratio: At the end of the Q2FY20, the bank reported Common Equity Tier 1 (CET1) ratio at 11.0%, which was above the minimum regulatory requirement. A strong capital ratio suggests that the bank is well placed to weather the current challenging environment. Further, the strong capital position would enable the bank to expand its balance sheet in terms of loan growth. Further, maintaining a strong capital position would help the bank in a consistent dividend distribution.

• A friend of income investors: The bank declared a dividend of CAD 1.06 per share on May 27, 2020. The dividend was in line with the previous quarter dividend; however, it was ~3% higher from the previous corresponding period (pcp). Despite the challenges presented by COVID-19 pandemic, the bank increased its dividend payment while most of the businesses are cutting down or suspending their dividend distribution. This shows the group's financial strength and suggests that the group is a friend of income investors. Moreover, BMO has a track record of consistent dividend payment over the past five years. At the last traded price, the stock was offering a lucrative dividend yield of 5.57%, which is approximately 10.27 times higher against the Canada 10 Year Benchmark Bond Yield of 0.51% and 1.51 times of the S&P/TSX 60 average dividend yield of 3.73%. However, the yield is a bit inflated because of the recent correction in the stock's price on a YTD basis, though the share price has recovered in the last three months.

• Relatively undervalued from a Price-to-Book Value standpoint: BMO shares are trading at an LTM Price-to-Book Value ratio of 0.83x, whereas the industry average Price-to-Book value ratio stood at 1.27x. The bank has a solid balance sheet and recorded a decent loan growth. Further, the bank had safeguarded itself against the future hiccups. Hence, we believe, the bank is trading at a discount compared to its peers.

• Risk Associated to Investment: The COVID-19 pandemic has heightened risks of higher non-performing assets for the FY20, which had led banks to create significantly higher provisions that had an impact on the bank's profitability. Further, a low-interest-rate environment and increased chances of loan default are likely to put pressure on the bank's performance, as the lower interest rate would drag NIM and heightened uncertainties will lead to slow loan book growth. 

Financial Highlights: Q2FY20 (for the period ended as on April 30^th, 2020)

Source: Company presentation.

BMO reported a moderate performance in the second quarter of the financial year 2020, primarily because of the economic turmoil led by the COVID-19 pandemic. The group's balance sheet remained strong with CET1 ratio stood firm at 11.0%, higher than the minimum requirement set by the regulator. The bank's net revenue for Q2FY20 declined to CAD 5,461 million against CAD 5,652 million reported in the year over period, owing to a challenging market condition. The decline was primarily driven by lower revenue from the market sensitive businesses, partly offset by a revenue increase in the P&C business segment.  Further, the bank's non-interest expense declined ~2% to CAD 3,516 million against CAD 3,595 million reported in the previous corresponding period. The bank reported a net income of CAD 689 million as compared to CAD 1,497 million reported in the year-ago period. The steep decline in net income was mainly driven by higher provisions made by the bank for credit losses. The group made a provision of CAD 1,118 million in the current quarter against CAD 176 million reported in the previous corresponding period. The Liquidity Coverage Ratio (LCR) of the group improved significantly to 147% from 135% in the previous quarter. In Q2FY20, the BMO was selected as the asset manager for the Bank of Canada's Provincial Bond Purchase Program and joint lead manager for World Bank US$8 billion sustainable development bond issue. 

Segment Performance: Q2FY20

Canadian Personal & Commercial Banking: The segment reported a revenue growth amid the challenging environment. Revenue stood at CAD 1,960 million, marking a 2.5% growth over the previous corresponding period. The segment’s pre-provisioning earnings increased to CAD 984 million from CAD 970 million recorded in Q2FY19. Provisioning expenses increased to CAD 497 million from CAD 130 million in pcp. Consequently, net income declined to CAD 361 million during the quarter. The group made provisioning of CAD 285 million on performing loans. Average loans recorded a growth of 7% during the quarter driven by commercial loans, while average deposits grew 15% on an annual basis.

U.S. Personal & Commercial Banking: Revenue from the segment increased 6% to CAD 1,046 million against CAD 989 million reported in a year-over period. This was largely driven by a 13% growth in average loans on an annual basis. Pre provisioning income increased to CAD 454 million from CAD 407 million in pcp. Provisioning expense increased to CAD 143 million from CAD 17 million; as a result, net income declined to CAD 246 million from CAD 305 million.

BMO Capital Markets: Revenue slumped by 15% on a YoY basis to CAD 1,051 million driven by a 22% decline in global market revenue. The segment reported a net loss of CAD 74 million against a net profit of CAD 250 million in pcp.

BMO Wealth Management: Net revenue slumped by 15%, driven by 6% reduction in the traditional wealth mainly because of legal provisions. Net income declined to CAD 144 million from CAD 305 million in pcp. Assets under Management remained flat at CAD 865 billion.

Stock Performance

At the time of writing (July 24, 2020, after the market close), shares of BMO have traded ~0.69% lower at CAD 73.73. In the year-over period, BMO shares have tested a 52W high of CAD 104.75 (January 22, 2020) and a 52W Low of CAD 55.76 (March 23, 2020). At the last traded level, the stock was approximately 33% above its 52W bottom level and approximately 30% below its 52W high price level.

Over the past three months, its shares have delivered approximately 9.20% return, however, relatively underperformed against the benchmark index. On a YoY basis, its shares have slumped approximately 26%, and down around 27% on a YTD basis.

Top-10 Shareholders

The top 10 shareholders have been highlighted in the table, which together form around 22.59% of the total shareholding. The Vanguard Group, Inc. and RBC Wealth Management, International hold the maximum interests in the company at 3.09% and 2.90%, respectively. Further, seven out of top-10 shareholders have increased their stake in the company since December 31, 2019, with TD Asset Management Inc. and RBC Dominion Securities, Inc. are among the top investors in the company which have increased their stakes by 4.57 million and 3.56 million, respectively. The institutional ownership in the BMO stood at 48.85%, and ownership of the strategic entities stood at 0.04%, respectively.

Source: Refinitiv, Thomson Reuters

Valuation Methodology (Illustrative): Price to Book Value based Valuation Metrics

Note: All forecasted figures have been taken from Thomson Reuters.

Stock Recommendation

BMO reported a moderate result in the second quarter of the financial year 2020 driven by the challenging macro-economic environment. The bank created provisioning of CAD 1,118 million in the second quarter, which implies that the bank has opted the safety-first approach during the quarter as it made a provision of CAD 705 million on performing loans, where the chances of default are relatively lower. Though the higher provisioning has taken a toll on the profitability, it is likely to provide a cushion against the future setbacks if non-performing assets surge.  Further, the bank’s balance sheet is strong enough to sustain comfortably against any blow. The bank’s CET-1 ratio of 11% stood well above the regulatory requirement, and Liquidity Coverage ratio of 145%, which reflects the balance sheet strength of the bank. The group is performing well in personal and commercial banking segment both in Canada and in the United States. Also, a lower interest rate environment is likely to help the bank in expanding the loan book, while it would put pressure on the net interest margin. We expect the performance of the capital market segment to improve as the global equity markets have recovered well, and millions of new investors and traders have joined the league.

From the valuation point of view, its shares are trading at a relatively discounted valuation in terms of the LTM P/BV against the peer’s average P/BV ratio. BMO’s LTM P/BV ratio stood at 0.83x, whereas peer’s average stood at 1.27x, which reflects a discount of 35% against the peer average.

Also, the bank is offering a lucrative dividend yield of 5.57%, with a history of consistent dividend payment, which is an important parameter from an income investor’s point of view.

Therefore, based on the above rationale and valuation done using the above methodology, we have given a Buy” recommendation at the current price of CAD 73.73 (as on July 24^th, 2020, after the market close) with lower double-digit upside potential, based on the forward peer’s average Price to Book Value multiple of 1.09x on the FY20E Book Value per share. We have considered Bank of Nova Scotia (TSX: BNS), Toronto-Dominion Bank (TSX: TD) and National Bank of Canada (TSX: NA) etc. as a peer group.

*Recommendation is valid at July 27,2020 price as well.

*Please be aware that dividend is variable and not guaranteed.

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