Investment thesis: 

• Bank of Montreal stock looks undervalued: Shares of BMO corrected more than 33% so far this year as weak economic environment amid the rapid rise in coronavirus cases took a toll on the banking industry. Meanwhile, the low-interest-rate environment and an expected decline in earnings of the bank’s customers is not a good sign. Notably, central banks around the world are cutting interest rates to cushion the economy. Meanwhile, significant demand destruction across industries is likely to weigh on the earnings of almost all the companies. Notably, Bank of Montreal’s loan portfolio remains diversified both by the industry as well as geography, which is encouraging. However, it has a slightly higher exposure to the oil & gas sector (which is going through a rough patch) which irked investors.While we expect near-term challenges to play spoilsport, Bank of Montreal remains well positioned to navigate through the current economic situation. Further, we can’t ignore the bank’s low valuation, which looks attractive, given the massive fall in its stock price. We believe it is time to buy the dip in the well-capitalized BMO bank stock. Bank of Montreal’s capital position remains strong despite regulatory changes, thanks to the internal capital generation from retained earnings growth. BMO reported CET1 ratio of 11.4% (as on January 31, 2020). Meanwhile, Tier 1 ratio stood at 13.0%. BMO stock trades at a lower valuation multiple (see the later part of this report for a detailed discussion on valuation) when compared to peers. We do anticipate earnings pressure for BMO in the short-term. But we believe the headwinds are transitory and BMO stock is likely to rebound strongly as the economy picks up pace. Further, central banks in both Canada and the US have announced measures to support the economy and keep the liquidity flowing, which should fuel the demand for the credit.

• A solid dividend play: BMO is an investor-friendly company and has the longest history of dividend pay-out, which makes it an attractive bet for income-seeking investors in the long run. The recent decline in BMO stock has driven its yield higher to 6.3%. BMO’s dividend has grown at a CAGR of 6% over the past 15 years. Notably, BMO has increased its quarterly dividend four times in the past two years, which is exceptional. While we do not expect any dividend hike in the near-term, we also do not foresee any cut in the pay-out. BMO targets a pay-out of 40% - 50%, which we believe is sustainable in the long-run.

Q1FY20 Operational Highlights: BMO posted revenues of CAD 6,747 million, reflecting an increase of CAD 230 million or 4% from the prior-year quarter. The year-over-year increase in revenues came on the back of improved performance across all operating segments. However, Notably, revenues net of CCPB (on the basis that nets insurance claims, commissions and changes in policy benefit liabilities) came in at CAD 6,031 million, up 8% on a year-over-year basis.

BMO’s net interest income (or NII) increased by 7% year-over-year to CAD 3,388 million, thanks to the growth in loans and deposits. BMO’s average earning assets increased by 8% or CAD 60.3 billion to CAD 804.5 billion in the first quarter. The year-over-year increase reflects higher credit off-take coupled with an increase in securities and cash resources. BMO’s overall net interest margin fell 1 basis point due to the lower deposit spreads in the US personal and commercial banking. Fed’s interest rate cut remained a drag resulted in lower deposit spread.

Non-interest revenue, net of CCPB, increased 9% year-over-year to CAD 2,643 million, thanks to the higher revenues across most of its segments.

Segment performance: Revenues in the Canadian Personal & Commercial Banking segment rose 7% year-over-year to CAD 2,082 million, reflecting higher loans and deposits. Average loans increased by 7% year-over-year. Commercial loans increased 15%, while proprietary mortgages (including amortizing HELOC) were up 6%. Average deposits jumped 14% year-over-year, reflecting strong growth in both personal and commercial banking. Adjusted net income increased 8% to CAD 700 million, thanks to the strong revenue growth. However, higher expenses and an increase in provisions for credit losses remained a drag.

Revenues in the U.S. Personal & Commercial Banking increased 3% year-over-year to CAD 1,030 million, reflecting double-digit growth in loans and deposits. Average loans in the U.S. Personal & Commercial segment increased 12% year-over-year, aided by 13% growth in commercial loans and a 9% increase in personal loans.  Average deposits rose 11% year-over-year, thanks to the double-digit growth in the commercial segment.  The segment’s adjusted net income declined on a year-over-year, reflecting higher provisions for credit losses, partially offset by higher revenues. 

Wealth and Capital Markets segment remained strong: BMO’s Wealth Management segment’s net revenues jumped 8% year-over-year to CAD 1,309 million. Growth in client assets coupled with a 12% growth in deposits and a 14% increase in loans supported the top-line growth. Adjusted net income for the BMO Wealth Management segment rose 21% year-over-year, reflecting higher revenue and tight control on expenses. 

Revenues at BMO Capital Markets surged 20% year-over-year to CAD 823 million, reflecting a 30% increase in global markets and 8% rise in investment and corporate banking. Adjusted net income soared 38% year-over-year, thanks to the stellar revenue growth. 

Provision for Credit Losses:  BMO’s total provision for credit losses increased by CAD 212 million to CAD 349 million. The sharp increase in the provision for credit losses was due to the higher provisions in the personal and commercial banking and BMO Capital Markets segment. The PCL ratio increased to 31 basis points, as compared to 13 basis points in the prior-year quarter. PCL ratio on impaired loans ratio came in at 29 basis points, as compared to 12 basis points in the prior year.

Despite higher provisions, adjusted net income increased by 5% year-over-year to CAD 1,617 million, thanks to the operating leverage. BMO’s operating leverage of 4.6% drove 270 basis points of improvement in efficiency, which is encouraging.  

Balance Sheet Highlights: At the end of Q1FY20, BMO’s total assets stood at CAD 879.7 billion, up from CAD 806.6 billion in the prior year. Loans increased to CAD 432.7 billion from CAD 399.2 billion in Q1FY19, reflecting stable growth across all segments. Deposits stood at CAD 582.3 billion, as compared to CAD 532.20 billion in Q1FY19, aided by balanced growth in both commercial and personal banking.

Key Financial Highlights (Source: Company Reports)

Top 10 Shareholders: The top 10 shareholders have been highlighted in the table, which together forms around 20.94% of the total shareholding. RBC Wealth Management is holding maximum shares in the company at 3.17%. RBC Global Asset Management, Inc. is the second-largest shareholder, representing a holding of 3.06% in the company.

Top Ten Shareholders (Source: Thomson Reuters)

Key Metrics: BMO net interest margin continued to increase in the past three years, reflecting steady growth in loans and deposits. The loan growth rate for FY19 stood at 10.9%, higher than 7.1% in FY18. The deposit growth rate for FY19 stood at 9.1%, higher than 8.6% in FY18. The bank remains strongly capitalized as Tier 1 ratio stood at 13.0%.

Key Metrics (Source: Thomson Reuters)

Key Valuation Metrics (Source: Thomson Reuters)

Valuation Methodology

Price to Book Multiple Approach

Price to Book Based Valuation (Source: Thomson Reuters)

Note: All forecasted figures and peers have been taken from Thomson Reuters

Stock Recommendation: The stock of BMO closed at CAD 66.95 with a market capitalization of CAD 42.82 billion. The stock made a 52-week low and high of CAD 55.76 and CAD 106.52 and is currently trading close to the lower band of its 52-week’s trading range. BMO is a fundamentally strong stock, stuck in a tough operating environment. The bank’s strong capital position ensures that it will navigate the current slowdown in the economy and will bounce back sharply as and when the economy shows green shoots.  The company has a balanced portfolio of loans and is well-diversified, which bodes well for growth. While challenges persist in the near-term, we believe the decline in BMO stock price presents an excellent buying opportunity for the long-term. Also, BMO continues to boost shareholders’ return through higher dividends. The current dividend yield stands at juicy 6.3%, and we do not see any cut in the payout. Investors should note that BMO stock trades at a discount when compared to peers. For instance, BMO stock trades at a forward P/BV ratio of 0.88, which is well below the peer group average of 1.12. We expect the multiple to expand in the coming quarters as the economic growth picks up.  We have valued the stock using Price to Book based relative valuation method with a target multiple of 1.0x. For this, we have considered peers like Canadian Imperial Bank of Commerce (TSX: CM), Royal Bank of Canada (TSX: RY), Toronto-Dominion Bank (TSX: TD), Bank of Nova Scotia (TSX: BNS) etc., and arrived at a target price which implies a lower double-digit upside (in % terms).  Hence, we give a ‘Buy’ recommendation on the stock at the closing price of CAD 66.95, down 1.49% as on April 3, 2020.

BMO One-Year Daily Price Chart (Source: Thomson Reuters)

Disclaimer

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