Published December 8th, 2016 by the Financial Canadian
Finding companies with 3%+ dividend yields, sustainable payouts ratios, and long histories of raising their dividend payments is difficult. Companies with one of these traits is easy – but it’s the combination of factors that makes these investments rare.
Now what if I told you there was an entire group of companies that satisfied these criteria? The group of companies I’m referring to is the ‘Big 5’ Canadian banks, which consist of:
- The Royal Bank of Canada (RY)
- The Toronto-Dominion Bank (TD)
- The Bank of Nova Scotia (BNS)
- The Bank of Montreal (BMO)
- The Canadian Imperial Bank of Commerce (CM)
With their high dividend yield, strong dividend growth history, and reasonable payout ratios, these banks all rank favorably using the 8 Rules of Dividend Investing. Further, most of these banks are members of the Canadian Dividend Aristocrats Index – a group of elite Canadian companies with 5+ years of consecutive dividend increases.
This post will analyze the investment prospects of one bank in particular – BMO.
BMO was also the last of the Big 5 to report their earnings, with the announcement coming on December 6th. This post will analyze that earnings release in detail.
Business Overview
Like the rest of the Big 5, BMO is an integrated financial services provider with operations in retail banking, wealth management, commercial banking, and capital markets. For reporting purposes, the Bank divides their operations into three segments:
- Personal and Commercial Banking
- Wealth Management
- Capital Markets
The Bank describes their operations in more detail with the following slide.
Source: BMO Investor Presentation
As you can see, the Bank has a very large operational scope, and is a very old business (established in 1817). With 45,000 employees, 1,500+ branches, and 4,500+ ABMs, BMO is the 8th largest bank in North America as measured by assets and the 4th largest in Canada.
However, that doesn’t mean the Bank is a slow-moving, slow-growing business. Rather, BMO has identified five strategic priorities to secure the future of their business, which they outline in the following slide.
Source: BMO Fourth Quarter Investor Presentation
BMO also has a significant presence in the United States, where they operate as BMO Harris Bank. This segment of the Bank’s operations should be a key driver of future growth, and will be outlined in more detail later in this article.
Financial Performance
On December 6, BMO reported earnings for the three-month and one-year period ending October 31, 2016. Their quarterly results are summarized as follows, with comparisons being made to the same quarter one year ago:
- Net income of $1,345 million, up 11%
- EPS of $2.02, up 10%
- ROE of 13.8%, compared with 12.9%
- Common Equity Tier 1 Ratio of 10.1%
On an adjusted basis, the results are very similar:
- Adjusted net income of $1,395 million, up 10%
- Adjusted EPS of $2.10, up 11%
- Adjusted ROE of 14.4%, compared with 13.5%
To top off these fantastic quarterly results, BMO also increased their quarterly dividend payment from $0.86 to $0.88 per share.
In the same press release, BMO also reported earnings for fiscal 2016. They are summarized in the following table.
Source: BMO Fourth Quarter investor Presentation
A few key highlights:
- Net revenue increased by 8% on an adjusted basis and 8% on a reported basis.
- Net income increased by 7% on an adjusted basis and 5% on a reported basis. Adjusted net income of $5,020 million is the most in BMO’s history.
- Diluted EPS increased by 7% on an adjusted basis and 5% on a reported basis.
- Common Equity Tier 1 Ratio of 10.1% is well-above the Basel III requirement of 6%.
All-in-all, the announcement was well-received by BMO’s investors, with the stock price jumping post-announcement. And it’s no surprise why – the Bank delivered strong growth in a number of key business metrics.
Moving on, I’m now going to cover the investment prospects of Canada’s fourth-largest bank. My investment thesis will center on the following topics:
- Geographic Diversification
- Dividend Yield, Safety, and Growth
- Leadership in Wealth Management
I’m also going to be discussing two of the main risks facing BMO (along with the other Canadian banks). Namely, these risks are:
- Oil and Gas Exposure
- Exposure to the Canadian Housing Market
Geographical Diversification
With the Canadian banking sector operating in an oligopoly dominated by the Big 5 Banks, BMO has looked internationally for drivers of future growth. Their focus has been in the United States.
BMO’s presence in the U.S. is older than many investors realize. They initial penetrated this market through the acquisition of Harris Bank in 1984. BMO has been making strategic bolt-on acquisitions ever since, most recently by purchasing General Electric Capital’s transportation finance business in 2015, which the Bank has renamed as BMO Transportation Finance.
Today, BMO has a significant presence in the United States. For fiscal 2016, the Bank’s U.S. segment contributed 25% to their overall earnings mix. The Bank’s U.S. operations were also a large contributor to net income growth, as detailed in the following diagram.
Source: BMO Investor Presentation
A 22% growth in adjusted net income for BMO’s U.S. Personal and Commercial banking division is very impressive. Investors should be happy to hear that there are still many parts of the United States that the Bank has yet to penetrate. This means that their operations in the U.S. still have plenty of room to grow.
To illustrate this, let’s consider a visual example of BMO’s U.S. operations. Their presence in the United States and in other international markets is summarized in the following diagram:
Source: BMO Investor Presentation
With the entire East and West coasts untouched by BMO’s P&C operations, it is reasonable to believe that the Bank’s U.S. operations will be a strong driver of growth for the foreseeable future.
Dividend Yield, Safety, and Growth
Canada is known for having one of the safest, soundest banking sectors in the world. For instance, the World Economic Forum ranked this nation’s banks as the safest in the world for eight years in a row.
This is evident in BMO’s dividend policy. During the global financial crisis of 2008-2009, none of the Canadian banks cut their dividend payments to shareholders (although they all stopped increasing them for a time). This is in stark contrast to the behaviors of their U.S. counterparts, many of whom cut their dividends in a significant way while facing serious concerns regarding insolvency.
Among the Canadian banks, there are many dividend-related observations that stand out about BMO. The Bank is the longest-running dividend-paying company in Canada, paying dividends without interruption since 1829.
This is an incredible 187-year streak of delivering income to shareholders.
Over the long-run, BMO also has a fantastic track record of increasing these dividend payments to shareholders.
Source: Publicly Available Financial Statements
With four years of consecutive dividend increases, BMO is one year away from being included in the Canadian Dividend Aristocrats Index, a group of elite Canadian companies with 5+ years of consecutive dividend increases.
Note that this index is different than the traditional Dividend Aristocrats Index, which includes companies with 25+ years of consecutive dividend increases. You can view a full list of ‘normal’ Dividend Aristocrats here.
BMO’s dividend is also well within the Bank’s payout ratio. BMO has a policy to pay out 40-50% of their earnings in dividends. In fiscal 2016, the Bank paid out 45.0% of their adjusted earnings in dividends, which means there is plenty of room for the dividend to grow even if earnings remain flat.
With all this considered, BMO is clearly a strong dividend investment.
Leadership in Wealth Management
One thing that helps BMO to stand out from the other Canadian banks is their leadership in wealth management. There are two ways that BMO differentiates themselves from their peers here.
The first is through their wide offering of ETFs. Since entering the ETF business in 2009, BMO has expanded their product lineup to offer more exotic funds such as global infrastructure, low volatility, and long provincial bond ETF.
Complementing BMO’s wide ETF offering is their SmartFolio investment service. Essentially, SmartFolio is a robo-advisor that automatically invests customer funds into a basket of ETFs based on risk tolerance and time horizon. Portfolios are rebalanced automatically, and new contributions are seamlessly invested with existing funds. SmartFolio is seen as a key hedge against up-and-coming fintech companies that seek to draw investors away from the big banks with the promise of lower management fees.
In the fee-conscious world that investors currently live in, BMO is well-poised to grow market share in their wealth management segment through low-fee ETFs and SmartFolio.
Oil and Gas Exposure
As with any investment, there are certain risks associated with an investment in BMO. In the next two sections, I’ll address the two major concerns: BMO’s exposure to the oil and gas industry, and the Bank’s residential mortgage portfolio.
I will begin with BMO’s exposure to the oil and gas industry. For some time now, we have lived in a world with bargain-basement oil prices. This has led to a tremendously difficult operating environment for oil companies, and default in this sector have been on the rise.
As the counterparty on loans to the oil and gas industry, BMO certainly has a lot to lose if their borrowers default on these loans. Luckily there are a number of key risk insulators that I will outline in this section.
First, taking a look at the Bank’s oil and gas book, it is clear that a large proportion of the bank’s loans come from the pipelines subsector.
Source: BMO Fourth Quarter Investor Presentation
30% of the Bank’s oil and gas loans are to pipeline companies. This is a key risk insulator because the pipeline subsector is less dependent on commodity prices than, say, exploration & development or manufacturing & refining. This is because pipelines are in the business of transporting oil, and these businesses get paid regardless of the price of the underlying commodity.
Secondly, a healthy amount (50%) of the Bank’s loans in the oil and gas industry are investment grade in nature. These loans are inherently lower-risk, which is reassuring for investors.
Looking at the Bank’s exposure to Alberta (an economy that is heavily tied to oil and gas), consumer loans in this province are only 6% of the Bank’s total loans, with the majority (>80%) being secured against some form of real estate.
Combining this with macroeconomic factors that suggest the oil bear market is coming to an end (for example, the recent OPEC decision to reduce supply), it appears BMO is well-insulated from potential risks in the oil and gas market.
Concerns About the Canadian Housing Market
Investors in the Big 5 banks are very concerned about the current state of the Canadian housing market.
Home prices in Canada have been on the rise for some time, particularly in two markets: Toronto and Vancouver.
Source: Dallas Federal Reserve
As you can see, these two markets have seen housing prices increases at rates much higher than many of their large American counterparts.
For investors, this could impact BMO if the bubble were to burst. If housing prices drop more than the amount of equity that homeowners have in their home, they might be unable to refinance – which will lead to massive amounts of mortgage defaults, hurting BMO’s bottom line.
There are three key risk insulators from the occurrence of such an event. First of all, a large proportion of BMO’s mortgage book is insured through the Canada Mortgage and Housing Corporation. This insurance, which pays BMO in the event of a mortgage default, has monthly premiums that are paid by the borrower along with their mortgage payments. The benefit to the borrower is that they can purchase a home with a smaller down payment (5% instead of 20%).
Secondly, I want to touch on the composition of BMO’s Canadian residential mortgage portfolio. Taking a look at following diagram, it is reassuring to see that residential mortgages compose only 30% of the Bank’s overall loan book. This is lower than some of the other Big 5 banks.
Source: BMO Fourth Quarter Investor Presentation
Of this 30%, only a portion would be exposed to Canada (with the rest being allocated to the U.S. and other international markets). Even among Canadian residential mortgages, only a portion of those are exposed to the hottest (and riskiest) markets in Toronto and Vancouver.
Source: BMO Investor Presentation
Taking a look at a breakdown of their Canadian residential mortgage portfolio, the first fact I’d like to point out is that 56% of the portfolio is insured by the CMHC. This means that more than half of the Bank’s mortgage book is protected in the event of default.
Secondly, the Bank’s mortgage book is very-well diversified across geographies. I’ve already mentioned that the largest concerns in the Canadian housing bubble are from Toronto and Vancouver – well, Ontario and British Columbia (the provinces that contain these cities) only account for $43.6 billion (42%) and $19.6 billion (19%) of the Bank’s total mortgage book. This acts as a further risk insulator.
To summarize: Canadian mortgages are only a small proportion of BMO’s overall loan book, the majority of their Canadian residential mortgage portfolio is insured by the CMHC, and their Canadian mortgage book is well-diversified across geographies.
With all this in mind, I am very comfortable with the Bank’s exposure to the Canadian housing market.
A Word on Valuation
Like most of the rest of the stock market, the Canadian banks are all trading around all-time highs. This might not be the best time to deploy capital into these companies.
Over the past 5 years, BMO has generally traded at a 9.5-13.0 multiple of TTM earnings. They currently are above their historical average at 13.9.
BMO’s PE ratio is also in the high range compared to their peer group.
- RBC: 13.0
- TD: 13.84
- BNS: 13.12
- CIBC: 10.3
As you can see, BMO currently trades at the highest PE of their peer group (in US dollars).
However, the same trend is not true for the Bank’s price-to-book value ratio. Over the past 5 years BMO has traded at a PB ratio between 1.15 and 1.80. The Bank is currently trading at 1.6 times book value, which is within their historical range. Their PB ratio of 1.6 compares more favorably to their peers than their PE ratio did:
- RBC: 2.1
- TD: 1.8
- BNS: 1.8
- CIBC: 2.0
BMO’s PB ratio is the lowest among their peer group. So BMO appears attractively valued based on assets, but not so much when based on earnings.
With this in mind, my investment approach is Buffett-esque in the sense that I don’t mind paying fair value for a high-quality company. The Canadian banks are high quality businesses, and while they are fully valued right now, I don’t think they are overvalued.
Comparing BMO’s 13.9 PE ratio to the 25.6 multiple of the S&P 500 is certainly reassuring, and I think BMO is fairly valued.
The Bottom Line
BMO is a great company from a wonderful peer group. They have many of the many of the characteristics of a great dividend investment – a great yield, a long history of increasing dividend payments, and a reasonable payout ratio.
These factors mean that BMO ranks highly using the 8 Rules of Dividend Investing. The Bank is an attractive investment at today’s levels.
