Bank Of Montreal: A Satisfying Result And The 6% Dividend Should Be Safe (NYSE:BMO)

Via SeekingAlpha.com

Introduction

The financial year of the Canadian banks doesn’t follow the calendar years and most banks have a financial year ending in October. This also means the quarterly results of the banks come at different times and the final weeks of May were the heydays for banks to report their financial results. I already had a look at the smaller banks National Bank (OTCPK:NTIOF) (which you can read here) and Laurentian Bank (OTCPK:LRCDF) (read here), but the larger banks like Bank of Montreal (BMO) have also opened their books and I was very interested in seeing how the big banks have dealt with the COVID-19 situation and the provisions for loan losses.

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Bank of Montreal has a very liquid US listing, so there is no reason for investors to trade in the bank’s stock on the TSX. However, as BMO is a Canadian bank and reports its financial results in Canadian Dollar, I will use the CAD as base currency throughout this article, and will refer to the Canadian listing.

The loan loss provisions five-folded, but BMO was still profitable

Just like its competitors, Bank of Montreal saw its interest expenses reduce quite fast. The banks saved C$500M in Q2 on interest expenses and this, in combination with a decrease of ‘just’ C$360M in interest income resulted in a net interest income increase of C$130M, or almost 4%.

Source: financial results

Unfortunately, the ‘other income’ remained below expectations as the fee-based income decreased by almost 50% to C$1.75B. The main culprit are the insurance revenues: the C$880M income in Q1 was converted into a C$166M loss in Q2 and this C$1.04B difference and the C$350M lower trading revenue are the main contributors to the (much) lower revenue.

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The total revenue in Q2 came in at C$5.26B, much lower than the C$6.75B in Q1 but fortunately, BMO was also able to reduce its operating expenses by C$150M, to C$3.52B. This means that pre-impairment losses, Bank of Montreal generated an operating income of around C$1.95B (after taking a C$197M income from insurance claims into account).

This allowed BMO to increase its provision for credit losses to C$1.12B (more than three times the provision recorded in Q1 and more than 6 times the provision recorded in Q2 2019). This brought the total provision in H1 to C$1.47B, up from C$313M in the first semester of FY 2019. So yes, BMO is taking swift action by starting to record larger provisions for future loan losses.

Source: company presentation

The CET1 ratio decreased, but there still is a large buffer

As of the end of its first semester, Bank of Montreal had a CET1 ratio of 11%, down from 11.4% at the end of Q1 2020 and YE 2019. The lower CET1 ratio is caused by a higher amount of risk-weighted assets (up C$23B QoQ), which is only partly mitigated by a higher CET1 capital (up C$1.3B).

Source: quarterly report

While a lower CET1 ratio isn’t exactly great news, we need to put some things into perspective. The higher RWA is predominantly caused by a larger loan book (up 1% in the consumer segment, but up over 15% in the business and government lending segment). As such, we can expect the net interest income to pick up again from this quarter on. This will result in higher pre-tax income and a faster build-up of CET1 capital (assuming the dividend payments don’t change).

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Source: company presentation

As BMO’s CET1 ratio remains comfortable above the percentage required by the OSFI, Bank of Montreal is going ahead with its next dividend payment and has announced a quarterly dividend of C$1.06/share (unchanged QoQ but up 3% compared to the same quarter last year) which will be paid out in August. BMO will allow its shareholders to receive the dividend in cash or in stock (as part of the dividend reinvestment plan) and the stock dividend will be priced at a 2% discount to the share price, making it more attractive for investors to elect the stock dividend. A higher take-up rate of the stock dividend means the impact of the dividend on the CET1 ratio will be mitigated.

To put things into perspective, a C$1.06 dividend that would be fully paid out in cash would cost BMO approximately C$680M. Given the RWA of C$348B, a cash-only dividend would have an impact of 0.2% on the CET1 ratio (if the CET1 capital wouldn’t be ‘reloaded’ with the quarterly net income).

Investment thesis

Looking at the Q2 performance, BMO’s dividend won’t be fully covered. However, I don’t expect the CET1 ratio to be impacted as I expect a substantially higher percentage than 6% of the shareholders will elect the stock dividend. This will reduce the cash payout ratio to less than 100% and allow for a further build-up of the CET1 capital. Yes, the existing shareholders will be slightly diluted but that’s only a marginally negative factor considering making the stock dividend attractive will help to keep the CET1 ratio at that 11% (or even slightly higher).

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I currently don’t have a position in Bank of Montreal and I sold the preferred shares I acquired during the March sell-off. But as BMO seems to be getting through the tough COVID-times without too much damage, I would be interested in going long (being fully aware of the exposure to the oil and gas sector as well as the overpriced real estate markets in Vancouver and Toronto).

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Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.