March 06, 2009 - 3:48pm EST by
2009 2010
Price: 21.28 EPS $3.66 $2.25
Shares Out. (in M): 540 P/E 5.8x 9.5x
Market Cap (in $M): 11,491 P/FCF NR NR
Net Debt (in $M): 0 EBIT 0 0
Borrow Cost: NA

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Bank of Montreal (BMO-NYSE:  $21.28):  Short/Switch.


Canadians are long accustomed to thinking of their financial institutions as being superior to that of the United States, Europe and abroad.  This belief has been upheld over the last five years for three reasons.


    A.  The 5 major chartered banks (RY, CM, TD, BMO, and NA) boast capital ratios that are claimed to be about 2X that of the more weakly capitalized global peers.  Canadians have bought into that view, hook line and sinker.


The perception that Canadian banks sport unassailable capital ratios, have caused short sellers to largely overlook Canadian banks. 


  B.  In the 11 years ending 2008, GDP per capita in Canada rose from $24,482 to $39,194 per person. The period of 1997-2008 encompassed two commodity price surges. The rate of GDP growth accelerated sharply during the period 2002-2007, in step with the commodity price boom.  In the six year period of 2003-2008, Canada's GDP (in national currency) rose from $868.3 billion to $1571 billion, or a compounded GDP growth rate of 10.4%.


This has created a view that the Canadian economy is somehow immunized to the global slowdown. The Canadian economy is directly and indirectly 80% export driven. The largest exports from Canada are automobiles and trucks, oil and gas, agricultural products, forest products and minerals. These exports were in great demand for the years 2002-2007. Such a period of prosperity was characterized by an abnormally lengthy period of high wages, paid to what  the developed world would consider to be unskilled or semiskilled workers.   


 C.   Residential real estate mortgages are not directly tax deductible in Canada.  This creates an incentive to pay down a mortgage as quickly as possible.  In theory, the "ATM" equity takeout risk is not an issue with Canadian banks.  In practise, Canadian banks have proven reasonably adept in tax planning that makes many residential mortgages deductible.


In such a boom period, corporations and individuals experienced a period of rising wealth unprecedented in Canadian history.  Loan losses during such a boom were of course well below normal for both corporations as well as individuals.


Canadian banks have held up relatively well in comparison to peers thus far in the global credit crunch.


Unfortunately for common shareholders, it is my belief that the much vaunted "strength" of Canadian banks is largely illusionary, and will be revealed as such before the global recession ends. 


At the conclusion of this thesis, I will suggest that investors switch/short what I consider to be the weak link among Canadian banks, the Bank of Montreal. I feel that the balance sheet is problematic, the loan loss provisions are woefully inadequate and the dividend less than safe.  The banking business model I consider to be ordinary, at best, during economic upswings. 


Risk controls at the firm are designed to allow the capital trading division to operate with relative impunity as a hedge fund.  Capital market trading is the single largest profit contributor to the bank bottom line.


The macro case for being a bear on Canada looks promising.


In 1997, Canadian GDP was $637.6 billion.  After just 11 years, GDP has grown by more than 150%.  This G7 high growth rate did not come about by adding additional capacity for domestically consumed manufacturing, rapid developments in high technology industries, scientific breakthroughs or innovation in health care. Rather, it was primarily fuelled by rising commodity prices and attendant cyclical growth that comes from extraction related industries.  


To accommodate this increase in wealth, the banking, insurance and real estate industry have grown disproportionately large, in relation to the real economy.  In 2008, the financial service and real estate industries accounted for more than 20.5% of total Canadian GDP.   In short, I consider Canada to have an investment banking and insurance industry bubble, built upon the proceeds from a commodity based bubble. 


The commodity bubble has ALREADY burst. Canadians institutions and individual investors are still in the early stages of denial.


The collapse in oil and gas prices will push western Canada into a VERY serious recession in 2009


In 2008, the western provinces of Alberta, British Columbia and Saskatchewan exported roughly 2.4 million barrels of oil per day to the United States. This region represents the 2nd largest exporter of natural gas worldwide (after Russia's exports to Europe). 


GDP from direct oil, natural gas and oilsands (bitumen) extraction were estimated at $114.1 billion in 2008.  At spot rates, this industry contribution to GDP will fall by $57 billion or more than 50% from the 2008 figure.


Capex by the Canadian oil industry exceeded $46 billion in 2008.  Estimates suggest that this level of capex will fall by 50% in 2009, should oil prices remain under $50 US per barrel.


This forecast may in fact be conservative.   More than half of Canada's oil output is derived from "tarsands" bitumen mining. Costs for long established operater are estimated to be in the range of $40 US per barrel.  At current prices, the overall synthetic extraction and processing industry is operating at less than break even.


Roughly 7% of western Canadian jobs are directly tied to the oil and natural gas industries.  However, approximately 14% of remaining western Canadian jobs are directly linked to businesses that supply needs the oil industry.  In short, more than 20% of the western Canadian economy is directly linked to the well being of the oil patch.


The income surge of 2003-2008 has created a real estate bubble.


In Western Canada, the residential real estate market has been the hottest in Canada for many years.  This has led to a vast increase in home prices.


In Saskatchewan, home prices rose by an eye popping 65% over the past 24 months.  In British Columbia, home prices rose by 7.5% for the comparable period.  In Alberta, home prices rose by 20%.  In Manitoba, home prices rose by 23%.


In Alberta, I estimate that approximately 7% of residential homes represent security for a secondary residence. This could be a rental property, a spec home for flipping, or a vacation home.  


Real estate purchases collateralized by a principal residence can be done in such a way as to create a "back door" route to making the primary residential mortgage tax deductible. Anecdotally, I am aware of many people in western Canada that have turned to real estate speculation over the past several years. 


On the heels of this real estate frenzy, western Canadians now carry more financial debt per household than residents in the United States.  The conditions for a housing price collapse equivalent to that of the US, and the attendant problems for banks are now in place.


A reduction of 50% of oil and gas' contribution to GDP reduces Canadian 2009 output by 3.6%. 


The collapse of the mining industry adds to the woes of Canadians.


Canada is one of the world's leading producers of base and industrial minerals.  The mining industry contributed $44.9 billion, or 2.8% of Canada's GDP.   In 2007, 363,000 workers were directly or indirectly employed by this industry.


In 2007, mining paid the highest absolute wages of any industry in the country.  In many communities, there is no effective employment substitution when mines shut down.  The average price of base metals in Canada has fallen by between 50%-75% from 2008 averages. 


Canada represents a high cost mining centre. It has been estimated that 75% of Canadian base metal mines are operating at or below cash break even.


Using spot prices for the various metals produced in Canada indicates that the mining contribution to Canada's 2009 GDP will fall by approximately $20.5 billion, or 1.3%.


The collapse of the forestry industry compounds the issue.       


Canada is the world's largest exporter of forest products.   It is estimated that the forest products industry accounts for 2.8% of Canada's GDP, and directly employs 339,000 persons.  This totals 5.3% of Canada's direct and indirect employment.


Based upon the decline of pulp prices, coated paper prices, softwood and hardwood lumber prices and other wood products, there is not ONE publicly traded forest products company in Canada that anticipates profitability in 2009.  Layoffs are underway throughout the industry, and will continue to accelerate in 2009.  Break even prices are estimated in aggregate to be roughly 25% higher overall than current spot prices for various products.


The decline in forest products prices looks capable of reducing 2009 GDP estimates by approximately .6%.


The travails of the auto industry are as bad for central Canada as it is for the rust belt of the United States.


Canada is one of the world's leading automotive producers. 158,000 people are directly employed in the assembly and component manufacturing industries.  12% of Canada's manufacturing GDP, or $22 billion, is directly tied to the automotive sector. With automotive revenues tracking at just 50% of 2008 levels, up to $11 billion of GDP may disappear in 2009. At least 1 indirect automotive job is associated with each direct job. A 50% reduction in auto sales will reduce GDP in associated industry sub sectors.


Which brings us to the tsunami steaming towards Canadian banks.


At 20.5% of 2008 GDP, the financial service, real estate and management industries represents a disproportionately high percentage of the Canadian economy.  Some investors have opined on the absolute size of the investment and real estate sectors in the United States.  They consider this to be problematic for the US economy.  In fact, Canada has an equivalent percentage of its GDP generated from the "financial" economy.


Virtually ALL of the private sector industries that Canada counts on to for high wages have collapsed simultaneously.  Accounting for the GDP declines in mining, automobile manufacturing, forestry and oil and gas at current prices; implies a GDP decline of as much as 6% in 2009.


This does not take into account the potential for GDP reductions in all of the industries which are directly or indirectly tied into these substantial sectors of the Canadian economy.  A 50% multiplier effect on indirect businesses suggests that a further 3% reduction in GDP is possible. 


Some Canadian banks are trying to deflect the potential Tsunami through the simple act of denial.


Canadian GDP estimates produced by Canada's top five banks, assume potential declines for 2009 between -.5% to -2%. Their methodologies are overly simplistic.  In most cases, bank economists extrapolate the limited damage to the economy thus far, and pronounce Canada as a good news story.  Firms such as Merrill Lynch Canada have performed detailed bear market cases, and were subject to scorn and derision.


I consider an economic decline of -.5% to -2.0% to be laughably optimistic.  A more realistic view is that Canada's dependence upon commodity exports simply creates a timing lag between slowdowns from importing nations to exporting nations.  What happens in the US inevitably hits Canada fully, after a delay of 3-6 months.


Why are my macro views so much more bearish than the concensus among the major chartered banks? 


I explain this using the premise of "garbage in-garbage out". (I appreciate that those who are long Canadian banks will consider my analysis to be the same "GI-GO" and have no issues with the irony).   A survey of the commodity price forecast issued by the most bearish of the firms (BMO who estimate a -2% GDP rate for Canada in 2009) suggests that oil and natural gas prices will have to RISE by 25% and 37% respectively to hit their commodity forecasts.


The average prices forecast for metals at BMO are more than 35% above spot prices, and forest products are almost 30% off spot.   Automotive sales are assumed to be almost 50% higher than current trends. In short, every assumption that is used to come up with their base cases does not hold up.


It is now almost impossible for commodity producers to forward hedge a year out and get even close to the prices now assumed, by the most bearish of the big 5 banks.   


When one goes to the more bullish of the five major banks, the commodity price basket assumptions are even rosier.   


At spot rates for the various commodities industries that contribute to the GDP basket, Canada's economy could plausibly decline by as much as 9% in 2009. The implications for loan losses with a heavily leveraged Canadian population would be staggering.


Canadians carry roughly equivalent financial leverage to US counterparts.


Despite the fact the mortgages are not tax deductible, Canadians are a free spending people.   Household debt to disposable net income has surpassed 127% in 2007.   Buoyed by years of rapidly increasing wages from the commodity boom, Canadians increased their indebtedness by more than 17% in the last two years.


Policy Initiatives in Canada cannot fix global problems.


The government of Canada has recently announced a stimulus package in the range of $30 billion.  This represents roughly 1.9% of 2008 GDP.  Unfortunately, much of this money is not new spending initiatives. Much of the program is simply a double counting of previously reported spending.


Irregardless of the size and details of the program, given the modest size of the Canadian economy; there is no capital spending program that can be undertaken by the federal government sufficient to even partially offset this recession.   


By the end of the recession, Canada's economic pain may surpass that of the United States.


Unemployment should reach similar levels to that of the US.  Debt defaults should be similar.  Differing from the US, Canada lacks a domestic market capable of purchasing aggregate output. Short sellers will find plenty of candidates to select from, at prices that are akin to shorting US stocks 3 months ago. 


Bank of Montreal is my selection as the "weakest link".


BMO is the 4th largest Canadian bank by assets and boasts a tier 1 capital ratio of 10.21%.   The firm has roughly $443.2 billion of assets, and total capital of $24.8 billion. Common shareholders equity on January 31st, 2009 was $17.3 billion.


Of the $443.2 billion of assets, 32.4% are held in trading securities and derivative instruments ($61.7 billion & $81.9 billion respectively). Residential mortgages and consumer loans represent 21.3% of the asset base.  Corporate and government loans represent roughly 19% of assets.


Bank of Montreal owns 100% of Harris Bank, a US Midwest bank with approximately $43 billion of assets.


Bank of Montreal's capital ratios are no better than several leading US banks, each of which has slashed dividends in the last 52 weeks.


BMO continually reports that it is either the "best" capitalized, or "among the best capitalized" of the major Canadian banks using tier 1 and tier 2 ratios. The reported tier 1 ratio on January 31st, 2009 was at 10.21%. BMO uses Basel II, not Basel I.


However, when appraised on a tangible common equity/total tangible assets basis (TCE/TTA) basis, the Bank of Montreal reports just a 3.4% ratio.  Assuming that a purchase of AIG's Canadian life insurance subsidiary closes as planned, BMO's capital ratio will be fall to just 10% in the second quarter.  First quarter earnings did not cover the dividend rate, ex the one time charges.  Accordingly, payout of the recently announced dividend will reduce the capital ratio to about 9.95%.  The corporate debt department of BMO has indicated that not all of the 2009 funding requirements are in place. This suggests that either a common or preferred share issue may be in the works at some point this year.    



US firms such as JP Morgan (3.9%) and US Bancorp (3.4)% have stronger capital ratios under TCE/TTA.  Both of these banks have reduced their dividends sharply for the balance of 2009.  Shares of JPM ($15.54) and USB ($8.52) have fallen by 69.5% and 81.1% respectively in the last 52 weeks.


By comparison, BMO has maintained its payout ratio to date.  This has held the stock up to a loss of just 58.6% in the past 12 months.


BMO's forecast core earnings appear inadequate to support the current dividend.


The Bank of Montreal issued $1 billion of common shares in the quarter ending January 31st, 2009.  The total share count is now 540 million.  At the assumed rate of $2.80 per share, cash dividends will total $1.512 billion in 2009. 


The Bank of Montreal's own investment brokerage firm forecasts 2009 cash earnings of just $2.80 per share, or exactly $1.512 billion.  It is notable that the Bank of Montreal's own brokerage firm carries the lowest earnings forecast on the street.  The brokerage firm recently expressed a concern that their forecast is overly optimistic.


The core banking business has no outstanding attributes.


In Q1, 2009, the firm reported after tax earnings of $.39 per share.  Cash earnings were reported at $1.09 per share.  On the surface, this represents basic dividend coverage of 73.3%.  However, earnings appear to have been bolstered by abnormally high contributions from trading.


Contributions from Canadian retail and corporate banking were below expectations.   Harris Bank posted a loss of $153 million US in the quarter just ended. 


Credit loss assumptions are rosy in relation to previous recessionary periods.


BMO employs an expected loss provisioning methodology whereby expected credit losses are charged to the operating groups and the difference between expected losses and actual losses is charged (or credited) to Corporate Services.


Credit loss assumptions were queried by analysts in the quarterly conference call.  BMO has been reporting a loss allowance approximately ½ its historic experience in downturns.   Specific allowances to gross impaired are being assessed at a 15% rate.  In previous downturns (none of the scale we are currently in) the Royal Bank analyst notes that BMO management used a 30% allowance.


Management's response was that they have an active and robust process for arriving at provisions.  The implication is that the Bank of Montreal considers itself to be superior to peers in the recovery process on problem loan.   


Unfortunately, a claim of appropriate loss allowances doesn't hold up under cursory scrutiny.  As just one example, BMO holds approximately $959 million of a bridge loan in Teck Cominco.  This is to support a $14 billion acquisition undertaken in October 2008.  Teck's market cap has now fallen to just $1.3 billion, and acknowledges that they may be unable to refinance this loan. Default is very possible, and at least a 60% impairment of the loan could result. This would be provided that the purchased assets are not resold at valuations consistent in the mining sector.


Bank of Montreal has also been aggressive in its attempts to grow Canadian retail loan market share in the past year.  Increased loan exposure as the credit cycle is turning negative runs the risk of being inappropriately provisioned for loan losses. 


The 2nd quarter of 2009 looks far worse than Q1.


Brokerage and asset management revenues should be down in line with capital markets. Net withdrawals seem to be rising among all of the Canadian mutual fund managers.  Corporate loan and consumer loan originations will almost be down. The corporate finance divisions of most Canadian banks have noted a virtual cessation of capital activities once again, after a brief pickup in December.  Bankruptcies and loan defaults in Canada are soaring in the current quarter.  It is virtually impossible to envision any Canadian bank matching Q1 results, in light of the current economic environment.   


The potential risk of additional write downs on SIV's (structured investment vehicles) rises in the current downturn.


The Bank of Montreal has approximately $2 billion of total potential exposure to asset backed commercial paper and structured vehicles.  Management reports this as being appropriately provisioned.   On pages 6-7 of the earnings call transcript, this appears to be a point of contention with the analyst at CIBC world markets.


Most of the other Canadian banks with exposure to SIV's have been proactive, writing them down to nominal amounts.  BMO has not recorded the same allowances, and is instead funding potential losses through a standby credit line.


BMO's own investment brokerage firm can't make heads or tails of the balance sheet or income statement


To my way of thinking, disclosures look very poor. Apparently, I'm not alone in this view.


In the most troubling assessment that I have ever seen issued by a wholly owned brokerage firm of a bank, BMO Nesbitt Burns took the unusual step of calling the first quarter earnings report of its parent "confusing".


If the level of disclosure is obfuscacious to the point that a wholly owned division of the Bank in question does not know what is going on; I consider this a clear red flag.


What is also troubling to me, is a greatly increased exposure to commodities and derivatives in Q1 2009.


BMO raised $1.15 billion of capital in the 1st quarter of 2009 to bolster the balance sheet.  This money was promptly invested in commodity and financial hedges.  While not picked up on (or expressed) by any analysts, I find this very surprising, and possibly disturbing.


In 2007-2008, the Bank of Montreal posted an extraordinary loss of $700 million + from the commodity and derivatives division on natural gas trades.  The firm indicated that a lack of internal controls led to this loss, and noted that they intended to scale back activities sharply.


BMO's commodity research department is currently using prices well above spot, in forecasts for their equity picks. These picks are now very underwater.  If the bank has used a portion of this equity capital for speculation on the long side of commodities, they may have taken sharp losses in the quarter to date.  If on the other hand, the bank has taken a short position on commodities, it flies in the face of positions recommended to their client base.  This would be a clear conflict of interest. The bank has clearly not learned their painful lesson of just over a year ago.


The macro overview of the Canadian economy and the unsustainable dividend payout for the Bank of Montreal suggest that this stock is a good switch/short.


It seems difficult to envision any bank paying out 100% of forecast cash earnings for more than one or two quarters.   With a heavy dependence upon trading and a fast weakening Canadian economy, there is too great a variability in earnings to assume a matching of first quarter results.   A dividend cut seems almost inevitable.  If such a reduction occurs, the stock should come under great pressure thereafter.


Without high dividend support, the only thesis for owning BMO vs. better run Canadian banks would be questioned. A shotgun marriage with a better run Canadian bank could ensue.


BMO is not a terminal short candidate, but could fall as much as 45% in the six months on the heels of  a dividend cut.  I assume that a dividend payout reduction could occur to bring the payout to $1.20 per share Canadian, or $.94 US.  At a cash yield of 8% (in line with Royal Bank), BMO could decline to an 8% cash yield, or about $12 US per share.


An overshoot of my target on the downside could occur in a panic. No major Canadian bank which has cut their dividend since World War II.  The negative repercussions of such an announcement cannot be understated.


A switch from BMO to Royal Bank (RY) appears sensible.  Royal Bank now has a capital ratio stronger than BMO.  Royal's earnings report is sufficiently clear that I believe the dividend rate is sustainable in the near term. 


There are long/short scenarios that can be easily being adopted, whereby an investor shorts BMO and buys Royal.  Alternatively, a paired trade whereby one shorts BMO and buys Toronto Dominion Bank (TD) also looks to have merit.



Dividend payout now exceeds 120% of my 2009 earnings forecast, and just 100% of the banks own investment firm's outlook.  BMO is the most likely of the Canadian banks to cut the dividend, based upon its poor earnings coverage.  This could panic shareholders and the Canadian markets in general.  Canadian economic deceleration will continue, leading to a sharp increase in required loan loss provisions.  Additional equity might be required to meet funding requirements for 2009.    

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